Posted: 23 May 2021 (edited on 24 May 2021)
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In this article, I look at what has been driving the wild swings in the markets over the past week and reflect on how I should reposition my portfolio.
1. Inflation concerns driving taper and rate hike concerns
Source: St. Louis Fed, Bloomberg
- 5-year and 10-year inflation expectations saw a pullback this week as the market is increasingly seeing the Federal Reserves as being more receptive to starting taper talks (i.e. to stop buying treasuries and mortgage-backed securities every month)
- Details of their April 27-28 meeting showed that a number of officials were open to discussing scaling back bond buying at upcoming meetings if the economy continued to make rapid progress.
- However, the Fed remains that this will not come until “substantial further progress” has been made on the employment and inflation goals.
- Next FOMC: June 15 – 16
Source: St. Louis Fed
2. Inflation or Deflation? No one seems to be sure.
As it stands, the market is now divided on whether inflation or deflation will come next. To be clear, there are broadly two types of inflation that we see – (1) monetary inflation and (2) demand-supply type inflation.
The first type of inflation – monetary inflation – is caused by an increase in broad money supply circulating in the economy which can come about because of (1) banks giving out more loans (recall: credit spends like money) and (2) governments increasing fiscal spending/stimulus. This typically sets the stage for the second type of inflation.
The second type of inflation – demand-supply type inflation – is what is typically observed across different markets when we see surge in demand or dips in supply causing prices of goods and services to rise. If you are into gaming / computers, this was observable in the prices of graphics cards or, say, the Playstation 5 when we faced supply constraints. If you are into investing, this was observable in the asset price inflation across the equity and commodities asset classes due to a confluence of factors such as easier accessibility to the financial market (e.g. Robinhood) and bond investors rotating to equities to seek yield.
The inflation narrative in short
On one hand, many argue that the continuous debt monetisation and stimulus/printing will put immense inflationary pressure on prices as money supply increases sharply amidst disruption in several supply chains (e.g. semiconductors (and by extension many other industries like Automotive/Consumer electronics) and lumber). Furthermore, the eventual reopening of the international economy will unleash a wave of pent-up demand, which adds to inflationary pressure.
The deflation/disinflation narrative in short
On the other hand, others believe that inflationary pressures are transitory and will blow over for a couple of reasons:
- First, the deflation-believer believe that the supply chain constraints will ease up once the Covid-19 situation improves.
- More fundamentally, the acceleration of investments in innovative solutions across businesses, spurred by the pandemic, will put deflationary pressure on prices as production/services become more efficient.
According to Cathie Wood from ARK Invest, an unexpected deflation can come from two aspects:
- One – In the post-GFC period, companies have catered to short-term oriented, risk-averse shareholders that demanded profits/dividends “now”. This resulted in many companies taking on debt to buy back shares, bolster earnings and increase dividend paid. In doing so, investment in innovation was tapered and products and services grew uncompetitive which eventually led to clearance sales and a bad deflation.
- Two – Conversely, other companies have been investing heavily in AI technologies and setting aside short-term profit. Cathie believes that such investments will bring down the cost of production and make products and services more desirable, thereby unleashing a new wave of demand and a good deflation.
3. How various assets perform in inflationary and deflationary environments
Cautionary note on asset class performance
While equities typically outperform bonds in such environments, this may vary based on the macro-economic environment we find ourselves in.
Given that inflation will cause interest rate hikes, which lower equity valuations and may cause a rotation from equity to bonds (reverse of what we saw last year), inflation this time may not be as ideal for equities.
Source: Capital IQ
Over the past year, we witnessed the age-old bond-equity relationship start to breakdown in the current environment – Typically, bond prices and equity prices tend to move in opposite directions, making them a good hedge for one another; However, this was not the case in the past year. Rather than displaying the inverse movements typical of bonds and equity asset classes, we are seeing bond prices and stock prices move up in tandem.
In fact, Michael Burry (the “Big Short” guy) has bought a sizeable amount of put options on the iShares 20+ Year Treasury Bond ETF, making it the second largest position on Scion Asset Management’s portfolio to date (by market value; click here to see Scion’s positions). Effectively, he is betting that bond prices will fall as inflation weighs in, bond yields rise and prices start to fall. He has been warning of inflation since a year ago when the Fed started the fiscal stimulus packages.
4. What's Next?
Where we are today - the final stage of the long-term debt cycle
Currently, the markets seem to be taking a “wait-and-see” attitude to what the Federal Reserves will do next – in particular, when it will start tapering the purchase of treasuries. When the tapering eventually comes, regardless of the magnitude, I expect equities to see yet another sell-off as market participants expect interest rates to start rising as a result. The street consensus seems to expect this to come either late 2021 or early 2022.
Ray Dalio hints that we are at the final innings of the long-term debt cycle, where the governments are injecting stimulus and monetising debts (i.e. central bank prints new money and buys debt issued by the central government. In effect, putting new money in the hands of the government to conduct various stimulus programs).
The dilemma of tapering treasury purchases
Right now, the governments are caught at a cross-road. On one hand, the government needs to sell a lot of debt to fund stimulus programs. But on the other hand, the heating economy and inflation concerns would require it to stop monetising debt and allow interest rates to rise. The dilemma is that raising interest rates could cause solvency issues (inability to repay debt/interest) as debt-to-GDP levels are at historical highs today.
If the government does not taper bond purchases, bond investors run the risk of holding onto an instrument that returns negative real yields (interest rate they earn is lower than inflation rate so they lose purchasing power). However, if the government does taper purchases, bond prices will be expect to fall, making it an undesirable asset to hold onto. This is why Michael Burry has bought put options on the 20Y treasury bond ETF.
Potential solution could be yield curve control?
