- February’s market advance followed a similar pattern to that of January: the first half of the month saw strong performance in momentum favorites only to sharply reverse at month end.
- Global equity markets continued their advance throughout most of February due to continued optimism over vaccination efforts that will help the world move past COVID as well as high expectations.
- U.S. small caps continued their strong run from January with the S&P 600 Index returning 7.7% versus 2.8% for the S&P 500.
- Investment grade fixed income posted a loss for the month as interest rates rose in anticipation of higher inflation and a large deficit-financed federal spending package.
- World central banks would like to see a return to normalcy via higher interest rates and inflation expectations but not for these expectations to get out of control resulting in tightening financial conditions that would then present deflationary risks.
Data Source: Bloomberg
‘Who Listens to Warren Anymore?’
"Nobody's going to listen to Buffett. Buffett doesn't have the energy to say what he said 30 and 40 years ago in 2021. And that's OK, he's basically earned the right to chill out and be the GOAT, but there have to be some other folks that take that mantle, take the baton and do it as well to this younger generation in the language they understand." - Chamath Palihapitiya, founder Social Capital, Bloomberg 2/14/2021
Credit to former Facebook executive and now billionaire Chamath Palihapitiya for making such a bold statement on famed investor Warren Buffett, Chairperson of Berkshire Hathaway. Whether history proves him prescient or Irving Fisher-esque (“stocks have reached a permanently high plateau” right before the 1929 market crash), there is no mistaking that Mr. Palihapitiya has planted a marker that clearly distinguishes one style of investing (valuations based on fundamentals) versus another (narratives matter more than fundamentals: digital assets and technology are the future). Apparently, Warren Buffett is about as relevant to today’s investor as an 80s Walkman is relevant to today’s music listener.
Although somewhat hubristic on the surface, Mr. Palihapitiya’s comments concerning Mr. Buffett harbor some grains of truth (although we doubt the observations of Mr. Buffett’s energy are correct). Mr. Buffett may be the greatest of all time (“GOAT”), but at least so far, no one of major media significance has adopted the leadership mantle for fundamental, valuation-based investing. Nor has Mr. Buffett elevated a successor nor communicated a succession plan to serve as the leading voice for this style of investing, increasingly viewed as outmoded and outdated in the age of technology growth stocks and cryptocurrencies. Alas, such is the challenge of cult-of-personalities; rarely do they survive the passing of the personality.
So, should Mr. Palihapitiya and his legions of social media/retail trading followers prove to be right, then professional investing will be characterized more by textual algorithms following social media postings and less by traditional financial analysis and operational due diligence. Goodbye CFA, hello python programmer.
Coincidentally, it just so happened that Mr. Palihapitiya’s mid-month interview nearly marked the all time high reached in Bitcoin (USD) (Figure 1), topping off near $58,000 before ‘correcting’ to its prior high of $46,000, although still well above where it started at the beginning of the month.
Figures 1 – Bitcoin Takes a Breather After Reaching All Time High
Mid-month also saw a reversion in risk sentiment from risk-on to risk-breather, whether measured by $USD weakness-to-strength (Figure 2) or corporate credit spreads (Figure 3 – high yield spreads broke through pre-pandemic lows before widening towards month-end), although commodity prices (Figure 4), along with favored Reddit stocks), are continuing their own moon-shot trajectories.
Figure 2 – U.S. Dollar Off the Lows But Trading in a Narrow Range Post November 2020
Figure 3 – High Yield Credit Spreads Break Through Pre-Pandemic Low Levels Before Widening Towards Month-End
Figure 4 – Industrial Metals and Oil Prices Shoot Higher in February
Even with the month-end breather in risk appetite, global reflationary/cyclical assets remain in the driver’s seat supported by positive news over declining COVID-19 positivity rates/hospitalizations, vaccinations progress (Figure 5) and developments (J&J receiving FDA emergency approval for their one-shot vaccine), and political progress over the next round of U.S. federal pandemic spending relief (estimated at $1.9 trillion bringing total U.S. pandemic relief spending to $6.1 trillion – Figure 6). U.S. businesses were also generally relieved that the Senate parliamentarian ruled that a federal $15 minimum wage mandate could not be included in the spending package as part of congressional reconciliation (although congressional Democrats are trying to figure out a way to impose this mandate).
