Whilst 2020 was a tough year for many, that does not mean 2021 cannot be even more extreme. Monetary policy will continue to be extremely easy throughout 2021 unless the virus is beaten back and inflation shows up very quickly. Whilst the Dems took both Houses, they do not have a majority that would allow them to easily pass significant tax increases. Even the discussion of tax rises is likely to be left until the virus is clearly beaten. That would suggest equities can continue to rally until those events come into view. Last week we saw the 10y yield move confidently above 1%. This is being justified by the expectation for nominal growth as stimulus and the vaccine combine to create excess demand later this year. The move in yields will likely continue unless we see the vaccine not working as planned.
Decades of inflation ahead
The strength in this move lower in bonds represents a significant shift. Yields have been falling since the early 1970s when inflation was beaten back, so if inflation is indeed returning we could be witnessing the start of a multi-decade inflation rise. This will depend on how much time the Fed gives to inflation, allowing the thought of higher inflation to sink into the psyche. If they are indeed true to their idea of targeting average inflation of 2%, they may find that trillions of dollars of QE, trillions of dollars of fiscal stimulus along with a surge in confidence as the virus is beaten back and people return to their normal lives, is just too much demand to hold down the inflation genie.
Not only will demand surge, but also on the supply side, commodity prices have risen sharply. Those input prices will take years to flow through into headline inflation.
Whilst consumer and corporate debt, at these low rates, are not going to cripple an expansion, they are still high by historic standards. The Fed Funds rate and yields cannot therefore be allowed to rise sharply without putting the recovery at material risk. The Fed will likely continue to keep rates artificially low, only raising rates in 25 or 50 basis point moves. No Fed Chair wants to be the one holding the bomb of mass credit defaults unless the alternative is so dire they are forced into the move; a la Volcker in the 70s.
The chart below shows yield curve steepness versus the broad stock market performance. The lower the line, the flatter the 10y-3m spread. Recessions are the grey shaded areas. The yield curve begins to steepen from its cycle low before each recession. In each of the lows highlighted yellow on the chart the spread is near zero as the Fed has tightened monetary policy (short term rates) vis a vis market expectations of growth (long term rates).
Looking at the recent low below zero in 2019 just before the pandemic, based on history, one could argue the recession was coming regardless of the pandemic taking hold in 2020 (i.e. the spread was below zero). What is striking is the shallow decline in the stock index following the spread hitting zero; being the lowest decline on the chart (green highlights). This decline occurred when the pandemic gained hold across the globe. The virus may simply have been a catalyst bringing about an inevitable market correction. That stock market fall may have been discounting the recession which was already due but simply ignited by the virus. Regardless, the stock market move in 1983 shows a shallow decline and recovery in stocks can occur whilst the yield curve steepens.
We can therefore continue to be long equities in 2021; albeit at the risk of a policy mis-step.
Whilst consumers have been repaying debt during the pandemic and corporates have raised capital (and debt), governments have had to dig deep to bridge the gap in incomes. With all major central banks buying up their government's debt yields have been artificially low for many years. However, with such large funding needs and rising yields, bond demand cover (demand vs supply) is likely to be low relative to recent decades. Indeed, government bond buying under QE has been front-run for many years now. Any marginal move lower in demand cover will have a material impact on portfolios holding bonds given rates are moving higher from such a low level. Long dated bonds are most exposed to this move and hence the yield curve could really steepen over 2021. This could hold down property demand.
This yield rise and the inflation risk which is causing the move, is a reason to short gold. The increase in dollar supply and signal by the Fed to devalue the dollar as they undertook QE has seen a rise in gold from under $1000 post the 2008 recession to over $2000 in 2020.
If the Fed or the Dems do falter and signal tightening, the market may take a sharp dive due to the perceived over-valuation in equities due to investors under weighting the benefit corporates enjoy from rising prices. When markets fall fast, all long positions tend to get liquidated at the same time. This means short positions on bonds and gold could be a great hedge to long equities and commodities. The fall could be short lived as both these assets could be bought up as safe haven assets if tightening looks like it will be implemented as opposed to threatened.
The devaluing of the dollar and expansion in the money supply has left investors searching for new a new asset class as correlations increase. Gold was traditionally the asset which held value against a falling dollar. This is historic and the recent emergence of Bitcoin answers many of the same concerns. It is not under any government control and hence cannot be devalued at will. Whilst is has no intrinsic value, investor acceptance of its worth as a store of value is sufficient in itself to re-enforce the function of acting as a store of value. Whilst private keys of large holders are stored in high security custody venues, for most holders, Bitcoin can be held free of charge either at their broker or at home or the office. Transferring Bitcoin also has a low cost regardless of the value being transferred and settles within minutes.
Whilst Bitcoin Cash has yet to take hold, it is likely that one form of wrapped Bitcoin will emerge as a payment currency. This will allow immediate payments and further encourage the holding of Bitcoin. It does however introduce the need for a central custodian which reduces the initial reason to hold Bitcoin; being highly secure.
My outlook for 2021 is long equities, commodities, Bitcoin and short gold, bonds and the dollar. I also favour emerging market equities and currencies as they benefit from the falling dollar. US companies with debt and overseas earnings and a low or declining fixed cost base will also prosper.