The End Game Ep. 13 – The Return Of The Lord Of The Dark Matter
December 20, 2020
James Aitken makes a very welcome return to The End Game to take a look back at 2020 and a look forward to 2021.
Where did he get things wrong and why? What went according to his forecasts, and, most importantly, what has this turbulent year taught him that will help him in the future?
From the dangers of ‘Big Dicking it’ to Robert Shiller’s nasty case of FOMO to the curious birth of the Equity Vigilantes, James shows precisely why his thoughts are so indispensable to his clients.
Summary of the main points
Liquidity is here to stay will continue beyond 2021. What will differentiate various asset class in 2021 is the companies which used this year to restructure their business. The companies who will be winner in 2021 also need to have considerable earning momentum. FOMO is very powerful for investors. academicians and economist. If discount remain very low, then stock prices can go very high.
Liquidity not going anywhere even if inflation picks up a little bit in second quarter. We had state contingent monetary policy for many many years but there is a wrinkle. Previously you had central bank guidance based on central bank forecast but now you will have central bank guidance based on outcomes and Fed in particular is very clear on that saying that we will keep on pushing till we get what we want. In addition to that some countries are deploying state contingent Fiscal guidance and Australia is the leader in that, Australia will keep fiscal support in place till unemployment heads below 6%.
When you have outcomes based monetary policy working hand in hand with outcomes based fiscal policy it is a powerful combination. This is what we were supposed to do in 09/10/11 but we did not because of Tea party and smash up in Europe. So this is the man story, Liquidity is actually a back story.
For right or wrong
CB are telling us that short term interest rates are not doing anything for long time to come.
For better or worse credit risk premia has been squashed and if we take CB at face value then they will not tolerate rise in credit risk premia
And if we assume that long term interest rates remain well behaved then only risk premia for allocators to harvest over the year would be equity risk premia.
Somethings looks extraordinarily rich versus reality and investors put in mathematical term for example if you assume equity risk premia in US at 4% and a SWF or endowment fund taking a 15-20 year view then they can generate 60-80% over next 15 years but they have to unlearn about asset allocation. Oh gosh I shouldn’t be doing this, but I have to…. You keep looking at thing’s things on bloomberg which makes no sense and we keep on comparing current valuation to early 2000 and we should but there is one key rider. In start of Jan 2000 10 year TIPS in US were about 410 BP and now they are -100 BP.
There is a conundrum and if we think the things are crazy today then you got this back story that real and nominal discount rate which is forcing people to play and who knows how silly it can get.
Lets think about in accounting term MTM, if we collectively have a billion dollar to allocate and we have no redemption risk and we meet as investment committee with our bosses. Everything is overvalued what should we do. We collectively decide to invest in instruments which are not Mark to Market and that is Private equity. The big problem in subprime crisis was that too little was invested in MTM assets. if I am as asset allocator and I have 25% in FANG and some antitrust happens then I lose face but I want to continue investing in these booming markets without embarrassing myself so its no wonder that institutional investors are taking this Non MTM assets.
10-year TIPS +400 BP in 2000 Now -100 BP.
You have to take risk at these levels of TIPS
Imagining what I will do if I have a mandate as central Bank. For 20 years CB have not been able to meet their inflation mandates. Along comes 2020 and you are CB you think oh gosh we have such a big carnage, job losses, credit defaults we will have undershoot of inflation and the conclusion is there is not much different then it is for past decade plus. If you are in service dominated world where there is perpetual excess labor supply and its cheap then the only way you are going to meet your inflation targets is via financial markets keeping financial conditions loose as possible for as long as possible. So from CB point of view what else can they do. There are occasional lips to financial stability, but it is a placeholder.
It is tempting to draw 2000 analogy. What is so different for this cycle is that if inflation shows up for any period of time then CB around the world is going to cheer and throw a party as opposed to stop it.
The great reset is about Fiscal policy is going to be here for a long-long time.
