FOMO – fear of missing out – has been around for as long as members of the human species have traded with each other. In the seventeenth century there was a mania among the good citizens of Holland for tulip bulbs. At one point during this frenzy the price of a single bulb – admittedly pretty but still nothing more than a flower – was worth more than the price of a home along one of Amsterdam’s canals. One century later, the center of global finance had moved from the Netherlands to Great Britain. A good many British investors fell prey to the South Sea Bubble, a faraway enterprise that sounded too good to be true because…well, it was too good to be true, as in it didn’t even exist.

And so it has gone through the ages and into the present day. There is something consistent about all these speculative bubbles. They start organically, gain traction by word of mouth and at some point reach the kind of momentum that gets everyone talking. Eventually they will gain enhanced legitimacy when self-styled experts weigh in to say, no, this is not a bubble for reasons X, Y and Z. At the height of the stock market mania in 1929 Irving Fisher, one of the most renowned economists of the day, opined that share prices had reached a “permanent plateau” from which they could only go higher. Which they did, until October 1929, and then they didn’t.

Think of all the institutional giants and their endorsement of the “New Economy” and its crazy valuations in March 2000, just before the Nasdaq took an 80 percent nosedive. Or all the seemingly sophisticated investors who bought into the Bernie Madoff scam of a “guaranteed” 15 percent and no risk.

All of which brings us to bitcoin. OK, let’s just get it out of the way. Here’s the chart that explains why every asset manager on Earth is now required to have a stated position on bitcoin.

Pretty impressive, no? And hey, if Elon Musk loves bitcoin (and he most assuredly does), then it must be a wise investment, right? (Refer above to the bit about self-styled experts weighing in to explain why something that looks like a bubble really isn’t a bubble). Motley Fool – probably the only company that grew up in the 1990s Internet era and has not even once changed its logo – also made a big to-do this week about adding bitcoin to its holdings. Social media being what it is, now everyone is supposed to either pronounce themselves on the bandwagon or defend to angry Twitter mobs why they are not.

We’re not here to judge. As asset managers, we are just here to evaluate whether there is some actual merit to the basic idea of bitcoin. What exactly is this thing – what actual function does it serve? Bitcoin is a digital currency (the popular phrase is “cryptocurrency” but that doesn’t actually mean anything other than a digital currency based on the decentralized technology of blockchain). So our evaluation focuses on how well bitcoin does what a currency is supposed to do, which is basically one or more of three things: a unit of measure, a means of exchange, and/or a store of value. Either bitcoin is a solution to an existing problem in one of these areas, or it is simply a solution looking for a problem.

Unit of Measure

How well does bitcoin function as a unit of measure? To answer that question, simply look at the chart above, to something that within the space of just two years alone has traded between $5,000 and more than $50,000. How is anyone supposed to measure anything using Bitcoin as a yardstick?

Or think about it like this: when you look at that chart, what is the actual unit of measure being employed? That would be US dollars, which does actually serve as a unit of measure. If a couple is out at a furniture store pricing a new sofa, they don’t think about how many bitcoins the sofa costs. They think of the cost in terms of dollars (if the couple happens to own a few bitcoins they may think, hey, we can cash in a bitcoin to buy the sofa…and then buy a Tesla with the remaining dollars!).

Until and unless people start thinking about their everyday purchases in bitcoin rather than in dollars, euros or yen, then bitcoin is not serving the function of a unit of measure.

Means of Exchange

Bitcoin cheerleader Elon Musk says that he plans to start letting people pay for Teslas in bitcoin. So is it coming into vogue as a means of exchange? Kudos to Mr. Musk for his bravado, but look again at that chart. Now put yourself in the position of being the owner of a store selling things priced in bitcoin. How are you going to manage your profit margins?

What about the idea of bitcoin as a “digital wallet?” There’s a lot of hype out there, as if suddenly digital payment systems have moved into a new age because of bitcoin. But wait. Digital wallets have been around for years. Apple Pay, PayPal, heck, even Visa and Mastercard, which have been around since plastic started to replace cash in the 1960s, have rolled out increasingly sophisticated digital wallets. There is nothing inherent in the technology behind bitcoin that makes it a superior means of exchange to any of these other financial technologies. In fact, processing capabilities for bitcoin tend to be somewhat clunkier than the hyperspeed capabilities of existing digital payment systems.

And there is a basic problem with those bitcoin wallets based on the underlying blockchain technology: if you lose the passkey that unlocks your bitcoins, you lose your bitcoins. Imagine that if you forget your Apple password not only could you not use Apple Pay, but you couldn’t even gain access to the bank account linked to your Apple profile! Now imagine that there is not even any tech support help to get you back to your money. How effective would that be as a means of exchange?

Store of Value

So that brings us to the final use of a currency: store of value. This is a trait shared by currencies (which are simply financial commodities) and physical commodities alike. An asset has a store of value if it has a defined use. That use is easy to define for industrial metals, like copper and nickel, or for sources of energy like crude oil and natural gas. Ditto for agricultural products like soybeans and wheat. Then there are precious metals, for which the actual practical uses are less clearly defined but which over the centuries have been seen as stores of value due to their relative scarcity. Modern-era national currencies, which for the most part are so-called “fiat currencies,” have a store of value simply because they are deemed to be, and widely accepted as, legal tender for exchange in their countries (or regions) of origin.

One of the arguments made about bitcoin is that it is a store of value because there is a limit – a ceiling – to how many can ever be produced (this is where you might hear the term “digital gold” applied to bitcoin). That was one of the original design intentions when the currency first came out in 2009. But hold on. Just because there is a limit to how many bitcoins can ever be in circulation does not mean that they are rare. Even today there are at least ten or fifteen other “cryptocurrencies” that use the same underlying technology, all of which would be fungible in any world that would use cryptos as a means of exchange. If there are variations between bitcoin and other cryptos like dogecoin or ethereum, they are more like differences between South African-mined gold and Russian-mined gold, or Kansas wheat versus Illinois wheat. Slight variations, maybe, but otherwise fungible. That’s what makes them commodities.

