Between Lightning and Thunder: Considering Risk

The policy response to coronavirus has given risk committees a new challenge to face – the threat of inflation.

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We take a look at gold and the US dollar, and what their price movements say about financial markets.

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It’s become a truism that Covid-19 has created deep shock waves within the global economy and markets. But as equity markets have recovered, in particular in the US, investors’ fears of a collapse in asset prices have receded even as the economy enters recession.

However, instead of dropping our guard, it is precisely this time which requires investors, and particular risk committees, to be vigilant rather than to relax. In a sense, our position is similar to being caught in a thunderstorm. The pandemic itself was the lightning, an illuminating violent shock whose power and magnitude was very difficult to assess. It’s now worth remembering that between the lighting and the thunder there is always a delay, as the sound of the shock takes time to travel.

In our view, the true effect of the pandemic may take some years to play out. It is fairly clear that there has been a major slump in demand, partially offset by the monetary and fiscal stimulus hurled into the breach by global policymakers – by now trained to deliver bailouts with Olympian speed. In the near term at least, it is likely to be the same old story: a furious battle by central bankers to contain deflation, something we have watched for the best part of 30 years. In the short term, it may well be worth trying to ride the rally of risk assets.

But, storm clouds are gathering over the horizon, not least the US elections, Brexit and the sick man that is Europe. Still, these are merely rain clouds compared to the storm that is inflation. Indeed, the massive injection of money into the world economy presents a clear threat that we may be entering an inflationary decade. From an asset-management perspective, this presents real challenges. Any upward movement in the risk-free rate presents a clear threat to the current valuation of risk assets, a move which would become much more likely should inflation break out. Furthermore, the consequent rotation to cope with the new regime – from Growth to Value, away from duration and towards inflation-linked products – would, in all likelihood, cause further devaluations and volatility. This, in turn, would require an adjustment in the construction of the 60/40 portfolio, the tool which has helped investors cope so well with the previous deflationary regime.

As such, any risk committee worth their salt will be thinking carefully about the major dislocation that could be posed by inflation.

The lightning may have struck, but we haven’t heard the last of the thunder.

The Rain Clouds

There are plenty of risks that we believe risk committees need to keep an eye on.

The first risk is that posed by the US elections. US President Donald Trump is behind Democrat nominee Joe Biden in the polls (Figure 1). Biden is currently committed to raising the US corporate tax rate to 28% from the current rate of 21% and a 15% tax on companies’ book income.1 This would reduce earnings estimates of the S&P 500 Index by 12%, from USD170 a share to USD150 a share, according to Goldman Sachs.

Figure 1. US Presidential Election Polling

Source: RealClearPolitics; as of 16 September 2020.

Uniquely, we also foresee an idiosyncratic risk to US equity markets from the sitting president. Donald Trump’s behaviour in office raises the possibility that he could do something erratic in reaction to tanking poll numbers. There is a concrete possibility that Trump may aim to boost poll ratings by initiating aggressive new policies, or potentially contesting the outcome of the election. Whilst polls still show a healthy lead for Biden, betting odds indicate a collapse in his lead in the wake of serious disorder in American cities during late August and early September (Figure 2), increasingly the likelihood of close, contested election result. We acknowledge that there has been no indication of these policies so far – but with a uniquely unpredictable president, the US stock market and the country’s trade flows are not immune to risk from both the Republican and Democrat candidates.

Figure 2. Average Betting Odds: Trump Versus Biden

Source: RealClearPolitics, as of 16 September 2020.

The second risk which remains live, but is being largely ignored by most participants, is the ongoing risk presented by a no-deal Brexit. Negotiations between the UK and the EU re-started on 7 September, but the deadline for extending the transition period passed at the end of June. This means that the default legal position is a hard Brexit and the immediate imposition of tariffs on cross-Channel trade should no agreement be reached. Whilst the risk of no deal presents a less alarming aspect when compared to the havoc wreaked by the coronavirus, it still bodes poorly for UK and European assets. Fortunately, although there has been some sabre-rattling from UK chief negotiator David Frost and continued intransigence from his counterpart Michel Barnier, there remains some impetus for a deal. It is unlikely that a comprehensive trade deal can be reached given the respective starting points regarding ‘level playing field’ provisions. Instead, we expect the agreement to cover less ground, providing a something of a soft-landing to a well-signalled hard Brexit.

