Chalets in Sochi

2021 kicks off with a riot of a week ...

The main developments this week centered on the Georgia runoffs and the subsequent raid on Capitol Hill. The market reaction came in roughly in line with the ones described in Georgia On My Mind. The "insurrection rally" was lifted by hopes of further stimulus that should lead to a sustained economic recovery. Economic data over the week continues to point to stalling economic growth in the US and Europe. Global growth is mixed globally, with China and other Asian nations recovering faster than Western countries. In Commodity markets, OPEC cobbled together a deal that resulted in further production cuts.

Democrats declared victory in Georgia, kicking off a wide range of Blue Wave trades despite the insurrection on Capitol Hill. I doubt the events that unfolded this week were as grave as Chuck Schumer suggested, ranking them alongside Peal Harbor, but I do think they have severe consequences in the future. America must now live with the idea that "it can happen here," where "it" implies political instability on par with Venezuela. One has to wonder what storming the White House will do to the future of American domestic politics and the US' role in the world. The halting of a transition of presidential power by an armed mob isn't something to shrug a shoulder at, and it will be interesting to see what happens to the Republican party. Does this "revolution" split the party into different factions? How does the Democratic Party respond, and more to the point, does this unify or further propagate differences between the Parties? Joe Biden will already lead the US with an asterisk, given at least a quarter of the country doesn't believe he won the election legitimately, but will policymakers be willing to work with him on his agenda? These are all open questions that markets will be pondering over the next few weeks, months, and even years.

Twitter pulls the plug on @realDonalTrump. On an announcement late Friday, Twitter handed Trump's Twitter account a permanent suspension citing concerns around the context of Trump's tweets and how they could be understood. Although some will view Twitter as putting principle over profits in this somewhat bold decision, the reality is, if they cared about how the public interpreted Trump's tweets, they would have banned him years ago. Although I'll save readers from a rant on social media, the bigger issue is that these platforms are a digital black hole for misinformation that tempts otherwise sane people into doing foolish things. As one analyst put it, watching people argue on Twitter has become something of a national pastime, like rubbernecking the aftermath of a car accident on a highway. The critical difference is that rubbernecking a car accident won't slowly change your political views and end with you aimlessly storming a government building looking for anti-gravity machines.

Donald Trump is in for a rough 2021. Nancy Pelosi and Chuck Schumer have both accused Trump of inciting an armed insurrection against the United States. Furthermore, Democrats are pushing to introduce an article to impeach the President. Despite this, it is very likely President Trump finishes his term barring any new evidence or a resignation. There are rumors of President Trump planning to pardon himself; I guess what's the harm in one last blatant abuse of power. If I were in Trump's shoes, I'd be calling up the Kremlin to see if I could get a Chalet out in Sochi; maybe even swindle some deal for protection.

... and markets continue to run away from reality.

Bad omens in the labor market. Non-farm and ADP payrolls both pointed toward job losses in December. Unsurprisingly, the rapid spread of COVID and the subsequent containment measures disproportionately impacted the service sector in December; and it's unlikely that service sector firms will be adding back positions until the virus is under control. Over the past few weeks, COVID-19 has spiraled out of control in the US, leading to record infections, hospitalizations, and deaths. A non-started for any small business susceptible to further lockdowns. Against this, I suppose the report's readthrough is simple; the case for more fiscal stimulus has gotten stronger. Extrapolation from this report, retail sales next week will undoubtedly be weaker, and, as a reminder to folks, consumer spending is the primary driver of US growth. The chart below shows the contribution to GDP changes each quarter; note the rebound in Q3 was due to consumption.

The prospect of more fiscal stimulus steepened sovereign yield curves, led by long-term rates. The blue sweep in Georgia has helped solidify a higher fiscal spending theme that has been brewing in markets since the US election. The chart below shows a decomposition of the 10-year Treasury yield and shows that the increase in yields since October has been due to rising inflation expectations. Some of that increase has been offset by falling real yields, a proxy for monetary policy accommodation. These types of gains in interest rates are healthy for financial markets and help keep financial conditions accommodative by bolstering riskier assets.

The idea of coordinated fiscal and monetary policy is stoking expectations for higher inflation. The level of market-based inflation expectations has reached the highest level since 2018. The chart below shows the level of breakeven inflation rates (derived from Treasury Inflation-Protected Securities) and a 5-year inflation swap, 5-years from now. The announcement of former Federal Reserve Chair Janet Yellen as Treasury Secretary for the Biden administration has increased speculation of a fiscal/monetary policy partnership in the future. Frankly, that speculation is probably well placed. Having a former central bank governor running the Treasury should help split the burden of kickstarting the US economy between monetary and fiscal authorities.

The equity market rotation continues. As highlighted in Georgia On My Mind, a large rotation trade this week away from big tech names towards more cyclical and value sectors. In reality, this has been manifesting for a few months now. The chart below shows the US sector returns since October. We can see that cyclical sectors have outperformed defensive sectors, like utilities and technology. The combo of a US election that went far better than markets were expecting (markets were pricing an unresolved election almost into January) along with vaccine trial results, which couldn't have been better, has turbocharged riskier assets.

Systematic investing strategies will continue to increase exposure to equities. With volatility dropping like a bag of hammers over the past few months, volatility targeting funds have been increasing exposure to equities. The chart below shows a volatility control model developed in house that estimates exposure to the S&P500. We can see that exposure is now at the 33rd percentile going back to 1960. That's in contrast to nearly the 99th percentile before COVID-19.

Thanks for reading,

Tiago Figueiredo