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Bridgewater eyes end to US equity outperformance and FX volatility ahead

A demand shock is fuelling inflation and the supply chain crisis. Elsewhere, investors need to prepare for lower returns in US equities and diverse economic performance from different regions as individual country’s pandemic response plays out.

Don’t expect another decade of outperformance from US equity while inflation, fuelled by a demand shock, is set to spike foreign exchange volatility impacting total portfolio returns, warned Rebecca Patterson, director of investment research, Bridgewater Associates speaking at FIS Digital 2021.

Perhaps one of Patterson’s more surprising comments was her argument that today’s supply chain crisis is the consequence of a surge in demand rather than a supply shock – and is here to stay for a while yet. Strong demand in both absolute terms and historically has produced a once-in-a-generation shock that hit companies dependent on just-in-time inventories.

The demand shock is evident in Chinese factories scrambling to meet US demand. They are running at maximum capacity (20 per cent higher than pre-COVID industrial production) so much so they have now usurped local energy supply. The demand shock is clogging up shipping lines and ports and the time needed to meet orders is taking longer. It is also spiking labour costs.

“We are seeing the tightest labour market we’ve seen in the US for generations; firms are saying they can’t fill their positions,” she said.

It will continue as US householders with cash in hand and rising disposable incomes (as wages go up) continue to spend with confidence. It will also support inflation into 2022, something she said many investors were not doing enough to integrate into their portfolios.

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“Most don’t have protection for very high inflation; we also think they should focus on how to benefit from rising inflation.”

Countries different responses to COVID will also begin to play out in the investment world. While the US, Europe and the UK embarked on massive fiscal stimulus and held down borrowing costs, other governments (like Mexico) did very little. The different policy reaction is resulting in a dispersion of economic conditions across different countries providing a rich seam of investor opportunities. “We are excited,” she said.

US underperformance

Using the US (where there was a strongest monetary and fiscal response to COVID) to illustrate how this dispersion could impact the investment environment, she flagged challenges ahead for portfolios with large US exposure. The stimulus has continued long after households began to recover their finances after the pandemic. Moreover, there is more to come as Congress readies a huge infrastructure bill that will lead to trillions more stimulus.

She noted that investors tend to extrapolate from the past to help explain the future. But in a new investment climate, last decade’s US corporate winners are most likely to be this decade’s losers. Investors are currently allocating more to US stocks and bonds now than at any time since the mid-1980s, and assets will have to grow beyond what is already priced in to attract more money.

But US companies will increasingly feel the pinch from less favourable tax and regulatory regimes compared to the last decade that have supported earnings. Now, new regulatory proposals are set to weigh on margins like taxes on big tech.

“We think the bar is high for the US to be an outperformer over the next decade,” she said, advising investors to expect better equity returns from outside the US, and ensure geographic diversification.

Currency volatility

The dispersion in global economic performance, and inflation levels, will trigger currency volatility. It could have an impact on total portfolio returns, she warned, urging investors to check their hedging position. In the past, a decision to hedge or not to rarely impacted total portfolio returns. Now, higher inflation and more volatile Central Bank reactions to its spike, could have a big impact on total returns, she said.

She warned that China’s renminbi will also get more volatile. She said China’s central bank is increasingly prepared to have a flexible policy as the RMB becomes a bigger, global currency which will trigger volatility.

Moreover inflation will be fuelled by commodity price spikes, heighted by the lack of capex investment by mining groups in recent years which is destined to keep commodity prices supported for now.

Fixed income

She advised investors to seek out bond-like returns that avoid traditional fixed income and said any bond risk premium will remain scarce ahead.

Responding to a question from Jean David Tremblay-Frenette, director of investment strategy research at AIMCo, on what the future holds for fixed income, she said high bond yields are emerging across different economies but from very low levels.

Investors should look at ways to engineer return seams that feel bond like, investing in companies that have stable, bond-like cash flows that provide a similar return seam to government bonds.

She also stressed the importance of diversification and inflation-proofing linkers and commodity baskets, as well as gold.

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