Great reset in fiscal policy is available in scale and happily monetary policy is not the only game in town. The big problem come out of 2009 was that fiscal policy was turned off way too soon and monetary policy became the only game in town and then was forced to do things which monetary policy is not supposed to do. The fact that Europe has arrived at joint and several liability and for a euro skeptic like me its here and its real and cut the left tail off lot of euro denominated assets. Thank goodness fiscal policy is allowed, thank goodness they are committing to fiscal policy
So few of warning signals which used to work till 15 years don’t work or not allowed to work. The game for last 25 years is to avoid liquidation of assets. If you are Fed telling the world over and over that you think the only route to higher inflation is via Maximum employment, then quite frankly Fed will have very little tolerance for any sustained tightening in financial conditions. If this ability is constrained then Fed will act, it is as simple as that
Because we have started to eliminate enormous labor market slack and if we are making far great progress in next 6-12 months then you have to assume that people are getting higher wages than they anticipate, or economy is doing far better they imagine which are two high class problem to have.
If we are imagining global rates higher than we are anticipating that global growth coming white hot in 2nd and 3 q of 2021 and that’s a good problem to have. Long term bonds can only go up if fed is happy with the progress of the economy and in this scenario some of these high flying companies which include high ROIC companies including tech will get smacked and investors will not get worried and they will rotate.
But on the other hand, if rates are moving up because of indigestion in bond markets then that is a big problem. We are going to get inevitable inflation scare in second quarter of 2020 because of base effect and maybe there is also pressure on rates but unless we simultaneously believe that we are making rapid progress on unemployment it is difficult to assume that is more than a speed bump.
The simplest index of inflation for me for many-many years is CRB raw industrial index and for some reason it turned around this June like a hockey stick. This index is a function of pure demand and supply and this index is telling me that reflation trends are very powerful. We don’t know yet if these reflation tailwind will turn into inflation headwinds but we will find that in q2 2021
The biggest mistake of 2020 was OVERTHINKING.
The extra ordinary feature of QE2 was that average duration of treasury which Fed bought was 12 years whereas the average duration of purchases was 6 years in 2020 which is quite short and which helped ease liquidity conditions.
The Fed meeting this week is green light for investors who are light on risk to load onto risk in the run up to the end of the year.
Some of the obvious speculative excess in QQQ and calls have come off dramatically so I am wondering if there is one last surprise in the crazy year for the stock market into year end. We might get a blow off top into the year end.
What is the risk of over doing monetary or fiscal policy? It is very low
The speed of arrival and delivery of vaccine is the best stimulus you could have hoped for. Getting a vaccine can take years and we got within months and if it works then we got 3 forms of stimulus
Monetary
Fiscal
Vaccine
When will these excesses matter?
Heroic valuations can get more heroic
As Paul James put it in marvelous video of 1987
You never ever short upward sloping parabola but boy if it breaks…. we do not know when it breaks.
We have got vaccine which is a major stimulus but there are companies which should benefit from it have barely rerated.
In science knowledge is cumulative and in finance knowledge is cyclical.
I think one of the outstanding reflation trades out there is OIL.
There are bargains out there
Sam Zell is available at book value. If I can take away some of my capital from these high-flying companies and invest with the people who have seen cycles, I can sleep good at night.
At a minimum core and headline inflation 2.25-2.50 for better part of the year before Fed gets concerned. So, focus only on labor market slack for taking a call on inflation.
We are coming out of an economic catastrophe to begin with very rapidly, we are going bit sideways here lot of uncertainty, lockdown difficult new year. It probably means that the data for first quarter of 2021 is not going to be great. You probably not going to see inflation pick up too much for a while then as you move through second quarter, the things start to pick up and that is why I keep using reflation i.e. recovery as opposed to deflation, disinflation. I am going to take it by degrees and as to my earlier point there are investments available today where you can hedge against some of these outcomes down the road and whether it is miners who have restructured the business, paying dividend including commodities. Things are available today which will serve in both reflation and inflation environment and it is so interesting that so many commodities and other markets breaking out and this is so far a reflation cycle. May be things are doing better than we thought
More dollars were liberated in 2020 and before and that you can see in commodities.
One CB is far more dovish than all central banks and that is the reason dollar is weak.