Observations by David Robertson, 10/6/23
The new quarter started off with a bang. Let’s dive in.
As always, if you want to follow up on anything in more detail, just let me know at firstname.lastname@example.org.
As we launch into the fourth quarter, there is a wide dispersion of views on stocks. On one hand, Brent Donnelly reports in his Substack letter, “But everybody knows that everybody knows Q4 is a super strong seasonal period for stocks and now it feels like the market is short stocks, and bullish … the first week of October could be a huge up week for risky assets.”
On the other hand, Andy Constan posted, “For all those seasonality junkies and equity positioning nuts Long only asset managers are as long as they have been all year and through Tuesday last week just started selling and hedge funds are the least short they have been all year.” In other words, it wouldn’t take much for stocks to take a spill here. To each their own, I guess.
The main observation, however, is the dichotomy of views, even from very qualified sources, is illustrative of the cross currents and uncertainty in the markets right now.
Oil has continued to tantalize investors with opportunity having risen from the high sixties at the end of June to over $90 by the end of September. As Rory Johnston pointed out, though, there was at least one identifiable crack in the story: Gasoline crack spreads have been in “complete freefall” since the end of July.
The market learned a little more about the story on Wednesday when the Energy Information Administration (EIA) released weekly data that showed demand for gasoline in the US continuing to drop. Oil prices reacted violently, dropping over 5% on the day.
Yes, there are other things going on and no, this doesn’t necessarily mean the three month ride in oil prices is over. It does indicate, however, the degree of volatility and uncertainty in the world’s most important commodity. It also suggests the demand environment may be changing. Perhaps there really was a good reason for Saudi Arabia to cut production over the summer?
Copper revisited ($)
I was therefore interested to read an investor note Bridgewater published earlier this week, arguing the metals cycle driven by the green transition will not be like other cycles. The reason is that the green transition is a demand shock that everyone sees coming from a mile away. As a result, governments and companies are providing supply incentives, exploring substitutes, and investing in technology to reduce demand. So the price picture is not as bullish as it may seem for nickel, lithium, and cobalt.
Marcus Garvey, who runs the commodities strategy team at Macquarie, thinks this demand shortage will follow the pattern of previous ones: the market will find a workable supply-demand balance, but only after a significant price spike creates an incentive. “Who knows what the equilibrium price that will resolve this deficit is,” he says, “But we don’t just arrive at equilibrium. At some point you will overshoot it.”
This piece from the FT focuses on copper, but raises a couple of important points for commodities in general. First, because “the green transition is a demand shock that everyone sees coming from a mile away”, we are likely to experience a metals cycle that “will not be like other cycles”. There are a lot of moving parts in a commodity cycle - and substitution, innovation, and demand elasticity all play roles in the outcome.
Second, the path of a commodity cycle is rarely smooth or linear. Most often it is characterized by wild swings. Overshoots are common in both directions. Not only are “significant price spikes” required to provide financial motivation for new investments, announcements of new capacity and/or reduced demand can cut off a price run in a hurry.
None of this is to say there won’t be some commodities that do very well over the next several years. It is only to suggest tempering expectations. While there is almost certainly opportunity, very little if any of it will come easily or without risk.
Gold has declined over the last couple of weeks which prompts a discussion over the reasons why. While the downturn does coincide with the recent uptick in long-term Treasury yields, gold prices have largely defied moves in long-term Treasury yields to date. Just this week, gold dropped as rates rose on Monday, but barely budged on Tuesday when rates continued to go up. Further, the premium to buy gold in China has continued to be very high which suggests significant demand there for physical product.
That factoid also points to a possible explanation for the trading behavior. As liquidity conditions tightened in the US, some entities sold gold ETFs (among plenty of other things) to generate cash. As a result, there is a good chance the price impact reflects liquidity conditions in general more than fundamental conditions for gold in particular.
On the subject of fundamental conditions for gold, the outlook keeps getting brighter. Clearly there is demand in Asia as the premium suggests. Further, with the recent bump up in expected Treasury borrowing and the House now vacated of its Speaker, the prospect for turbulence is as great as ever.
This chart from @SoberLook depicts sentiment for workers in the UAW strike against auto makers. Across the general population two-thirds side with the striking auto workers. We’ll have to wait to see what ultimately comes of this, but sentiment has clearly shifted from capital to labor. It is hard to imagine such lopsided support won’t appear in political action in some form.
By the same token, sentiment appears to be shifting away from private equity (a manifestation of “capital”) as well. The FT published an editorial a week ago extolling the virtues of private equity and lambasting FTC Chair Lina Khan’s efforts to rein in the industry. Based upon a single anecdote, the author criticizes Khan for not “seeing the reality” of the beneficial effects of private equity.
