For me, it’s actually like a Monday because I took a 5-day holiday over Easter and am coming back to work today with relatively fresh eyes. So, let me make this a longer post, telling you what I am thinking and why I am mostly upbeat. And I will provide some mea culpas along the way too.
My 2021 evolution: how it started
I like to look back at my previous writing on a continual basis to get a sense of where I get it right and where I get it wrong. It helps me to be intellectually honest. And that also helps me to pivot.
This morning, I did a brief look-back to the beginning of the year and I felt like I came away seeing an upbeat evolution toward greater optimism on the viral front, the economic front and the market front. I actually like the framing all along the way – because it shows my openness to non-base case outcomes. But there is also a clear and consistent trend toward a more bullish mindset. So let me take you through that with a few excerpts.
So, as bad as 2020 was, 2021 offers us hope for the future. How much can we hope? I am thinking mid-year i.e. the Fall before a reasonable sense of normalcy resumes. That’s my hope. And when it resumes, my hope is that the life support governments have administered to households and businesses will have been enough to see us through the fallow period. Further, I am hoping – and expecting – there to be pent up demand for the services we’ve lost – the vacations, the travel, the hotel stays, the dining out – all of that, before we settle into a new post-pandemic rhythm.
–Happy new year 2021, Jan 4, first post of the year
I entered 2021 with a hopeful mindset because “we have not just one or two different vaccines that are in production, but a baker’s dozen. By the end of this year, you might have several different ones to choose from.” And for me, the pandemic was all-consuming for the global economy as the year began. I figured that it was only a matter of time before we were out from under lockdowns and recession. The only questions were how long it took, what (permanent) damage would be done getting there, and what the economy would look like afterward.
I was hopeful. But my bias was toward downside risk. In that first post, I wrote that “I am personally in a more glass half full frame of mind. I still see the European and US economies in recession this quarter, taking the global economy into recession. But I am more in the glass half full camp because I think the vaccines give us that beacon to sail toward. And I believe that will help us to avoid worst case outcomes.”
Europe went into recession, yes. But we didn’t have a global recession, in large part because the US did not, something we will come to shortly. The long and short is that, if you look back to the beginning of the year, I was right to be hopeful but I was not sufficiently bullish about the resilience of the US economy – which greatly impacts bond yields, the credit cycle and share prices globally.
The right framing for 2021 (in pandemic terms)
A lot of this is tied to the pandemic, which as the year began was the key factor in near- and medium-term economic outcomes. I first described 2021 as a foot race between the virus and mass vaccination on January 30. “The question is how quickly we can get through vaccination to protect people before the virus mutates and causes further damage.” That’s the right framing.
But, back on January 13, I wrote some thoughts on this latest wave of coronavirus ongoing at that time. This was the most glaring error in that post:
For the US, then, the implication of what has happened in the UK and the viral spread that Canada and Switzerland are talking of is that we are going to see a severe situation by early February. That’s my takeaway.
Uh…no. It was Europe where the increase occurred, not the US… or Canada. And even in Europe, the spike began somewhat later. My logic was based on timing of the introduction of mutant strains and I quoted a Globe & Mail article that said the following:
The model shows the “takeoff” generally occurs at three to four months. At that point the variant begins to quickly outpace the older version of the virus and causes a rapid escalation in total case counts. If there was such an October introduction, that would mean the variant would be starting to have a significant effect now.
What we see now is that the introduction of the B117 mutant strain into Europe was earlier than it was in North America. And in both continents, the transmission timeframe was delayed relative to what the Globe & Mail article outlined. That has meant that the footrace between the baker’s dozen of vaccines and the virus is more important. As I put in the Jan 13 article:
My hope is that the Biden Administration corrects the incoherent coronavirus policy of the Trump Administration and puts the US back on the right footing. Germany shows you that even competent responses won’t allow you to escape Scot-free.
Biden did put the US on the right path, with the US now vaccinating 3 million a day. I have an appointment for my first shot on Thursday. And Germany (and the EU) have not done a good job on vaccine administration. The result: the US is outperforming economically as Europe is crushed by another wave of the virus. And Canada is likely to meet the same fate as Europe due to its poor vaccine rollout.
So, this is where the rubber hits the road in terms of predicting outcomes – or at least framing potential outcomes and predicting likely paths based on that framing. And in looking back through 2021, I like my framing a lot more than the initial predictions. Here’s why.
This frame from January 21 still holds up:
I would frame the economic risks this way:
- How long is the economic tunnel between now and the post-pandemic period compared to what’s ‘priced in’?
- How does the economy develop between now and then?
- How do markets develop in that time period?
- And what is the new normal relative to current expectations?
The answers to these four questions will still determine what your predictions are. For example, back on January 21 I wrote that “If you asked me where I lean now, it’s away from the sharply steepening yield curve” because I saw “growth as weak enough now and for the rest of the pandemic to prevent that outcome”.