Bitcoin and Armageddon

Will bitcoin ever have a better claim than it does today on being a viable and necessary currency? It is conceivable. If the socio-economic stability of the US, the European Union, Great Britain, Japan and China were all to disintegrate to the extent that all of their respective national currencies ceased to be worth the paper they were printed on, and nation states generally collapsed into a worldwide Time of Troubles, then arguably something like bitcoin could be the only viable means for human trade and commerce.

Or, alternatively, such an apocalyptic scenario could also involve the crashing of the world’s electrical grids and with it all the digital technology. As it is, the mining of bitcoins is incredibly energy-intensive. Cryptocurrencies are no friend of the environment (which makes Elon Musk’s fascination with bitcoin somewhat ironic). So would it be bitcoins or barter? Such are the shortcomings of wild speculation.

Bitcoin and the Super Bowl Coin Toss

Our assessment of bitcoin, and so-called cryptocurrencies in general, is that they fall squarely in the realm of pure speculation rather than being a viable strategic asset for purposes of long-term portfolio performance. Pure speculation means the world of bets on sporting events or rolling the dice on the craps table in Las Vegas. A bet on bitcoin going from, say, $50,000 to $100,000 or more is just that – it’s a bet. It is something that has a probability greater than zero and less than one hundred. Just like rolling sevens or having the coin come up heads or Tampa Bay upsetting the Kansas City Chiefs. Speculation is fine, for those who enjoy a bit of a thrill. But it’s not asset management, at least not the way we define it.

Let’s start this week’s commentary with a simple statement: the stock market is a sideshow. If you want to try and understand what market trends are reflecting about the larger economic and geopolitical story, then you want to be paying attention to what is happening with commodities prices and bond yields. The S&P 500 and even more so the tech-heavy Nasdaq are in their own little sandbox where pockets of insanity pop in and out of existence against a canvas backdrop of passive fund flows and mindless algorithmic price triggers. Bond yields, on the other hand, tell us a great deal about real economic matters like inflationary expectations. So do commodity prices, and that will be our focus this week.

The Economy’s Raw Inputs

Commodities come in a variety of flavors, but many of them share a common function: they are the raw materials that make up the initial stages of economic production processes, including manufactured goods, food products and the like. Here is a chart showing recent price trends in four such raw inputs: copper, crude oil, corn and nickel.

Not shown in the chart above are precious metals commodities like gold and silver, because they are traditionally less correlated with economic growth cycles and (particularly in the case of gold and platinum) seen more as a defensive hedge for portfolio protection against risk assets (their effectiveness in that role has been rather spotty in the past, which is why we typically do not see them as necessary strategic asset classes for our allocation models).

As the chart shows, these commodities – representative of energy, industrial metals and agriculture – have been steadily rising since last fall. Think of this trend in commodities as another side to the activity in bond markets that has been a topic of several of our recent commentaries; namely expectations for an increase in economic activity, and a commensurate rise in consumer prices, in the second half of this year.

To recap the essential features of this story: global demand will rise significantly as more populations achieve something close to herd immunity from the coronavirus. A flood of new money coming into the economy from pandemic relief programs will put a strong tailwind behind the organic demand. Meanwhile supply chains will still be adjusting from last year’s disruptions and trying to catch up to demand. All these aspects of the story point in the same direction of increased prices. So if you are a commodity investor, it makes sense to be taking a position sooner rather than later.

Supercycle In Search of Catalyst

The steady run-up in commodity prices has some observers talking about a new supercycle. Such talk may be rather premature. To understand why, let’s think about the last commodities supercycle, which ran for the better part the first decade of this century. The chart below shows the price trend for copper, perhaps the most representative industrial commodity, over that time period and through to the present day.

Industrial commodities had a long run over multiple economic cycles. The collapse in prices following the market crash of 2008 was brief, and it took only a year or so for prices to recover and then surpass their previous highs. That’s what is meant by the phrase “supercycle” to distinguish it from shorter cyclical fluctuations.

But the 2001-10 supercycle had a single overriding catalyst: the rise of China from economic also-ran to the second largest economy in the world. During this period China became the world’s largest consumer of just about any industrial commodity you could think of, as its growth was powered by massive investment in manufacturing and physical infrastructure build-out. Absent China, the supercycle would not have happened.

That’s why we think talk of a supercycle today is premature. China’s growth trend has matured, and the growth taking place now is more balanced towards services and consumer activity, with less of the raw physical power of its earlier supercharged phase. So what would be a similar catalyst for another sustained period of growth? This question brings us right back to the theme of many of our recent commentaries; namely, inflation.

If you go back even further in time, the last commodities supercycle we saw before the China cycle of the 2000s was in the 1970s. That cycle was indeed due to the prolonged inflationary trend of that period. As we have said many times in recent weeks, we believe that a more likely path for inflation will be a brief spike in the later months of 2021 (possibly extending into the early part of next year) followed by a stabilization and reversion to recent (pre-pandemic) historical trends. That would imply that the current run-up in commodities would be more likely to run its course well before a supercycle trend would imply.

Of course there is a chance for things to turn out differently – and that is why, as we said at the beginning of this piece, we are paying more serious attention to current activity in the bond and commodities markets than we are to the daily carnival of silliness that is the present state of the stock market.

Observers of the financial markets with long memories will no doubt remember the words of former Federal Reserve Chairman Alan Greenspan, who in a 1996 speech asked, “But how do we know when irrational exuberance has unduly escalated asset values?”

