Weekly CEF Market Report - January 10, 2021

Macro Picture

As I noted in the chat this week, markets will look past the noise in Washington and they did. Equities rose for the fourth week in a row and hit new highs across the board. Investors see hopes for additional stimulus after Democrats won the two Senate seats in Georgia. Trump also conceded the election but we still have political theater ongoing with possible articles of impeachment again. If people didn't have a low approval of government of congress before....

Small caps outperformed large caps by a large margin and value against outperformed growth. So the cyclical/value rotation continues. In my equity DCA bucket, I have shut off my contribution to my large cap growth funds and have been doubling up into value. For one, my growth side is a bit larger thanks to outperformance. Secondly, I want to position for the best upside which I think is on the value side. Value socks are the best way to play a rising rate scenario.

On the econ front, the other big news was the weak non-farm payrolls report that came out Friday. The data showed 140K jobs lost in the month snapping a 7-month string of job gains. The biggest driver of that was the imposition of restrictions and colder weather curtailing dining. The hotel and restaurant sectors lost over 400K jobs in the month. The lone bright spot was the significant upward revision to the prior two months.

We also had a strong Purchasing Managers' Index ("PMI") number come out at 57.2, well above the 54.5 expectations (anything above 50 is growth, above 55 is moderate growth, and above 60 strong growth). This is a good number and implies the broader economy is doing well despite the headline payroll numbers. What we are basically seeing is the lower tier jobs- mostly hourly jobs at retail, restaurant workers, and hotel employees- get furloughed again but everything else is doing well. Definitely a K-shaped recovery.

Separate Politics From Investing- ALWAYS!

I just want to reiterate the need to separate politics from investing. It is amazing the number of inquiries I received about Wednesday's events. I've seen it for years. People fret over the candidate that they don't support winning the election. What you can see is financial paralysis where they sell everything or a large portion and go to cash.

Just remember, 99% of what the market does is completely unaffected by whomever occupies the White House. Some policy can drive markets a bit as we have seen with the stimulus packages. It can also effect interest rates to some extent.

But that is really it. Watching CNN, Fox News, or MSNBC can really affect your investing outcome. If you are the type that reacts to headlines in your portfolio, then perhaps a financial advisor is a the right course of action. For less than 1% fee, Vanguard has found that the typical advisor provides about 3% of additional value. A large portion of that comes from what they call "behavioral coaching." This is otherwise known as preventing clients from doing something radical.

Rising Inflation Concerns

On the news, the biggest story of the week was the rise in the YS 10-yr yield to 1.09%. That is a 0.15% since Christmas Eve as markets have begun to incorporate rising inflation expectations. I posted a couple of charts on the chat about this. For one, QE-driven spikes in US deposits has been unprecedented with M1 rising more than 65% yoy. In 2008/2009, the number was about 25%. In 2010, when the first round of QE started up, it hit 30%. So we have had 2-3 years of strong money growth in the past as a good example to reflect on.

I also posted this chart which I also saw posted (a different version of it) from one of the talking heads on CNBC as a means of confirming his forecast for higher inflation. It sows PMI moving higher and the correlation with actual inflation.

I would note that PMI is unlikely to stay this high as it implies 4%+ GDP growth- something that is not sustainable. As we see in the 2009-2011 time frame, PMI was substantially above inflation and I can recall many fearing a burst of inflation then too. But what happened? PMI came down. Inflation did rise a bit briefly to 2% but then began a long trek lower for the next 4 years.

I think the same thing will occur today. I'm putting on my forecast hat which is kind of beat up and dirty because of it being unused and not worth much. But I think 2021 and 2022 will look a lot like 2017 and 2018.

In November 2016, Trump was elected with a Republican congress so his spending would go unchecked (like today but Democrat). Rates rose on the back of the higher forecasted spending and inflation expectations rose. After about a year, when GDP growth subsided a bit, those inflation expectations began to inch lower, as did interest rates.

I suspect the same will occur in 2021 and into 2022. The Democrats have a weak majority in Congress (and no majority in the Senate). The out-of-favor party tends to win midterms so if the GOP takes back even one chamber in 2022, then spending will stop (much like we saw post-2010 with the sequestration). That will slow spending, slow growth, and bring down both interest rates and inflation. My two cents which is about what its worth.

Income Investing Commentary

Discounts tightened up slightly across the board this week despite the added volatility in both the markets and geopolitics. It feels like the CEF market is trying to have the January Effect but that road blocks keep appearing at every corner. Still, I will reiterate, we are not far off from where we were a year ago- with taxable CEFs about 50 bps wider today.

On the week, taxables, convertibles, and taxable munis widened out while loans and preferreds tightened. On preferreds, the reason it tightened was due to prices falling faster than NAVs. The preferreds sector was down 2.4% on the week. Taxable munis were down 20 bps and investment grade, another area of concern if rates rise, were down 66 bps.

Outside of taxables, real estate was the weakest sector falling over 2% in price and 1.4% on NAV. MLPs were the strongest sector rising almost 11% on the week in price and 9.6% in NAV.

In terms of valuation change (i.e. which sectors saw discount tightening and which widening), loans rose over 1% in value on the week. Make sure you have capital here! Money flow is likely to strong and it will push up both price and NAV! Convertibles were the weakest on the bond side widening half a percent.

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