Chris Watling's allocation tips for long term investors

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Livewire Markets

Long-term readers of Livewire will be familiar with the views of strategist Chris Watling, the founder and chief economist of London-based Longview Economics. Watling earns his keep providing independent analysis and tactical portfolio positioning to best of breed global and domestic fund managers. Fortunately, he has also been kind enough to drop by and chat with the Livewire audience from time to time, sprinkling us with his candid perspectives. 

A current focus point for investors is making sense of the recent rally in bond markets, which appears at odds with expectations of rising inflation. We took this point of ‘disagreement’ to Watling and asked him to explain how he is interpreting these movements, why they matter, what it means for portfolio allocations and where he sees attractive long-term opportunities.

For an average investor with a long-term timeframe, you need to think about the long cycles, and I always think that every new economic cycle has big themes to it. You can see that in the global stock market and you can see it going back over many decades. 

Find the full interview in the video and a transcript of the highlights below. 


Chris Watling
CEO & Chief Market Strategist
Longview Economics

Edited transcript:

What are bond markets telling us right now given it is creeping lower? 

I think the bond market is doing what it always does: regulating growth. Think about it, we are investing in 10, 20, 30 year bond yields here so we're thinking about what are interest rates going to be doing over that time; what the economy is going to be doing over that time and so on. What the bond market is doing is looking through the stimulus. So the stimulus comes and goes, and within two or three years it'll largely have dissipated somewhat and we'll be left with how the economy really tends to work back in the old days. 

When the Fed's not in the way and trying to push it hard one way or tother, the bond market regulates the growth of the economy and it does it via the key cyclical areas of the economy, areas like housing, autos and so on, and you can see that in the housing data.

Bond yields backed up hard at the end of last year into early this year, and this starts having an impact on housing. The cost of mortgages becomes more expensive, you get a response from housing and it slows a bit. We see the housing data come off and to my mind then bond yields follow and you get into this this step up or a track sideways, and then later in this year or into next year, bond yields will start backing out once again. That's certainly the economic side of it, there's also some technical sides and some liquidity sides, but to my mind the bond market is doing what it always does. It regulates the growth, and it gives you a mini cycle in the wonderful way that it does.

What is the most compelling reason for investors to pay attention to the bond market?

The bond market is the beginning and foundation of financial markets. The U.S. 10-year bond yield is the risk-free rate and the basic building block for any valuation model. Equities are valued relative to bonds within the equity market. I like to think there's three sectors in the global equity market, these being cyclicals, growth stocks, and defensive stocks. You think of consumer staples and bond proxies, utilities, they're all about the bond yield. That dictates an enormous amount of their movement. Growth stocks tend to like lower bond yields and they don't like high bond yields. Again, that's not always the case but often it is. Within cyclicals, financials is the obvious example: they tend to correlate very highly with bonds yields. You think about a bank, it borrows short and lends long, so the steeper the curve the more the bank valuations tends to go up and the more it's earnings growth comes through.

So the bond market is telling you about growth, it's telling you about earnings growth, it's telling you about those three big sectors in the economy. It has an enormous bearing on financial markets and how they play out. 

What is your outlook on inflation?

I'm with the Fed, I think it's transitory in the short term. We've had these two big Core CPI (Consumer Price Index) prints of 0.9 and 0.7. You can see that within the 0.9 figure, 30 basis points of that is just car prices and then another 15 are one-off factors. There's a lot of one-offs in there linked with the reopening. We had a bit of this when they reopened last year in Q2; July 2020 had a big spike up in Core CPI. So Core CPI is very much transitory. 

The other thing I'd say in the short term is that the supply side of the U.S. economy and the global economy is in very good shape surprisingly. Bankruptcies absolutely collapsed last year which was extraordinary. 

If you go back 12-14 months, we were all talking about the massive insolvency risk and the huge bankruptcies that would come from one of the deepest recessions on record for many, many, many decades. It is very impressive what policymakers have done in terms of bridging that economic chasm. 

With bankruptcy low the supply side is good to supply into that demand near term. In the short term, I don't think there's a big inflation problem, in the medium term I would say I think there's a changing inflation landscape and I think it will be much more challenging once you get 2-3 years out. 

How should investors act in response to pending inflation?

If you're a longterm investor, it's going to be a very different over the next few years compared to the last few years. The last 10 years post-financial crisis is very much about growth stocks. Those days are largely behind us and many investors have already started shifting, as they should, into more cyclical and value stocks, reflation trades and so on. That trend is having a bit of a pause at the moment and that pause may last for quite a few months.