The third risk is the sick man that is Europe. In response to the coronacrisis, the EU has launched a recovery fund dubbed Next Generation EU, a combination of EUR360 billion of loans and EUR390 billion of grants, directed to European countries on the basis of harm done by the coronavirus pandemic. To fund the programme, the European Commission will borrow EUR750 billion from the financial markets. This action is being heralded as a ‘Hamiltonian Moment’ for EU, the moment which sets it on an irreversible path to a federal state.

This may well be the case. The fund is due to be repaid by 2058, with the European Commission establishing a yield curve of liabilities. Whilst a deal has been reached regarding member states contributions, like it or not, every single cent of EU funding comes from taxes paid by the citizens of individual, and it is they who will carry the can for the bailout. But it is important to remember that no national electorate has voted for fiscal transfers. Indeed, it is instructive to remember the last time the EU’s role was transformed without the explicit consent of national electorates – the Maastricht Treaty of 1992. Not so coincidentally, 1992 also marked the re-birth of the British Eurosceptic movement. The principle of democratic consent was an important part of the Brexiteer discourse and it is no exaggeration to say that the seeds of Brexit were sown at Maastricht. Next generation EU can be justified in terms of necessity, but it may be harder to convince the Dutch, German, Austrian and Scandinavian electorates that it is in their best interests. And if the EU does proceed with more fiscal transfers without explicit democratic consent, it may be that Euroscepticism becomes much more popular throughout northern Europe.

Furthermore, the news of the deal strengthened the euro against other currencies (Figure 3). This move captures the tragedy of the single currency. Seven hundred and fifty billion euros is a relatively small amount of money given the overall size of the bloc and the long period which it will be spent over, but the announcement of the deal was enough to materially strengthen the currency against its competitors. In a sense, the euro oscillates between behaving like the Italian lira in reaction to bad news, and strengthening like the Deutschmark in reaction to good. Unfortunately, when the currency strengthens, it reduces the demand for European products, which has an outsized effect on the weaker economies in the bloc, in particular that of Italy, destroying any positive effects of the fiscal transfer.

Figure 3. Euro Versus Trade-Weighted Basket

Source: Bloomberg; as of 21 September 2020.

However, none of these risks can hold a candle to the biggest risk we believe financial markets is facing: the return of inflation.

The Bigger Evil: Inflation or Deflation?

One of the key components of inflation is the size of the monetary base.

As we’ve previously written, the quantity theory of money explains inflation as:


where M represents the quantity of money, V the velocity of money, P the general price level and Q the quantity of goods produced. Basically, for an increase in the general price level, we would expect to see an increase in either the quantity of money or its velocity, assuming that the quantity of goods is constant.

This year, the size of the US monetary base (or the ‘M’ in the equation) has rocketed (Figure 4). However, the decline in the velocity of money has more than offset this as Americans save in record quantities (Figure 5). On the other side of the equation, the pandemic-fuelled output gap has resulted in the Q collapsing, resulting in the P remaining roughly constant.

Figure 4. US Monetary Base (M2)

Source: Bloomberg; as of 21 September 2020.

Figure 5. US Savings Rate

Source: Bloomberg; as of 21 September 2020.

The issue is that we have central banks which are so terrified of deflation that they are willing to let inflation run. The Fed has recently moved to a rolling-average inflation target at the Jackson Hole Economic Symposium, in which inflation above the central bank’s usual 2% target would be tolerated and even desired. This might be appropriate policy for the moment, but there are multiple scenarios in which the velocity of money could increase, with the most obvious being the discovery of a coronavirus vaccine. What makes the Fed believe it will be able to contain inflation, even after letting it run, given their inability to contain deflation?

A further factor is the swing of the political mood against globalisation and towards protectionism. For the last 20 years, this trend has been a major driver of disinflation: as more of the world has joined international markets, the cost of labour and goods have persistently become cheaper, acting as a brake on inflation in developed markets. One element of the slowdown in globalisation has simply been its own success – unlike in the 1990s, very few countries are now left outside the embrace of global markets. With fewer and fewer countries left in the cold, it is unsurprising that the trend is slowing down. However, the trend is now toward an active opposition to globalisation, manifesting itself in the vote for Brexit and Donald Trump. If a more protectionist world does emerge, the prospect of a new era of tariffs and trade wars may well increase labour and input costs, driving inflation over the longer term.

