Synopsis: “A Brighter Future” – Episode 40
In this episode Richard Calhoun, CEO of Laidlaw Wealth Management, discusses whether the rise of interest rates will slow the pace of economic recovery, whether inflation’s upturn is transitory or secular, whether the VIX index subsiding is a signal for a “risk on” market environment and how investors should consider Bitcoin and crypto-currency investment now versus the 2017 run-up.
The topics discussed in this episode are: Is the market forcing the Fed’s hand on interest rate policy?, Is the upturn in inflation a sign of something more permanent? How should investors consider the pull-back in the VIX index and should they go “risk on”?, and Does Bitcoin stand a chance of becoming “the digital equivalent” of gold?
Please tune in for more timely insights.
Hello and welcome to another episode of “A Brighter Future” Laidlaw & Co’s podcast series. I’m Rick Calhoun, CEO of Laidlaw Wealth Management, and I am joined again by David Garrity, Chief Market Strategist for Laidlaw & Co.
David, it’s been a few weeks since we last spoke and we have a lot to cover, so let’s get right into it.
We saw stocks set new highs again last week with a myriad of factors grabbing a piece of the spotlight, including Congressional hearings aimed at deciphering the recent GameStop trading frenzy, ongoing Washington negotiations over the details of the fiscal aid package, and economic data that continue to paint a picture of an economy that is enduring lockdown headwinds, but is also primed for a jump amid rising vaccinations.
But what caught my attention, and the market’s, was the upward move in interest rates. A 10-year Treasury yield of 1.3% may feel like a nonstory, but the recent move higher in longer-term rates is unlikely to proceed unnoticed, both for the reasons behind the increase as well as the implications higher rates pose to the market’s path ahead.
And that’s where I’d like to start today. As I mentioned, ten-year rates have now doubled since September. While that trajectory may feel abrupt, I want to remind our listeners that this brings 10-year interest rates back to where they were last February and the yield on 10-year Treasuries is still at the lowest level in history.
At the same time, we are also seeing global yields rising with Treasury yields. The German 10-year Bund yield has risen +17 basis points over the last month, compared to +28 basis points for the UK 10-year government bond. So, rising yields is a global phenomenon, which means it’s based on the market’s expectations for a global economic reflation and uptick in inflation.
Practically, that makes the trend of higher yields more sustainable going forward, and it’s one of the key differences between this episode of rising yields, and some others where Treasury yields may have been rising, but global yields were falling.
But this move has caused a lot of discussion on Wall Street about the movement up causing money to come out of risk assets.
In your opinion, could this movement up in rates choke off economic growth? Could this uptick in rates be the proverbial “fly in the recovery ointment “ ?
Rick, the rise in interest rates is a reflection of the success of the past year’s combined fiscal and monetary stimulus has had in sustaining the global economy through the pandemic in 2020 and positioning it for growth as COVID vaccine distribution efforts scale in 2021. As we know, interest rates typically reflect real economic growth plus inflation.
Current economic forecasts call for 2021 world GDP growth of +5.2% following the -3.6% contraction in 2020. Inflation is expected to come in above the Federal Reserve’s policy threshold of +2.0%, but given the August 2020 policy shift to average inflation rate targeting this is not expected to trigger a round of Fed tightening. That said, the moves higher in 5-year and 10-year Treasury yields to pre-COVID levels last seen in 1Q 2020 have investors concerned of an equity market reset as discount rates increase.
Important here to keep a close eye on the CME FedWatch data series as the Fed Funds Futures curve shows that the odds of an interest rate increase in 2021 are beginning to rise, albeit to modest levels. The chance of a rate increase at either of the 4/21/21 or the 6/16/21 meetings stand at 4.0% each, up from 2.1% last week. Further out in the year, the odds of an increase at either the 9/21/21, 11/3/21 or 12/15/21 meetings are now 9.7%, also up from 2.1% last week.
The interest rate moves come at a tricky time for the stock market as the 4Q 2020 earnings season, while quite strong, is largely over and 1Q 2021 earnings season won’t begin until mid-April. At present, based on FactSet data, Wall Street analyst estimates for 2021 and 2022 are trending sideways and most likely will not see meaningful upward revisions until the 1Q 2021 earnings season gets underway.
