2020 Covid Shock
Pre-emptive Hedging:
At the beginning of the year, we highlighted the highly unusual confluence of the three cycles: 1-3 year mini reflation cycles, 5-10 year business/credit cycle, 4 decade disinflation cycle. We pointed out the end of 1-3 year mini reflation cycle would probably mean the end of 5-10 year business cycle, which would potentially result in the transition away from the past 4 decades of low inflation into a future higher inflation regime. We did not predict Covid-19 would serve as a key catalyst to end the mini reflation cycle and the business cycle. We indeed anticipated full-blown MMT in reaction to the recession as a key catalyst for the inflation prognostication, which we later coined monetary inflation.
While we thought that we were marching into the tail end of the 5-10 year business cycle, from a timing perspective, we thought that Powell’s pivot and specially the “Not-QE” LSAP (large scale asset purchase) had the potential to engineer another mini reflation cycle and extend the business cycle that began with the financial crisis. At the same time, our leading economic indicators were pointing to very weak economic growth momentum at the beginning of the year. Lastly, our quantitative indicators pointed to short-term risks for risk assets in general.
Within this general backdrop, we recommended that investors gradually reduce risk exposure at the beginning of the year. However, we did not advise outright de-risking, but rather the following hedging strategies: 1. Long US Rates (or/and conditional curve steepeners). 2. Short selected EM countries (mainly Brazil and South Africa) 3. Direct hedges using put spreads on QQQ.
On January 18th, we recommended investors to receive rates either outright or via options due to low implied volatility. See “US Econ Scan – the Raven of Zurich”.
Chart: US long bond future
We encouraged investors use options to have a levered impact on the portfolio due to the low implied vols. For more sophisticated investors, we suggested conditional bull steepeners: “Investors can structure a conditional bull steepener with significant cost savings to provide highly asymmetrical hedges to their equity exposure”. Here is the reprint of the chart we used while making this recommendation (the result was a 25x return according to one of the trades ideas we constructed in 2019).
Chart: US 2s10s vs. Fed Fund Rate chart dated on Jan 9th, 2020.
At the same time, we recommended shorting selected EM currencies to hedge risk assets such as South Africa and Brazil. See note “Ag Shame South Africa”.
Chart: USDZAR spot
Chart: USDBRL Spot
On Feb 21, we issued a note “Imminent Reversal, Bull Intensity Index”, recommending direct hedges using put spreads on QQQ (NASDAQ 100 Index).
Developing and Executing Monetary Inflation
We anticipated that fiscal spending monetized by central banks would be the policy response for economic recessions going forward. However, we did not expect that it would happen so large and so fast.
In March, we encouraged investors to take profits on the hedging instruments, and gradually scale into risk assets. More specifically, we recommended risk reversals - selling 20% OMT puts and buying 10% OMT calls on the S&P 500 index to capture the rebound - “Our indicators show increasing probability of a potentially drastic short-term rebound. We continue to like risk reversals by selling 3m 19% OTM put to fund 10% OTM call with zero cost.” See note “Contagion” dated March 14th, 2020 and “Mirror Image of Volcker Shock” dated March 21st, 2020.
Our investment actions for the balance of the year have been guided by the thesis of Monetary Inflation and managing the expressions, timing and sizing of this thesis.
On April 20th, 2020, we recommended buying deep OTM payers on US long rates with long expiry per note “Cross the Rubicon”.
Chart: US 30y Treasury Yield
On May 17th, we encouraged investors to add back precious metal exposure per note “The New FANG”.
Chart: Gold Spot
Chart: Silver Spot
On June 8th, we recommended overweighting EM against US stocks per our note “The Great Uncertainty”.
Chart: Ratio of Total Return Index of EM vs. US Stocks
In mid-June, we developed a major thesis for the turn of the US dollar cycle to the downside and laid out the investment implications. From a currency perspective, we turned bullish on the EUR, AUD, NOK and selected EM currencies. As for stocks, we were especially constructive on emerging markets, value and cyclicals. Please read our note “US Dollar Cycle Part 1, and 2” dated on June 13, and June 22.
Chart: US Dollar Index
We started the pivot to value in the summer. Please refer to our note “The New Dawn of Value investing” dated on August 17th, 2020.
Chart: Total return ratio of value to growth stocks
On August 24th, we turned bullish on the Chinese RMB. Since then, it has been one of the best performers among major currencies, appreciating more than 6%. Here is the reprint of the chart when we published the note.
Chart: USDCNH Spot – dated August 21.
On October 19th, we reiterated our bias towards cyclical assets, such industrial and materials. See note “Rising Vols”.
Chart: Industrial ETF XLI
We turned bullish on commodities in general towards the end of October and beginning of November. Though, our favorite play had been copper, and the base metal producers (XME is the ETF), We started to turn more constructive on energy stocks per our note “Embrace Volatility” dated 11/1/2020. We later turned bullish on the entire commodities space on 11/15.
Chart: XME – Metal and Mining ETF
Chart: Energy ETF XLE
In the 10/15 note “The Great Rotation,” we reiterated our bias towards EM, value, cyclicals and small caps, and we expressed the hypothesis that large tech stocks might have peaked relative to small caps. Here is the reprint of the chart.
Chart: Ratio of Total Return Index of QQQ (ETF of NASDAQ 100) vs IWM (ETF of Russell 2000 index)
