Volatility Drivers of 2021

The fusion of fiscal and monetary policy with massive federal government budget deficits and large-scale purchases of Treasuries and mortgage-backed securities by the Federal Reserve sets up a potential scenario for rising inflation. The inflation scenario puts the back-end of the Treasury yield curve in play, regardless of how long the Fed anchors the short end with zero rates. And there will be an increased focus on Treasury Inflation-Protected Securities (TIPS) for those looking to get a market read on evolving inflation expectations. We want to make several observations about the inflation process to assist in analyzing the probabilities of meaningful inflation pressure arriving in the US in the second half of 2021 or in 2022:

First, once serious inflation pressure gets started it can be very hard to stop. Similarly, long periods of price stability anchor inflation expectation at or below 2%, so that creating inflation pressure is extremely difficult.  The US has seen both of these environments. The inflation pressure that arrived in the late 1960s and gained momentum through the decade of the 1970s was hard to defeat. To paraphrase former Fed Chair Paul Volcker, it took a big hammer of 20% short-term interest rates in 1980-82 to force the economy into recession and get inflation expectations headed lower. By the same token, the 1950s through the early 1960s, and again from the mid-1990s through 2020 were both periods of price stability, which anchored inflation expectations at or below 2% and extended the time frame for expansionary policies to lead to future inflation pressure.

Second, serious inflation pressure, say above 5% or more, is usually associated with currency depreciation in a vicious cycle of each factor re-enforcing the other. The US dollar was quite weak in the 1970s when inflation pressures were rising. And in the 1980s and into the 1990s, dollar strength help create a re-enforcing virtuous circle of lower inflation expectations leading to the long period of price stability which began around 1994.

Third, expansion of the Fed’s balance sheet may not be a sufficient condition to lead to significant future inflation pressure. The Fed’s massive asset purchases (i.e., QE or quantitative easing) have clearly led to asset price inflation yet not goods and service price inflation. Put another way, the maxim of Nobel Laureate Professor Milton Friedman that “inflation is anywhere and always a monetary phenomenon” has been challenged by the structural change in how goods and services are bought. In the 1950s and 1960s when Professor Friedman did his monetary research, goods and services were purchased with the cash bills in your wallet or the funds in your checking account. From the 1980s onward, as interest was paid on checking accounts, as credit cards became ubiquitous, as money could seamlessly flow between checking, savings, and investment accounts, as payments could be made from smart phones, etc., the relationship between measures of the money supply, such as M1, M2, or M3, lost all association with consumer spending, and therefore with inflation. For monetary expansion to lead to inflation, consumer spending has to meaningfully exceed the supply of goods and services available, and if consumer spending no longer depends on the Fed’s balance sheet, the Fed is no longer able to generate consumer price inflation even if it can generate substantial asset price inflation.

Fourth, from our perspective, the question of whether the demand for goods and services is pushed well above the economy’s ability to supply the goods and services and will lead to inflation depends on the type and quantity of government spending. In this regard, government borrowing to finance direct payments to individuals or loans to corporations are unlikely to create inflation regardless of how large the payments and loans are because economic agents will make their own spend, save, or invest decisions that takes the current economic environment and economic risks into account. By contrast, new government spending on goods and services that otherwise would not be present has the potential to push demand well above current supply and create inflation pressure. This almost always happens in war time, when governments purchase military equipment in size, and wars are typically associated with bouts of inflation. Also, in the 1930s, the various US work programs helped end the depression, although WWII spending truly ended it. In the 1960s, the guns and butter policies (i.e., Vietnam War and Great Society programs) get considerable credit for igniting the inflation pressure that took hold in the 1970s. What this means for 2021 is that analysts like ourselves will be studying fiscal policy carefully as it evolves to understand if it starts to tilt to infra-structure spending either directly or through grants to state and local governments that can create inflation, or whether fiscal policy focuses on transfer payments and loans which may have only a muted impact on inflation if at all.

Big tech drove the US stock market to record highs in 2021 on the back massive fiscal stimulus, an accommodative Fed, and optimism for widespread distribution of a vaccine in 2021. The post pandemic economy with a change of administrations and party control in Washington is likely to see US policy initiatives that may bolster health care, challenge big tech, and support industrials and materials with infra-structure spending. Equity indices that favor big tech (Nasdaq) or large capitalization stocks (S&P500®) may react quite differently than the more domestic small cap indices, such as the Russell 2000.