It has now been nearly 25 years since the term “irrational exuberance” permanently entered our financial vocabulary. But recent developments – such as the wild trading in GameStop Corp., the buying binge in silver, or the proliferation of “blank check” special purpose acquisition companies (SPACs) – bring the phrase to mind with new relevance.

However, if we look past these recent aberrations, we may find evidence to justify at least some sense of “rational” exuberance for financial market prospects in 2021. Certainly there are several reasons for optimism:

• Vaccinations against Covid-19 are now available, and while the roll-out has certainly been less than perfect, this bodes well for the U.S. economy to resume a more normal trajectory later this year.
• In the meantime, there seems to be recognition among political leaders of both parties that more relief and stimulus are needed in the near-term, even if the magnitude of the aid package is still up for debate.
• The Fed remains committed to using all the monetary tools at its disposal, including “lower for longer” interest rates, to help keep the economy on the road to recovery.
• There is also a real possibility that the U.S. government will finally commit to policies in support of meaningful infrastructure investment, as the Biden administration unveils its broader economic plans.

All that said, many things have to go right in order to maintain the current buoyant state of the financial markets, including (but not limited to) the items we noted above, as well as a lack of unpleasant surprises on the global political and economic front.

One of the “unpleasant surprises” could be a change in U.S. tax policy. The nation is facing enormous budget deficits, due in part to the costs associated with Covid-19 stimulus programs.  The cumulative deficit for fiscal 2020 exceeded $3.1 trillion and in December 2020 alone, the federal deficit was $144 billion – more than 10 times the level a year earlier. Some form of tax increase will undoubtedly be required to ease this fiscal burden, although it remains to be seen whether that will come in the form of a reversal of prior tax cuts, changes to the estate tax, or other measures. We continue to monitor this situation closely and will advise our clients to the extent that any changes in their own financial strategies are appropriate.

Overall, given that the U.S. economy was basically in a “slow and low” growth mode during the 2020 fourth quarter, it will not take much to keep this gentle momentum going. We have been rebalancing our clients’ portfolios in a measured way, modestly increasing the allocation to equities as fixed income investments remain largely unattractive in view of prevailing interest rates.

In summary, we at MV Financial are proceeding in a manner consistent with our well-established, long-term oriented philosophy, by continuing to manage our clients’ portfolios in a way that is intended to promote diversification and avoid over-exposure to risk. As you might imagine, we believe that speculating in highly volatile, “crowd mania-driven” assets in an effort to capture quick trading gains, is the very definition of “irrational exuberance” – and is the last thing any prudent investor should be doing.

As always, please feel free to reach out to us at any time to discuss your investment and financial questions. We wish you and your family abundant health, joy and success in 2021.

The news this week has been mostly on the positive side when it comes to the virus. New cases in the US are down from the lofty 300,000+ levels of last month to the low 100,000s (though in a broader context that is still on par with the levels seen during the mid-late summer surge last year). The fatality rate is still much too high for anybody’s liking, but that should start to trend down in the wake of lower daily cases.

On the vaccine front, Johnson & Johnson has applied for FDA approval for its jab – although the efficacy appears lower than that of the other two US-approved vaccines it still comfortably clears the FDA’s standard minimum efficacy threshold of 50 percent. And the AstraZeneca vaccine (approved for use in the UK and parts of the EU, though not yet in the US) appears to have additional capabilities in helping to reduce incidence of transmission. Even Sputnik-V, the much-derided Russian vaccine, is getting a second look from EU regulators. Hey, if it works it works, regardless of origin, right?

Fiscal Relief Odds Increase; So Do Interest Rates

The bond market has been putting its chips on the likelihood of the Biden administration getting its relief bill through Congress. That bet got a boost last night when the Senate worked its way through a tedious list of more than 800 proposed amendments to agree (by simple majority) on the $1.9 trillion package, setting up the somewhat arcane budget reconciliation process through which a bill can pass through Congress without triggering the Senate filibuster (which would require 60 votes and thus Republican support that appears not to be forthcoming). The already steep yield curve could add some further degrees of difficulty to that slope.

Follow That Dotted Line

Why is the bond market so confident that rates have further to rise? After all, the Fed has no intention of raising short-term rates any time ahead as far as the eye can see. The Fed funds rates and short-term Treasuries, respectively the solid crimson and green lines in the above chart, are likely to stay tethered to zero for many months, if not years, to come. Core inflation (the dotted red line) has been well below the Fed’s two percent target rate since the pandemic began. As we have mentioned several times in recent commentaries, inflation has not been a significant economic factor for many decades.

But that $1.9 trillion relief package is going to bring a lot of new money into the economy at a time when the economic news is neither uniformly bad nor demonstrably getting worse. Three different jobs reports this week – the ADP survey midweek, the weekly initial claims number yesterday, and the monthly BLS employment report today – all point to conditions that are at least stabilizing in the labor market if not yet turning into growth. By the time the money from the relief package actually gets put to work on behalf of households and small businesses, millions more Americans will have received a vaccine, increasing the likelihood that we will not see another surge in new cases similar to what happened last fall.

Demand Hot, Supply Not

The most likely outcome of this convergence of improving health and improving finances is a temporary – this is the key word and we will come back to it – imbalance between the demand for goods and services and the supply of the same. Global supply chains are still working out the disruptions experienced last year. Many small and mid-sized businesses, particularly service providers like restaurants, beauty salons and mom & pop retailers, have gone out of business (and there will be a lag before new enterprises come along to replace this lost supply). More money will be chasing fewer goods – and that is the textbook definition of inflation. Higher inflation in turn will continue to put upward pressure on interest rates in maturities beyond the direct reach of the Fed’s short-term zero lower bound target.

