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Who is scared of Inflation? Thumbnail

Who is scared of Inflation?

Central banks have a problem. No matter what they do, investors are not satisfied…

This is at least the idea you get when reading the central bank’s publications and the reactions at the stock markets. However, maybe this statement reveals a deeper laying issue. When thinking about the central bank’s functions you will find a variety of duties but nowhere will you find their raison d’etre as pleasing investors. Looking back at the last decade, this fact can easily be forgotten. Printing endless money and keeping up purchasing programs did please investors. But not necessarily the general public. 

The question remains what is going on in the people’s households. Interestingly the savings rate in Switzerland during the past year went up to 26.6% from about 15% in 2019. The situation is similar in other European countries like Germany, where the rate went to 17% last year compared to 10% in the year before. While this is one consequence of the current measurements not everyone was lucky enough to increase their savings. The question remains, how much of the saved money will be spent once economies open up again.

Coronavirus: Status Quo 

Wherever you go, the coronavirus is already there. Maybe not physically, but at least in terms of news and opinions. We absolutely get the corona fatigue and therefore we keep our opinion deliberately short and only talk about it in this section. This way you can easily skip the paragraph if you want.

While the U.S. and China both already administered over 100 million vaccination doses, Europe is still discussing the distribution of the vaccine. Consequently, there are severe concerns about a third wave. 

Governments released new, stricter measures to keep the danger of an out-of-control situation at bay. Especially considering the Easter holidays, governments and health authorities are concerned. Despite this situation, there is light at the end of the tunnel, considering that the vaccination programs can eventually start after Easter and will allow quick releases of measurements afterward. While many promises were given in the past, we have to wait and see whether they can be honored this time. Especially the Easter season would have been a great opportunity for people to spend some money that they have saved during the lockdowns.

In general, the expectations in Europe are that all people who want to be vaccinated will be by the end of summer. The hope is that the governments will open up the economies during this process systematically so that people can travel and bring their money back into the economy.

Equities: There are Alternatives

When observing the markets it is not a secret that most of the recovery is priced in already. This results in the question of how much potential remains. While the start of 2021 has been quite impressive, investors are getting more nervous as the 10-year treasury yield rises and skeptical voices arise more frequently. The risks that result in another correction are numerous. We want to talk about three potential “alternatives” to equities below.

Firstly, let us have a look at fixed income. The U.S. government issues the 10-year treasury notes. When doing so, a fixed coupon is paid every six months. This coupon currently lies around 1.1% per year, meaning that for USD 1,000 invested into a 10-year treasury note, you will receive USD 5.50 every six months. Currently, investors require a yield of about 1.6% per year, which means that they are not willing to pay more than USD 954 for a USD 1,000 10-year treasury note. If treasury notes, as one of the safest investments, become cheaper, other fixed-income investments must become cheaper as well. Therefore, fixed income is becoming more attractive for investors again.

Secondly, we want to share a bit of a more unconventional perspective. During the last year, investing in the stock markets became very popular with retail investors flocking the market. As economies open up again, retail investors might be willing to liquidate their investments to enjoy their re-gained freedom, spend more for restaurants, and travel again. As we could see with GameStop, these groups of investors are indeed able to affect stock prices. If they now decide to leave the markets and “invest” their money into their wellbeing, that might lead to sell-offs in the months ahead.

The third alternative, which benefits from a lot of attention at the moment, is cryptocurrencies (we will examine this asset class in more detail below). While some people shake their heads in disbelief when hearing that Elon Musk decided to invest a considerable part of Tesla’s liquidity in Bitcoin, others see it as proof that Bitcoin will gain more acceptance in the mainstream in the years to come. While cryptocurrencies have been highly speculative, and still are, more and more investors are considering this area as an alternative asset class, due to a lack of other investment opportunities. Especially in areas like Europe and Switzerland, where banks charge negative interest rates on cash balances, putting some part of its liquidity in cryptocurrencies becomes a real alternative.

Having said that, we believe that a correction of about 15% - 20% is quite likely within the next couple of months. However, we do not have a crystal ball and therefore do not know when this exactly will happen. We do not believe that it makes sense to be completely out of stocks since the music might continue for some more time. However, due to our conservative approach, we believe that having some cash (in stable foreign currencies) aside from being able to react once the correction occurs makes a lot of sense. Therefore, in the first quarter of this year, we already realized some gains to make sure that there is enough liquidity when an opportunity presents itself. The goal should not be to avoid any losses but to have a portfolio that is positioned appropriately to the investment horizon of each investor. As history shows, markets will eventually recover from their lows and there are always investment opportunities that arise out of a correction.

Monetary Policy: Who is scared of Inflation?

As stated in the beginning, central banks are in a difficult situation. On one side, they must go along with whatever stimulus package the government releases and on the other side, they have to comply with their legal obligations. It seems they have not much more wiggle room left. With the different challenges they face, it turns out the expected development of the inflation rate is the biggest threat. Keeping this in mind there is one further instrument central banks have at their disposal: Yield curve control.