In my opinion, the article came across as an old school example of sexism and patronization, not a well-reasoned and substantiated argument. Apparently I wasn’t the only one. As Matt Stoller posted: “Private equity is furious at Lina Khan. Everyone else is furious at private equity.” It will be very interesting to see how this “fight” progresses and how it becomes manifested in politics.
Harald Malmgren posted the following note on X:
In run up to election no votes from either party to raise taxes or cut spending
Hard reckoning comes in 2025 and thereafter. This is why Malmgren- -Glinsman Partners are warning FY2024 ballooning borrowing needs means still higher interest rates for bonds ahead
Yes, this is someone talking their book, but that someone is also a veteran political insider who has a far better idea of how government works than the average commentator.
While it is not exactly a secret that neither party has any interest in raising taxes or cutting spending, exceptionally few have discussed the consequences. At some point, and Malmgren argues it will be in 2025 (which sounds about right), “ballooning borrowing needs” will result in even higher interest rates for bonds.
At some point, those ballooning borrowing needs are also likely to boomerang back on the US dollar as well. When it does, expectations for inflation and opportunities for hard assets like gold and other commodities are likely to re-set higher.
In the Fed’s ongoing effort to extinguish inflation, it is useful to remember that inflation first appeared after the GFC - in the form of asset price inflation. Through the Fed’s campaign of Quantitative Easing (QE), it continued to infuse cash into the financial system, but not the real economy. Financial assets inflated, but not consumer prices.
Now, that may be changing. Baby Boomers are the largest generational owner of financial assets. They are also at, or rapidly approaching, retirement. With the reality or imminent prospect of loss of regular income, the security of assets becomes of paramount importance. With bonds getting beaten up and stocks looking shaky, another alternative is to simply spend some of the money.
That spending can go to travel, to a nicer home, to hobbies, to help kids out, and to a whole host of other things. The money has to go somewhere. The point is, this is how financial asset inflation can get converted into consumer price inflation.
Bob Elliott picks up on exactly this point: “The problem the Fed faces at this point is not a price of credit problem but a price of assets problem. Until asset prices come down, it is unlikely we will see inflation durably remain at the Fed's mandate.” The Fed knows this and therefore is unlikely to relent based upon a couple of months of improved inflation reports.
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Investment landscape I
Why fear is spreading in financial markets ($)
By comparison with the bond and foreign-exchange markets, the stockmarket has been slow to absorb the prospect of sustained high interest rates … Yet it appears investors had also taken a pollyanna-ish view of interest rates
This is one of the bigger puzzles in markets today: Why are stock prices remaining as resilient as they are given much higher interest rates? To date, idiosyncratic reasons have been given - and largely accepted. The gilts crisis in the UK last fall prompted central bank leniency. Ditto the bank mini-crisis in the US in March. The hype of artificial intelligence propelled stocks through the spring and the debt ceiling resolution had the counterintuitive effect of easing financial conditions by flooding the market with Treasury bills.
These “reasons” have given bulls enough confidence to keep pressing. Of course, the power of these “reasons” has also been supported by the fact “investors have simply not believed that interest rates will stay high for as long as the bond market expects”.
That may be changing. Not only are rates not reversing, long-term rates continue to rise. It is fairly easy to trace the inflection of the rate trajectory: Long-term rates started moving up when the Treasury announced in the middle of the summer that it was going to almost double the amount of bonds to be issued in the fourth quarter. This means asset owners will need to sell assets of some sort in order to make way for the newly increased supply of Treasuries. This is where the rubber hits the road.
The selling, or preparation to sell, appears to be starting. As it does, sellers need to get cash from wherever they can - which means whatever is liquid. The effect is to put quite a bit of stress on asset prices. This in turn is putting pressure on the “pollyanna-ish view of interest rates”. It is also illustrating just how fragile the foundation of flows into stocks has been.
Investment landscape II
Thrown for a LOOP ($)
The increasing trend towards passive investment and systematic portfolio rebalancing is contributing to market inefficiency, with fixed weight rebalancing strategies lacking a self-correcting mechanism
Despite the uncertain timing of a correction in mispricing, it will occur. Investors are unlikely to time it, and the catalyst is likely to be qualitative rather than quantitative. The current bond/equity mispricing closely resembles the persistent “cheapness” of value, and it’s a reasonable fear that it can persist longer than anticipated
Mike Green has beat the drum on the effects of the proliferation of passive investing, and I keep beating that drum too because I believe it is probably the single most important and underappreciated force in the investment landscape today. Green highlights the differences between a demand-driven landscape, which is the “free market” most investors assume, and the supply-driven landscape, which is the environment dominated by passive investing:
When the behavior is being driven by the demand side of the equation, TDFs [Target-Date Funds] (and other fixed-weight rebalancing strategies) stabilize returns by selling equities and buying bonds. But when supply is the driver, prices become MORE volatile as the price must flex to absorb supply in the face of fixed demand.