Figure 5 – This Summer Could Witness Near-Full Vaccination Should Current Rollout Progress Continue to Improve
Figure 6 – 2020-21 Pandemic Relief Spending To Dwarf 2008-09 Great Recession Spending
And the appetite that has driven reflationary/cyclical risk assets higher spilled over into the bond market as this month’s sharp spikes in interest rates and bond market volatility are now reflecting a not-so-immaterial concern that economic conditions are about to overheat.
Central Bank Policies and the Risk of Overheating
Following the Federal Reserve’s January meeting and Chairperson Jay Powell’s congressional testimony in late February, Fed officials remain committed to keeping their benchmark rates near the zero bound for the foreseeable future (at least through 2023) until employment has fully recovered from the pandemic. Up until February, it seemed that fixed income markets were largely aligned with the Fed’s policy outlook as long-term interest rates rose from their pandemic lows but in a slow and measured way that did not threaten overall financial conditions.
That suddenly changed in February as Treasury rates rose across most of the curve in a particularly volatile manner, especially during the final week of the month following Powell’s congressional testimony and an ill-timed Treasury auction of 5- and 7-year paper that was poorly received by the markets. As the 10-Year U.S. Treasury Yield rose to a post-pandemic high of 1.50% (before settling at 1.40% by month-end), the intermediate part of the curve witnessed a volatile sell-off that saw 6+ standard deviation spikes in intermediate rates (as can be seen by the 2-5-10 year butterfly spread that compares the 5-year yield with the 2- and 10-year yield (Figure 7)).
Figure 7 – Spike in Interest Rates (Especially Intermediate Rates) Now Reflects Increased Uncertainty Towards Future Fed Policy
Fed Funds and euro-dollar futures are also pricing in the first Fed Funds rate hike in two years, rather than three. Clearly, the markets are signaling to the Fed that the coming inflation will likely be more than just ‘transient’, forcing the Fed to pivot closer to what’s being priced in the rates market.
And that is the current debate right now – whether the inflationary pressures building up post-pandemic will prove to be temporary or more permanent in nature. Time will tell whether the 25% year-over-year growth in M2 Money Supply will prove to have a more lasting effect on inflationary trends (much of this will depend on ‘velocity’ or whether the excess money supply parked within the banking system will find its way into the broader economy via loan activity). Chairperson Powell has also dismissed this risk suggesting that standard monetary theory of inflation espoused by the late Milton Friedman is largely outdated (as suggested by First Trust Brian Wesbury’s 3/1/2021 economic note). The Fed’s mantra remains stalwart around any inflationary pressure as nothing more than ‘transient’ until the economy returns to full employment (Treasury Secretary Janet Yellen actually maintains that the true unemployment rate is closer to 10% rather than the official reported 6.3% (Figure 8) making the case for more stimulus spending).
Figure 8 – Is the True U.S. Unemployment Rate Closer to 10% than 6%?
From an alternative perspective, this month’s rate hike could reflect near-term concerns of a Treasury supply glut following the expected passage of the $1.9 trillion American Rescue Plan legislation, as some left-leaning economists such as Larry Summers and Olivier Blanchard are warning of “economic overheating” from the spending package just as the world is recovering from the pandemic. The month-end sell-off in Treasuries coincided with an anemic reception to the 5- and 7-year Treasury auction. Support for this viewpoint can be seen in the nature of this month’s fixed income sell-off, which was driven more by a rise in real (inflation-adjusted) interest rates (Figure 9) rather than rising inflation expectations (Figure 10), which have actually dropped to below 2% for the first time this year.