In addition to the retreat of globalisation, the coronacrisis has tilted the balance between the private and public sectors, with the private sector bearing the brunt of the post-pandemic downturn. Taking France as an example, government spending accounted for 55.6% of GDP in 2019, with the French economy shrinking by 13.8% in the second quarter of 2020, according to Trading Economics. In a downturn, the state’s share of GDP shows no volatility. This means that the private sector, which forms France’s tax base, has contracted by some 31%. This trend has been reflected globally and will have an inflationary effect. The public sector is monopolistic by nature and does not face competition on the price of their services. Without price competition, it is highly likely that we may see an inflationary effect as state spending assumes a greater share of the economy.

The difficulty is in controlling this inflation – the last time we saw an inflationary environment during the 1970s, it took policymakers the best part of a decade and punishingly high interest rates to bring inflation under control.

And inflation bulls do have good reason to believe that this time it really is different. The classic argument advanced by inflation bears is that we have seen it all before: after the Global Financial Crisis, we saw quantitative easing from both the Fed and the European Central Bank, neither of which created inflation. This assertion is only partly true. The difference this time is that previous rounds of QE were focused on bailing out the US banking system and the European government bond markets, respectively. As a consequence, we have seen a decade of sustained inflation confined to financial assets. With government bonds purchased by central banks and yields at rock bottom, asset managers were forced up the risk curve, creating a sustained lift in both corporate bond prices and equities. The coronavirus stimulus is qualitatively different, as it is being placed directly into the pockets of consumers via various furlough schemes.

This type of bailout is far more likely to deliver inflation than previous interventions. Crucially, as we have mentioned above, the velocity of money is artificially depressed due to lockdown. This savings rate cannot persist once the lockdown ends and the US returns to work, forcing the velocity of money up again. The question is, will a normal velocity of money combined with an unprecedented expansion of the US monetary base produce inflation? These circumstances raise enough questions in our mind that we believe that inflation should be the key topic of discussion for any risk committee.

US Equity Risk: Growth Mania

So, there is a long-term risk of inflation. However, in the short term, we are much more likely to see the continuation of deflation due to the demand gap created by the coronavirus-led recession.

The effect of this may be to exacerbate the current lop-sidedness of the US equity market, and in particular, its skew towards Growth stocks over Value.

Investing 101 tells us that markets determine a fair value by discounting cashflows using the risk-free rate plus a risk premium. After the onset of the pandemic, global interest rates have been slashed, and are now very low if not negative. With such a sharp contraction of the denominator, theoretically at least, the NPV of future cashflows rises sharply. And we are seeing that with the Growth rally, which has been driven by the largest tech stocks. For a large part of the market, although the risk-free rate has fallen, the risk premium has risen. This is not the case for tech firms, whose business model is particularly well-suited for a lockdown environment. Indeed, the FAAMG stocks – Facebook, Amazon, Apple, Microsoft and Google – have added more than one-third to their market values in 2020, during the sharpest recession on record and a pandemic. The performance of just these five Growth stock has allowed the S&P 500 to be up 2%, while the other 495 companies in the index were down 5%, on a cap-weighted basis.2

It is likely that this Growth rally has also been driven by retail flows, as Americans sit on their couch without much to do. Robinhood, the no-fee stock trading app, now has 13 million active users, up 3 million since December 2019.3 Possibly the biggest wake-up call was when the platform saw 40,000 users become new owners of Tesla in four hours on 13 July, 2020.4

Figure 6. Net Investor US Equity Future Positions Versus Robinhood Distinct User Positions

Source: Goldman Sachs; as of 30 June 2020.

Overall, however, retail investors are not in the irrational stage yet: as of 17 September, bearish sentiment as determined by the AAII Investor Sentiment Survey (or expectations that stock prices will fall over the next six months) was at 40%, while bullish sentiment was 32%. Likewise, professional investors are not particularly bullish given positioning: net US equity futures positions have collapsed since February (Figure 7). If the tech rally continues, it is more than likely that these bears could be converted into bulls – and with so many to convert, the rally may have a long way to run yet.

Figure 7. AAII Bulls - Bears

Source: Bloomberg, AAII; as of 21 September 2020.