The stock market depends on two components: earnings and interest rates. If earnings are flat and rates are up, the odds are good that markets will be down, all else being equal. That said, I only see the correction as temporary until we get more indications of fiscal and monetary support. To that end, we look with interest to Federal Reserve Chair Powell’s Humphrey Hawkins testimony before Congress on this Tuesday.
One last observation is that while there are concerns that the increase in U.S. borrowing attendant on the passage of proposed fiscal stimulus and infrastructure investment programs may lead to debt service payments crowding out other categories of government spending, the level of interest rates at which such borrowing may occur are sufficiently low as to leave U.S. interest expense as a percentage of GDP below the 1.4% median seen since 1940 through 2024. If ever there were a time to borrow to build America back better, this is that time.
David, let’s talk about a more Macro topic that was addressed in our Laidlaw 5 for 2021 and has been written about a lot recently – Inflation.
Without even accounting for the aid package proposed by the new administration, the U.S. has already provided about $4 trillion of fiscal support, or about 20% of GDP, to get the economy back on track.
These measures, together with the $3 trillion expansion of the Fed’s balance sheet, have been highly effective in providing liquidity to businesses and consumers and preventing a prolonged recession. However, over the long term, excessive government debt and deficits can exert some upward pressure on prices.
In addition, the pandemic and resulting shift in demand patterns (as consumers redirected spending towards goods, like computers, furniture, etc. instead of services) has disrupted global supply chains and caused bottlenecks. For example, the shortage of semiconductor chips reported recently is costing automakers billions of dollars in lost revenue. Shipping and raw-material costs are also rising with commodity prices to their highest levels in more than a year.
The recent data from the survey of purchasing managers at manufacturing firms confirm that prices paid in the production process are rising. This is a leading inflation indicator because producers will most likely pass along the price increases to consumers.
David, anyone who has ever walked in NYC or Chicago on a windy day has felt a strange wind effect. Wind speeds can be moderate when walking near one side of a tall building, but, after turning around the corner, strong wind gusts can suddenly appear. Should our listeners worry that inflation is about to do a similar about-face?
Rick, you put it quite well in saying that the winds of change are blowing in the financial markets as investors begin to consider the growing prospect of our seeing a post-COVID world in 2021 and try to assess how best to position themselves in a global economy that it is characterized by massive unemployment and supply chain bottlenecks reflecting largely capacity that was shut in during COVID and that will take time to restart.
Last week’s Producer Price Index clearly showed the impact of supply chain bottlenecks. We believe that as the world economy reopens that these bottlenecks will be cleared and that the transitory price increases associated with them shall pass.
It is important to note when considering the pace of the world’s recovery from COVID that it is highly uneven, being largely dependent on the success of scaling COVID vaccine distribution efforts while maintaining necessary public health protocols. While it is encouraging that the level of vaccination doses per hundred persons has begun to rise with the U.S. at 16.5, Britain at 23.8 and Israel at 78.1, there are countries where levels are far lower such as Denmark at 7.3.
When it comes to viewing inflation data, bear in mind that as the brunt of the global economic shutdown to contend with COVID fell in 2Q 2020 that the year-over-year comparisons will be pronounced through July 2021. Given the substantial slack remaining in the global economy, inflation is likely to moderate going into 2H 2021. Within this framework view of global excess capacity, we also consider the rise in oil prices as being a transitory development.
Nevertheless, there is a clear shift in the market as investors are looking to position themselves to preserve purchasing power in the face of inflation. We have previously noted Paul Tudor Jones’ May 2020 paper, “The Great Monetary Inflation,” which lists 9 investments that are expected to perform well during reflationary periods such as we are experiencing post-COVID. Rather than paraphrase, we quote the paper here:
1. Gold – A 2,500 year store of value;
2. The Yield Curve – Historically a great defense against stagflation or a central bank intent on inflating. For our purposes we use long 2-year notes and short 30-year bonds;
3. NASDAQ 100 – The events of the last decade have shown that quantitative easing can rapidly leak into equity markets;
4. Bitcoin – There is a lengthy discussion in the paper;
5. US Cyclicals (Long)/US Defensive (Short) – A pure goods’ inflation play historically;
6. AUDJPY – Long commodity exporter and short commodity importer;
7. TIPS (Treasury Inflation-Protected Securities) – Indexed to CPI to protect against inflation;
8. GSCI (Goldman Sachs Commodity Index) – A basket of 24 commodities that reflects underlying global economic growth;
9. JPM Emerging Market Currency Index – Historically when global growth is high and inflationary pressures are building, emerging market currencies have done quite well.
