Benjamin Lavine, Co-CIO
3D/L Capital Management
As we approach the end of January 2021, the market advance that took off in early November shows few signs of abating. The manifestation of investor risk appetite can be witnessed at the market fringes, such as accelerating call option volume (that forces option dealers to hedge their book by purchasing the underlying securities, driving prices ever higher) and fundraising in special purpose acquisition company (SPAC) funds that help bring public market financing to speculative technology companies, bypassing the initial public offering process (and often very dilutive to end investors).
Figure 1 – Single Stock Call Option Takes Off, Creating a Virtuous Cycle of Rising Prices as Option Dealers Hedge Underlying Book
Figure 2 – Out of the 2021 Gates: A Surge in SPAC Capital Raises
Many strategists would argue that the sharp market advances and giddy risk appetite are not necessarily indicative of a ‘bubble’ but, more simply, a rational response to prospects of post-COVID vaccination normalization and the onset of a new economic order dominated by tomorrow’s advances in “disruptive innovation” and green policy initiatives. However, both sides of the bubble debate would not likely ‘debate’ the extraordinary accommodative stances (e.g., zero/negative interest rates, balance sheet expansions), adopted by global central banks notably the U.S. Federal Reserve, that have that have greased the skids for our current market backdrop of multi-decade highs in equity valuations, sharp increases across industrial and agricultural commodities, and absolute lows in interest rates (both sovereign and corporate credit).
And underlying these accommodative monetary stances: global core inflationary pressures are expected to remain anemic for the foreseeable future. This outlook relieves the pressure for central banks to preempt (or get ahead of) inflationary pressures by removing their accommodative stances (i.e. tapering). The Federal Reserve continues to signal that rates will likely remain near the zero percent bound at least through 2023 (Figure 3) as Chairperson Jerome Powell is expected to quell any discussions of a ‘taper’ – a reference to the taper tantrum of 2013 that saw the last major volatility spike in interest rates.
Figure 3 – Federal Reserve Dot Plot Forecasts Point Toward Zero Interest Rates Through 2023
Which brings us to one of the key debates that will drive risk asset pricing this year: namely whether inflationary pressures emanating from increased ‘bottlenecks’ across manufacturing and transportation along with negative real (inflation-adjusted) interest rates near multi-decade lows (Figure 4) will prove to be ‘transitory’ as Fed officials and mainstream economists largely expect.
Figure 4 – 5- and 10-Year Negative Real (Inflation-Adjusted) Interest Rates Are at Multi-Decade Lows
Whether inflationary bottlenecks that emerge in 2021 will prove strong enough to force the Fed to pivot its accommodative stance is a debate being fought in the bond markets as a steepening yield curve (2 vs 10-year Treasury yield spread) and rising inflation expectations (break-even rates between TIPs vs nominal Treasuries) (Figure 5) can be interpreted in multiple ways so fit one’s narrative outlook.
Figure 5 – A Steepening Yield Curve and Rising TIPS Breakeven Rates Point Toward Reflation (High Inflation Is Another Matter)
On the one hand, such a steepening is expected as the year-over-year base effects alone could result in an overall consumer price index (CPI) print of 4% heading into the spring but not necessarily indicative of more permanent inflationary pressures as global economies would eventually respond to supply chain bottlenecks whose underlying capacity shortages were a result of the pandemic shutdowns. Plus, some of this rise in inflation expectations priced into TIPS could be the result of technical buying from the Fed, which now owns 20%+ of the TIPS Market (Figure 6).
Figure 6 – Fed TIPS Purchases Artificially Driving Inflation Expectations Higher?
Source: Bloomberg Intelligence – 1/25/2021
Those who are worried about incipient inflationary pressures turning more real and significant would suggest that the destruction (or, at best, reduction) in capital expenditures across the supply chain resulting from the pandemic will lead to a longer recovery time as cap-ex (especially in mining and drilling) tends to move very slowly (largely based on ‘5- and 10-year’ outlooks when such plans are presented to corporate boards, who tend to have long memories). Combined with an expected sharp recovery in pandemic-induced pent-up demand and calls for higher minimum wages, the markets are not necessarily set up to absorb inflation shocks (see this BNN interview with Rich Farr from Merion Capital as a good synopsis of this risk).
The burden of proof remains on the Inflation Cassandras versus the Pollyannas as prior inflationary scares over the past three decades have proven to be just that – temporary scares with no meaningful sustainable trends. If commodity prices were to spike (similar to 2007 and 2014), it is debatable whether ‘core’ inflation would move higher to prompt the Fed to reverse course on its accommodative stance, even if absolute low levels of interest rates are contributing to the speculative activity driven by investor animal spirits. Even Rich Farr suggests stocks remain a viable investment as ‘There Is No Alternative (TINA)’ – a banner that has helped push equity valuations (on some measures) to new highs.
Regardless, the bottleneck pressures continue to build up, whether in commodity prices (Figure 7), tighter inventories (Figure 8), and shipping costs (Figure 9). If these supply chain bottlenecks are met with rising employment costs (clues may come from the next several U.S. Employment releases), then inflation risks may prove to be more than ‘transitory’ and start to pose a real risk to the market narrative.
Figure 7 – Rising Industrial Metal and Oil Prices
Figure 8 – Tighter Inventories (Wholesale and Copper)
Figure 9 – Rising Shipping Costs
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By: Benjamin Lavine