Probabilistically Navigating a Monetary Stimulus Future

Navigating the Biden Vision

The world economy over the next four years is in a precarious position and economic stimulus is most likely going to be the main driver of markets. If Joe Biden becomes the next US president, the Democrats keep Congress and Republicans most likely retain the Senate. The stimulus talks will continue between the next treasury secretary and the Republican senate majority leader Mitch McConnell. Internationally, the future of stimulus is mixed, as the divided Europeans are still recovering from Brexit, while the Chinese government has a lot of power to impose their stimulus vision. Finally, with an escalating dependence on technology in combination with rising nationalism around the world, trade negotiations between EU, US and China are likely to result in tough compromises, which make COVID-19 plans and foreign policy even more important. Worth noting is that this type of division prohibits visionaries from pushing change, as they have to compromise with people of more conservative viewpoints. With a weak Biden in charge, a powerful China, and a divided EU, democratically elected leaders will have less leverage when it comes to economic stimulus packages.

Joe Biden

Where were we Pre Corona?

Despite financial pressure from Brexit uncertainty and various trade wars, the world economy started of strong in 2020. This was particularly true in the US, were business was booming and a record low 3.5% unemployment rate was achieved in February[1]. Then the Corona spread from Wuhan occurred quicker than a Thanos snap, which lead to lockdowns and a 14.5% US unemployment rate in March. Fears of continued lockdowns lead to historical daily financial market drops and on March 12th the S&P 500 dropped a record 9.5% in a single day. Investment strategies such as L/S equity and long bias ETFs underperformed spanning first and second quarter because they were long market beta. Worth noting is that all investments are exposed to market beta, as all stocks and strategies move either with or opposite to the market. If the market is driven by fear then most stocks are likely to sell off together with those investment strategies that banks on a growing economy. However, there are some stocks, strategies and assets that are exposed to idiosyncratic risk and benefits from fear. The most well-known inverse moving investments other than shorting a stock are long positions in put options and the VIX index. The former is exposure to a contract that bets against the market and the latter is an index measuring volatility. The value of these two investments increases with higher volatility, which occurs in market sell-offs. When it comes to individual stocks there must be something inherently idiosyncratic that outweighs directional market beta exposure to generate performance. In the Corona crisis, people are forced to stay at home so firms like ZOOM, Netflix and Peloton benefitted heavily from the lockdowns. However, the value of these stocks might be overextended. In the fourth quarter of 2020, Pfizer released information to the public that their Corona vaccine is more than 90% effective so ZOOM, Netflix and Peloton tumbled more than 20%, 8% and 25% respectively. Extreme drops are typical proof of overextension, especially in a market with lots of stimulus.

Peloton provide home workouts and is therefore a stay at home stock.

Why did Markets Turn Around?

From studying economics at Boston University, I learned that most of the time politicians rely on economists for optimal advice when conducting fiscal and monetary policy. These trusted economists in turn depend on mathematical models forecasting the economy. The utilized models are balanced between simplicity and complexity, as adding to much complexity means overfitting to historical data, which comes with a lot of tail risk. Complex models overfit because they generally consist of more variables, which therefore tend to pick up spurious relationships. When these relationships breakdown overconfidence in complex models can have huge negative ramifications on the economy (Google the Russia crisis in late 1990s caused by the quant hedge fund LTCM). Unlike physics, economists model the financial system based on variables impacted by human emotion including unemployment rates, inflation, and interest rates. Human emotion is per definition much more difficult to model on a large scale than natural occurring relationships in physics. Famous behavioral economist., Daniel Kahneman proved for example that humans are more likely to take risk when there is a chance of losing money compared to when there is a chance of winning the exact same amount of money. These irrational behaviors infect the economy like Covid itself and a model that worked well 30 years ago might be completely useless today. These behavioral biases also mean that the output of more complex models is difficult for economists to understand relative to simpler ones. However, when economist use simplified models then they are likely to not capture the whole picture. Now, I am not arguing against quantifying economic policy, but it is dangerous when politicians are dishonest about the power of the models being utilized. What is even more dangerous is when politicians completely throw out models and that is what has happened over the past 13 years. Ever since the great recession in 2008, central banks across the world have stimulated the economy by lowering interest rates and printing money, despite not considering the negative impact this might have long-term. Stimulus is most likely why the market flipped back so quickly in the second and third quarter of 2020 amid an ongoing pandemic. The US passed the 2.2 trillion dollar CARES ACT providing unemployment benefits, supporting small businesses and providing 1200 dollar direct payments to all US citizens. The EU passed their own 857 billion euro version aimed at helping less wealth countries in the union with most of the money being grants rather than loans needed to be repaid. Besides causing obvious tension between rich and poor countries within EU, this commitment by the European central bank is creating artificial stock market prices. In China, the government has not only passed stimulus bills, but they intervened directly into the stock market, which is a an even more dangerous conduction of monetary policy than stimulus packages. This continuous money printing is more addictive than heroin to a heroin addict and the world is now full on addicted to fiscal and monetary stimulus, but it has reversed markets.