Green concludes, “Unfortunately, these dynamics lend themselves to markets that can hit extreme outcomes and then correct in an impossibly rapid fashion”. And this is why I think the work is so important: I don’t believe most investors realize their retirement savings are riding a gut-wrenching roller coaster.
Long-term rates are the topic du jour and Jim Bianco shares his observation and analysis:
Bond traders have gone from bullish to dip buyers.
We are going to need a good old fashion capitulation to end this selloff.
This strikes me as pretty insightful. You don’t buy dips if you are afraid of the consequences. You buy dips because you “know” prices will bounce back. This is consistent with the Economist’s perspective of a “pollyanna-ish view of interest rates”.
As Bianco rightly notes, the only way to end such a fantasy is for a “good old fashion capitulation”. This suggests rates can continue higher.
Of course, with lots of money still sloshing around, investors are still keen to make bets on any little short-term discrepancy they can find. As a result, the prospect of an imminent reversal in yields is tantalizing for many speculators.
This makes the landscape even more difficult for long-term investors to navigate. Is it time to raise allocations to bonds? Have long-term interest rates peaked? If not, why not? What are the key drivers?
PauloMacro chimed in on the rates discussion with an excellent thread on X that addresses many of these questions. He explains, “Many seem surprised that real rates are screaming as nominals rise and inflation expectations remain anchored. But that’s only because inflation swaps or breakevens haven’t moved.” In other words, yes, the term premium has risen, but who’s to say “expected” inflation is right? What if those expectations are too low?
This is a point I have argued as well. In fall of 2020, who had 8.9% CPI for June 2022 on their bingo card? It certainly wasn’t five-year inflation breakevens which had inflation pegged at about 1.6% at the time.
In my Market Review for the third quarter last year I wrote, “Another point is while a strong case can be made for higher inflation, this is not widely discounted yet. The 10-year inflation expectation for September registered just 2.3%, still very close to the Fed’s 2% target.” I went on to conclude, “When long-term inflation expectations do break higher, a lot of longer duration assets will get hit.”
This assessment dovetails nicely with PauloMacro’s: “But the Trade After the Trade is not yet fully baked. I think a shift where the rise in nominals hands off to the rise in breakevens is still a few weeks out — call it November opex plus or minus as a window (yes coincidentally where shutdown got kicked out to).”
In other words, the “Trade” is for long-term rates to moderate/consolidate after a tortuous run up. But “the Trade after the Trade” is for rates to continue even higher yet driven by rising inflation expectations. In short, the move up in longer-term rates has only been the first leg of a longer journey, not an aberration to be resolved.
So, one major takeaway is that long-term rates can go higher. As a result, it’s not a great time to load up the truck on long-term bonds. Another major takeaway, however, is that there is a clear pathway for inflation to rip higher and the US dollar to weaken. This day is some way off, but it’s getting closer. When it arrives, it will be a blow to mega cap tech stocks and a boon to gold.
One of the implications of rapid market moves such as the recent spurt higher in longer-term interest rates is they can be hard to react to. Is there new information? Why didn’t I hear about this before? What should I do? Or not do? Getting bombarded with news doesn’t clarify very much and often just makes the situation worse.
This is why I normally focus on longer-term trends and mention short-term phenomena mainly in the context of those broader trends. For example, I warned of the prospect for higher rates in the 1/6/23 Outlook edition:
As with other economic and financial phenomena, the future of rates depends critically on one’s worldview. Insofar as the repurposing of leverage is the way forward, rates will have to go higher in order to provide the proper incentives to attract investment in real businesses and to discourage financial speculation.
Later in the year, in the Market Review for the second quarter, I explicitly homed in again on the issue of longer-term interest rates. Namely, I described how the Biden administration’s industrial policy suggested “it is important at some stage to allow long-term rates to rise above short-term rates”.
I do this so readers and investors have the time to read the arguments, digest them, investigate further if necessary, and to act - before it’s too late to do any good. If you are only hearing about things in the heat of the moment or after the fact, it doesn’t help you achieve better outcomes. This doesn’t matter so much when asset prices keep going up. It makes all the difference in the world when they are going down.
So, I continue to believe a lot of investors are offsides, i.e., poorly positioned for what is coming. At least part of the problem was fifteen years of an artificially maintained investment landscape that investors grew habituated to. A lot of money was made over that period of time, but it can be lost even more quickly.
In order to avoid that fate, something more than just going along for the ride will be required. Nor will quick reflexes get investors very far. Rather, this is an environment that demands research, strategic thinking and risk management. Get on board with that and things will start making a lot more sense and become much more manageable.
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