Back to that key word – temporary. If this supply-demand imbalance is a one-off phenomenon that flashes like a supernova between, say, April and December of this year then it should not be a longer-term concern. That is the scenario Fed chair Jay Powell articulated in the post-FOMC press conference a couple weeks ago. Inflation may jump up well above the two percent threshold for that time – and longer-term nominal Treasury yields would probably follow suit – but then subside back closer to recent historic trends hovering below or at that threshold, with a resumption of slow growth and restored equilibrium between supply and demand. No harm done.

Still, that $1.9 trillion of new money coming into the economy is hardly chump change. Prior to the coronavirus pandemic, the largest relief package in US fiscal history was the $787 billion American Recovery and Reinvestment Act of 2009, the Obama administration’s program to stimulate the economy after the financial crash and recession of 2008. By comparison the smallest – smallest! – of the pandemic relief packages – the one signed into law last December – ran to $900 billion.

Unquestionably this tsunami of relief has helped us get through this terrible period much better than we would have otherwise. But we still do not know how much of an impact all this new money will have on an ongoing basis, once the virus and the economy it created have disappeared beyond the horizon of the rear-view mirror. We will have the answer in due course.

The Battle of Hadrianople took place in 378 CE, two years after a multitude of Germanic Gothic tribes had gained permission to cross the Danube River into the Roman Empire. The Gothic hordes killed the eastern emperor Valens and embarked on further hostilities against the Romans that led to the sack of Rome itself, in 410 CE. The western Roman Empire itself, though, hung on for more than a half century longer after being sacked before finally expiring for good in 476. For most of this last century, from the Goths crossing the Danube to the valedictory of Romulus Augustulus, the last emperor, the elite segments of Roman society sought various ways to make peace with, accommodate and – most of all – derive personal power and profit from the invading Goths.

Not unlike, perhaps, the mindset of presidential hopefuls with their eyes on 2024 as they bend the knee to the mobs who stormed the Capitol earlier this month. And not unlike the professional hedge fund managers who – terrified of the power of online Reddit mobs laid bare in the real world of markets this week – are tossing aside their spreadsheets and quantitative models and, in oleaginous fashion, scraping data from the chat groups of short seller-hating trader bros. Who’s got the next hot tip?!

Game Stop’s Got the Beat

The storefront façade of Game Stop would not have looked out of place in a mall scene from “Fast Times at Ridgemont High,” attracting surfer dudes and gum-chewing mall rats with its physical copies of video games meant to be played on clunky, boxy consoles. In short, it’s not all that great a company, an opinion shared by many professional fund managers that engage in short selling. You sell a company short when you think it has a crummy business model and should be trading for less than its current price. Good old-fashioned healthy capitalism, right? What you don’t want to see as a short seller is this:

Short selling is a fairly risky part of the market: you take a bet on something you don’t actually own (hence the meaning of “short”), put up the money needed to cover the obligation to the other side of the trade, and hope that the price will go down (where you pocket the difference between where the price was when you made the initial trade and where it is when you close out the position). If the price doesn’t go down but rather soars like a bottle rocket – see chart above – you’re on the hook to cover the difference.

Melvin and the Greuthungi

Game Stop’s shares never traded above $10 until late last fall. This week they traded almost as high as $500 at one point. That’s a whole lot of difference to cover, as the managers at a hedge fund called Melvin Capital know all too well. Melvin got caught by the mob – literally. The denizens of a coarsely colorful chat group called r/WallSteetBets had been targeting the professional short seller for several months because, well, they subscribe to the Barstool Sports dogma that stock prices should always go up and anyone (like short sellers) who does things to make stock prices go down is a Bad Person.

So the Reddit mob went after Melvin Capital just like the Greuthungi – one of the Gothic tribes that was initially denied asylum by the emperor Valens when their Trevengi brethren crossed the Danube – went after the hapless emperor and lopped off his head. The portfolio manager at Melvin was a bit luckier than poor Valens – not only did he manage to avoid decapitation but two other hedge funds stepped in with a $2.75 billion bailout to let Melvin close out the short without going bankrupt.

The Social Network

Perhaps the crazy gyrations in the share price of Game Stop and a handful of other subpar companies caused by online mobs should not come as much of a surprise – we live, after all, in a world framed by social media. The same dynamic that has reduced our national political conversation to context-free bursts of 280 characters works just as well in finance. Amplification – the ability of like-minded communities to find each other and create a powerful hive with the potential to make an impact on the real world – this is what social media platforms make possible. Social media communities render the expertise of hedge funds irrelevant. Financial technology makes the cost of going after the Melvin Capitals of the world next to nothing. All the professionals can do – the quant jocks with their spreadsheets and elaborate models and value-at-risk calculations – is toss it all out and troll the Reddit sites for nuggets about what might come next (heaven forbid it might be their turn!).

All of which can endure for a very long time – after all, it was a full hundred years from when the Goths crossed the Danube to when Rome fell for good.

Joseph R. Biden, Jr. was sworn in as the nation’s 46^th president this Wednesday, and Kamala D. Harris became the country’s first female, African-American and Asian-American vice president. The speeches, songs, poems and pageantry of the day reflected much of what is best about our republic. Alas, the time for celebrating was brief as the new administration got down to the business of confronting the many crises that make this one of the most challenging times in the country’s history. These challenges, and how the administration responds to them, will have an impact on how markets fare this year – and likely in unpredictable ways.

400,000 and Counting

Another grim round number was reached earlier this week as the US death toll for Covid-19 passed the 400,000 mark. That is twice the number of deaths in Brazil, the country with the second-highest total. It is almost three times higher than India, a country with 1.4 billion people to the 331 million who live in the US. A number of executive orders signed by the new administration this week are aimed at speeding up the delivery of vaccines (100 million within the first 100 days is the goal) and putting in place a variety of limited relief measures to mitigate the economic pain. But the centerpiece item for addressing the health crisis is the $1.9 trillion relief package announced last week.