Within the bond yields, there are chapters; it's not just a straight line. The main trend in the bond yield is up over the next few years, but it is actually pausing at the moment. Looking at sector allocation, the main trend in the next few years is to buy value, cyclicals, and commodity plays. This is great for Australian equities and great for the Aussie dollar, all of that is very positive now and it's a very different world from the last 10 years coming into this. But there is a pause in that now. That's the point, it's just not a straight line. We had a very aggressive move into cyclicals, value, and financials until recently and I think this will pause a bit over the coming months while we reset and digest the changing monetary policy landscape.

What is the next step for governments after this debt supercycle?

There's lots of drivers but I think one very important one is the fact that in a dollar-fiat world, you don't have an anchor in the international monetary system. If you look back over history, pretty much every system over several hundred even a couple of thousand years has had an anchor. There's always been some sort of anchor (Gold Standard, Gold Silver Standard), and what the anchor does that's really important, is it limits the ability of the financial system to create liquidity. 

It's like Mervyn King, our former Bank of England Governor said, "Whenever a commercial bank makes a loan, it creates new money." So 97% of the money supply that's in existence today was created by commercial banks, and in fact that was done when they mostly made mortgage loans. That's primarily what they've been doing over the last 20 or 30 years, Australia is a case in point just like the UK. You have a very concentrated banking system with four banks that basically do a tonne of mortgage debt. And that is their primary driver of profits and the primary thing on their balance sheets.

The fact that we haven't had an anchor in the international monetary system has allowed this massive creation of mortgage debt over the last few decades. I would argue that the reason house prices are so high, it's not because a lack of supply of houses, although that's certainly the argument that goes around in the UK. 

Look, there's a bit of that if you're in, the most exclusive areas, Bronte Beach comes to mind. In London we'd say Mayfair, there's only so many houses in Mayfair and people really want to live there, so there's a lack of supply there but there's not a lack of supply of housing in general.

The reason house prices is so high in general across the globe is because of massive creation of money and massive supply mortgage debt. That's what has pushed house prices up. And the only way you can achieve such massive creation of mortgage supply is by having an unanchored international monetary system where you can create as much liquidity as you want. We have a debt supercycle that is three decades old. Global debt has just taken another leg higher in the pandemic. It's a tide system and really beyond its sell-by date and it needs to be changed. The only challenge here (and a big one indeed) is finding political will and politicians that are going to make it happen. At the moment there's an absence of them but over time hopefully they'll come up and step up to the plate.

Politicians need to finally address this issue, a new Bretton Woods Conference as they did post-World War Two. Get together, sit around the table and discuss how a new system could work. 

Looking forward to 2023, how should investors be positioning themselves?

For an average investor with a long-term timeframe, you need to think about the long cycles, and I always think that every new economic cycle has big themes to it. You can see that in the global stock market and you can see it going back over many decades. 

For example, in the last 10 years, performance has been driven by growth stocks. You shouldn't have been in commodities, you shouldn't really have been in emerging markets on the whole, and the U.S. Dollar has been a strong currency post-GFC and so on.

The prior 10 years to that and the run-up to the GFC was very different landscape. You should have been in emerging markets, you should have been in commodities, in banks, in energy stocks, in Aussie dollar, in Aussie equities, and the like. So you've got to pick up the big theme of the next few years, and I think the big theme is very much that bond yields are trending higher so that's not a great place to put your money. With that, you'll find that financials do well, we've got a comeback for the banks globally. It's most obvious in the U.S. and Western Europe, particularly the UK, but even in Australia, I wouldn't be surprised. 

I know you've got a slightly different cycle going on but commodity prices should do well which will be great for Aussie equities and the like, great for the Aussie dollar, and good for emerging markets.

I think there are lots of ways of playing this. One way I really like is that this is going to be a good few years for global trade and there's a lovely basket of Southeast Asian equity markets such as Malaysia, Thailand, Indonesia, and places like that which do remarkably well in their stock markets when global trade does well. I think this will be a theme of the next few years. There are lots of things to do but primarily I would say underweight sovereign bonds for the next few years. It'll nip and tuck and overweight the value reflation cyclical areas of the market. So if I were a private investor or long-term investor, I'd take the opportunity of the next few months to capitalise on a bit of a counter trend movement in those themes and take that opportunity to put money to work.

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