Welcome to our second monthly investor letter!
As we are still in the process of launching the portfolio, expected shortly in March, this month's letter will focus on the unfolding macro backdrop, shaping the market sectors, styles, and themes on which the portfolio will be focused on.
One of the most important macro events over the past month was the sudden rise in ten year bond yields in the U.S.. As you can see from the chart below, 10 year yields bottomed in August of last year and have been rising since. Most recently they have risen very quickly, by the standards of that market.
These yields play a central role in financial markets. They represent the nominal risk-free return, which is the ever present alternative to taking risk. Last August, when they hit around 0.50%, they were widely seen as an invitation to look else where, but as they have risen to the neighbourhood of 1.50%, and as investors have reduced their return ambitions to some degree, they begin to represent a reason to take some risk off the table.
In fact, as stocks have risen over the past six months, the dividend yield on the S&P 500 at 1.57% at the beginning of March 2021 is now at about the same level as the 10-year treasury yield, which may cause some investors to take the “risk-free” route and exit stocks.
Bond yields also play a role in the relative attractiveness of industrial sectors within the stock market. High flying tech stocks in recent times have reached extremely high valuations because investors look to the promised future growth in earnings and discount those future profits back to today, to arrive at a fair stock price. Of course, they do this with all stocks, but the further out the promised growth and the more that tomorrow's earnings (as opposed to today’s earnings) support the stock price, the more pronounced the benefit of low interest rates as a negligible discounting of tomorrow’s results. Atzero rates, in theory there is no discount at all. As rates have risen quite dramatically from August 2020 to today, the tech stocks have naturally taken a bigger hit than some other sectors, as they are more dependent on discounting tomorrow’s growth.
By contrast, banks, which make their money by borrowing from depositors on a short term basis, and lending the money out on a longer term basis, benefit from the widening of the spread between short term rates and longer term rates, which has occurred as the 10-year yield expanded, while the Fed kept short term rates near zero.
You can see this in the charts below, which show the performance of the main sectors of the S&P 500 over the past three months (first chart) and the prior three months (second chart). In the earlier period Tech (pink) was the leader. More recently Energy (Teal), Financials (blue), Industrials (light blue) and Materials (black) have been leading.
While Tech is interest rate sensitive, commodities like Energy and Materials are inflation sensitive. Materials stocks make their money mining metals and producing chemicals for industry and agriculture. And many of these markets are on fire right now.
The reasons for this change in leadership relates back to the reason for the rise in yields. Typically, yields rise when inflation expectations rise, as bond investors demand additional return to compensate for the expectation of reduced purchasing power of the currency to be received when the bond matures. And today there is an expectation of inflation stemming from the reopening of economies post-pandemic. But to a degree this price action in the markets is also just a consequence of herd behaviour. Commodities had become massively out of favour as tech stocks consumed investors' attention, making commodities relatively inexpensive as compared to tech stocks, to such an extent that when tech stocks started to slip, a rotation occurred into these cheap beneficiaries of a cyclical recovery.
One of the biggest winners of the rotation was the sector that had got slammed the most in the earlier period: energy, a member of the commodity complex. As the chart below shows, energy has been a big winner recently in both relative and absolute terms.
Meanwhile, as 10 year yields fell, so did the trade-weighted dollar index - this is an average dollar exchange rate weighted by the countries with whom the U.S. does the most trade.
As the chart shows, the dollar initially spiked in March of last year as the pandemic emerged. That is not unusual, the dollar is always the go-to asset in a panic. But since then, as the Fed slammed interest rates lower, the relative attractiveness of the dollar dropped. Until recently as rates have begun to rise again at the long end.
A falling dollar is good for commodities, since almost all are priced in dollars, worldwide. This shouldn’t be a big surprise as it means commodities are cheaper for everyone whose home currency isn’t the dollar. Recently the dollar has stopped sliding, at least temporarily, but if we zoom out and look at the bigger picture, this looks temporary. As you can see from the chart below, we are sitting on a support line, which, if it breaks, very likely spells trouble.
The dollar’s weakness is readily understood. Like every country in the world, the United States has not managed its currency as advertised, meaning with a view to protecting its purchasing power. Politicians like to spend money and there is a limit to how much tax they can impose, and so they bridge the gap by printing money and there by debasing their currencies. We addressed this in the January letter, so we won’t dwell on it again this month, but what’s interesting is that despite the fact that the 10-year yield has recently risen so dramatically, and other countries’ yields have also risen, but less dramatically, the dollar has not benefited much. You might think that if you can earn 1.50% on the most important currency in the world and only negative rates on, say the euro, the yen, or the swiss franc, that the dollar exchange rate would benefit a lot. The fact that it hasn’t is potentially ominous. When a market doesn’t rise on good news, it often means that it will fall mightily when bad news comes, and bad news always comes eventually.
Spoiler alert - the likely next bit of bad news for the dollar may come when the national debt hits $30tn, most likely shortly after the $1.9tn stimulus bill currently in the congress becomes law later this year. To see this, consider the following: in recent years (pre-pandemic, and using round numbers for illustration) the U.S. has collected about $3tn in taxes and spent $4tn on the things governments spend money on. That represents a $1tn deficit, in good economic times mind you. Of that spending, about 10% or $400bn was for interest on the national debt. Say inflation begins to rise (those commodity prices will soon feed through into the real economy) to as much as 4% and that bond investors demand a 5% interest rate as a result - high by recent standards but then not an unusual rate historically, especially when we have had normal inflation. At 5%, the interest on the debt would amount to about $1.5tn or 50% of the budget. That would certainly spell bad news for the dollar if it were to happen. What would spell worse news for the dollar is if in reaction the Fed were to double up on their QE program (it is currently $120bn/month!) to artificially cap long dated interest rates. Is that unlikely? Given that the government can’t afford for 50% of the budget to be spent on interest, arguably it is not unlikely, in other words, the Fed will not allow rates to get to 5% and the dollar will likely be the casualty of those efforts.