But we know now that the US has vaccinated faster than any large advanced economy except the UK. We also know that US economy powered through the third wave in Q4. And we know that we have had one stimulus of almost $1 trillion under Trump and one of almost $2 trillion under Biden in short order. So that tells you that the economic tunnel is shorter in the US and that the economy has and will continue to develop well.
For me, it’s been watching credit markets in that time frame that has been the tell. There has been no distress in credit in the US at all. In fact, high yield bond spreads are at their lowest levels since 2007. If the lowest rated bonds are showing no signs of stress, you know the credit cycle is supportive of growth. And that should give you confidence that this recovery has legs. So when we look at how markets have developed as we reach the end of the tunnel, it makes sense that equities are higher and bond yields too. The only question remaining is what happens in the post-pandemic new normal.
I have evolved toward that stance. Whereas, on January 21, I was still in the ‘weak growth’ camp because of the mutant viral strains, on February 12, I was already talking of my bullish economic thoughts and the three yield curve outcomes. By February 25, I was writing that “the balance of risks is now completely tilted to the upside in the US economy. And that means we have to explore those upside risks. What a change this is.” And I called the post “Thinking about the blowoff top“.
That’s quite a change in a month’s time. But I hope laying out how I was framing the issues mentally tells you why I made that pivot. The lack of mutant viral infection and the progress on vaccination were the key ingredients for me. As I put it on February 12, ” why shouldn’t we think about scenarios where we win the vaccine footrace against” the mutant strains?”. Even now as we await a likely fourth wave from those strains, I do think having some 100 million people vaccinated will put a dent in the public health and economic impact.
The bond stair-step
So, for some time, I have been thinking about 2021 in 2018 terms. I first wrote about this in detail on February 17. See “Shades of 2018 as steepening yield curve great for banks, not tech“.
The gist here is that – with the risks now on the upside – we have to think less about bear flattening from long duration yields declining and more about steepening. Look at it through the yield curve lens I first used on January 15: The reflation trade and three yield curve outcomes.
- Scenario #1 is the ‘upside risk scenario” where the yield curve was steepening before the bullish economic outcome had crystallized.
- Scenario #2 is where the yield curve steepening is arrested, stopped in its tracks as we await further progress on vaccination. And more steepening occurs only when its clear that we are at or near the end of the tunnel.
- Scenario #3 is where the market susses out that true inflation is nowhere and the lack of consumer demand means weak economic growth and earnings. The yield curve there flattens, making discount rates lower and only potentially buoying the shares of companies that can benefit in the slow growth environment (if any).
Back when I wrote that post, I wrote that “I lean toward outcome number three, of course. But I leave the door open for the other two, secretly hoping for outcome number two. But, remember that hopes and reality are two very different things. And so, I see outcome three as more realistic than the other two.”
Now, on April 6, I would say I think we actually are living a version of scenario #2 (plus #1 in part) because of the vaccination progress. What’s happened is that the stimulus and vaccination have combined to send economic growth into orbit in the here and now. So when I said “more steepening occurs only when it’s clear that we are at or near the end of the tunnel,” I now believe it’s clear that we are near the end of the tunnel (fourth wave notwithstanding).
My views (at the moment)
So, we have a bond stair step path happening against a bullish economic backdrop, where the US is leading the global economy out of the pandemic. In 2018, the stair step was one precipitated by tightening, with the potential that the Fed could cause the next recession. That’s a contrast to today and we have to work out what that means for the US dollar and the reflation trade favoring value vs growth.
My view at the moment is still that the bond stair step has legs just as it did in 2018. I realize we have just come off the worst quarter for US Treasuries since 1980. But, if the US is leading the global economy, it suggests that there is more room to run for global growth. And that is supportive of rising yields. Let’s see.
As I write this, the 10-year US bond is down to 1.686%. – meaning the run at 1.75% has stalled. We are still in the 1.50% to 1.75% trading range. And if you go back to my framing on the three outcomes, that’s the bullish scenario #2 “where the yield curve steepening is arrested, stopped in its tracks as we await further progress on vaccination.”
If we do see a greater rise in yields – and that’s my base case for now – I also think that increasing yields favor value over growth, banks over tech if you will. And while that had played out as a relative value play, since February it has been negative for growth as the Nasdaq topped on February 12th. It is making a comeback, but it topped out almost two months ago. To me, that highlights how the stair step higher in rates is causing problems for companies where the vast majority of net present value of earnings is in the terminal value of their discounted cash flow valuations.
I am going to end today’s post there. I would summarize it as upbeat and say it marks an evolution from my seeing risks as mostly to the downside throughout 2020 and as we began 2021 to hoping and praying 2021 would be better than expected as the year began to thinking it actually will be better than expected today.
Upside risk is preferable to downside risk! But still, the risks there are inflation, rising bond yields, and overheating. Growth is less attractive on a relative basis in that environment. And while that upside risk may not come to pass or be short-lived it is now the bigger risk.