The CARES act meaning

Where are we Now?

At least as of November 2020, the stock market has continued its path to the moon after the drawdown in Q1 by fully ignoring a Covid pandemic, lockdown, pro tax US president, divided US congress, China trade war and Brexit. A possible reason for this rocket ship is that the stock market already prices in the Moderna and Pfizer Covid vaccines. However, economic impact usually lags behind damages created by high unemployment and loss of profits so we could be in for a rough start to 2021 even with a vaccine. What has really caught my eye is the oxymoron on Joe Biden’s campaign site, which goes against any economic model that has ever been created, as Biden believes that the US must do whatever it takes, spend whatever it takes, to deliver relief for US families and ensure the stability of the US economy. To access funds for spending whatever it takes, Biden will try to increase taxes from 37% to 39.6% on people earning more than 400,000 USD and corporations from 21% to 28% and also monetize treasury bonds. The increase in tax revenue will dampen stock market returns, but the positive market impact from monetization vastly outweighs the economic impact of any tax bill (2). To recover from damages created by the Corona crisis, the Biden vision likely involves a larger economic stimulus package then the record breaking 2.2 trillion CARES ACT. Worth noting is that Biden will most likely use some of the funds to invest in a new green initiative as well. However, the market should not fully price in Biden’s vision, as massive stimulus spending is not aligned with the conservative view of Mitch McConnell. Republicans who supported Trump stimulus are now reborn deficit hawks and the record high US national debt is a massive roadblock for Biden to overcome.

Who will create a vaccine first?

How do Investors Navigate the Next Year?

Having a plan that accounts for a probabilistic amount of future monetary stimulus and niche growth areas is key for investors trying to emerge victorious in a global market that consist of a divided US and EU in combination with China as an additional super power. When it comes to monetary and fiscal stimulus, China has by far the greatest ability to influence their market. Central banks across the world may very well continue with their stimulus policy, as markets have not seen the type of inflation in prices of goods and services that is expected. However, I believe we could be in for a stimulus surprise with divided nations because it will be difficult for politicians to decide who should receive what. If politicians are successful in printing more money, but perhaps less than expected, then that money will flow to areas such as ESG and those in society that needs it the most rather than to everyone and Wall street. Investors should therefore tilt their portfolio exposures towards areas that can transition into a world where environment, corporate governance and social inclusion matters. When it comes to helping those that needs money the most that involves direct payments and social benefits. This money will not go into the stock market so the concept of marginal utility extends to this money in the classical sense rather than asset inflation. If more money is added to the system then that marginal dollar decreases in value. At some point, the marginal value of the dollar will be so small that the whole system will come crashing down. It is the job of the central bankers and treasury chiefs to understand the inner workings of a massive world economy, and yet these so called experts tend to disregard models and give into public pressure to stimulate the economy. This massive money printing across all developed nations has led to asset inflation. If there is a negative dent to any stimulus expectations, we can expect the market to drop pretty quickly. When that liquidity is withdrawn from the stock market in combination with direct stimulus to the people then that has the potential of pushing up prices elsewhere in society, which is normal inflation.