While the Pynk Thesis Portfolio has not yet gone live, many of the Theses we plan to invest in are sector focussed and so it is instructive to observe how the relevant sectors have performed.
To recap, the Theses in the portfolio are shown below, and next to each one is a summary word or phrase showing its sector-focus, style-focus, or theme-focus - there is a commonality in every Thesis. Our focus here is on sectors.
The charts below show yearly market sector performance. To date, January and February 2021 saw Commodities at the top of the charts.
While the charts do not single out Energy within the commodity sector, it has been a major winner, as previously discussed. It can be seen that emerging markets have been a winner too. This is in part because many of these countries are commodity exporters, but also because they benefit from a weak dollar (as discussed in the January report) and because they had underperformed for a long time and were receiving well-deserved attention from investors.
We should note that value (as a style relative to growth) has been out performing recently. Value refers to stocks that tend to trade at modest valuations as a result of generally having modest long term earnings growth potential. In practice value is taken to refer generally to sectors such as retail, financial, energy, materials, industrials, and such sectors. As lower valued stocks, they tend to be less hurt by rising rates (as discussed above) and they also tend to be cyclical beneficiaries of an economic reflation such as most investors are currently expecting.
The chart below shows that value has been outperforming growth in the last few weeks while 10-year yields exploded higher.
So where does that leave us? In other words, are yields going to continue higher? That is probably the foremost question on investors' minds right now, and as usual there are two schools of thought.
Probably the most widely believed school of thought is that there is a limit to how much higher the Fed will allow yields to rise, at which point it will step in. So where is the trigger level and what would they do about it? Some investors believe that there is a level, perhaps at 1.75% or 2.00%, at which they would intervene; others believe there is no absolute level, but rather they will step in when they see rates rise to the point where they are causing problems, for example a stock market debacle. As to how they may react, there are various possibilities: in the past under similar circumstances they performed what they called at the time “operation twist” where they sold some of their T-bills with short maturities and used the proceeds to buy longer dated bonds, thus twisting the slope of the yield curve to a flatter and lower level. After WWII, the last time government debt was as high as it is now relative to GDP, they performed what is called “yield curve control” by simply capping long term yields by buying additional longer dated bonds. (N.B. the Fed is already buying $80bn of Treasuries and $40bn of Agencies every month under their QE program, but they can certainly do more.) The Japanese central bank does this actively today but so far the Fed has demurred when asked about yield curve control. Anyway in sum, this school of thought argues that longer dated yields have a maximum level, and we are close to it. In fact, some would argue that the rapid drop to just under 1.50% which occurred after yields popped suddenly to just over 1.60% recently was the Fed intervening.
The other school of thought would argue that in the past the Fed has generally allowed long term yields to rise to reflect investors’ perceptions about inflation. This is a self-correcting route because higher yields are expected to slow the economy and inflation with it. The last time we had major inflation in the 1970s, they certainly allowed rates to rise, although they lagged inflation until then Fed Chairman Paul Volker ended the inflationary psychology in 1980 by raising short term rates to 20%.
Unlike 1980, debt levels today are probably too high in the estimation of the Fed to tolerate higher rates. Thus, they may start with operation twist and graduate to yield curve control. As discussed in the January letter, this must be part of a plan to inflate away the debt through higher inflation over time or it solves nothing and simply postpones the day of reckoning to a time when debt is even higher as a percent of GDP.
If that is how it plays out, the Fed may soon have to act, and when it does, the market will most likely respond positively, although we don’t know how much of this expectation is already discounted. In any case, any bounce may be short-lived given the very high valuation levels of today. In any case, such is a recipe for negative real rates, which is good for gold and is supportive of the reflating economy, which is good for commodities, bad for the dollar, and therefore again good for emerging markets, so more of the same.
Speaking of gold, it is the one beneficiary of inflation that has underperformed recently. In fact, it's been falling since yields started to rise last August.
Rising nominal yields is not an unreasonable explanation for this drop, given that gold is highly sensitive to real rates, and while real rates remain negative, they have been rising with nominal rates. But more likely we believe the drop in gold is reflective of a risk-on mentality that has seen rampant speculation driving everything from Gamestop to Bitcoin, and when that speculation ends, gold should have its day in the sun once again. In any case, the $350 drop since the summer was preceded by an $800 rise and nothing climbs up in a straight line for long.
So, in a nutshell, the story of today is rising dollar rates at the long end of the curve, consistent with an economic reflation and the emergence of inflation generally. While all of this is good for many of the sectors and styles we have focused on, the markets overall, in our opinion, are not priced to survive a continuation of rising rates, and so we expect Fed intervention at some point to keep the stock market alive and the government solvent. They can only succeed at this for so long, and so we have tried to position ourselves to benefit from the market evolution that will likely occur.
We look forward to launching the Pynk Thesis Portfolio this month and our next monthly investor letter will therefore speak more about how the portfolio is performing.
Meanwhile, stay well and invest thoughtfully.
When investing, your capital is at risk and you may recover less than the initial investment.