Updated: Feb 18
As we head into the beginning of the year twenty twenty-one, we can expect that most of the traditional financial sector is back from holidays in February.
This means a fresh look at the trends of 2020, from the people who traded the assets.
Going in December, investors and fund managers would have closed off some positions, cleaned up their portfolios – especially of risk – so that they could spend the break with some level of peace.
Where bellweather assets such as oil and energy, soft-commodities and equities – these are risk-on assets that will perform well in an inflationary scenario – continued their bullish trajectories with limited volatility with the notable exception of Bitcoin (still bullish but more volatility).
With the election finalised, we know that there will be a $1.9 trillion USD stimulus in the US of A. The package includes direct cash injections to Americans of another $1,400 each.
For those unconvinced on inflation, here are the 1-year (pre-Covid) price increases in a year that the IMF estimated a global GDP contraction of -3.5% (end result reported at -4.2%)
January, 2021, 1 year chart
We do already know that inflation is to be directly targeted by the Federal Reserve (as in, they are encouraging inflation) which has a mandate from Congress to attain maximum employment and price stability. With U.S. corporate debt over $10.5 trillion, and with enormous amounts of stock-buybacks behind this debt (See a fantastic commentary on the state of corporate debt via buybacks here) – from the Bank for International Settlements article ‘Mine the buybacks, beware of the leverage’.
This debt buy-back normalises the ability for companies to achieve an operating profit in irregular financial conditions with leverage that is not related to their ability to produce revenue (sell their goods/services e.t.c.). A gentle inflation would help this debt, as well as government debt which is now 122% of GDP in the United States. This debt would increase relative to GDP in a deflationary scenario.
So, inflation it is.
The Federal Reserve believes that they are able to control inflation, likely due to the knowledge of Japanese monetary (and fiscal!) policy interventions, which struggled to achieve inflation during their ‘lost decade’ of the 1990’s in which they attempted to stabilise economic growth after their bubble.
We believe that the United States (and by proxy, the world) is in a fundamentally different position to Japan here for several main reasons.
Firstly, because the U.S. dollar is the worlds reserve and settlement currency. The world relies on the U.S. dollar to be money and it is the final store of value for most chains of transactions, from retail to wholesale to factories to commodities to financial institutions, in the world. When the U.S. dollar is changed, the input of almost every single value chain on earth is affected.
Secondly, global trade frictions were systematically lowered during the 90’s with effects felt well into the 00’s and with a large number of free trade agremeents in both decades.
These free trade agreements firstly opened up the global economy, reducing friction such as tariffs, secondly increased the consumer-base of corporations, creating enormous economies of scale and technology also enjoyed unprecedented growth at the same time, and all of these factors are enormously deflationary. I have never seen these considerations come into play when discussing inflation or the effects of monetary manipulation, and cannot help wondering how much of the success in manipulating interest rates and the money supply is hidden in these factors.
Now, however, these factors have plateaued somewhat, or reversed in the case of trade frictions, with China and the U.S.A both responsible for reintroducing tariffs into the global market. China has also shown the world that its trade agreements are worthless by introducing its own internal politics into its foreign policy. China had interfered with Australian imports for political reasons and barred imports in a punitive attempt at control Australia after they had the temerity to question the origination of the Pandemic that killed 2,000,000 people.
This obviously failed, as it was always going to, but showed that the demands of internal Chinese politics were dominant and that those politics were willing to be petty and dysfunctional – cutting the nose to spite the face, to save face. Along with its wolf-warrior diplomacy, Chinese supply chains will likely be a concern to global trading partners.
Thirdly, the Coronavirus epidemic has also created a discussion about bringing supply chains back into a nations borders, and acts as another friction to global trade.
Fourthly, the Federal Reserve attempted to tighten historical monetary policy by raising rates and shrinking their balance sheet in 2019. It was an immense failure when the repurchasing market froze December 2019 requiring upto $500 billion USD in the market. This was before the extraordinarymonetary and fiscal policy decisions of 2020 that, given this experience, must go on to have a similar effect, on top of that effect.
Fifth, Japan was recovering from a bubble bursting, which fundamentally shakes sentiment in the business community.
Lastly, the U.S. dollar money supply charts, M0, M1 and M2
As something else worth considering that I haven’t given enough time to thinking about the ramifications, the U.S. runs a negative current account compared to the Japanese exporting nation. This is a fundamentally different ecology in which Japanese outputs have U.S dollar inputs and U.S. customers – is a currency importer, compared to the U.S. being price taking on goods that have U.S. dollar inputs, as well as an exporter of currency.
So, what are we looking for in early 2021?
So the case that we are making here, is essentially that the Federal Reserve, and central banks are likely operating on false assumptions, and that their idea that they can control the economy with changes in monetary policy is false.
