The guest commentary below was written by written by Diego Parrilla. This piece does not necessarily reflect the opinions of Hedgeye.
In my view, we are currently witnessing a major disconnect between markets and the economy, and the greatest financial bubble ever.
The disconnect originates from the relentless combination of Monetary policies without limits feeding Fiscal policies without limits, in what is known as Modern Monetary Theory (“MMT”), or Magic Money Tree, a major force distorting markets and valuations.
MMT is just the latest expression of a dynamic that has dominated global macro markets over the last decade, which I summarize as “the transformation of risk-free interest into interest-free risk” that, amongst other implications, has resulted in artificially low - even negative - interest rates and artificially low credit spreads that have fuelled Bubbles too Big to Fail.
The case of “pre-existent fragility” was exposed by Covid, a shock without precedents. The response from Central Banks and Governments via MMT is also another shock without precedents in terms of size, speed, and scope, that dwarfs the monetary and fiscal response to the Global Financial Crisis of 2008.
In addition to distorting valuations, MMT has reinforced the narrative and belief in the “Central Bank Put” which assumes that “don´t worry about risk, mummy will come to rescue us”, which has been a self-fulfilling prophecy as Central Banks feed reckless behavior that becomes systemic and forces them to step in, which in turn trigger a BTD (“Buy the Dip”) mentality, alongside FOMO (“Fear Of Missing Out”), or TINA (There Is No Alternative), which are very reminiscent of the 2001 mania and Dot Com bubble.
Unfortunately, MMT does NOT SOLVE problems, rather simply:
- DELAY problems via more debt (“kicking the can down the road”),
- TRANSFER problems via “beggar thy neighbour” currency wars,
- TRANSFORM problems from “bubbles too big to fail” into inflation, and
- ENLARGE problems, creating systemic risk, which ultimately brings us back to 1) as “mummy Fed and daddy US Government” are forced to come back to the rescue.
The current narrative is extraordinarily powerful and has been conveniently adapted as needed. For example, the recent Democratic “Blue Wave” in the USA - which a few months ago was feared due to the risk of higher taxes or regulation is being complacently ignored, at least for the moment, and conveniently adapted to the complacent view of the Fiscal Stimulus and Infrastructure expansion is good news for the markets.
Whilst there is a growing recognition of the problem of ballooning US debt, most participants are ignoring this problem. Even Yellen, in her new capacity, is asking to “act big to take advantage of the (artificially) low-interest rates".
Higher yields in US Treasuries (which have now surpassed the spike during 1Q20) have not resulted in stress in either equity or credit markets. Part of the reason is that, unlike in 1Q20, when equity valuations and fixed income were collapsing at the same time, the recent sell-off in US Treasuries has been more than cushioned by strong gains in equities, and thus 60/40 balanced portfolios remain balanced, at least for now…
The increase in nominal yields (current 10-year UST at 1.11%) has been relevant but moderate, has been closely matched by an increase in inflation expectations (current 10 year US inflation break-even at 2.11%, highest since Oct 2018).
Important to note that in 4Q18, the Fed responded with inflation of about 2% with a tapering (Powell´s famous “Fed in autopilot to hike interest rates”) which the Fed was forced to reverse as the collapse in equities exposed the excessive debt and fragility of the system. A wake-up call for the Fed that the abuse of the previous decade would be difficult, if not impossible, to unwind.
Despite the recent increase in inflation and inflation expectations above the historical ceiling of 2%, the Fed is in Powell´s words, “not even thinking about thinking about higher interest rates”, confirmation of our view that we are in a new paradigm of higher inflation AND lower interest rates, which I summarize as “the transformation of Bubbles TOO BIG TO FAIL into INFLATION, (or perhaps more worryingly, STAGFLATION)” which is THE ONLY WAY OUT of this mess that Central Banks have created.
The debate between inflation vs deflation is widely open. Yes, I recognize the many deflationary forces in the system (unemployment, weak economic activity, technology, demographics, overcapacity, malinvestment, …) but there is one major force single-handedly offsetting them all: MONEY PRINTING.
Don´t fool yourself. Inflation is here and rising. As I always say, “inflation is NOT about asset prices going up, inflation is about the value of the MONEY going DOWN”. Put differently, the principal of 100 USD or EUR you will receive in 10, 20, or 30-years will not buy you much at all.