Here we are back in the fixed income area. When having a bond, the required rate of return of the bond depends on the expected inflation. Therefore, the higher the expected inflation the higher the return must be, the lower the price can be. When practicing the “yield curve control”, a central bank obligates itself to buy as many treasury notes as necessary to prevent the price of treasury notes to sink below a pre-specified level. The European Central Bank already uses this instrument, albeit it is not explicitly calling it what it is. Experts believe that the Fed will go down this same path in the second half of this year when inflation further increases. For central banks to use such a tool, they must have plenty of credibilities. If investors challenge the central banks on it, it will become very expensive for them. However, if they do have enough credibility, it often has quite an impact just announcing that they will use yield curve control. 

As unconventional as this tool is, it is not new. Back in 1942, during WWII, the Fed agreed with the US Treasury to set interest rates for the entire yield curve. More recently, the central bank of Japan made use of this concept and kept the 10-year sovereign interest rate a 0%. The central bank in Australia did also set the 3-year interest rate at 0.25% as a reaction to the COVID-19 pandemic.

We at WHVP believe that central banks will stay the course and do whatever is necessary to support the economy. Since central banks and governments collaborate very closely, the risk of entering a bear market as we have seen back in 2007 to 2011 seems not to be right around the corner.

The U.S. Dollar; if Experts are agreed…

During 2020, the U.S. dollar index (DXY) lost quite some value and experts agreed that this is only the beginning of a new phase of a depreciating U.S. dollar. Now, three months later, we see the USD becoming strong again. This despite the USD 3 trillion stimulus package and seeing the government planning another USD 4 trillion infrastructure program. Since the beginning of the year, the USD index (DXY) appreciated by about 3.25%. While a depreciating USD supported our portfolios’ performance last year, we now experience what it means when the reference currency moves against you. For many investors, the strength of this countermovement is surprising but does not change the long-term view on the currency itself. When reviewing the development of the USD since 2007 it becomes clear that even at levels seen last year the USD is still quite expensive.

We believe that the strength of the USD is temporary and must be seen as a countermovement to the support the index has around 89 USD. In the longer-term, however, we are confident that the pressure will stay high on the USD.

Cryptocurrencies: Hard to Ignore

While cryptocurrencies have been famous for pure speculation in the past, the sentiment has changed and there is a growing number of investors accepting cryptocurrencies as an asset class. Cryptocurrencies, based on blockchain technology, do indeed offer a benefit in an environment of high-priced stock markets and negative interest rates. As markets recovered at a stunning pace, cryptocurrencies did so too. However, the data available shows, those cryptocurrencies do not show any correlation to other asset classes.

In the meantime, we do accept the fact that cryptocurrencies have the legitimacy to be added (with a small exposure) to the portfolio. For some time we have been working on a solution for our clients, but have not found what we are looking for yet. However, the world of cryptocurrencies is still in upheaval and will be so for quite some time. There are more than 4,000 cryptocurrencies on the market. A majority of these cryptocurrencies are not worth anything or bears a huge risk. Therefore, it is important to stay on top and make sure to understand the environment and the risks of the cryptocurrency when considering it as an investment.

Commodities take a Breath

While commodities experienced an insane rally since last March, they are taking a break. With the current insecurity, investors are taking some money off the table. When doing so, investors prefer realizing gains to taking losses. Amongst others, the oil price could eventually get back to over USD 60 per barrel, which for many oil firms is still a critical level, but give some air to breathe. The blockade through a grounded cargo ship in the Suez Canal put some pressure on the oil price. On March 23, the cargo ship “Ever Given” grounded in the Suez Canal, blocking the transit for other ships. Among the waiting ships, there were oil tankers too. In the graph below you can see the movement in the oil prices from the incident on March 23 until the ship was freed on March 29. When the oil price was low, there was hope for a timely solution, when the price raised, investors were concerned that the clearance of the Suez Canal will take weeks.

Precious Metals: The Power of Endurance

While being invested in precious metals was joyful in 2019 and 2020 it became a bit frustrating so far this year. However, even with gold and silver having a phase of weakness, there are encouraging signs, especially for the gold price. The graph below shows when commercial traders were building long positions and short positions. There are two interesting points there. It seems that commercial traders have nothing to do with the current weakness in the gold price. On the contrary. They use the current weakness to build long positions in gold.

Considering this graph coupled with the developments described above, we believe that the current gold price represents an opportunity to enter instead of selling. The arguments are:

  • Commercial traders are building a long position in gold
  • The USD is currently in a counter-movement but will eventually proceed with its downtown
  • There is a fair chance that the Fed will insert the yield curve control which will bring down the achievable returns on a fixed income

Additionally, we see a reason to believe that with the actual reopening of the economy the silver price joins the rally in the gold price. However, while we believe in gold as a long-term stabilizer of our clients’ portfolios we see an investment in silver more as a mid-term opportunity. Therefore, our exposures in silver are lower than our exposure in gold.

Attention: Even if we believe that the current levels in gold and silver represent an opportunity, there is a fair chance that especially the gold price will test its support around USD 1,650 per ounce before substantially recovering.

If you would like to discuss any of the above or if you have any question, comments or feedback, please do not hesitate to reach out to us: