It is interesting to see that while the Brazilian Real has remained weak against the USD in the past 9 months, the Mexican Peso has strengthened significantly (MXN is up over 25% since its low reached in the beginning of April).
What happens to Mexico in 2021? As Brazil, the country has been deeply impacted by the pandemic, and the vaccination campaign has been running very slow (0.5 doses given per 100 people), which could lead to travel bans with some countries where the vaccination campaign has been much faster (US, UK…). With the tourism industry representing 17.5% of the country’s GDP, political and economic uncertainty is very likely to rise in the coming months, which could lead to significant MXN depreciation.
The upside gain on MXN remains very limited, while the downside risk is big; watch the USDMXN rally (i.e. MXN fall) this year !
While the Fed is expected to purchase 240bn USD of Treasuries each quarter in 2021, net Treasury supply is estimated to be significantly higher at around 600bn USD per quarter (2.5 times higher); and this does not even include the recent 1.9tr USD Biden proposal. Even if the Biden administration does not end up being as aggressive as initially proposed, even a 1-trillion-dollar ‘stimulus’ program will significantly increase the divergence between net Treasury issuance and net Fed purchases.
What will happen to US interest rates in 2021? On one hand, we know that long-term interest rates cannot rise too much from current levels as a significant (upside) move in the 10Y yield could end up having a dramatic impact on the equity and/or corporate bond markets. On the other hand, if the Fed goes ‘all in’ and matches 1-to-1 the net issuance of US Treasuries as they did in 2020, other central banks (i.e. ECB, BoJ) will have no other choice than to fight the USD depreciation as policymakers will certainly not let their currency appreciate indefinitely.
In the past few months, gold has been showing some signs of ‘fatigue’ with market participants starting to price in a smooth ‘Covid-19 exit’ with the vaccination campaign. However, major drivers of the precious metal such real interest rates or the total amount of negative-yielding debt are still sending bullish signals; we think that market participants are underestimating the impact of social distancing and travel restrictions in the medium term.
With another 3tr USD of liquidity expected to reach market this year, it looks like the downside risk on gold remains limited as we think that most economies will rely on debt (therefore more liquidity) in the coming two years, which implies strong demand for the ‘currency of the last resort’.
Main risks in the near term: rising optimism over the vaccine campaign, warmer days and USD strength.
One striking observation we can notice in the past cycle has been the speed at which the equity market recovers each time it experiences a significant drawdown (> 10%). For instance, while it took it took 7 years and 3 months and 5 years and 6 months in the past two economic recessions for the S&P 500 to recover to its previous highs, US equities recovered to their February 2020 peak in just 6 months after crashing by over 35% during the Covid19 panic.
As we previously mentioned, the drastic rise in liquidity to finance the high cost of lockdowns has been one of the major forces behind that historic rebound, and that a repeat of the 1930s period with stocks having a period of hope followed by a drastic selloff will be very unlikely this time.
Hence, market participants have constantly tried to buy the dip each time the market was experiencing a selloff. Figure 2 (left frame) shows that people were looking to buy stocks at the heart of the panic regardless of how dramatic the impact of Covid19 will be on the economic activity, especially on the service sector. Even though it has not always been a successful strategy in the past 100 years, ‘buy the dip’ has been a winning trade in the past 25 years (to the exception of 2002, 2008 and 2018); figure 2 (right frame) shows the average weekly performance of the S&P 500 following a negative week. If investors bought the dip in 2019 and 2020, they would have generated a positive average performance of 0.6% and 0.7%, respectively.
With another 3 trillion USD expected to reach markets this year (at least), we think that the ‘buy the dip’ strategy will prevail in the near to medium term.
In the past 15 years, we have seen that the dynamics of the exchange rate in Japan (JPY) has had a significant impact on equities; it has been described as a negative ‘Pavlovian’ relationship where a cheaper currency has usually been associated with higher equities. This chart shows the significant co-movement between Japanese equities – TOPIX – and the USDJPY exchange rate; hence, we are confident that policymakers in Japan are strongly aware of that relationship and therefore the BoJ is carefully and constantly watching the exchange rate.
It is interesting to see while the Japanese Yen has been constantly appreciating against the US Dollar amid the aggressive liquidity injections from the Fed (relative to BoJ), equities have strongly recovered from their March lows and are currently trading at their highest level since October 2018. However, we do not think that this relationship will persist in the medium term; as we previously mentioned, a strong Yen will not only dramatically impact the economic ‘recovery’ but also weigh on LT inflation expectations. The last time the relationship broke down between the two times series was in the beginning of 2018, with the TOPIX rising to nearly 1900 while the Yen was gradually strengthening against the USD, but it did not take long for equities to converge back to their ‘fair’ value.
We are not suggesting that trend in equities is about to revert, but investors should be careful as the ‘Short USD / Long The Rest’ trade has become very crowded.