A return to the ‘Roaring 20s’? Maybe, but be cautious about inflation risk

President of asset management firm on the potential for the strongest global economic surge in decades

A return to the ‘Roaring 20s’? Maybe, but be cautious about inflation risk

Drawing parallels with the “Roaring 20s”, David Picton believes we could be on the cusp of the strongest surge in global economic growth in decades.

One hundred years ago, people were celebrating the end of the war and end of a pandemic, prompting an outpouring of fun and freedom. In 2021, when the vaccine rollout is complete, economies fully reopen and travel is possible once again, could we see a similar defining period?

Picton, president of Picton Mahoney Asset Management, told WP that’s very possible as we discussed the themes in his firm’s Q1 review and outlook white paper titled Building the Bubble. Just like in the 1920s, there is pent-up demand, the prospect of huge rebuilding and manufacturing, as well as a build up of incredible excess.

Conditions, he added, are set to significantly boost equities and risk assets this year. Monetary and fiscal support remain extraordinary, while central banks are committed to maintaining stimulus even as western economies recover. There are risks, naturally, but the report concludes that the “challenge will be to enjoy enough of the boom before risks such as inflation take the wind out of its sails”.

Despite this backdrop, Picton said the biggest and simplest reason to be cautious is that there is so much exuberance in the market. While there was a significant amount of deleveraging when the GameStop saga occurred, the underlying confidence was rapidly recaptured.

This is normally the time to be a contrarian given the levels of “short-term optimism built into the marketplace”. But Picton said the offset to that is we haven’t had these levels of fiscal and monetary support before.

He said: “There is absolutely some euphoria that’s built into pockets in the marketplace, there is definitely some speculative excesses being built in, and there's bullish sentiment," he said. "You could see some of that be a negative in the short run where you have to unwind that excess. But I believe that there's a pretty firm bid below the marketplace and limit to the downside, for now.”

The challenge for investors is to navigate this scenario. For Picton, it’s important to have equity positions and then find ways to deal with fixed income. For those who have been used to a 60-40 model, bonds don’t provide much of a return cushion any more and could, in an inflationary environment, even lose money. Diversification strategies are, therefore, important.

He added: “I'd also be a little cautious on the highest-multiple, sexiest parts of the marketplace - those are the most extended. Whereas if you took the growth components out of the overall equity market, the rest of the market is reasonably valued; it’s not really excessive, other than a few pockets.

“So, make sure that you have diversification within equities. Don't be just constrained to technology and the hottest new growth idea. At the same time, maybe take a little bit more out of the fixed-income component, and look to get a little bit more diversification from there.”

What no one appears prepared for right now is a change in tune from central banks.The backdrop for growth is strong but any surprise deviation from the Fed’s policy of low interest rates would undoubtedly shake things up.

Picton told WP this was not a scenario he had been worried about until recently. The Fed did what was required to stabilize us through a rapid depression but to commit to a policy for a period of time requires unwavering consistency.

“They’ve said lots of things through history, and then they end up changing their mind as conditions change," he explained. "We’re very much focused on changes in fundamentals. As things start to heat up, do they, therefore, have to change their opinions? I am worried about it at that stage.

“I have no idea if it's this month, if it's this year or next, but I believe there will be a policy change. There is potential, at that point in time, to see a lot of air come out of some of the more bubbly areas in the marketplace.”

Of course, the biggest risk on people’s radar now is inflation. After years of no inflation, the Fed hinted at the future when they changed its policy to average 2% inflation rather than a 2% target.

Picton explained that the past decade featured a commodity deleveraging cycle environment where there was lots of capital spending and commodity production but not enough supply to soak it up. It took a decade to work through those excesses but now those forces are going the other way; there's not enough capital spending in many traditional commodities, like copper, or even oil, and demand is set to accelerate.

Globalization trends have kept inflation at bay, but he believes there is now a degree of de-globalization given the breakdown of supply chains through COVID.

“There are some forces that seem to be changing at the margin that are much more inflationary in scope than maybe what we've been used to for the past decade. I do think there will be risks to portfolios,” he said.

“We spend a lot of time on portfolio construction services helping individuals understand risks they might have. One that stands out to me is that there is a significant interest-rate risk that’s embedded within a lot of traditional portfolios and they are most exposed negatively to an inflationary uptick.

“So, yes, I am concerned very much that if all these things come together, it might be a little bit of be careful what you wish for when it comes to how current portfolios are positioned.”

So, while it’s good to have this “amazing backdrop” which should grow and inflate, propelled by the Fed insisting they won't intervene, caution should always be in an advisors’ mind.

Picton added: “If [the Fed] wakes up one day and decides to do something about it, that's going to be a significant deflating event. If it happens much sooner than people think, maybe this market doesn't have as much runway as we currently believe.

“I don't think that's a problem to worry about for the next three months, probably six months, but it might be something that people have to put on the radar screen as we go through the towards the end of 2021.”