Figure 9 – Sharp Rise in Fed Constant Maturity 10-Year Real (Inflation-Adjusted) Rate Suggests Sell-Off Driven More by Fiscal Spending Plans and Less by Inflation Outlook
Figure 10 – Month-End Drop in Long-Term Inflation Expectations (Break-Even Rate Between TIPs vs Nominal Treasuries) Also Confirms This
Mortgage lenders could have also contributed to the sell-off as they reduced their interest rate hedging (the so-called convexity unwind) in the face of higher rates that have reduced the appetite for refinancing. However, thanks to the Fed’s purchases of mortgage-backed securities as part of its emergency quantitative easing program that has ballooned the Fed’s balance sheet to just over $7.5 trillion, the unloading of Treasuries by mortgage lenders is not as feared as perhaps it was back in 2003 (the last major convexity unwind). The Fed does not hedge its interest rate risk on MBS purchases, so it has acted as a stabilizer of sorts in the mortgage market. Yet, mortgage lenders unwinding their interest rate hedges in response to higher rates has probably contributed to rate volatility.
And this leads us to the likely key for ‘Fed Watch’, namely the state of ‘financial conditions.’ Bloomberg Briefs US Economics maintains that the Fed has an ‘exit strategy’ but may not be sufficiently hawkish for some traders. But shaken by last year’s market meltdown, one can surmise that the Fed has little appetite for a repeat of financial market seizure. Indeed, financial conditions have tightened with this year’s rise in interest rates (Figure 11), yet conditions remain relatively loose since the depths of the pandemic shutdown. Ideally, world central banks would like to see a return to normalcy via higher interest rates and inflation expectations but not for these expectations to get out of control resulting in tightening financial conditions that would then present deflationary risks.
Figure 11 – Financial Conditions Are Tightening with the Rise in Interest Rates But Remain Relatively Loose Over the Past Year
Sometimes the cure for higher interest rates is higher interest rates (presuming higher rates help cool an overheating economy), and the Fed keeping its foot on short-term rates while long-term rates rise may be the kind of policy prescription the Fed is hoping for. However, central banks may be tempted to implement yield curve control (YCC) to try to keep a lid on long-term rates (as Australia is currently attempting to do). Such actions will need to be coordinated less investors flock to the currencies whose central banks are not resorting to YCC. A showdown is brewing between central banks and fixed income traders. Will traders go along with central bank attempts at yield curve control (i.e. trading ahead of expected central bank purchases like what we’ve seen in the European Union) or will they test the central banks’ mettle by trading against them in anticipation of inflationary pressures getting out of control? These next few months may prove out who has the correct inflation stance and who needs to pivot.
Tail Risks: Bottleneck Watch
Last month we began a ‘Tail Risk’ watch with supply chain bottlenecks representing inflationary risks and COVID-19 mutations deflationary risks. As U.S. vaccinations progress at an accelerating rate (1.5 million daily and rising) and the FDA’s approval of Johnson & Johnson’s single shot vaccine, the COVID-19 deflationary risk has faded although vaccination rates are much slower across Europe and non-Asian emerging markets.
We’ve been writing about one risk (becoming less out-of-consensus by the day) to the market narrative, which is the emerging bottleneck risk we first wrote about since last August (see “Pig in the Python: the Growing Threat of Inflation”, “The Coming Bottlenecks”, and “Transitory” as well as our prior Monthly Market Commentaries.
Bottleneck risk is increasing as manufacturers and businesses are facing higher input costs (as reported by this month’s ISM survey) as reports of shortages continue to increase with the global economy on the mend and facing a pent-up consumer. Figure 12 displays another critical bottleneck forming, namely the sharp rise in steel prices.
Figure 12 – Steel Prices Shoot Higher
Electricity for power generation may also be in short supply as the recent winter storms across Texas demonstrated. In addition, the amount of electricity consumed by bitcoin mining has now surpassed the amount consumed by Norway (Figure 13). Interestingly, China just announced they were cracking down on bitcoin mining across the Inner Mongolia region, which ironically helped drive up the price of bitcoin.
Figure 13 – At 120 Terrawatts/Hour (Annualized), Bitcoin Mining Consumes More Electricity Than Norway
Despite the rise in fiat currency alternatives like bitcoin, gold prices continue to trend downward from last year’s high of around $2000/ounce while copper prices continue to rally (Figure 14). Industrial metals like copper continue to benefit from supply shortages and increasing demand resulting in a net deficit state for the foreseeable future.