For example, since equities hit bottom in March, the Russell 2000 has outperformed the S&P 500® by about 33%, bringing the ratio of the two indexes to its highest point since May 2019. The relative outperformance of small cap stocks coincided with a sharp rise in inflation expectations, as measured by the difference in yields on nominal US Treasury 10-Year Notes and 10-Year Treasury Inflation Protected Securities (TIPS), from a March low of 0.5% to a recent high of 2.1%.

That the fortunes of small cap versus large cap stocks would track inflation is not a new phenomenon. Since 2010, small cap equities have tended to outperform large caps during periods of rising inflation expectations and underperform during periods of falling inflation expectations. 2020 was no exception.

Looking back further in history, small caps stocks tended to outperform during periods of economic turbulence and in the early stages of economic recoveries (1979-83, 1990-94, 1999-2005, 2008-2013). By contrast, large caps tended to outperform in the later stages of economic expansion (1984-89, 1994-99, 2006-07 and 2015-19). Perhaps small firms are, on the whole, better at navigating periods of rapid economic change than their larger peers.

From March 20, 2020 into early 2021, the US dollar lost almost 15% of its value versus the euro before settling back a bit. Since May 27, 2020, the Chinese yuan has gained almost 10%. USD weakness versus the euro appears to have been driven by changing risk assessments of the US, while the strength of the yuan seems to have reflected China’s quick and rapid domestic recovery from COVID-19. Emerging market currencies offer an array of interest rate differentials versus USD, arguing for a return of the FX carry trade where the emerging market risks seem acceptable.

In simpler times, exchange rates were mostly driven by the interplay of interest rate policy and economic growth prospects. That is, relatively strong economic growth prospects would attract capital and lead to currency appreciation. A country with sluggish economic prospects that saw its exchange rate depreciating might elect to defend the currency with a relatively high interest rate policy. This latter approach has been repeated often in the case of emerging market currencies. Note that the trade balance does not play much of a role in FX determination because capital flows tend to overwhelm trade flows. The exception is for countries whose economic growth prospects are tightly linked to commodity exports, and for these countries, export growth matters a lot for the currency.

As we move into the 2020s, however, two additional factors are in play in exchange rate determination: risk and debt.

First, there is rising risk associated with the US dollar as the world moves increasingly to a multi-power environment and away from the US-dominated “Pax Americana” of the post WWII era. In this multi-dimensional world of global power politics, both the euro and the Chinese yuan are well positioned to gain ground on the US dollar, and both did so in 2020. The past may not necessarily be a harbinger of things to come, but the changing nature of the risks associated with the US dollar is an important emerging feature of exchange rate determination.

Secondly, the roles of rising debt loads in mature developed industrial countries may change the dynamics of interest rate policy decision-making. The more debt a country has, public and private, relative to the size of its economy (i.e., GDP) and growth prospects, the more fragile and sensitive the economy will be to central bank rate hikes. With pandemic-induced fiscal policies generating huge budget deficits financed by government debt issuance, central banks, such as the Fed, are going to be increasingly cautious about raising short-term rates, even if inflation pressures do raise their head. Indeed, the Fed has provided forward guidance that is crystal clear that if any inflation pressures were to emerge in the US, the Fed plans on allowing inflation to over-shoot its 2% target for an extended period before considering rate hikes. This means that highly accommodative Fed policies may stay in place well after inflation pressures arrive, which might create a re-enforcing vicious circle of rising inflation and a declining currency. Of course, the inflation pressure has not arrived yet and (see the above section on Rates) is not a foregone conclusion by any means.

When supply and demand are both rising, if unevenly, prices can be more than little volatile, and this is likely to be case for oil in 2021. But there are also regional differences. Demand is likely to grow faster in Asia, slower in Europe. A return of international air travel will increase jet fuel consumption relative to other refined products. Divisions within OPEC+ can lead to different supply environments for different grades of oil.

Following Russia and Saudi Arabia’s market share war this past spring, OPEC+ has shown a remarkable degree of discipline in maintaining production amid a volatile demand environment. Rather than setting production levels every six months, they have been adjusting them on a more frequent basis to meet rapidly evolving demand conditions. The result has been a recovery and stabilization of oil prices despite still soft demand. For example, air travel accounts for 10% of global petrol consumption. International air travel has not even started to recover. Domestic air travel has recovered in China, but in the US it is still down by about 62% year-on-year.

The key short-term challenges for oil producers include the rapidly evolving pandemic and still high levels of inventory. At the beginning of 2021, inventories were much higher than they were at the beginning of the previous three years – though not too far from where they began 2017.

