Q4'20: The Emperor Has No Clothes
Welcome to our first quarterly memo. Here you will find a snapshot of market trends and themes we're watching. This quarter we focus on structural macro variables, the effects they had this year, and what they may mean going forward. Please subscribe to receive future post notifications.
Diametric State of Affairs
The combination of U.S. equities posting all-time highs in the face of record unemployment and a severely handicapped economy was a far cry from consensus when Covid-19 forced the country into the isolation of their own homes in March. There are several factors at play, which have produced possibly the greatest license to speculate in recent history.
Monetary Policy - The Emperor Has No Clothes
Quantitative easing (QE) is often glorified as money printing, but the mechanism in which this liquidity is provided is much more nuanced and hasn't had the desired stimulative effect on the real economy. When the Federal Reserve expands its balance sheet to purchase treasuries from banks, they print money by digitally crediting the banks’ accounts at the Federal Reserve. While these accounts are attributed to the banks, the banks do not have access to these funds. They can be thought of as collateral accounts, as the banks can lend against them but not access the cash. The treasury securities have effectively been retired by the Federal Reserve, and all else equal the supply of treasuries decreased.
For illustrative purposes only
By providing a constant bid for treasuries, currently to the tune of $80 billion per month, the Fed is helping to keep interest rates artificially low. Fed purchases also pave the way for the absorption of new treasury issuance, which is bought primarily by banks, and the proceeds are deposited in the Treasury General Account (TGA) at the Fed pictured below.
In 2020 alone, the U.S. money supply (M2) increased nearly 25% by a magnitude of $3.8 trillion[i]. $1.1 trillion of which is seen above, unused, in the TGA (the recent Covid-relief package is set to draw down the TGA by $350B). Another $1.3 trillion can be found in banks' reserve accounts at the Fed. This is the result of the Fed's QE purchases.
The Fed's intention is that by boosting bank reserves through QE it enables banks to lend more. It's important to note that in March the Fed eliminated the reserve requirement of 10%, meaning that banks can now lend 100% of their reserves held with the Fed. However, the banks aren't playing along. Increased lending is a critical piece of the liquidity injection mechanism, but instead, banks are tightening lending standards. Despite the initial increase in loans due to companies drawing down their revolvers in the depths of March, commercial and industrial loans have increased just $300 billion.
Why are the banks not lending? Simple, they believe their risk-adjusted returns on any loans are worse than the 0.10% they can get on their reserves at the Fed. This phenomenon is not new. The same bottleneck took place over the last decade, which is why the inflation so many called for after the Fed began their QE in 2008 never manifested. The Fed's herculean efforts have not made their way into the real economy. Fed Chair, Jerome Powell, knows the Fed alone can't produce inflation, which is why in nearly every appearance this year he has highlighted the importance of fiscal support. The premise that the Fed is engaging in rapid money printing is actually a facade, but Powell promotes the idea in hopes that he can psychologically induce inflation since the expectations of future inflation can themselves produce inflation. The missing link is the cooperation of the banks who are stifling the money multiplier.
However, 2020 brought the combination of monetary and fiscal policy in the form of QE-financed fiscal stimulus, which bypasses banks as a transmission mechanism and injects cash directly into the economy. This is undoubtedly money printing, and inflationary as this money is chasing real goods, but so far the funds distributed through the CARES Act have helped to fill the GDP output void created by Covid-19. Covid-19 was a significant deflationary shock, but thanks to government intervention, has resulted in modest inflation. If fiscal stimulus continues to play a role in the recovery, those freshly minted dollars should manifest in inflation well above the Fed target range of 2%.
