“There is always a disposition in people’s minds to think the existing conditions will be permanent. When the market is down and dull, it is hard to make people believe that this is the prelude to a period of activity and advance. When the prices are up and the country is prosperous, it is always said that while preceding booms have not lasted, there are circumstances connected with this one, which make it unlike its predecessors and give assurance of permanency. The fact pertaining to all conditions is that they will change.” – Charles Dow, 1900
When we look back on 2020, most of us will remember it as the worst year of our lives. Looking at the year strictly from the perspective of the financial markets and our portfolios, it was actually pretty good. Large-caps and long-term Treasuries are both up more than 15%. Small-caps and gold are up more than 20%. Even Bitcoin has more than tripled in value, if that’s your thing.
Even better for investors is that these returns were achieved, for the most part, without much volatility. The bear market that cut more than 30% off the value of the S&P 500 in just over one month is the clear exception, but the subsequent recovery has nearly been a straight line up with little volatility to speak of.
Of course, we can thank the Fed and the government for most of this. The central bank swiftly dropped interest rates all the way to 0% at the beginning of the COVID-19 crisis, while Congress passed the CARES Act, a $2.2 trillion stimulus bill that included one-time cash payments to individuals as well as increased unemployment insurance benefits and loans to small businesses.
While much of this was necessary to prevent an even deeper economic slump, it doesn’t come without consequences.
The stimulus cash and record low interest rates quickly brought investors back into risk assets and sent the S&P 500 back to record highs less than 5 months after it fell more than 30% during its March low. This occurred despite U.S. GDP cratering 31% in the 2nd quarter and the unemployment rate nearly hitting 15%. It was one of the greatest disconnects between the state of the economy and the financial markets we’ve seen.
With the global economic recovery hinging on the success of the COVID-19 vaccine and the ability of the government to bridge the gap financially between now and when the vaccine can contain the virus’ spread, I’m paying attention to two major themes which are likely to drive the narrative in 2021.
Debt & Inflation
I mentioned the consequences that come with pumping an endless amount of dollars into the economy, and here it is.
The total federal debt will have more than doubled in just the past decade. When all is said and done, the government will have added more than $5 trillion in debt to its books in 2020 alone. Investors may look at the value of the S&P 500 and think that debt isn’t so bad if risk assets are hitting record highs, but all of that money pumped into the economy dilutes the relative value of existing dollars. Just look at the value of the dollar index throughout 2020.
Ever since Congress and the Fed went into action, the value of the dollar has steadily declined. If COVID restrictions remain in place throughout at least the first half of 2021, it’s reasonable to believe that economic expectations will be revised downward, which likely pulls the dollar down even lower.
Stock prices may be near record highs, but don’t for a second assume that there aren’t consequences for these actions.
The Case For Higher Volatility in 2021
My primary concern for the new year is this: The COVID-19 pandemic has made the global economy especially vulnerable. The mountain of cash thrown at the economy by Congress and the Fed may be assisting in accelerating an economic recovery, but it’s also adding another layer of instability through soaring levels of debt. The dollar is already declining in value and may continue to do so in 2021.
All of this will lead to much higher levels of volatility than we’ve become accustomed throughout the post-bear market rally in stocks.
If you look at the current inflation rate in the United States, it’s somewhere between 1.2% and 1.6%, depending on the metric you use. That’s below the Fed’s 2% target (or previous target now that it’s moved to an inflation averaging model), but it’s far from a deflationary environment. If you don’t believe that inflation already exists, look at what’s happening in the real economy. Food inflation in the U.S. is around 4% right now. The Case-Shiller Home Price Index is up more than 8% year-over-year. Medical care services costs are up more than 3%. The parts of the economy that perhaps hit consumers’ pocketbooks the hardest are already experiencing above average rates of inflation.
Let’s put it this way. What do you think will happen to more discretionary spending habits when consumers, armed with thousands of dollars of stimulus cash and record low interest rates, see the jobs market stabilize and restaurants, businesses, movie theaters, etc. open back up for business? They’re going to spend!
Will the Fed do anything to slow a potential rise in inflation? I’d say it’s really unlikely anytime soon. The inflation averaging policy essentially raised the bar on how high inflation can go before the central bank acts. They’ve already gone on record saying that they expect to keep interest rates at near zero through at least 2023. And let’s not forget what happened when they slowly tried to normalize interest rates back in 2018. The market plunged 20% and the Fed quickly pivoted back to a dovish stance.
All of this creates instability in the financial markets. A rise in inflation, which already exists in many corners of the economy, probably leads to a rise in the long end of the Treasury yield curve. Higher yields equal falling bond prices, something investors haven’t seen at a sustained level in years.
What we’re left with is a tug of war between investors who see optimism in risk assets due to the COVID vaccine and a global economic recovery and those fearing a rapid rise in inflation, higher interest rates and an interest in remaining defensive.
That’s your recipe for higher volatility in 2021.
Now, I’ve seen people pull out this chart as evidence that inflation isn’t and won’t be a problem.
This is the velocity of money, or basically the rate at which money is moving throughout the economy. A high velocity of money indicates that consumers are buying more frequently and vice versa.
You can see that the velocity of money has plunged to their lowest levels in at least a half century. In other words, the government is pumping a lot of money into the economy, but consumers aren’t really spending it.
Here’s the counterargument. We don’t need velocity to have inflation. Yes, velocity helps to ignite inflation for certain, but it’s not a requirement. The 1970s are a good example.
Fear of Missing Out
The current market is starting to look very similar of last year’s 2nd quarter market rebound. Despite the economic recovery showing multiple signs of stalling out, despite retail sales activity slowing, despite increased political risks and despite an economy that is demonstrating job losses again, stocks just continue pushing higher. The only solid reason for this sentiment is stimulus optimism, which has been the magic potion for the financial markets above all else. While another trillion dollars injected into the economy would certainly improve GDP growth expectations over the next 12 months, it doesn’t come without consequences.
Regardless of the short-term benefits of more stimulus, it’s just blowing up the debt bubble bigger and bigger. Inflation expectations continue to push to multi-year highs, TIPS keep outperforming and long-term Treasury yields are on the rise. The debt effects are indeed showing up even if it’s not yet in equity prices. I remain convinced that inflation is one of the bigger threats to an economic recovery in 2021, but it’s unclear when that risk might ultimately get priced in.
The Strategy For High Volatility
It’s possible to achieve superior returns over the long-term both on an absolute and risk-adjusted basis by examining intermarket behavior. That means taking risk off the table when conditions favor higher volatility and adding risk when conditions are less volatile.
People may argue that this idea goes against the traditional investing tenet that you should buy and hold. That may be the case if you’re willing to stick with that discipline and ride out the highs and lows. Most investors, however, don’t. As I’ve often said, the ability to stick to a strategy is more important than the strategy itself.
When it comes to investing, I consider myself a weatherman. I can’t tell you if you’re going to get into a car accident, but I can tell you when conditions are suggesting you should slow down.
And while there are not guarantees when it comes to investing, I think it’s safe to say more volatility and uncertainty will likely plague the long-term future, which provides opportunities for both risk-on, risk-off strategies to continue to prove the idea that if you want to kill it in the stock market, you have to not get killed.
And remember – the one fact pertaining to all conditions is that they will change.
Feel free to reach out if you have any questions.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President