It looks like inflation is emerging, is potentially already here. It looks like risk assets are being bid while the U.S. dollar keeps falling lower.
We are entertaining the idea of a melt-up in stock prices to reprice from current expectations to a dramatically different future.
So all in all, markets are quite weird heading into 2021.
The short U.S. dollar trade is repeatedly being warned of as one of the most crowded trades - and betting against the crowd at the right times is often when you are successful.
But is this a normal time in markets? Retail traders (and investment banks!) picked the low after the Coronavirus crash, forcing many professional investors to buy back from them much higher.
Retail punters (with the potential help of some big fish behind the scenes) have potentially just taken scalps from major short-selling investment firms in the GameStop gamma squeeze.
It is very early, but we still float the idea that this is a new regime in markets. As early as October, risk assets have been bid, in the case of the S&P500, trading above long-term technical structures in a display of extraordinary appetite for the assets.
We like commodity currencies – Australian and Canadian dollars. We don’t see any reason for the Yen to turnaround at this point (besides a reversal in USD).
We like gold as a hedge against currency devaluation, and think that the gold trade is going to have a great 2021 (full disclosure, I have been long gold miners all of 2020), as well as Bitcoin and Silver.
There are still bears in risk assets, and we think that the bears must be fully converted via the sword – and that they will be! But if the markets do manage to do this, all bets are off.
The caveat for everything here is the US dollar.
There is an idea that the enormous amount of debt denominated in US dollars worldwide means that there is a permanent and insatiable demand for US dollars. A USD rally would fundamentally change everything we have talked about, and as mentioned, given its status as a very crowded trade, is possible and should be considered / hedged with all other trading and investment decisions.
In textbook examples of inflation, soft commodities are the first place that inflation turns up.
Inflationary conditions are clear in the last month in soft commodity markets, with Soybeans, Corn, Soybean oil, Soybean Meal, Wheat, Cotton and Oats all higher by over 10% (!).
Canola, Sugar, Lean Hogs, Live Cattle, Coffee, Rough Rice were also trading higher.
Only Orange Juice, Cocoa and Lumber were trading lower by marginal amounts.
In textbook examples of inflation, energy shows inflationary conditions after soft commodities.
After being an uncertain factor on cost-push inflation for most of 2020, inflationary conditions are clear in Energy in December and January. Crude Oil in WTI and BRENT as well as Heating Oil and Natural Gas all trading higher by over 10%(!)
January, 2021 1 month chart
Asset Purchases, Money Supply and Interest Rates (to come)
Items of Note
M2 Money Supply increased by 10.7% Year on Year in November 2020 (above expectation)
China Central Bank Balance Sheet
M2 Money Supply higher by 8.5% annualised in November 2020
European Central Bank Balance Sheet
Monetary Base higher by 16.5% Year on Year in November 2020 (under expectation)
Monetary Base higher by 18.3% Year on Year in December 2020 (over expectation)
M2 + CD Money Supply increased by 9.1% Year on Year in November 2020 (above expectation)
Bank of Japan Balance Sheet
M2 Money Supply higher by 4.6% annualised in November 2020, and 14% Year on Year
Bank of England Balance Sheet
USD Consumer Credit Change in November was $15.27 billion USD, much higher than the expectation of $9 billion.
M2 Money Supply higher by 17.5% annualised in November and 25.77% Year on Year on December 28th
Federal Reserve Balance Sheet
With the US dollar sliding all month, with less volatility as previously but perhaps greater certainty that it would end up below its 2018 low in the next month or two, Bitcoin has been bid very aggressively in the last month. Monetary policy late into 2020 has been a little unexpected, with a significant expansion of M1 late in the year.
Bitcoin is historically bid alternatively as a tech asset, a risky asset and a store of value competitor to the USD and it is likely that it attracted all 3 types of bids in the last month as well as having asset-specific news and hype over the period. As the lower liquidity asset in decentralised markets it also shows more volatility.
Gold and silver have both traded similarly, with some disappointment in the last week for investors who see them as a store of value whose time has come. However, it is likely that time is required here, that gold traders and investors are seeing movement in Bitcoin and getting ahead of themselves as higher liquidity, less volatile and less complicated investments. We expect both assets to break all-time highs by the end of March if nothing else changes.
Tips retraced its break of all-time high, perhaps in similar trading conditions to gold and silver. The message is not to get ahead of oneself, especially in comparing the mature TIPS market to Bitcoin realising itself as a mature asset.
Other Risky Assets
We are also seeing this inflation turn up in other risky assets, with the S&P500 through all-time highs each consecutive week.
By Thomas Kuhn, CFA
Thomas is the author of 'Bitcoin: A Revolutionary Investment' and has previously written for the Asia-Pacific Research Institute of the Chartered Financial Analyst Institute, QuantumEconomics, Hackernoon and Medium.
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