Balancing risk and reward is key when investing.

A Portfolio Accounting For Inflation

Hedge the Long Only Portfolio

The market is on an epic bull run. It might make sense to protect a portfolio that most likely is exposed to market beta. Put options on large equity indices is a straightforward investing technique that provides downside protection to these traditional portfolios. Other ways to insure against a long market beta portfolio is selling some equity exposure and reinvest the amount in uncorrelated assets such as precious metals, insurance linked securities, a multi-strategy hedge fund or a CTA.

Crypto and Gold

When central banks print money there is a diminishing value to the marginal currency all else equal. Crypto Currency and Precious Metals are two assets whose value is controlled by supply and demand and not buy any sovereign nation. Precious metals such as gold is traditionally considered as the optimal hedge against inflation. However, recently crypto currencies such as Bitcoin have emerged as an alternative to precious metals as an inflation hedge because just like gold these currencies have the property of being a definitely scarce resource. There is a limited supply of both Bitcoin and gold, which means that a sovereign is unable to manipulate their supplies. It is important to note that gold outperforms only when real yield fall and this yield equals nominal yield minus the inflation rate. If nominal yields increase more than the inflation rate then the real yield will increase, which in turn means that gold and also Bitcoin doesn’t always perform well under inflationary environment. However, a low nominal yield is a natural function of MMT so in this inflationary scenario gold and Bitcoin would perform exceptionally as hedge. I would say that due to its history, gold is a more trusted asset class than Bitcoin so Adaptive Alph would recommend that your portfolio hold a much greater percentage of gold than Bitcoin. However, the minimum amount of Bitcoin that should be allocated to crypto is 1% of the total portfolio. As a hedge gold has both strengths and weakness compared to Bitcoin. Gold has a longer history, is more durable and more fungible. Bitcoin, however, is more portable, verifiable, divisible and censorship resistant.

ESG

In the future, government owned institutions and some other institutional investors might be unable to buy shares of companies that pollute the environment and inefficiently contributes to creating a society that works for everyone. When lawmakers create future legal frameworks or policies on how public pensions should invest, they will outline methods so that investment flows will go to those companies that have adapted their corporate mission to maximize stakeholder value rather than shareholder value. The next big thing within the hedge fund industry will therefore be a manager that is able to combine old school Chicago valuation methods sprinkled with some proprietary touch in combination with a method to measure impact. Investing in ESG would generate some alpha.

AI

Artificial intelligence is the future for quantitative investment strategies, product enhancers and improved operational efficiencies. Those investment firms and other corporations that utilize AI will improve returns and lower costs. These companies can instead use revenues to reinvest in future revenue generating projects. Finding niche firms or funds that leverage AI technology is therefore a great source of alpha for investors in the future.

Real estate and land

Real estate and land are just like gold considered to be commodities limited in supply, but these investments also has an inherent value because they serve human needs. In a low yielding environment where money is cheap and interest rates are low, it makes sense to hold the same position as the sovereign government in your country. If the country has a high debt to GDP, which would be the case under MMT, then one should borrow money to buy house. If inflation picks up as a result of the economic stimulus, the loan is inflated away and one would get house really cheap.

Inflation protected bonds or TIPS

Inflation protected bonds or TIPS is basically the most straightforward investment to protect the value of the cash held in your portfolio. If inflation is higher in the future it means that the value of the relative value of the domestic currency will decrease. However, if inflation were higher, then the inflation-protected bond would compensate the lower value of the domestic currency by a corresponding hike in interest rate received on your investment. The main problem is that if real yields become more negative, then the TIPS yield could be negative as well, but it still protects the value of your currency at a premium.

[1] https://www.statista.com/statistics/273909/seasonally-adjusted-monthly-unemployment-rate-in-the-us/

·[2] https://taxfoundation.org/joe-biden-tax-plan-2020/