Why is the inflation debate so important at this juncture? If inflation were to return, interest rates would rise. Every financial asset is effectively priced off the risk-free rate or the price of money. As the price of money rises, the demand for assets falls and the cost of carrying record debt levels increases, further reducing spending. The Fed is between a rock and a hard place. They want the resurgence of some inflation to encourage spending and ease the burden of public deficits, but at the same time want low nominal interest rates. This cannot exist without significant intervention in the Treasury market, implementing Yield Curve Control (YCC) and thus, cementing the longevity of negative real rates. Inflation will be a key metric to watch in 2021 and further fiscal stimulus a likely trigger.
License to Speculate
So while the Fed's policies have not worked as intended to reintroduce inflation, they have had some (unintended?) effects on asset prices. By driving interest rates to zero, they have forced investors up the risk curve in search of yield. Pensions, endowments, and insurance companies all have return hurdles in the neighborhood of 5-7% per year in order to offset their liabilities. From 1965 through 2008, the U.S. 10-Year averaged a 7.24% return, today it yields just under 1%[ii]. To compensate, pensions and the like, have increased allocations to global equities, private equity, and real estate, which carry higher return (and risk) profiles.
Structurally speaking, "there is no alternative", which sets the stage for 2020. The S&P 500 delivered a 16.26% return amidst the most destructive economic event in recent history[ii]. The Covid-19 pandemic ignited the resurgence of retail trading. Whether it be individuals working from home or the recently unemployed, the disappearance of leisure activities, coupled with the emergence of commission-free trading, brought retail participation to 20% of all U.S. order flow through June, a 10-year high[iii]. Despite many downplaying retail investors' small capital base, it's the marginal buyer that sets the price. Retail is also disproportionately attracted to "get rich, quick" opportunities, their presence is felt most in high growth tech, cannabis, electric vehicles, SPACs, and whatever else is on the menu du jour at r/wallstreetbets among Robinhood investors. Social media platforms have made retail investors more coordinated, further amplifying their effect on single names. Their poster child? Tesla, whose stock closed the year up over 700%[ii]. Shares of TSLA exhibited another dominant theme in 2020: massive call option volume.
Large volumes of call options can have significant effects on the underlying shares of a company. When a call is purchased, the market maker who sold it hedges by buying shares of the underlying in proportion to their delta, which is the probability of a call option closing in the money. Delta is affected by changes in price, implied volatility, and time to expiration. An increase in price, a decrease in implied volatility, and a decrease in time to expiry all mean the probability the option expires in the money increases, which means market makers must buy more stock to keep their exposure neutral. When retail speculators, or the likes of Masa Son's Softbank, pile into call options on single names, market makers buy shares and then buy some more as price increases further increase delta and so begins a euphoric feedback loop. The tail is wagging the dog. Retail traders now account for nearly 60% of the U.S. equity options market[iv].
Another side effect of speculative activity is new issuance, as private investors look to capitalize on frothy public market valuations. In the tech bubble of 2000, the vehicle of choice was IPOs, in 2020 it's SPACs (Special Purpose Acquisition Companies). These are blank check companies whereby capital is raised by a management team seeking to acquire a private company. This year alone SPACs have brought nearly 250 companies public, raising over $80 billion[v].
Many of these companies have little to no revenue, and rather are taking advantage of hot market trends. Take QuantumScape ($QS), a producer of solid-state lithium-ion batteries for electric vehicles. QS shares were up over 11-fold since the acquisition announcement in September, representing a market cap of $40 billion, exceeding that of Ford ($F). The catch? QuantumScape, as stated in their investor presentation, doesn't expect to generate a single dollar in revenue until 2024[vi]. This excessive optimism has driven segments of the market associated with disruptive themes to record-high valuations. SaaS companies growing in excess of 20% a year are trading at a median enterprise value-to-forward sales multiple of 30.5x[vii]. Amazon at the peak of the dot-com bubble traded for just 11x forward sales[ii].
