Making Sense of the Nonsensical

by | January 11, 2021

The past week was marked by shocking images of violent protestors occupying the US Capitol. The unprecedented scenes brought into stark relief the country’s political divides and dramatically highlighted the need for new individual, social and public policy responses.

Yet no matter how consequential the storming of the Capitol may be, the horror barely registered in financial markets. Or perhaps it did, but in ways that are not obvious at first glance.

The big financial moves of the past week were rising bond yields and record-setting levels for equities and Bitcoin. How can those outcomes be squared with a failed insurrection, even a failed coup?

To begin, the violence was quickly repelled and within hours thereafter the US 2020 presidential election was certified. The transfer of power may not be peaceful, much less typical, but it is assured. Meanwhile, the outcomes of the Georgia runoff elections that same day provided Democrats with a razor-thin majority in the Senate (by virtue of VP-elect Harris’ tie-breaking vote) to accompany a small Democratic majority in the House of Representatives. 

The violence and the ensuing response of Republican leadership exposed deep rifts within the GOP, ones that may hinder Republicans from effectively resuming their familiar opposition politics of obstruction. If so, the way may be paved for more effective and even bi-partisan governance in the US, an unalloyed positive for the economy and markets, supporting both higher bond yields and higher equity prices.

In addition, given Democratic control of the executive and Congress, another round of federal fiscal stimulus, including larger transfers to individuals and support for cash-strapped state and local governments, is now more likely. The unexpected decline in US payrolls on Friday also enhances the odds that the new Congress will support more stimulus. 

Lastly, as we’ve argued before, the combination of falling US political risk premiums and unfolding global vaccination against the pandemic is a powerful source of economic and market stimulus, boosting growth and earnings expectations.

Accordingly, higher bond yields make sense. So does rotation to cyclically sensitive stocks, sectors, styles and regions. To be sure, broad equity market valuations are challenging and some stocks may fade under the pressure of higher bond yields; but valuations, alone, are unlikely to undermine markets that enjoy this degree of support from improving growth, expansionary monetary and fiscal policies and falling political risk premiums. 

What are the risks? One is surely valuations. Global equity markets are not cheap (certainly not US equities), even if some sectors or regions are not yet overly expensive. 

But the looming risk is sharply rising bond yields, which could occur for one of three reasons. 

First, real interest rates could rise because growth expectations improve. That source of risk for equities is comparatively small, insofar as it would reinforce expectations for higher earnings. But, at some point, faster growth will lead to questions about the sustainability of very easy monetary policies, which have supported soaring stock prices over the past year.

Second, yields could rise because of accelerating inflation. Indeed, due to base effects, year-on-year inflation will pick up in Q2 2021 across much of the industrialized country complex. But a more pernicious form of inflation would reflect rising demand against pandemic-related disruptions to production and distribution, leading to a shortfall of aggregate supply. Investors will find little refuge in any asset classes if inflation accelerates more fundamentally, forcing markets into a deeper re-think about bond valuations and central bank responses, with clear negative implications for equity and credit risk premiums. Inflation remains the largest risk to global portfolios in 2021 and the years thereafter.

Third, government bond yields could rise because of increased credit (default) risk. While that prospect is remote for government debt of countries where central banks willingly hoover it up, public sector default risk could emerge at the governmental ‘margins’ – for instance for US municipalities and states not supported directly by the Fed or via a withdrawal of ECB support for national government within the Eurozone.

In short, much still depends on central banks. They have nurtured and underpinned the economy, public finance and markets since the global financial crisis, even more so since the pandemic. But if growth, inflation or institutional constraints lead investors to question those central bank commitments, a tipping point will have arrived which will be all the more worrisome and disruptive to portfolios given the high level of current bond and equity valuations.

Finally, what are we to make of Bitcoin, now trading north of $40,000?

To begin, despite its meteoric price rise, Bitcoin and other cryptocurrencies do not seem to be enjoying much, if any, demand increase for use in transactions. In other words, soaring prices do not (yet) reflect a desire to flee fiat currencies into cryptocurrencies for ordinary commercial transactions. Instead, rising demand for Bitcoin is financial in nature.

On the surface, as well, Bitcoin does not offer much diversification to global equities. The correlation between them is too positive to diversify portfolio risk. Of course, that high correlation might not last and investors may even believe today that if global equity and bond markets fall sharply, Bitcoin and other cryptocurrencies will do well.

Still, the greatest source of Bitcoin demand comes from asset allocation shifts, where private and institutional investors have decided to initiate crypto holdings in their portfolios. Given limited supply against very large potential demand, the impact of asset re-allocation on Bitcoin prices is strong. Investor interest is then compounded by positive price momentum.

Importantly, there is little corroboration for the notion that rising Bitcoin prices reflect fears of currency debasement and inflation. If that were the case, private agents would be abandoning fiat currencies, government debt, private debt and equities en masse. Commercial transactions would shift to crypto payment. That is clearly not the case today.

In the near term, Bitcoin prices are more likely to rise than fall. Asset re-allocation is only just underway. Yet the impossibility of establishing intrinsic value for a financial instrument that is purely speculative will ultimately make it difficult for many investors to see Bitcoin in the same way as they do other cash-flow yielding assets, such as bonds or stocks, whose characteristics and relationships to one another allow for fundamental portfolio analysis in ways that cryptocurrencies do not. Ultimately, that shortcoming will cap interest in cryptocurrencies or lead to further evolution in their supply, usage and relationships to claims against real assets. 

Not everything is as it seems. Making sense of the nonsensical requires such thinking. Insurrection is wretched, but from its failure many see hope, if not yet for society then at least for better governance and better economic outcomes. Risk is shifting, most fundamentally toward rising bond yields, which could confront investors with hair-raising choices. And Bitcoin is not what some believe. Its soaring price today has legs, but not solid foundations. 

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior leader with two decades of experience growing and transforming organizations in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the U.S. Secretary of Defense. He is a member of the board of directors of Franklin Resources, Inc. (Franklin Templeton), a member of the Council on Foreign Relations, Chairman of the Advisory Board of Project Syndicate and a board member of the American Alpine Club. Friedman is a regular contributor to a range of newspapers and thought leadership groups and is also the author of Babu’s Bindi, and The Big Thing, both children’s books. He is an avid mountaineer and rock climber and led the first major climb to raise money for charity through an ascent of Mt. McKinley. Friedman holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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