Q2 Letter - 2021
I love fireworks. I can stand on the sidewalk for hours like a child, mouth open and dry, watching them explode in the sky. Each firework, no matter how small, has its own personality—some linger and twinkle in the sky after their initial act, others make a high screech on the way up but then disappear without a trace, and then there are the ones that simply go boom. It doesn’t matter to me. They are all beautiful even if only for a moment, I want them all.
After every 4th of July, I always take a moment to analyze firework sales data. Crunching them on a spreadsheet is not as exciting as watching them in the sky, and my findings will most likely never rise to the challenge of a real use case, but having tracked this data over many years I have come to appreciate its subtleties [Fig 1]. You can see the dot-com bubble burst in 2000 as the growth rate crashes from 22% to 6%, a rise in patriotism post-9/11 as the growth rate rebounds in 2002, you can even see the economic wave caused by the Global Financial Crisis as sales plateau between 2007-2012. The history of our nation is written in fireworks.
Based off firework-related injuries data, I’ve estimated that 70-80% of fireworks purchased each year are specifically for the 4th of July. In a way, that makes this chart the perfect barometer of our nation’s heartbeat. It reflects the amount of patriotism flowing through our communities as well as the financial stability of individual households, since fireworks are notoriously expensive. Two years ago, I highlighted how annual firework sales were on the cusp of reaching $1 billion.
When I pulled up the 2020 numbers last Monday I was shocked. Though fireworks sold for display purposes plunged from $375 million the year prior to just $93 million, which makes sense considering the health restrictions placed on large gatherings, consumer firework sales skyrocketed to a mind-boggling $1.9 billion. While our nation battling with a deadly pandemic, the spirit of America was evidently alive and well in our hearts.
With the pandemic largely defeated in the U.S., life is reverting back to normal faster than most would have imagined. Restaurants are full again, the price of oil is no longer negative and employees are returning to the office (in some cases against their own will). Unfortunately, the global financial markets have been altered in a more permanent way. Today, long-term interest rates in the U.S. are so close to the zero bound that investors are stuck with one of two choices for next year’s firework show—a box of rockets that’s been collecting dust since the early ’70s, or a string of newly designed imploding firecrackers. I know for a fact that I do not want to be standing anywhere near the box from the ’70s when they go off, and imploding firecrackers? Is that even possible?
A blast from the past – the forgotten paradigm
12 months ago inflation was a dead concept. Decades of central bank attempts at stoking inflation had been so futile, it became widely accepted that the progression of technology would solidify deflation as the dominant force into eternity. This year however, that new-school thesis was put to the test and it didn’t take long for conviction to buckle. Seemingly overnight, hyperinflation was everywhere you looked—lumber, used cars, even home prices in Pleasanton, which rose 30%.
In response to the pandemic the federal government injected $4 trillion of stimulus into the economy and the Federal Reserve simultaneously launched a $4 trillion asset purchase program (have you ever heard the saying “sales solves all problems”?). While it definitely helped bridge the economy through a challenging period of time, it inadvertently formed a tidal wave of liquidity that is currently drowning the capital markets. This is evidenced by the unprecedented usage of the reverse repurchase market over the last month [Fig 2], whereby every night large banks are deliberately returning upwards of $1 trillion in excess cash back to the Federal Reserve in exchange for a negative overnight interest rate. With so much cash in the system that large banks are literally bidding to give it away, it is no wonder that some of it is finding its way into asset prices. This should not be taken lightly, we are currently witnessing the highest level of inflation in decades, not to mention there are still trillions of dollars in stimulus and infrastructure spending on deck, waiting to enter the economy. Inflation is back.
Rising inflation is typically realized in the financial markets via rising long term interest rates. It is a tight relationship that has persisted throughout market cycles and it makes logical sense—if the price of goods and services are increasing by x% each year, then you’d require at least an x% return on treasury bonds to preserve your purchasing power over time. Over the last twelve months though, the Federal Reserve’s asset purchase program has created a significant artificial deviation—Core CPI growth is pushing 4% whereas the 10Y yield remains well below 1.4% [Fig 3]. This is a precarious situation to be in, especially since the Federal Reserve announced just last month a plan to begin tapering its asset purchases. If the Federal Reserve follows through with the plan and steps back as the largest buyer of treasury securities, the subsequent re-pricing of the 10Y yield could result in a 40% correction in the equity markets.