Given all the money printing that has occurred, the S&P 500 could well move higher in the near to medium term. M2 growth is highly correlated with the growth of the S&P 500 (Figure 8). Without any signs that the Fed will move to restrict liquidity, and plenty of reasons to assume that monetary stimulus continues, we believe that it is highly likely that the S&P 500 will continue to be supported by M2, and may even break higher if we see continued monetary growth.

Figure 8. The Relationship Between M2 and the S&P 500 Index

Source: Bloomberg; as of 21 September 2020.

We therefore have to stress that we don’t think the end of the tech Growth rally will occur any time soon. The situation is reminiscent of 1998: the Shiller CAPE ratio in the US is now at 30.63, roughly where it was at the start of the Dotcom bubble, which subsequently inflated to around 44 at its height in 1999 (Figure 9). What is startling is that the Dotcom bubble was able to inflate with the US 10-year Treasury yield at around 5.5%, which had a materially dampening effect on valuations by reducing the value of future cash flows. With the current US 10-year yield at 0.55%, it will be much easier for this bubble to inflate further.

Figure 9. Shiller CAPE Ratio

Source: Robert Shiller; as of 31 August 2020.

As such, there may be little point in trying to fight the short-term tide. Credit is cheap and as long as the output gap exists, Growth stocks may well continue to surge. But the threat of inflation, and the danger of sector strength becoming irrational exuberance are reminders that investors cannot afford to neglect risk management.

Reworking the 60/40 Portfolio?

In our opinion, the main effect of a change in inflation regime will be that the 60/40 portfolio, comprised of equities and bonds, may have to rapidly adapt. We believe the equity markets are exceptionally vulnerable to a style rotation from Growth to Value. In fact, we would go a step further and say it would not at all surprise us if Value stocks started to lead the market again, after more than a decade where they have been killed by a thousand cuts. If the next market regime is inflation (CPI at 3-4%), this change in leadership will be the logical outcome, it seems to us. At the very least, it is definitely not the time to capitulate on Value given our worries about inflation risk. Furthermore, government bonds, even high-quality ones such as 10-year Bunds or Swiss bonds, provided very little protection during the February selloff (Figure 10). The fixed-income buffer managers could previously rely on may provide limited protection, unable to cope with the impossible hurdle of -1% yields. Bonds also usually suffer in inflationary environments, as the real purchasing power of their cash flows is eroded.

How, then, should investors adapt? If we do see inflation break out, investors may benefit from having inflation-linked products in their portfolios. Both Growth and Value will still be necessary, but in a bifurcated market, buying the index will no longer be a cheap answer to all investment questions, and the value of active management should re-assert itself. In a more inflationary environment (and as the coronavirus pandemic has shown), not all Growth stocks behave the alike – online retailers have thrived whereas ride-hailing firms have suffered. As such, stock-picking, and within the Growth sector in particular, will likely become even more paramount. We believe an inflationary regime reinforces the need to have uncorrelated strategies like hedge funds, whose shorting ability can provide downside protection in an increasingly risky market. Likewise, many may need to consider the weighting of commodities in their portfolio, especially traditional inflationary and recessionary hedges such as gold, as we discussed last year (Figure 11).

Figure 10. Generic 10-year Bund and 10-year Swiss Government Bond

Source: Bloomberg; as of 21 September 2020.

Figure 11. Gold Spot

Source: Bloomberg; as of 21 September 2020.


There is no certain way of knowing when the current inflation regime will end. But given the reliance of the US equity market on one factor, which is in itself reliant on low discount rates, investors must be wary. It may be impossible to avoid taking part in the Growth bubble – indeed being early to call a bubble can be worse than not seeing one.

But the flash of coronavirus has briefly illuminated the investing landscape. The conditions for a new inflationary regime, and a major rotation away from Growth are set. Now more than ever, risk committees must pay attention to the coming thunder, or else risk being caught in the storm when it finally breaks.


1. The Tax Foundation; “Details and Analysis of Former Vice President Biden’s Tax Proposals”. As of 29 April 2020.
2. Source: Barron’s; as of 25 July 2020.
3. Finance Magnates; “Robinhood Tops 13 Million Users, Raises $280 Million at $8.3 billion Valuation”. As of 4 May 2020.
4. Arstechnica; “Tesla’s Stock Soars As Tens of Thousands of Robinhood Users Buy It”. As of 14 July 2020.