The implications of higher inflation are enormous: investors must be mindful that CASH, FIXED INCOME, CREDIT are SHORT INFLATION. Investors should replace them with ANTI-BUBBLES, Real Assets, and Equities which are LONG INFLATION.
I often use the analogy of the “frog in boiling water” to describe the problem of inflation. If you throw a frog in boiling water, it will jump out. If on the other hand, the water is warm and slowly brought to a boiling point, the frog will never jump and will boil to death.
The same thing for inflation, a 2% inflation is a tax that reduces your purchase power by 2% per annum. It may sound like little, but our purchase power is being diluted (taxed, stolen, pick your word) and compounding to 20%+ over just 10 years and 50%+ over 20+ years. At my age, “20 years is not what it used to be”. Deflation is the enemy of government debt. For savers inflation (not deflation) is the enemy.
The Covid shock from 2020 is now entering its third wave and is not yet completely resolved. The pain is being patched by money printing and debt, but you can not solve solvency problems with liquidity.
The dramatic economic situation stands in contrast to the euphoria in certain markets. The economic data is not reacting as positively as we all hoped (unemployment, for example) but the narrative is complacently back to “bad news is good news” as the market prices more support.
A corollary of artificially low-interest rates and spreads and the desperate search for yield is duration risk, not just for fixed income, but also for equities, as evident by ballooning PE multiples, a double edge sword that hurts equity valuations via higher nominal yields, which if popped, will result in lower yields…
Another major driver of the market has been the vaccines (Russia has announced today theirs is 100% effective!!). As a fellow engineer, I want to believe that the vaccine is yet another example of the extraordinary achievement for human ingenuity and technology, and I am hopeful that the vaccines will be very effective, but as a risk manager also worry about the fact that the success seems to be completely discounted.
Negative news around the vaccine is a clear tail risk, which is exacerbated by the fact that Covid risk seems to have become almost irrelevant, as lockdowns, more dangerous and more contagious strains, or deaths (including those of vaccinated people) are largely ignored.
The next few weeks will be important as countries leading vaccinations (such as Israel or UK) confirm or reject the effectiveness. I sincerely hope that we solved the problem, but we are “hoping for the better and preparing for the worst”.
Another key factor is RETAIL investors (such as the notorious Robinhood platform) that are notoriously driving certain stocks higher, such as Tesla or Bitcoin (in my opinion text-book bubbles) where retail believes valuations are attractive and/or hope is that institutional investors will buy at even higher prices. Who knows, perhaps it is different this time and retail was the smart money. Or perhaps not. Time will tell.
Volatility is one of the key anti-bubbles in the system and in my view will expose explicit and hidden risks in the systems. Higher volatility mechanically translates into risk reduction, forced liquidation, and higher realized volatilities, which feed back into higher volatility, forced liquidation, and so on, in a vicious cycle that can accelerate and spin out of control very quickly, as we have seen multiple times, most recently in 1Q20. We have a strategic and tactical long position in VIX via options. The term structure results in painfully expensive carry which we try to mitigate as much as we can.
The timing of a potential reversal is impossible to predict and we often hear the argument that there is “no catalyst insight”. The problem is that we don´t always need a catalyst to expose excesses in the system: imbalances also tend to resolve themselves. Look at the Feb20 spike in the VIX, for example.
Whether there is an “official catalyst” or not, the risk ex-ante will find a reflexive explanation ex-post (“prices follow news, and news follow prices”). Despite the current bullish consensus and complacency, we are seeing several red flags, including the high level of volatility of volatility (vol of vol) that support our tactical long option in the VIX, a position that worked very well for the strategy back in March 2020.
As of today, and despite multiple efforts to break lower, the VIX remains stubbornly above 20%, which is a moderately high level, significantly above the 10% to 15% VIX we saw prior to Covid. A move down in the VIX towards 15% could be the last nail in the coffin that could trigger another MELT UP in risk assets.
As of now, trend followers, risk parity, and vol targeting strategies are somewhat underinvested.
On the other hand, the risk in portfolios could be dramatically reduced if volatility was to spike higher. As I always say, volatility is the “speedometer of the markets”. If you are driving at 200 mpd and the speedometer says 80 mpd…. What will you feel if you had an accident?
Clearly the real speed, regardless of what the speedometer read. Same thing for the markets. What losses will you incur? The ones predicted by the implied vol, or the real risk you were running? The danger here is that artificially low volatility can give the impression of low risk ex-ante, but the real risk will always show ex-post.