While my understanding on this topic is limited, many market participants have began calling on the possibilities of a yield curve control by the Fed since the start of the year. In short, yield curve control means to keep interest rates artificially low by having the central bank step in to buy up bonds at the low rates which other investors would not have bought. This allows the government to continue receiving funding while keeping interest rates (cost of funding) low. To gain a better understanding of this topic, I highly suggest you check out this post written by Lyn Alden.
According to Lyn Alden, yield curve control can be done (1) across the entire spectrum (short-term to long-term) or (2) only on the short end of the curve.
In the 1940s, the U.S. adopted the full-spectrum yield curve control which saw the Fed’s Treasury holdings increase by tenfold in three years. By doing so, it kept interest rates low in the 1940s until the economy rebounded and only allowed rates to rise when growth and productivity picked up to counteract the inflation problem. However, this is often seen as a last resort.
The second option is to only purchase the short-term Treasuries to peg short-term rates near zero and let longer-duration treasury yield go up as inflation runs high. This helps to keep the government’s funding cost low while allowing longer term yields However, this exposes the government to more interest rate risks as it has to re-borrow as treasuries mature (also known as “rolling over” the debt).
According to Lyn Alden, the gist of it is that the first option of full-spectrum YCC is generally beneficial to asset prices across the board, other than cash and bonds (which get sharply devalued in inflation-adjusted terms). The second option, on the other hand, puts downward pressure on several asset classes, which could “take froth and speculation out of the equity market” and could potentially lead to corporate credit problems. This will be good for bank stocks.
Whatever the case is, both solutions call for greater amount of debt monetisation which will cause greater monetary inflation if the new money does not go to productive use (e.g. education, infrastructure spending etc.). Because of these things that have been playing out in the economy, Ray Dalio says that this type of inflation — monetary inflation — is the one that he is most concerned about.
Source: Bureau of Labor Statistics, Prof. Robert Shiller, Lyn Alden
Sector plays (SGX)
Source: Capital IQ
Undervalued: Utilities, Healthcare, Consumer Staples and Energy
A quick screen of all SGX-listed companies shows that these four sectors seem to be undervalued when compared to historical valuation multiples (P/E and EV/EBITDA). Following the highly speculative play on healthcare stocks and their eventual sell-off, the valuations of glove stocks listed on SGX have remained depressed despite having spectacular results to show for. The market seems to be pricing these Healthcare stocks as though Covid-19 will be eradicated / frequent vaccinations will not be required and the world will get back to the same place as we were in 2019 – hence, treating these spikes in earnings will be rather one-off in nature. However, I believe there is mounting evidence that this will not be true. As such, this could be a potential mispricing which may be worth investigating.
(Not financial advice, DYODD)
Tail risk 1: Disinflation
If we look abroad, the tech sell-off over the past month or two may have provided a good margin of safety as valuations “reset”, as Cathie Wood puts it. This may present an attractive opportunity to be a contrarian investor to sweep up some big-tech stocks as a bargain if we eventually get to disinflation rather than inflation.
That said, I am not too keen on loading up on the tech sector given that the recent narrative has been heavily centered around how significantly interest rates will affect growth stocks. Regardless of how mature a tech company is, in the short-term, the dominant move will always be flows before pros. Hence, a sell-off in more speculative stocks like Palantir and Tesla will also have knock-on effects on the large tech players.
Tail risk 2: Leakage to crypto (i.e. less money in traditional markets)
While the likelihood of a major rotation to crypto is extremely low at the moment, there is still an off chance that yield-hungry investors may rush into the crypto market, especially with the increasing dominance of de-fi (decentralized finance) protocols earning as high as 11% on USD stablecoins (see here).
That said, I think the wide speculations in the crypto market, coupled with Elon Musk’s erratic tweets, have casted more doubt in the minds of people who have yet to explore this market. With the increased news coverage of regulatory “clamp-down” on crypto, this will likely cause more investor to shy away from cryptos. However, I urge all readers to remain open-minded as the cryptoverse goes way beyond serving just speculative purposes, especially as human capital continues to flood in.
Hence, while this is a low-probability scenario, it is still one that is good to keep in mind. As it stands, the De-Fi protocols have over USD 53 billion locked in for various purposes (lending protocols, exchanges (DEXes), derivatives, payments, etc.). Should asset allocation start to veer towards crypto, this could represent a huge leakage that could lower valuations on equities (i.e. less money in stock markets).
Tail risk 3: COVID Variants
The third tail risk to talk about is the covid variants. As we’ve seen, the coronavirus continues to mutate as the world struggles to get back to where we were more than a year ago. The concerns with such mutations include (1) a more infectious variant and (2) a more resistant variant.
A virus is only capable to causing such a widespread pandemic if it possesses the right balance of transmissibility and deadliness. Hence, if a variant becomes more infectious, this could escalate the current predicament that we are in.
Furthermore, should a variant subsequently render the current vaccines ineffective, we will have to go back to square one and develop new vaccines. (Please note that I have not researched this topic in depth and this is just a mental exercise off the top of my mind. If you do get the chance to vaccinate, please do vaccinate!)
Should either of the above two scenarios play out, the recovery built into the current valuations prescribed to the markets will likely crumble and we will likely see yet another decline in the stock markets, much like what we saw in March 2020. However, things will be worse this time round as the central banks’ hands are tied as it looks to battle the inflation, unemployment and economic growth woes with ultra-low interest rates and money printing already in action.
For now, I will look to take some money off the table (for higher-risk equities) when a suitable opportunity comes in order to keep some powder dry and buy in when (and if) a dip happens. People tend to push it so I will not be surprised if we do see a few more all-time-highs for the various indices in the weeks and months to come. But always remember that a bird in the hand is worth more than two in the bushes!