Going into 2021, our “Laidlaw Five” forecast indicated that investors could be well-rewarded by favoring value-oriented sectors such as Energy and Financials as well as stock markets outside the U.S. The tables below show year-to-date performance for styles, sectors and geographies.
|Performance: Year to Date 2021 – Style, Market Cap & Sector|
|Index||Price Change||vs. S&P 500|
|S&P Communications Services||7.4%||3.4%|
|S&P Real Estate||3.6%||-0.4%|
|S&P Health Care||0.9%||-3.2%|
|S&P Consumer Staples||-3.7%||-7.7%|
|Performance: Year to Date 2021 – Geographic|
|Index||Price Change||vs. S&P 500|
|– U.S. Dollar Index||0.6%||-3.5%|
|MSCI Emerging Markets||11.3%||7.3%|
|MSCI South Korea||8.2%||4.2%|
|MSCI Emerging Mkts ex-China||6.9%||2.9%|
|MSCI Frontier Markets||4.4%||0.4%|
David, in basketball, they call it a “head fake”, in baseball they call it a “change-up”, but in markets they call it a “blip” and that’s exactly what we got when the VIX broke through the 20 handle, closing at 19.77 (last seen 2/21/20). Yes, it’s been a year almost to the day since we last saw stability, but now continue to operate under the mantle of volatility. To some it elicits “fear”, to others it represents “opportunity”; and we prefer the latter.
Each week in our meetings, we look at what many call the Fear & Greed Index – the VIX. The VIX helps investors measure the expected volatility in the stock market, and since a spike to just below 40 in the last week of October, it has been in free-fall mode.
In a research note, FundStrat’s Tom Lee said the VIX dropping below 20 would be a major risk-on signal, as it would suggest that investors see lower volatility in the coming months. In other words, this would be more firepower to buy equities.
I know we have touched on the VIX in the past, but could you offer some insights into the VIX and then share if you agree with Tom Lee’s suggestion that the recent drop below 20 is a “risk on” buy signal.
Rick, I agree that a decline in the VIX can be viewed as a buy signal, but for the reasons indicated earlier as to earnings expectations marking time ahead of the 1Q 2021 earnings season and the impact of rising interest rates it may be best for investors to view the VIX signal cautiously.
This is underscored by considering the CBOE VIX Term Structure which represents what the market is expecting in terms of future volatility past just the next 30 day. As the curve shows levels above 29 from June to October 2021, well over Friday’s 22.05 level, we should understand that higher risk levels are being priced into the options market. So, again, best for investors to view the VIX signal cautiously.
One thing to note here is that volatility as measured by the VIX has a historical tendency to cluster. Volatility does not adhere to the famous “random walk” of stock prices. Instead, it clusters in high volatility periods like 1998 – 2003 and 2008 – 2012 and times of low volatility like 1992 – 1996, 2003 – 2007 and 2013 – 2018. After high volatility periods, it generally takes more than 12 months before US stock prices see even average daily price churn. VIX futures rationally reflect that reality even before factoring in current high equity valuations and/or the possibility of a Fed rate increase and higher long term interest rates.
David, as we bring another episode of “A Brighter Future” to a close, could you offer some insights into what has been happening recently in the Crypto Currency markets.
We have seen the price of Bitcoin go through $56,000 and Ethereum is now above $2,000 for the first time. Bitcoin is up more than +91% so far this year!!!!! The rally has been helped along by new institutional interest in crypto — big names like Mastercard and Morgan Stanley warming to the idea of digital currencies not backed by governments — but the sustained run up also suggests that some of the same retail investors that powered Bitcoin’s last bull run in 2017 are coming back, buying and holding the asset for the long haul.
