2020: Financial Markets in Retrospective

Key Takeaways

• Despite a challenging year for society as a whole, financial markets mainly returned positive results (unless you’re 100% in crude oil or the US Dollar). This has mainly been possible due to the unprecedented intervention of central banks and governments to support the economy and financial markets.

• US Tech, Gold, and Bitcoin did very well, whilst the US Dollar and Crude Oil were the big losers of the year. Within equity markets, the narrative was straightforward, rewarding businesses that did well during the lockdown (Digital and Logistics) and punishing those who were severely affected by it (Airlines and Retail).

• Fiscal stimulus might be the catalyst that breaks the 40+ years disinflationary trend, which could drive significant adjustments to portfolio allocations (towards commodities) and performance outlooks.

Foreword

It is fair to assume that 2020 was a surprising year on the back of a Black Swan event that led us all to hyperventilate at the first sign of sickness, Rudy Giuliani style. To us, 2020 was like an Internet Explorer malware that was supposed to hit in 2012, and whilst it arrived customarily late, global democracies seemed to still rely on free McAfee anti-virus software that everyone constantly forgot to upgrade. Microsoft (read Bill Gates) did warn us about the risks of a malware attack (read pandemic), and some experts did warn us about how this was not just a flu, but we were all too busy trying to figure out if Carole Baskin did, in fact, kill her husband.

The number 21 has some mystic to it (blackjack, the number of spots in a standard die and the age in which US citizens have legal blessing to poison their liver), but before we look forward into next year, let’s have a quick look back at the most important things to remember about financial markets in 2020.

What happened in 2020

• Socially: The pandemic has killed 1.8 million people so far (with fatality rate likely below 2%), forced more than four billion people to live under some sort of lock down, led to school closures that affected 1.5 billion children (a third of which did not have access to remote learning), significantly increased divorce rates and income inequality, increased the number of “avoidable” cancer deaths due to diagnostic delays, and is likely to have added 80-90 million people to extreme poverty (the US registered the largest poverty increase in a single year since it began tracking it in 1960). These are all rough stats, but it’s less of a Contagion scenario than we envisioned in February or March.

• Economically: According to the IMF, the economic shocks of 2020 lowered global GDP by 4.4% (worst since WWII), increased unemployment to 8% in Europe (from 6.6% in 2019) and 8.9% in the US (from 3.7% in 2019) primarily among Millennials and Gen Z, led to a global coordinated fiscal response of c. $12 trillion and increased global public debt to GDP from 83% in 2019 to a record high 100%. Basically, the economy collapsed, disproportionally hitting the young and the poorest, and the only thing keeping things together is the fiscal support of governments, which comes at the expenses of higher debt levels (increasing the economic burden to future generations). Thanks a lot, Boomer…

• Between February and March, the pandemic triggered the fastest 30% sell-off in the history of equity markets, exceeding the previous records set during the Great Depression (in 1934, 1931 and 1929), putting an end to a bull market that began March 9, 2009 and led to a 400% gain (#stonks). However, one could also look past this recent correction (similarly to what we did in the 2018 correction) as equity markets in the US have gradually recovered to close the year near all-time highs on the back of (1) unprecedented monetary and fiscal stimulus (2) the continued support of passive flows and (3) the enthusiasm of retail investors who, confined at home, partially used their stimulus checks to buy stocks and derivatives, many of them doing so quite successfully, in their pajamas nonetheless.

• Equity markets in Europe didn’t perform as well as in the US given that they did not benefit from the incredibly resilient US Tech sector (which we still believe is in the midst of one of the most spectacular bubbles in history), which throughout the market meltdown started trading as a bond proxy (read safe heaven) given their reliable stream of cash flow, lack of leverage and strong balance sheets. Big Tech added $3 trillion in market cap in 2020 and continues to be extremely hard to build a bear case around it. Btw, does anyone actually call Google “Alphabet”?

• Emerging markets as well as Japan have performed incredibly well into year-end and recovered all their losses as the reflation trade (i.e. a return to economic growth on the back of monetary and/or fiscal support) became the main narrative driving financial markets into 2021, and the US Dollar continued to lose ground against local currencies. The consensus opinion into year-end is for these assets to continue to trade well into 2021.

• Beyond equity markets, there were many other noticeable moves. The US Dollar, the most important asset in the world (after crispy end-of-the-week brewskis), has been steadily losing ground into year-end as investors worry about the US increasing its debt at the fastest pace among major economies (see chart below), and its future direction is one of the most heated (and important) discussions to have in 2021. The US Dollar drives emerging markets, commodities, global trade, and is a key component of global debt levels (many countries have US-dollar denominated debt), which is why so many people care about its movements.

• After a quick sell-off in March due to investor’s need for liquidity, gold outperformed through August, when it hit all-time highs (ATHs), as investors moved capital into gold and gold miners to position themselves for the possibility of high levels of inflation down the road as a result of the continued monetary and fiscal expansion of central banks and governments. Gold is for financial market participants what water is for heavy drinkers – boring to own (or drink), but necessary to minimize hangover. After hitting ATHs, throughout the last quarter, gold, silver and related mining shares lost some ground as the uncertainty around the US elections faded and positive vaccine developments re-instated bullish sentiment all across the market (i.e. investors stopped drinking water as the party was actually still on). We expect the fundamental narrative around gold to continue to stay positive as supply tightens (production is down 5% yoy, despite the recent pick up in 2H2020), and on the demand side, investors and central banks continue to allocate capital to the asset class on the back of the potential inflation risks that lie ahead. #drinkwater

• Crude oil futures hit negative prices in April 2020 for the first time in history (though it was only the one-month forward contract) given the level of oversupply in the market amidst a world that did not need much oil (no one travelled or drove, and energy production also came down). Traders were literally paying counterparties to take their oil contracts (imagine how Daniel Day Lewis’ character in There Will Be Blood would have reacted to this madness). The fundamentals since then have improved significantly, with crude prices up by 20% in the last six months as (1) fears around the economic damage ameliorated (2) we began to have some clarity around the potential return to normality and (3) fiscal stimulus continued to improve the demand side of the equation.