What worries us the most in this scenario is the market’s complete lack of preparedness. Conditioned by 40 years of deflation, the large majority of investors are allocated passively in identical indices whose compositions are highly concentrated around identical growth factors. A synchronized portfolio rotation out of these positions could lead to a dramatic consequence where everyone is suddenly rushing towards the same exit. Even scarier, most investment professionals stepping into Managing Director roles today were not even alive for the latest period of rising rates in the late ’60s early ’70s. If we happen to be heading towards this forgotten paradigm, be ready for some napalm.
Imploding fireworks – a new paradigm
Take a step back to get perspective on the long-term path of interest rates, and you’ll realize that the recent inflation scare is entirely unsubstantiated [Fig 4]. 4% CPI growth, albeit high, is most likely transitory, and absolute prices, or at least their first derivative growth rates, should return to normalized levels as vaccinations reach developing nations and the global supply chain reopens. It is also important to point out that deflation is not required for interest rates to remain low. True, inflation has historically been linked to interest rates, but they are not the same thing, and there is no reason to believe that a divergence cannot persist indefinitely especially when the largest central bank in the world is openly tipping the scales.
Although the Federal Reserve has announced a plan to taper, it will not be done at the expense of financial market stability. We need only look back to the Fed policy flip-flops in 2019 to understand this truth. The taper will be incremental as to avoid inducing any volatility in the treasury markets. And because of how efficient our capital markets have become at capturing incremental returns (some would call that a bubble), the Federal Reserve might realize that their ability to silently taper is more limited than originally anticipated. Thus any notion of tapering today will only be partially realized, interest rates will remain low even in the face of elevated inflation, and the next financial crisis may force the Federal Reserve to push rates negative.
Twenty years ago, the term “negative interest rates” was not even in the dictionary. Today, every economist considers it a highly probable outcome. Other developed nations like Germany, France, and Japan have already gone negative, and even overnight repo rates in the U.S. went persistently negative in June before the Fed stepped in to raise rates. Why is the Federal Reserve so hesitant to entertain a negative interest rate policy (NIRP), and why would it imply a new paradigm for the global financial markets? Because a positive interest rate is the foundation on which all of modern-day finance is derived from. NIRP would break classically developed asset pricing models, rendering them useless. Money would be explicitly destroyed through the passage of time, and the capital markets would enter a twilight zone where investors prefer receiving one dollar a year from now rather than today. The international financial markets are largely viewed as secondary to the U.S., so negative interest rates in those markets aren’t likely to cause any global systemic shockwaves (although the ECB’s negative interest rate policy is already starting to show localized side effects in the banking sector), but NIRP in the U.S. would mean capital destruction on a global scale. So what does an imploding firework look like? No one knows, it’s never happened before. But if we are heading towards this new paradigm, we will find out together.
Should I wear safety goggles?
Regardless of which direction interest rates head from here, most investors are not prepared. The transition into either a rising-rate world, or NIRP, will seem gradual at first, but as with all things in life, there is plenty of time to prepare until there isn’t. The path forward will undoubtedly result in major long-lasting impacts on the future of capital markets and geopolitics. It is a frightening yet exciting time to be investing, so we cannot stand passively under an imploding firework and wait to see what it does. Now, more than ever, investors need to be deliberate and aware of the risks they choose to be exposed to, which is also why now, more than ever, an active approach to managing investments is so important. Our style of individual security and factor selection means that our strategies are not blindly exposed to broader market risks, which benefited us both going into and coming out of the worst of the pandemic. Over the following months, you may see some changes in our portfolios as we swap certain risk factors, and position ourselves for a new kind of firework show.
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Information presented reflects the personal opinions, viewpoints and analyses of the employees of Mirador Capital Partners, LP, an SEC-registered Investment Adviser. The views reflected in the commentary are subject to change at any time without notice. Nothing herein constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Mirador Capital Partners, LP manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results. Visit us at miradorcp.com for more information.