That plan is likely to face a rough time of it in Congress, where a number of Republicans have clearly signaled their intention to fight the new measure. How the Biden administration and Democrats in Congress intend to engage the discussion is at this point unclear. The goal of obtaining bipartisan support – which would be in keeping with the calls for unity that characterized much of the rhetoric at the inauguration – will face the hurdle of a filibuster-minded Senate and the time pressure created by the urgency of new cases, hospitalizations and fatalities.

Any signal that the legislation – or some form of it that comes out of negotiations – is likely to pass would potentially give more support to the rotational play into the cyclical themes that was characteristic of the first couple weeks of the year. That rotation hasn’t been as much in evidence this week, perhaps for no particular reason at all or perhaps as a sign that investors are hedging their bets while the relief bill’s fate remains unclear.

A Winter of Discontent

Next week we will get a first look at GDP for the last quarter of 2020 as the Bureau of Economic Analysis releases its preliminary report. The current consensus among economists is for GDP to rise by 4.3 percent from the third quarter to the fourth quarter. But this has been an exceptionally noisy period for macroeconomic forecasting, and the actual number that comes out next Thursday could be much higher or much lower than the estimate.

We already know that conditions early in the first quarter of 2021 are challenging, with heightened job losses, poor retail sales figures and continued stress on small businesses, particularly in the services sector. Now, markets have mostly been looking past the travails of winter and banking on the green shoots of spring. The S&P 500 has enjoyed a healthy start to the year, and there is no sign yet of any diminished appetite for the speculative crazes (Tesla, bitcoin, penny stocks) that have finally brought about the irrational exuberance that was missing throughout the entirely of the 2009-20 bull market.

The tailwinds should hold up as long as the upside narrative of vaccine deliveries and adequate relief for households and businesses to bridge the time between then and now remains in place. Much attention will now be focused on Washington to validate – or not – this narrative. It was good to see the principal figures of the new administration get right to work following the inauguration. They’re going to need to keep at it every day.

Last week was a very tumultuous one in the world of US politics, but it was fairly benign for US stocks. Or so it seemed. We got a number of calls from folks wondering why markets were not reacting more to the drama in Washington. Here’s the short answer: the market was in fact pricing a political story – just not the one that was unfolding at the Capitol on Wednesday afternoon. Always remember that the market is a cold-blooded and amoral beast. If it can’t put a price tag on something it largely ignores it, however much that thing may be jarring for humans with our emotional human sensibilities.

The Blue Wave’s Delayed Arrival

The political news that the market was paying attention to last week was the victory by the two Democratic candidates in the Georgia senate run-off, John Ossoff and Raphael Warnock. The impact of that news can be seen in one metric in particular: a resumed steepening in the 10-year Treasury yield curve. The chart below shows a two year comparison of the 10-year yield, the 2-year yield and the Fed funds rate.

The Georgia victory ensured that the Democrats will control the House, Senate and White House following the inauguration of President-elect Biden on January 20. For markets, this meant dusting off the “reflation trade” that had been put on hold after Election Day when predictions of a massive “blue wave” failed to materialize. The wave that finally arrived may be more of a gentle swell than a full-blown Waimea Bay giant, given that the Democrats’ margin in the House is smaller than it was before the election and the Senate hangs in the balance of a 50-50 split with Kamala Harris holding the tiebreaking vote in her role as presiding officer of the Senate. Nonetheless, it is enough to firm up the narrative of a torrent of new spending, pushing inflation – and therefore intermediate and long-term bond yields – higher. Indeed just yesterday the president-elect unveiled the first of two major policy initiatives, calling for $1.9 trillion in new spending on pandemic-related economic support and vaccine acceleration measures. A second announcement will follow next month and is expected to focus on infrastructure and healthcare.

But Will It Come to Pass?

The reflation trade is worth paying attention to for several reasons – it could extend the rotation out of growth stocks into value, small cap and other relative underperformers in recent years. And, of course, the curve steepening puts downward pressure on intermediate and long-term bond prices. But mostly it is worth paying attention to because a structural upward movement in inflationary expectations has the potential to cause some lasting damage to asset valuations. That said, it is far from certain that reflation is going to play out the way some of these pre-emptive moves in yields suggest.

Consider that $1.9 trillion relief package announced yesterday, for one. You can think of that as an opening gambit more than as a piece of legislation to hang your hat on. There will be plenty of opposition from Republicans in the Senate, where it still would need a filibuster-proof majority to pass via the conventional legislating process. The proposal contains relief aid for states and municipalities which was one of the two issues keeping relief from getting passed last year (the other was liability protection for businesses; both of these issues were ultimately dropped from the $900 billion relief package passed at the end of the year).

The reflation trade could die an early death at the hands of political gridlock. But even if the new administration adroitly works its will on Congress and gets some meaningful legislation passed, that does not by itself argue for a structural shift in inflationary expectations.

The key word there is “expectations.” Inflation becomes a problem when it factors into longer-term assumptions about prices by businesses and households. The last time this happened was in the 1970s, and there were plenty of good reasons for that – the US was running ever-larger budget deficits after the Vietnam war and social spending programs of the 1960s, OPEC sharply cut crude oil supplies and sent prices soaring, and the US dollar devalued sharply after the collapse of the Bretton Woods exchange rate mechanism in 1971.

We have a different situation today. A short-term inflationary jump can be expected later this year when the vaccine has scaled out to a majority of the population and demand soars for all the things that have been off limits for more than a year. But that jump would likely be temporary. Prior to the pandemic the economy was growing at a modest rate and consumer price inflation never sustained a rate above two percent. Even today the Fed’s Open Market Committee members don’t see inflation hitting a sustainable rate above two percent until late 2022 or even later.

As long as inflationary expectations are confined to a one-off post-pandemic event then the reflation trade, while it might persist for some time, is unlikely to imply much structural damage. But because the cost of a more extreme scenario is so high, it is wise to not lose sight of the fact that it could still happen.

Happy New Year! As is our custom, we open the year by presenting our investment thesis for the twelve months ahead. This thesis will be central to the Annual Outlook we will be publishing within the coming two weeks. The year ahead promises to be full of twists and turns – though we hope that every week will not be quite as full of stomach-churning drama as was this first full week of the year. Let’s get to work.

2021: Priced For Perfection

In 2020 assets of just about every shape and stripe had a banner year. Equities, fixed income, commodities of both the risk-hedging and risk-taking variety – all had their day in the sun while the world struggled with a rampant health pandemic. Now in 2021 the end is at least in sight for the Covid-19 pandemic to exit off the stage with the arrival and mass scaling of multiple vaccines. The conventional wisdom – and scarcely has there been in recent years a more unified consensus across the spectrum of economists, analysts, traders, bankers media pundits and assorted hangers-on than there is this year – is that just as everything investable flourished in the bad times, they will flourish ever more in the coming good times.

The case for continued growth in asset markets is strong. But markets are priced for perfection: for vaccines arriving on time, for virus mutations not running out of control, for enough of a fiscal and monetary bridge to get households and businesses over the pandemic’s final chaotic months, and for a pre-2020 mentality of giddy consumerism to return and propel corporate sales and earnings back to health. Thus our thesis, while on balance positive, is not without caveats, risks and what-ifs. Here it is.

Low short-term interest rates and supportive monetary policy should continue to be a tailwind for risk assets as the global economy finally transitions from the pandemic to a resumption of consumer spending on the things we all missed for the last twelve-months plus (assuming mass scaling of vaccinations is achieved at least by sometime in late summer). The low rates plus upbeat prospects for corporate earnings should keep valuation concerns more or less in check, though there may be more upside room for less stretched corners of the market like value, small cap and non-US than for the growth darlings of the past five years. But intermediate and long-term interest rates have the potential to steepen (and are less influenced by central bank actions in the absence of an explicit change in standing policy). One potential near-term risk to market upside could be an unexpected surge in inflation. The entrenched groupthink of the bullish consensus itself could also be a risk if it leads to unwarranted overconfidence. Watch out for imprudent enthusiasm by those who fail to distinguish innovation from hype. Longer-term structural risks may or may not have a direct material impact in 2021, but they are nonetheless present (let 2020 be a warning for the tyranny of the unexpected).

• The Fed is committed to using its full complement of monetary tools to stimulate the economy back to full recovery. The central bank may get some previously unexpected help from fiscal policy following the surprise win by Democrats in the Senate runoffs in Georgia and thus – albeit barely – a unified government with the potential to bring up and pass critical relief and stimulus legislation. Expansive monetary and fiscal policy could justify a continuation of the “buy the dip” approach that has worked for the past decade whenever markets hit a rough patch. Key risks: The Fed has less influence over intermediate and long-term rates. These are subject to a variety of influences from diminished demand for Treasuries from foreign investors to a rise in inflationary expectations as the economy grows. An unexpected inflationary surge is a particularly noteworthy risk because very few experts have expected it. The members of the Fed’s Open Market Committee on average believe that inflation won’t breach even the central bank’s target 2 percent level any time before the end of 2022. It would be hard for the Fed to withstand upward pressure on longer term rates in the face of a jump in expectations. A more pronounced steepening of the yield curve will, all else being equal, have a negative impact on equity valuations as well as on activity and behavior in the real economy.

• China is in a stronger position at the beginning of 2021 than it was a year ago. The world’s second-largest market has broadened and deepened its strategic impact on the global economy with trade deals in the Asia-Pacific region and the EU (both of which conspicuously exclude the US). It, along with other regional Asian economies, is farther along on the return to growth than the mature markets of North America and Europe. Demand for Chinese assets by foreign investors is high and growing. Key risks: Recent actions by Beijing to bring leaders of China’s burgeoning fintech industry to heel (in particular Jack Ma, the founder of Alibaba and Ant Group, its fintech subsidiary) offer a clear reminder that the Chinese Communist Party is very much in control and plays by a different set of rules, which can at different times work to the benefit or to the detriment of holders of Chinese assets.

• The European Union and the United Kingdom start the year afresh following the conclusion of their terms of divorce at the very last hour in December. The EU would seem to have the better end of the deal, including a new lease on life for its financial services industry as volumes flow out of the City of London to regional bourses. Separately, a deal with China gives a new leg up to the EU’s export-dependent manufacturing businesses (not to mention another strategic coup for China as noted above). The euro is poised for more upside against the dollar. Key risks: None of the Eurozone’s structural weaknesses that brought the single-currency region to the brink of disaster in 2011-12 have been reformed; the issues have simply been kicked down the road time and again. The region’s tremulous financial system is never more than a systemic bank failure away from coming unraveled. Political ruptures between the autocratic drift of eastern Europe and the rule-of-law ethos of Brussels took deeper root in 2020 and continue to threaten the region’s stated goal of ever-closer union.

• US corporate earnings are expected to rise by a bit more than 22 percent in 2021, after falling by some 13 percent in 2020 (based on the current outlook for as-yet unreported Q4 numbers). This anticipated upturn is heavily weighted to earnings in sectors like industrials and consumer discretionary, which are expected to boom at mid-double digit rates in a post-vaccine world of Disney World holidays, packed sports stadiums and surging global sales of industrial goods. That would be good news for investors concerned about starting off another leg of the bull market with valuations as high as they already are. Key risks: Analysts are perennially upbeat about future earnings and regularly overshoot reality. Meanwhile stocks are priced about as closely to perfection as imaginable. Any number of setbacks – from vaccine hiccups to consumer demand that doesn’t materialize to another out-of-the-blue factor that renders all predictions useless in the manner of the pandemic in 2020 – will challenge the market’s hitherto blasé attitude towards valuation levels. Last year the earnings bar was low; this year it is high.

• In 2020 governments raised record amounts of debt to cushion the blow of the pandemic to businesses and households. Meanwhile, businesses took advantage of low interest rates to flood the market with corporate bonds of both the investment grade and speculative (junk) variety. More debt is on the way in 2021. The Fed will offset some of the new volume with its monthly bond-buying program; however, a larger portion than usual of Treasury debt planned for this year will fall into longer-dated maturities that are outside the Fed’s QE sweet spot. Demand from foreign investors has fallen in recent years; in 2021 foreign central banks will also have an expanded opportunity to add euro-denominated sovereign debt to their foreign exchange reserves via the EU’s new €750 billion bond issuance program. Key risks: Interest rates represent the price of money. Lower demand for dollar-denominated debt obligations will put upward pressure on interest rates, while the supply of new issues by the Treasury Department and state & local municipalities continues at record-setting pace. This in turn could have a domino effect both on valuations of a broader range of assets and on business conditions in the real economy.

A year of both innovation and hype lies ahead, and one of the big challenges for investors will be separating the two. For an illustrative case in point look no further than Tesla. The newest addition to the S&P 500 boasts a market cap either side of $700 billion on any given day, which is more than the combined value of the nine largest car manufacturers by sales – including GM, Ford, Fiat-Chrysler, Toyota, Daimler, Volkswagen and Peugeot. Pretty impressive for a company that sells less than one percent of all automotive vehicles sold worldwide in 2020. Tesla is not alone. 2020 was a year when investors grabbed onto seemingly anything associated with one of the major innovations percolating up from the labs over the past decade – from clean energy to blockchain technology and next-generation artificial intelligence. Key risks: Recall that in 1999 any company that slapped a “dot.com” next to its name seemed able to increase its value by magnitudes of many overnight. A few durable winners for the ages came out of that frenzy. The underlying promise of the revolutionary technology represented by the Internet was not off the mark. But for every Amazon there were hundreds of Pets.com – sock puppets tossed onto the flotsam of history’ speculative frenzies. Buyer beware.

Well, it’s finally here, the last day of 2020, and there’s a popular meme going around the byways of the Internet to the tune of that timeless Ramones song “I Wanna Be Sedated”: “2020-24 hours to go!” Forget all the usual year-end retrospectives and listicles that proliferate at this time of year; for most of us, the door cannot close behind Old Man Time soon enough. Unfortunately for us humans with our arbitrary temporal divisions, the world of nature and viruses does not pay any attention to the transition between the last day of December and the first day of January. To invoke yet another icon from the golden musical age of the 1970s – Alice Cooper – “We’ve still got a long way to go.”

Plus Ça Change

2020 has certainly earned its place in the history books that are yet to be written. Much of how that history will ultimately be told depends on how the year’s legacy evolves as civilization works its way past this pandemic and tries to get back to some semblance of the world we left behind back in March. There are some who believe that the pandemic will leave a lasting imprint – that things have changed well beyond our ability to ever fully recapture the Before Times. Others are of the view that the more things change, the more they stay the same; that once the dust settles and the noise of all the radical distortions has dissipated, we will quietly go back to the slow-growing, mature, post-industrial world of 2018.

We imagine the actual outcome will fall somewhere in between those two extremes. Here are a few trends we will be following closely as 2021 gets under way (and yes, despite the complete arbitrariness of calendar dates it does feel really satisfying to write “2021” in place of “2020”). How they play out will help shape our thinking about longer-term investment strategies.

Work and Technology

It is said that 2020 accelerated the evolution of workplace environments, achieving in a few months what otherwise might have taken half a decade or more. Many workplaces, of course, were devastated by the pandemic and will be relying on fiscal relief for a long time to come (if they in fact survive at all). For many others, though, the transition from office to home, from in-person to remote meetings was close to seamless. We learned that technology platforms from Microsoft Teams to Zoom to Salesforce really do deliver on much of their marketing hype. Already a number of major companies have signaled their intention to extend some element of remote work, at least on an optional basis, well past the point where mass vaccine immunity has set in.

While we were all chatting away on Zoom and sharing spreadsheets on Google Docs, though, millions of square feet of urban and suburban office space continued to rise from their foundations. One of the big themes at any pre-Covid confab for global strategists was the inevitability of the mega-city as a growth hub. These strategists had the hard evidence: several decades in which population shifts witnessed a massive migration of the educated and ambitious to the country’s major urban centers in search of opportunity and quality of life. If that trend is in reverse it has profound implications for a great many asset classes from commercial real estate trusts to shares in early-stage technology stocks.

And we may only be at the cusp of the encroachment into whatever remains of our work lives that has not yet been taken over by technology. Breakthroughs in artificial intelligence have quietly worked their way into the platforms and applications we use on a daily basis, pushing the vast power of analytical Big Data out of cloud hubs to the so-called “edge” technologies where our eyeballs are trained each day.

Debt and Inflation

Another way that 2020 will likely be remembered is as a year in which a whole heck of a lot of debt was created. Debt at the federal, state and local levels of government ballooned to fund fiscal pandemic relief support as public infrastructure strained under the weight of an all-pervasive health crisis. Private sector companies unleashed a torrent of corporate bonds, taking advantage of the Fed’s low interest rate policy in record volumes of both investment grade and speculative (high yield) debt, which yield-hungry investors attacked like an all-you-can-eat buffet. Households borrowed a lot too – in many cases to pay for essentials like rent and food following employment layoffs.