Figure 14 – Copper Prices Continue to Rally While Gold Declines
February 2021 Market Review
February’s market advance followed a similar pattern to that of January: the first of the half month saw strong trend following in momentum favorites such as growth stocks and emerging markets only to sharply reverse during the latter half of the month. Two risk-on asset categories that bucked this trend were U.S. small caps and commodities (more on that below).
Global equity markets continued their advance throughout most of February due to continued optimism over vaccination efforts that will help the world move past COVID as well as high expectations for a $1.9 trillion federal stimulus spending package to be passed shortly.
After having advanced just over 6% through the first half of February, global stocks (MSCI All-Country World Index) turned down but still finished positive for the month (+2.3%). The U.S. Market (S&P 500) and MSCI Europe ended up outperforming other major regions (Figure 14) after having lagged through most of the month. S&P 500 returned 2.8% followed by MSCI Europe (+2.4%). MSCI Japan and Asia ex Japan returned 1.5% and 1.4%, respectively while MSCI Emerging Markets returned 0.8% after having been up as high as 8% through the first half of the month.
Apparently, Emerging Markets took the brunt of the sharp rise in global interest rates and counterrally in the U.S. dollar. In addition, Brazilian markets came under pressure following reports that President Jair Bolsonaro fired the head of the state-owned oil company Petrobras for failing to keep diesel prices low.
Figure 15 – U.S. and Europe Lead Major Regions While Emerging Markets and Asia Lag
U.S. small caps continued their strong run from January with the S&P 600 Index returning 7.7% versus 2.8% for the S&P 500 (Figure 15a). Small caps were able to hang onto their leadership throughout most of the month. S&P Pure Value returned 10.6%, outperforming S&P Pure Growth which returned 1.6% (Figure 15b). Both styles were performing in line with each other through most of the month but then diverged following the sharp rise in interest rates.
Figure 16 – U.S. Small Cap and Value Outperform Large and Growth
U.S. and Emerging Market small caps (green and yellow lines, respectively) are expected to experience a sharper earnings recovery over the coming year versus large caps and Europe/Japan (Figure 16).
Figure 17 – U.S. and Emerging Market Small Caps Expected to Lead Earnings Recover Over the Next Year
Source: Bloomberg for the period ending 2/28/2021. Time series indicate % increase or decrease of current forward EPS expectations versus expectations from the prior year.
Once again, Energy was the top performing sector (Figure 17) in February benefitting from rising oil prices. Financials benefited from a steeper yield curve while cyclicals generally outperformed defensive sectors which were partly hurt by rising interest rates.
Figure 18 – Energy Outperformed on the Heels of Rising Oil Prices
Among risk factors, ‘Momentum’ underperformed all other factors (Figure 12) after having led throughout most of the month. Value and High Quality outperformed High Dividend and Min Vol, both likely hurt by higher interest rates.
Figure 19 – Value and Quality Outperform
Investment grade fixed income posted a loss for the month (Figure 19) as interest rates rose in anticipation of higher inflation and a large deficit-financed federal spending package. The Bloomberg/Barclays US Aggregate Bond Index dropped 1.4% mainly due to a rise in interest rates. However, U.S. high yield continued to enjoy moderate gains as high yield spreads remain below 3% after having broken through pre-pandemic lows before widening at the end of the month. The Bloomberg Barclays US High Yield Index returned 0.4%. Foreign currency and emerging market debt underperformed due to a combination of higher interest rates and a stronger U.S. dollar.
Figure 20 – US High Yield Outperforms Other Fixed Income Sectors
Within equity alternatives, Commodities posted another strong month with the S&P GSCI Commodities Index returning 10.6% on the strength of oil, industrial metals, and agricultural prices. Precious metals continue to remain weak as they represent the antithesis of the reflationary trade and were especially hurt by a rise in real (inflation-adjusted) interest rates. The Dow Jones REIT Index performed in line with the broader U.S. market (Figure 20).
Figure 20 – Commodities Continue Their Rally While Precious Metals Lag
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