Financial Outlook October 2020

It’s been some time since I last shared my opinion on the markets, a lot of things have happened ... although everything looks quite the same after the reopening bounce.

First and foremost the relatively unusual fact that more than 20% of existing dollars have been printed this year, and we are getting closer every day to the US accepting as valid the premises of the MMT (Modern Monetary Theory), something unacceptable for those of us who live in countries like Argentina and saw the very real effect of the destruction of the purchasing power of our currencies.

The immediate effect of these monetary policies: reflation, preventing the price of financial assets from cascading down and contributing to the deflationary effect of the decline in growth in the real economy.

In this sense, the "reflationary" trade was very favorable when measuring the performance of any asset class in dollars ... basically all assets had an inverse correlation with the dollar; gold, stocks, and commodities in general rose while the dollar went down and went down when the dollar rose. The markets are communicating a single clear message: with more stimulus and a devaluation of the dollar, we can continue rising.

This is my simple explanation of the "gap" between the real economy and the valuation of the S&P, or as the specialized media say, Wall Street vs Main Street.

Specialized media, as well as the rest of the media, politicians, or most of what can be found on Twitter, are more interested in selling "what to think" instead of "how to think." And the most effective way to sell "what to think" is through simple narrative (memes).

Examples of very popular narratives today are:

• Earnings to beat expectations
• Stimulus package
• Vaccine optimism

These narratives basically say:

1. The worst is behind us! (Ignoring that revenues for most of the S&P 500 companies are contracting, that there is a record of bankruptcies, and that many of those that are not bankrupt are adding more debt and leverage)
2. With a trillion dollar package the economy is saved! (Overestimating the real capacity of monetary and fiscal policy to generate jobs and profits in the listed companies.)
3. Lock-outs are over! (Ignoring where we are in the business and credit cycle. Most probably, we are moving from a depression to a conventional recession.)

Let's make an effort and move from "what to think" to "how to think." 

1. As Ray Dalio published a few years ago, the two most important variables that the financial market looks at are Growth and Inflation, with more emphasis on Growth. 
2. Let's add another component, as Keith McCullough very judiciously did: the response in terms of the Fed's monetary policy to the four quadrants that are generated by variations in Growth and Inflation, which is basically restrictive when growth and inflation grow, and accommodative when growth and inflation increase. growth decreases (here it does not usually matter much what happens with inflation). 
3. Let's add a dimension that comes from the financial market and not from the economy, resorting to the simplest of technical analysis, the definition of a trend when prices have peaks and valleys that move in the same direction. 
4. Finally let's add a measurable component of risk perception: I think Mandelbrot use of implied volatility is more than suitable.

Did you recently read something on the Wall Street Journal that considers at least three of these factors? Did you see something on CNBC that considers two of these factors? Or is it easier to choose a narrative and find a couple of explanations that seem exhaustive and discard all the contradictory evidence?

Of course, you cannot act directly on "how to think", and you can on headlines such as:

1. Pullback into elections could be good buying opportunity
2. Home-builder sentiment hits record for third straight months
3. A blue wave on Election Day may unleash $2.5 trillion in stimulus, Goldman Sachs says

We are only humans, and our distinctive evolutionary characteristic with respect to the rest of the living beings on the planet is the ability to make rational decisions... but we are usually too lazy and prefer to evaluate the merit of any argument by its internal coherence and the number of times that we listen to it, without contrasting with concrete facts or other opposing arguments.

So, what now?

The reality is that the FED failed in its explicit mandate, it failed to prevent unemployment from growing notably, with permanent unemployment numbers still on the rise; It also failed to prevent a record of bankruptcies, nor the fall in revenues of most of the companies listed. What it achieved was the bailout of asset prices, something that for me is its secret mandate: to rescue the class that owns stocks and debt.

In the near future it is most likely that the US will head towards a conventional recession, where the economic and credit cycle will set the pace of the market. Financial repression caused by the FED has been disguising some very obvious risks, such as the JUNK bonds, which today are artificially expensive while they have a worse recovery rate than in the global financial crisis.

There is little doubt that the answer to this is going to be more monetary and fiscal intervention. 

Returning to the issue of “how to think”, it is quite clear that growth is looking south, with no V recovery in the real economy, what is not so clear is what happens to inflation.

Lyn Alden does a very interesting analysis that I recommend reading: https://www.lynalden.com/fiscal-and-monetary-policy/

The immediate issue is that bankruptcies, defaults, unemployment, and artificially low rates coupled with record prices on most financial assets are the optimal recipe for a deflationary shock ... and trillions of dollars of stimulus with very-low or negative rates are the optimal recipe for hyperinflation.

The simplification at this point would be to cross your fingers and pray that these effects are canceled and the status-quo is maintained. Real world is messier and seldom resembles linear arithmetic.

My expectations are more in line with a deflationary shock in the short term (not unlike the one we had in February-March of this year), followed by a disproportionate monetary-fiscal response that results in real inflation well above the assumed 2% wanted.

What to do?

First, acknowledge that the current regime of volatility demands you to be nimble. With the VIX north of 30, most market movements are difficult to take advantage of, and since March it cannot go below 20, a value that in the last 6 years would have been considered “risky”.

With this warning, the most obvious recommendation is to decrease positions. Or look for some type of hedge, for your portfolio assets, or as a growth strategy (for example puts for the deflationary scenario and calls for commodities / gold for the inflationary scenario). 

Historically, in periods of contraction and with strong uncertainty regarding inflation, the assets that show the best performance are Utilities (considered defensive), Gold and North American bonds.

Portfolio movements:

Metals: My position to precious metals and mining companies at the moment is minimal, waiting for a correction to increase the position again.

Indices / Sectors USA: Reduced position in XLU (Utilities). Waiting for a volatility event to short technology.

Bonds: Lower position in North American bonds, rearming position every time the US10Y exceeds 0.75.

Dollars: Maximum position.