All the while interest rates remained low and inflation barely budged – just about the only macroeconomic headline number that looked pretty much the same during the pandemic as it had in the many years prior. The current projections of members of the Fed’s Open Market Committee anticipate core inflation remaining below two percent – the central bank’s longstanding target rate – until at least the end of 2022. This assumption – the non-emergence of inflation – has taken root at the core of spending decisions by businesses and potentially gives the government more leeway – for example to finally embark on those infrastructure projects we were supposed to be getting four years ago.

Because the assumption of tame inflation is so fixed in the minds of business and government leaders, an unexpected inflationary surge lurks as one of the biggest near-future economic risks. An inflationary surge would catch the Fed flat-footed in its monetary stimulus programs and most likely put significant upward pressure on intermediate and long-term interest rates. That, in turn, would be an almost-immediate catalyst in reducing equity valuations and pulling the rug out from any argument that low rates justify the sky-high valuations already present in the market. Now, investors would probably not react drastically to a short-term burst of inflation associated directly with the resumption of many activities once mass vaccine immunization has been achieved. Anything beyond that, though, would be cause for concern.

Preparedness and Civic Discourse

If the history of the 2020 pandemic were to be written today it would not be kind in its assessment of our country’s ability to come together and make the collective sacrifices necessary to protect the lives of the most vulnerable among us. It is hard to imagine any future historian ascribing the label “greatest generation” to any facet of our performance as a nation in 2020. Yes – our medical and biopharmaceutical leaders did break records in developing effective vaccines, and that is no small accomplishment. But the by now more than 330,000 lives lost, many of them preventable, will be a black mark on the legacy we leave behind.

History will be kinder to us, though, if we change the story before another disaster sets in. There is no shortage of potential catastrophes that could emerge at any time in the months and years to come to challenge us again. Another pandemic is certainly not out of the question. Dramatic climate change is already clear and present in our lives. Cyberterrorism is the danger we can’t even quantify because we don’t know the extent to which our major systems are already compromised. And a world stitched together by trillions of dollars of interlinked financial products is always vulnerable to the kind of systemic failure we witnessed in 2008.

To be better prepared as a nation for future disasters means somehow finding our way back to the ability to sustain a healthy civic discourse. We don’t have one now. In place of spirited debates over public policy we have competing Twitter mobs. Social media frames the entirety of our public life, and it does so in an almost uniformly corrosive fashion. Reclaiming our civic virtues will not be easy, and there is little evidence at hand to suggest that those at the top of our elite institutions are prepared to try. But perhaps if there is one enduring legacy of 2020 that provides a silver lining it will be this:  a collective realization that we have to do it better next time along with the conviction that there very likely will be a next time. The time to start burnishing that legacy is now.

May 2021 be full of joy, good health and success for you and your loved ones, in all that you do.

The human brain loves patterns, and it loves a good story to weave around the patterns it perceives. So here is a story that is gaining some currency among some of the more optimistic market pundits looking down the road at what may be in store for us in the coming decade.

War, Pestilence, Famine and…Flappers

At the beginning of the 1920s, a weary country had recently struggled its way through war, pandemic and recession. The 1918-19 influenza had killed hundreds of thousands of those who had survived the trenches of the First World War. The recession of 1920 was by many measures the most severe since the 1890s. But in 1921 the economy started to turn up. This happened just at a time when three of the most far-reaching inventions of all time – electricity, the internal combustion engine and telecommunications – were scaling up into realized commercial applications.

A surge of energy seemed to burst forth organically from all corners of the country. The Roaring Twenties were under way. Radios and telephones appeared in more and more homes, which were now connected to the emergent electrical grids that had sprung forth from the handiwork of Thomas Edison a half century earlier. In many ways the 1920s was the first decade of what we would recognize as modern consumerism. Department stores, mail order catalogs and even annoying advertising jingles all came into fruition during this fecund decade of flappers, risqué jazz clubs and shoeshine boys with hot stock tips.

Life After Covid

Fast forward to the present. We haven’t dealt with a world war in our recent past (thankfully) but we certainly have been besieged by those other two horsemen of plague and recession. With the anticipated scaling up of the Covid vaccines to mass distribution, hopefully by early in the second half of the year, many observers are indeed discerning parallels between 2021 and 1921. Just as with the experience 100 years ago, this emergence from a health and economic crisis will converge with emergent technologies springing forth from innovations that have been percolating under the surface for some time. Among these are robotics and artificial intelligence, which have been spreading into an increasing array of business processes across virtually all industry sectors.

There is also energy storage, for example the carrying capacity of lithium batteries that power electric transportation. Advances in genetics deriving from DNA sequencing opens up new avenues for healthcare solutions to longstanding biological challenges. Blockchain technology has widespread potential to upend financial services in ways that go far beyond today’s speculative realm of cryptocurrencies.

The commercial innovations that proceed from these innovative technology platforms will find ready segments of demand, from climate change solutions to advancements in physical and mental health to improved financial transparency. As with anything disruptive, they also come with plenty of risk. For investors, risk may come in the form of betting on the wrong horse. For society in general, risks may come from the misapplication of the technologies, from corrosive political appropriation of them, or from increased social inequality that may evolve organically from their encroachment into ever-greater spheres of life. There are no guarantees that any of the technologies will ultimately deliver net-positive benefits.

Will the 2020s resemble the 1920s? Well, there are always ways to spin a narrative and there is always an audience ready to be told that things happen for a reason (the human love affair with patterns). The reality is likely to be much more complex than that (though we would add that there can be discernable patterns in complexity itself). But we believe it will be a decade of changes and surprises, both good and bad.

To all of you and your loved ones, may this be a holiday of health, good cheer and the anticipation of happy and fulfilling times ahead.