So, let me ask you a few questions on this topic:
Given market attention on the first and most popular cryptocurrency, bitcoin, how should we view it relative to a traditional currency?
Rick, Bitcoin was initially conceived as a disintermediated means of exchanging value anonymously and instantaneously with transactions verified through a distributed blockchain ledger. There is no government authority with taxing power that supports the value of Bitcoin, so its value lies in how highly individuals prize its characteristics.
Now, what is different from its 2017 run-up is, as you rightly point out, that the level of institutional interest has grown markedly. We noted earlier, Paul Tudor Jones’ endorsement of Bitcoin as an inflation hedge. However, as important is the fact that regulators have begun to offer guidance to financial institutions as to the use of Bitcoin and other crypto-currencies in existing payment systems. To that end, the 1/4/21 guidance from the Office of the Comptroller of the Currency titled, “Authority to Use Independent Node Verification Networks and Stablecoins for Payment
Activities,” should be viewed constructively as an indication that this time round crypto-currencies are gaining actual traction.
Bottom line, Bitcoin and other crypto-currencies are not currencies in the strict sense offered above, but are merely payment system tools that should be only remotely as a possible store of value. In approaching possible investment in the area, we urge only nominal exposure and best if done through a diversified approach. Caveat emptor.
I heard an interview with Michael Novogratz where he said “there are 118 elements in the periodic table, yet gold is the only element to be designated safe-haven status. The same designation can extend to bitcoin in a digitized world, especially given growing risk of debasement of fiat currencies and raised prospects of a higher inflation regime”
Should Bitcoin be viewed as a store of value, akin to a “digital version of gold?”
Rick, Michael Novogratz has been an early proponent of Bitcoin, in particular, and crypto-currencies in general, so pardon the cynicism if one says that he is talking his own book of business.
To the specifics of whether Bitcoin should be considered a “digital version of gold,” it depends on whether Bitcoin is capable of retaining its value in a manner equal to or better than physical gold. To the extent that Bitcoin is becoming accepted as a payment mechanism, it is superior to gold.
However, as Novogratz appears to hang his view of Bitcoin’s value on the growing risk of debasement of fiat currencies and raised prospects of a higher inflation regime, a significant part of the argument for Bitcoin (and gold, for that matter) depends on the extent to which a higher inflation regime becomes the norm. Clearly, monetary and fiscal policy are intent on reflation and allowing the global economy to run hotter than in the past. Apart from this element, the shift away from globalization occurring under the previous Administration promises to constrain supply chains leading to the PPI spike seen last week.
Bottom line, Bitcoin is not yet the digital equivalent of gold, but a secular rise in inflation may assist it on its way to becoming so.
Can you address the scarcity issue? In the same interview, it was discussed that the scarcity of bitcoin (there is a finite amount of around 21 million) will reinforce its value.
Rick, the design of Bitcoin is to allow a maximum of 21 million tokens to be mined, a limit expected to be reached in 2040, versus a level of 18.5 million mined by mid-December 2020, or roughly 88% of the expected total.
As such, the quantity of Bitcoin is relatively fixed. As institutional and regulatory acceptance of Bitcoin as a payment medium grows, this will create greater demand for a relatively fixed supply, with Wall Street expectations that the price of Bitcoin could rise to anywhere in a range of $146,000 to $400,000. Clearly, if these forecasts are accurate, then Bitcoin still has the potential for appreciation from current levels.
Finally, is there any easy way for the average investor to participate? I personally have used a platform called CoinBase, but it forces you to choose one. Is there an ETF, Mutual Fund or a company that can give people some exposure?
Rick, at Laidlaw Wealth Management, we have created a Disruptor Portfolio which offers investors exposure to a range of emerging technologies such 5G, artificial intelligence and blockchain. A range of ETFs are used to implement a diversified approach to each technology. For blockchain, the Amplify Transformational Data Sharing ETF (NYSE: BLOK) is employed in the Disruptor Portfolio.
In approaching a fast market such as Bitcoin, investors are better served to gain indirect exposure so as to moderate the risk of possible loss and thereby improve the likelihood of realizing sustainable gains.