When Fed Chair Jerome Powell was asked a few weeks ago about elevated equity valuations he responded with the following:
If you look at P/Es, they’re historically high. But in a world where the risk-free rate is going to be low for a sustained period, the equity premium, which is really the reward you get for taking equity risk, would be what you’d look at. And that’s not at incredibly low levels, which would mean that they’re not overpriced in that sense. Admittedly, P/Es are high, but that’s maybe not as relevant in a world where we think the 10-year treasury is going to be lower than it’s been historically from a return perspective.
Translation: "the duration bubble we (the Fed) have blown in fixed income justifies an equity bubble". The reason the 10-year treasury trades near 1% is because of Fed actions, and so using relative valuations to rationalize historic equity valuations seems a bit misguided.
Cisco ($CSCO), one of the tech darlings in the dot com boom, actually turning a profit at the time, traded as high as 150x forward earnings in 2000[ii]. Despite growing revenues 8.45% and earnings 12.8% annually for the next decade, shares fell 37% through 2010[ii]. In fact, buyers of CSCO shares in 2000 are still underwater today. Granted, there are several differences between the longevity of Cisco in 2000 and the longevity of some companies undergoing similar speculation today, but the point being: the price you pay matters. Great companies do not always equal great investments.
"Speculation is most dangerous when it looks easiest" - Warren Buffett.
Another major theme in 2020 was the fall in the U.S. dollar relative to a basket of currencies, represented by the DXY's 7.03% decline. The DXY is heavily weighted to the Euro (57.6%), which appreciated 9.05% versus the dollar[ii]. The prominent narrative for the USD weakness is continued monetary and fiscal support, but the Federal Reserve is hardly the only central bank backstopping its economy. The chart below compares the ratio of central bank balance sheets to GDP.
On a rate of change basis, the Federal Reserve reacted the most aggressively in 2020 but still has the lowest balance sheet to GDP ratio. Globally, this is the collective debasement of fiat currencies relative to hard assets, but relative to each other the U.S. dollar still carries strength as the world's reserve currency. Recent USD weakness may simply be attributed to an expanded trade deficit. COVID-19 has severely impacted demand for some of the United States' largest exports, including industrial machines, commercial aircrafts, petroleum products, and travel. The result is a substantial decline in the balance of payments, which the U.S. dollar has tracked accordingly.
A global reopening would reverse this trend, and potentially mean a strengthening of the dollar, which in turn has immediate effects on the pricing of financial assets and liquidity conditions. Can the 7% decline in the dollar have contributed to a 7% appreciation of USD assets? This would mean 43% of the S&P 500 2020 return came from simple changes in exchange rates, while that's overly simplistic a weaker dollar can contribute to increased demand for dollar-denominated assets from foreign investors and they are not buying U.S. Treasuries.
Meanwhile, hard assets continue to reap the benefits of global currency debasement, which looks poised to continue in 2021 and beyond. Bitcoin, which we believe to be the hardest money on earth, appreciated over 300% in USD terms on the year, while Gold gained a formidable 25%[ii].
We believe these macro themes will play an important role in shaping markets in 2021.
- Fiscal Policy - Is fiscal stimulus here to stay? What does this mean for inflation?
- Speculation - How long can this level of speculation persist? What might be the catalyst for reduced speculation?
- U.S. Dollar - Could the dollar actually strengthen in 2021?
The above targets are estimates based on certain assumptions and analyses made by the advisor. There is no guarantee that the estimates will be achieved.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status, or investment horizon. You should consult your attorney or tax advisor.
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[i] Federal Reserve Economic Data (FRED). St. Louis Fed
[ii] Koyfin Financial Data.
[iii] Linford, Jeehae. Recent Trends in Retail Investing: What does it mean for issuers?. IR Magazine. 2020
[iv] Henderson and Wigglesworth. How a retail options craze fueled SoftBank's whale trade. Financial Times. 2020
[v] SPAC IPO Transaction Statistics. SPAC Insider. 2020
[vi] QuantumScape Investor Presentation. QuantumScape Investor Relations. October 2020.
[vii] Public Comps Data. Publiccomps.com.