• As expected, in 2020 the Yield Curve in the US has moved significantly lower, in hopes that the easing of financial conditions would help speed up the recovery from the pandemic-related disruptions. Whilst the reflation trade has allowed yields to recover some ground in the last months, it’s unlikely that the US will allow them to go significantly above 2% (they’ll likely implement Yield Curve Control should that happen) as it could cap the economic recovery that is so desperately needed.

• Lastly, 2020 marked the resurgence of bitcoin, and with it of many other cryptocurrencies. Bitcoin is up 310% this year (flying through the top of the last bull market which ended in December 2017) and maintained its dominance of c. 70% of share of the total market cap of the cryptocurrency world. It is estimated that c. 100mn people hold or have exposure to bitcoin, c. $30bn worth of bitcoin are held as treasury assets, and in the past year several world class investors have disclosed a certain level of allocation to it, including Renaissance Technologies ($150bn AUM), Guggenheim Partners ($250bn AUM), Stanley Druckenmiller (some consider him the best investor ever) and even Paul Tudor Jones (a legendary trader). Companies like MicroStrategy and Square have also disclosed moving part or the totality of their cash from fiat currencies to bitcoin, as bitcoin continues to be perceived as a potential hedge to inflation as well as an asset that is uncorrelated to any other, meaning it has a role in a diversified portfolio. We are quite bullish on bitcoin in particular and have started covering the space, and you should expect a comprehensive introduction to it in January 2021.

THE THREE MOST IMPORTANT CHANGES OF 2020 FOR FINANCIAL MARKETS

#1 – Fiscal spending has taken center stage, which may potentially break the 40-year long disinflationary trend for inflation.

Fiscal measures around the world have taken various forms, from a six-month cut in VAT rate (Germany) to support for innovation (France) to the purchase of corporate bonds or direct helicopter money. All are focused on giving households some cushion to withstand the economic damage created by COVID (or, for many, capital to go long TSLA call options) whilst the vaccine is being distributed. The Biden administration has also planned a $2 trillion investment plan in infrastructure and clean energy to be deployed in the first presidential term, which it expects to generate two million new jobs in the auto industry, construction, and energy sectors.

This level of fiscal spending is necessary to avoid economic contractions, but it comes at the expense of ballooning debt levels, as well as the risk of inflation in the mid-term. Whilst velocity of money (a measure that tracks how quickly money moves around the economy, which is frequently associated with economic growth and thus inflation) continues to be very low, fiscal measures such as direct transfers of money to households have the potential to be significantly more inflationary than the monetary stimulus of Quantitative Easing, with the key difference being how efficiently it reaches the real economy. Stimulus from Quantitative Easing has tended to get stuck on bank balance sheets (due to either the unwillingness of banks to make loans or reluctance of businesses to borrow), failing to reach the economy and generate inflation. With fiscal stimulus, money reaches the economy in a much more direct way – had you ever received a check from the government before? – which could potentially lead to a pick-up in Velocity of Money (how did you spend that government money?), and potentially a rebound in inflation expectation. In summary, whilst the pandemic was clearly a disinflationary shock, it could eventually become the catalyst that justifies the measures needed to finally generate inflation.

#2 – If fiscal stimulus really has the potential to change the inflation outlook, then we might be on the cusp of a commodity super-cycle as well as a generalized allocation move towards inflation-hedge assets like commodities and bitcoin.

Commodities (oil, copper, gold) are real assets that are generally associated with being inflation-hedges (their price rises when inflation accelerates) and should thus benefit from a reversal of the 40-year disinflationary trend. Commodities should also benefit from a lower US Dollar and the growth of the Chinese economy (the only major economy to post positive year on year economic growth in 2020 and the only major market where investors can still find positive real rates), which should help continue to fuel capital inflow. With the current underinvestment in the space (investors have, rightfully so, been focused on other sectors like Tech), and with low inventories keeping the supply side in check, commodities could start a multi-year outperformance. This has already started to happen into the end of the year.

Similarly, the case for bitcoin follows the same narrative as gold (store of value given it’s the most effective way to store value), but in the digital sphere. It is a scarce asset that is uncorrelated to other alternatives, but above all has three massive tailwinds: (1) it is just now being considered as a portfolio allocation candidate by fund managers (2) Wall Street brokers will likely aggressively enter the market given the potential revenue opportunity for them (3) the ecosystem is maturing, and it is now significantly easier to add or trim exposure to the space, both from an institutional perspective as well as a retail one. Bitcoin has some benefits against gold which we’ll explore in our January introduction to the space, but the main difference between both stores of value options is that the gold market is 20x the size of bitcoin, and as such a generalized level of adoption should have a disproportionate impact on bitcoin prices when compared to gold.

#3 – Government bonds do not hedge equity corrections anymore, and investors are now forced to find alternatives.

With bond yields so close to the 0% boundary, equity market corrections cannot be hedged with increases in bond prices. This fundamental change that has mainly occurred this year has great repercussions on asset allocation decisions, and as such we believe that some of the portfolio allocations that have historically been directed towards bonds might now find their way towards gold and gold miners, US Tech, green energy or other alternative assets that might provide investors a more suitable way to hedge their overall equity exposure.