July 2021 Thoughts and Insights
We hope everyone is enjoying summer and taking those long-awaited trips to see loved ones! The Trouvé's traveled to France for a wonderful family visit and can report back that the airports, shops, and restaurants are bustling!
Market Function and Our Process
We have often talked about how the investing landscape has dramatically changed over the past 5 years. The greatest difference is that ETF assets now account for over $6 trillion under management and global hedge funds assets are $3 trillion. Furthermore, 90% of the equity trading volume in the US is accounted for by systematic trading (machines and algorithms). The proliferation of index-based investing and the concentration of hedge fund assets that can “short” stocks have made the financial markets much more sensitive to macroeconomic risks than ever before.
That said, the markets have experienced periods of increased volatility every month this past year followed by periods of normalcy. Each of these volatility episodes in 2021 has been due to the large number of index strategies following the same investment theme, all using leverage. When an economic event occurs against their thesis, the crowd needs to quickly unwind their trade and cover their debts (leverage) by selling their good assets which causes prices to move down in a disorderly fashion. The founder of Hedgeye colorfully describes these events saying, “it’s like trying to push mash potatoes through a garden hose when they all exit a trade at once.” By using our technical research and the Hedgeye tools we have in place, we know how to risk manage when these events occur. This, of course, does not protect us from losses, but we do know when a price decline is only temporary versus when a permanent shift has occurred, and we need to adjust.
Q2 2021 Equities
In our last note we discussed that the economy was in Quad 2 for the second quarter of 2021. Quad 2 is when we have accelerating growth and accelerating inflation at the same time (see the chart at the end of this letter as a reminder of the Quads). Listed below are the investments we concentrated in for Quad 2 in our equity model portfolio and their investment returns through the end of the quarter.
We are pleased with our overall equity returns and our investment selection process.
Q2 2021 Fixed Income, Gold, and Inflation
Our fixed income strategy to focus on yield and short dated maturities continues to hold strong and our fixed income portfolios had positive returns as compared to the broad bond market.
However, at the Federal Reserve meeting on June 16th, the Fed announced they would raise rates by 0.5% two years from now (2023). This macroeconomic event caused another round of episodic volatility. The 10-year treasury declined, and the 2-year treasury rose, flattening the yield curve and impacting both the fixed income and gold markets. In its meeting statement, the Fed acknowledged the obvious, that they were behind on recognizing the economic recovery. This flattening of the yield curve resulted in real rates rising, causing gold bullion to decline by 7% giving up this year’s gains. We believe the drawdown was a temporary reaction to the perceived change in the Fed posture towards potential monetary tightening.
Nonetheless, the Fed policy remains highly accommodative as they believe inflation is only temporary or transitory. We, however, believe inflation will be here for a while. We may have seen the peak in goods and services inflation which is why the Fed insists on the idea of transitory inflation, but the largest components of the CPI index are Energy and Rents, both of which will likely remain elevated for the foreseeable future. Labor inflation is also taking hold as many states are adopting $15 minimum wages and employers are forced to pay more for labor. High inflation causes real rates to decline, which is extraordinarily strong for gold. We will continue to hold our gold positions despite the recent declines.
Looking out to the third quarter, economic projections point to the rate of change of growth declining while inflation continues to accelerate, shifting the economy into Quad 3-Stagflation. In this Quad, we hold Commodities, Technology, Energy, and Industrials. We will move out of our emerging market equities that point to Quad 4 for those countries and buy more European stocks that point to Quad 2. We will also position more defensively. Gold is a significant overweight in Quad 3. We will hold steady in fixed income and once rates rise permanently, we will shift to longer dated maturities.
Since the global pandemic, investing has become much more complicated despite what the media portrays. The hardest part about this profession is that everyone seems to be winning all the time and the reality is this is not true. At DTIM we are committed to risk management and protecting our money when markets decline. We are not willing to take on the risk of keeping up with mainstream media or Redit/retail investors. We know that you all appreciate our commitment to use the latest tools/research and we thank you for your support as we continue to improve our investment process.
As always, we remain dedicated to serving you and your investments. Please feel free to call or write with any questions or concerns you may have. We are incredibly grateful for your trust in us.
* Returns are presented in aggregate from 1/1/2021 through 6/30/2021 and may differ across portfolios depending on timing of individual purchase. Past performance is not indicative of future results.
Opinions expressed herein are those of their writers alone and are based on information believed to be accurate at the time. Danda Trouvé makes no warranties as to the continued accuracy of such information.