The hours draw close as we eagerly await our clocks to chime at midnight, eager to put this year behind us and turn the calendar to what is hoped will be a new, more normal year. This year will go down in history not only for its huge social and emotional impacts to societies at large, but for its unforgettable financial and economic impacts on our way of life.
We as portfolio managers have been challenged in all spheres of our lives, not only for how to manage risk and volatility but also how to manage our emotions, expectations and sanity, all while commanded to our living quarters for weeks on end without a soul with whom to connect. When one looks at the markets' performance for 2020, it would appear as any other 10%+ market performance in a bull market trend, but it has been far from average. As we step into the New Year, the theme most talked about and feared is inflation.
Einstein defined insanity as "doing the same thing over and over again, but expecting different results." I'm not entirely sure if he knew some central bankers during his time, but Einstein was not far from the truth.
After years upon years of quantitative easing, the mere fact that money can be printed out of thin air without any apparent consequences has made central bankers numb to the outcome. But could this time be different?
Dare I say it, but this time it is certainly different.
During other cycles of money printing, one of the biggest reasons why inflation never managed to materialize was that it was mostly about dollar debasement; the money went into the hands of institutions that put that money into markets, boosting asset prices, not the real economy. This time, we are not only seeing a huge monetary policy response but also an aggressive fiscal policy response, too.
To put it into context, back during the Lehman Bros. crisis, the Federal Reserve printed about $120 billion per month; by contrast, it was doing this every few days in 2020. The Fed balance sheet increased $3.4 trillion in a matter of three months. Now there is talk about another $1.5 trillion of fiscal stimulus to get the economy going via infrastructure spending. And another variant is that the U.S. government is literally handing out money to individuals through stimulus checks -- $1,200 per person in the first round last spring and $600 per person now, with talk that it should be $2,000. And all this "free" money is literally going into the real economy.
As China and other economies use infrastructure and clean energy bills as ways to grow out of the recession, we are already seeing an impact on commodities such as copper, iron ore and steel as they surge to highs above 2018. With all the direct stimulus money, we are now starting to see the price impact on a consumer level, too.
If one looked at break-even inflation rates back in 2008, it took over 18 months to come back to pre-crisis levels; this time around, break-even inflation rates are back to pre-Covid levels in just six months. There is no doubt that we are witnessing inflation already. It is just the Fed's measure of looking at inflation via its Consumer Price Index (CPI) basket that is a bit distorted. Or perhaps it is another excuse for the Fed to keep things running hot until it knows for sure the economy is firing on all cylinders before raising rates or normalizing its balance sheet.
Back around 2004-2007, money printing was never a problem as it was accompanied by massive Chinese urbanization that led to high global growth. GDP growth when accompanied with higher prices is a good type of inflation. But inflation that is not accompanied with solid economic growth is called stagflation; it is the worst kind. It is every Fed's nightmare, especially given that rates are already close to zero and in some cases negative and central bankers do not have much wiggle room.
Today, the average portfolio manager is around his or her mid-40s. It means no one really has any idea how to make investment decisions in a proper inflationary environment. We need to go back to the 1970s and refresh our class notes.
Equities, contrary to sell-side opinion, generally do not fair very well during periods of high inflation. Bonds, more so, are one of the worst investment hedges ever. The 60-40 will be in serious trouble if this is the case. The true leaders of inflation are hard assets and commodities. Commodity prices work on demand vs. supply balances, and during inflation the demand is very extreme. It takes a while for the supply side to catch up. This is where we are in most commodities, especially in base metals and precious metals, not really in oil yet.
The markets currently are focusing on all the excess liquidity which will bode well during the first half of 2021. However, at some point, in the second half of 2021 we could get an inflation scare when China takes its foot off the pedal and global growth slows.
For now, follow the liquidity. U.S. bond yields are threatening the psychological 1% level. The Fed is trying hard to maintain yield curve control, but if we breach it fast it will not bode well for risk markets in general. The delicate balance between growth and inflation needs to be monitored very closely next year. Either way, inflation is a guarantee; growth may not be.