How will the Fed respond? I believe the Fed is by now totally aware of the fragility of the system, and ready to act pre-emptively in response to potential shocks. This does not mean that there will be no shocks. There will be shocks. It means that the Fed will be ready and fast to act.
The current consensus and complacent expectation is that the Fed has everything under control (“the Central Bank Put”). I disagree. The main problem is that the size of the problem is getting larger and larger with each iteration (current bubbles in 1Q21 are much greater than in 4Q18).
The other problem Central Banks are exhausting their conventional and unconventional tools, which are subject to the law of diminishing returns. Remember for example how QE3 was dubbed “QE infinity”?
Personally, I believe the Fed is ready to step in with Yield Curve Control (“YCC”) which is already in place in Japan and controls long-dated yields. Basically, they will print more and buy more US Treasuries. Eventually, I expect 30-year US yields to follow the path of Europe and Japan to zero or negative yields. If you add higher inflation, it means 30-year TIPS have some decent potential for appreciation.
But for the time being, the Fed is “happy” letting nominal yields go up – for as long as they don´t translate into higher volatility (“THE catalyst”) and/or sell-off in risk assets.
Overrunning the entire macro set up is the concept of WEALTH EFFECT, a major double edge sword that contributes to inflating bubbles via virtuous cycles (higher valuations result in lower borrowing costs, more complacency, etc) and to the collapse of bubbles via vicious cycles (“the bubble Emperor had no clothes”).
Look for example at the Wealth Effect from equities such as Tesla, with $800b capitalization and 1700 PE is beyond anything we have ever seen. Or crypto currencies, with a combined valuation of $1T (yes, 1 Trillion!). The $1.8T in Tesla and crypto alone is large enough to become a systemic risk, in my view. Investors have the impression that is $1.8T wealthier but I am afraid they are NOT.
Should the Tesla and Crypto Emperor have no clothes, the collapse is not just a zero-sum-game between “early movers” and “greater fools”, but also a major distortion to the markets as it was the case in 2001.
Or look at the recent craze in “Penny Stocks”, where “tick-tock financial influencers” are tipping retail investors how to spend the next Stimulus check to make 10x in 1 week. Yes, reality beats fiction.
My recommendation to the Tesla and "Bitcoiners" and Penny stock “traders” is to pay for the Lamborghinis with cash (selling bitcoin or Tesla) rather than taking a loan, because the loan will stay if/when the bubble bursts.
Back to timing, I think Tesla can be an interesting “Canary in the Wall Street Mine”. For now, it all looks stable, but in my view, it is yet another case of “unstable equilibrium”, as I discuss in the opening pages of my book, The Anti-Bubbles.
Overall, we believe will be a bumpy ride and more printing and debt that will be very supportive for real assets in general and Gold in particular. The performance of gold since August, when it made all-time highs in USD, has been disappointing.
The recent divergence between gold and crypto in my view is indicative of the complacency of the market and suggests that crypto currencies may closer to Tesla than gold. Perhaps those of us who believe in gold are “dinosaurs”.
Or perhaps not. Time will tell.
My view is, similar to the collapse of the 2001 dot com bubble when my friend and former colleague Jeff Currie published his famous paper “The Revenge of the Old Economy”, I believe the path ahead will be bumpy and believe that the bubbles will be tested and exposed via higher levels of volatility, which will invariably result in more money printing, more debt, and eventually more inflation, all supportive of real assets, where gold will lead the “The Revenge from Old money”.
EDITOR'S NOTE
Diego Parrilla has two decades of investment and senior leadership experience at global leading institutions in London, New York, Singapore, and Madrid, including JP Morgan, Goldman Sachs, Merrill Lynch, BlueCrest Capital and Dymon Asia, and is currently a Partner at Quadriga Asset Managers in Madrid. Diego is the co-author of best-selling book, The Energy World Is Flat: Opportunities from The End of Peak Oil (Wiley) with Daniel Lacalle, and a selective contributor to the Financial Times Insight Column, El Mundo, CNN, CNBC, Real Vision TV, or Bloomberg TV, amongst others.
Diego holds an MSc mineral economics from the Colorado School of Mines, an MSc petroleum economics and management from the French Institute of Petroleum in Paris, and an MS and BS in mining and petroleum engineering at the Madrid School of Mines at the Polytechnic University of Madrid.