Looking deeper into 2021, there remains the possibility of a sharp surge in oil demand as the world starts to fully re-open its economies, perhaps as soon as this summer or early fall. By that time, at least in the wealthier nations, a large portion of the population may have been vaccinated. OPEC+ can turn the taps back on quickly to meet rising demand.

The same extraction patterns relative to oil prices are not true of the US shale producers. Typically, they wait for about four months after prices have risen to begin drilling again and then it takes, on average, several more months for them to begin extracting significant quantities of oil. As such, the combination of weak and volatile short-term demand as well as high inventories, plus the possibility of a sharp rise in demand later this year that could outstrip the ability of oil producers to keep up, could make for an exceptionally volatile year in the oil markets.

We would be remiss if we did not observe that natural gas is on the move, too. Weather is a big factor. The winter of 2020-2021 in Europe is frigid, and it is driving up demand for natural gas. In turn, cargoes of US LNG are headed for Europe at elevated prices.

The post-pandemic world and the rise of China argue for strong support of industrial metals from copper to aluminum and beyond. Gold, on the other hand, has a competitor in Bitcoin, which could siphon off some of gold’s appeal as a portfolio diversifier as well as compete with traders trying to hedge future inflation risks. Moreover, Bitcoin’s supply is tightly constrained, while it is likely that 2021 will bring increased gold production given current prices.

As noted, China holds an important key for industrial metals and the growth of world trade. The virus started in China, hit China hard, yet China contained the virus first and began a robust economic recovery while another wave of the virus curtailed the economic rebound in Europe and the US in Q4/2020. China’s strong 2H/2020 economic recovery, as noted, led to strength in the Chinese yuan, and push the prices of copper, aluminum, and other industrial metals higher. One can also see in the global trade statistics that the China has led the world back to almost a full recovery in world trade activity.

The Bitcoin-gold rivalry that we are starting to observe is a little more complex to analyze. Given the current price range for gold, it is highly likely that increased production will be a feature of 2021. By contrast, Bitcoin has a tightly controlled supply based on the rules of “mining” Bitcoin. Fixed supply does not mean less volatility. Indeed, it can mean the opposite. When supply is relatively inelastic, then the dynamics of shifting patterns with demand can have very large and abrupt impacts on prices. Bitcoin definitely appears to illustrate this point.

We have also noticed that gold does not appear to be a “go to” asset any more in terms of global political risks. Indeed, in the 2017-2020 period, the mostly ups and occasional downs of the gold price appeared to be directly tied to Fed policy shifts more than anything else. Since equities were responding to the same driving force, the gold-equity relationship tended to become a little more closely associated, weakening gold’s appeal as a portfolio diversifier.

For soybeans and corn, rising demand from China may be a key driver in 2021. Regional price action may respond to how China allocates its purchases. Regional differences may well be complicated by a strong La Niña which has the potential to diminish rainfall in Brazil and Argentina, while increasing it in Australia. Elevated price volatility often occurs during La Niña.

From 2012 to 2019, the price of soybeans largely tracked the Brazilian real. When the real fell versus the US dollar, soybean prices usually fell too. That relationship, most likely driven by the Brazil’s emergence as a leading global exporter of soybeans that rivals the United States, broke down in 2020. Soybean prices soared as Brazil’s currency weakened slightly versus the US dollar.

There appear to be two factors at play: 1) weather and 2) China. With respect to weather, a powerful La Nina has developed in the Pacific Ocean –the strongest since 2010. This has coincided with a severe drought that has impacted much of South America including key soybean growing areas in Brazil and Argentina.

Meanwhile, China’s economy has rebounded strongly, with its manufacturing sector showing growth rates of 8% or more year-on-year since May. As China’s economy has recovered more quickly than most others around the world, the currency has advanced by 10% versus the US dollar, increasing its purchasing power. With the Sino-US trade war winding down, China has returned to the market as a major purchaser of soybeans.

For sure, 2020 looked nothing like 2019, and 2021 is going to be a totally different story from the pandemic year of 2020. The global economy is not going back to pre-pandemic norms. Instead, certain trends have been accelerated, new policies are coming, and the world order is shifting. Markets will have many cross-currents and new themes to digest.

• US Treasuries are on inflation watch.
• Equity indexes are dancing to different drummers as big tech and small cap diverge.
• The role of the US dollar is shifting.
• In emerging market FX, there are interesting opportunities available due to differences in interest rates and risk assessment.
• Crude oil faces conflicting scenarios as both supply and demand rise, while regional differences in demand and production complicate the picture.
• Natural gas is responding to frigid weather in Europe.
• Corn and soybeans are seeing higher demand from China, while a strong La Niña creates drought conditions in South America.