Observations by David Robertson, 10/7/22
The quarter started off with a bang and soon we’ll be in a potentially contentious earnings reporting season. If you have questions or comments about anything, let me know at firstname.lastname@example.org.
On Monday the S&P 500 was up 2.6%. On Tuesday the S&P 500 was up over 3%. Some of this was just the other side of significant selling in the last week of the quarter. There were also plenty of signs of speculative interest as many took the decline in job openings as a signal of an imminent pause or pivot by the Fed.
The best overall view, however, is furious bear market rallies are very much part of the longer-term process of correction. We are still in the middle of that process so it is fair to expect more periods of sustained selling punctuated by furious rallies. Hang on!
On the earnings front, KMX, NKE, and RCII all lit up the news a week ago with high profile earnings misses. These were also punctuated by TSLA coming in low on deliveries for the third quarter. Each stock got slammed on the news.
Beyond these specific instances, sell-side analyst estimates are also coming down broadly. While it is clear some activity dropped off significantly in the third quarter, it is also clear a lot of business remains strong. In short, there are a lot of mixed signals. It will be interesting to follow third quarter commentary from earnings calls to get a feel for the economic pulse.
Great points raised by Rory Johnston regarding the OPEC+ meeting on Wednesday. It is amazing how dramatically the complexion of the meeting changed over just a couple of days.
For now, it looks like the cut is intended to keep oil prices anchored around $90. Of course, this is the price Saudi Arabia and OPEC+ want and clearly not the price the US or the West wants. With Saudi figuratively poking the US in the eye, there promises to be a whole new level of tension between the two countries.
The short-term effect will be for oil and gas prices to shift a bit higher. The longer-term effect will be greater geopolitical uncertainty. This isn’t over.
Central Asia, the “pearl of the Silk Road”, used to be Russia’s back yard but now it’s China’s front yard. In other words, China is slowly encroaching on the stans now, preparing for the possibility of a collapse in Moscow’s ability to command the country let alone the peripheral countries, from the center.
Very interesting take on the Russia-China alliance by Dr. Pippa Malmgren. Rather than viewing the relationship as something akin to an “axis of evil”, Malmgren makes a compelling case this is more an element of long-term Chinese geopolitical strategy. To wit: “China smells a massive opportunity if Moscow implodes and there is a power vacuum.”
Another dynamic she addresses is that of the “localization” of political power. According to Malmgren, Ukraine’s staunch defense against a much larger country is energizing populations worldwide. Groups that have lived under foreign authority or have been repressed in their own countries are gaining confidence to resist.
On one hand this suggests “It seems very likely that both Russia and China are no longer going to be as ‘Communist’ as they have been.” On the other, it suggests a pathway by which large groups of people will have greater political legitimacy and as a result be able to be much greater productive forces. Interestingly positive take on current geopolitical conflicts.
Last weekend and into the week, Twitter was all aflutter at the prospect of a major European bank being on the cusp of bankruptcy a la Lehman in 2008. The stocks of well-known miscreants, Credit Suisse and Deutsche Bank, have been hammered this year and they topped the betting lists for the “first things to break”.
As @MacroAlf points out in the thread above, while European banks have had a tough road to hoe since the GFC, that doesn’t mean they are in imminent danger of blowing up. It just means things have been, and continue to be, tough for European banks.
Part of the speculation is just an emotional reaction to the fact that declines in stocks and bonds year-to-date are really beginning to hurt. Part of it is an effort to scare the Fed into pausing or pivoting on its path of tight monetary policy.
Another take by @jeuasommenulle argues for something of a middle ground. Yes, capital is needed, but not in a desperate liquidity-driven event kind of way but in a massive restructuring kind of way. This makes a lot of sense. Bottom line: Yes, CS is a disaster but it’s not the kind of disaster that is likely to be the next Lehman Brothers.
One of the lessons that comes out of this episode is that too many people are trying to pick the single event that breaks things and too many people are focusing on banks. Both efforts are misplaced.
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While the banks were a big problem in the GFC, that problem was largely fixed (no, not the bad behavior, but the inadequate capital that can lead to crises). In addition to banks, however, shadow banks or nonbank financial institutions were also a big problem - but they were not fixed - and are still running wild.
The problems are centered around a number of financial activities that blossomed under a regime of “lower rates for longer”. Investors desperately sought decent yields but had to go up the risk spectrum to get them. Wall Street was happy to oblige with a variety of offerings such as asset-backed securities (ABS) and collateralized loan obligations (CLOs). It is these structures that are now receiving the attention of the regulatory and policy machinery behind the scenes.
As @Stimpyz1 suggests, there is a broad policy effort to rein in these financial structures - and for good reason. In important ways, these arrangements bypass banks in the money creation process. This creates two large problems: For one, it vastly undermines the ability of the Fed to manage money supply. For another, most of the structures fall through regulatory cracks so it is hard, if not impossible, to know where the problems are.
Of course, yet another problem is these structures generally don’t create economic value. All told, there are good reasons to weed this type of activity out of the financial system. It will be painful for originators and investors alike.
A Brief History of the Past 10,000 Years of Monetary Policy and Why Last Week Was a Big Deal
Every bit of financial innovation over the past ten thousand years or so – all of it! – has been in service to one or both of those two activities: securitization and leverage.
The real problem is that every pension fund in the world has implemented some sort of Wall Street securitization/leverage concoction, intentionally designed to make the managers look good in their quarterly reviews, intentionally designed to use short-term leverage against long-term obligations, intentionally designed to use the math of the past thirty years to obfuscate the risks of a regime change not found in the past thirty years.
For those who are interested in more background, Ben Hunt does a nice job of providing historical context for bank and finance activities. In doing so, he also provides a good, high-level explanation for the emergence of so many confounding financial products.
He also delivers another important message: Pension funds are especially at risk from the “securitization/leverage concoction”. This is because at most institutions, the career risk of a pension manager losing his/her job has been greater than the risk of buying dubious financial products, at least until now.
One takeaway for pensioners or prospective pensioners is to expect lower payouts than you have been promised. Another takeaway is many of the asset classes that have been pitched as diversifiers, like private equity, real estate, and corporate bonds, are going to suffer disproportionately as leverage gets repriced and liquidity dries up.
More and more of the important investment calls are predicated on one’s view of inflation: Either inflation is quickly going back to the targeted range of about 2% or it’s likely to persist at a higher rate. Regardless, the prospect for inflation is arguably the single most important factor for any investment decision right now. As a result, I thought it would make sense to recap the reasons I have discussed over the last couple years why inflation is likely to go up and stay at higher levels. Such factors include:
The absence of continued disinflationary pressures from Russia dumping cheap commodities and Chinese effectively exporting cheap labor
Continued underinvestment in commodity supply which means higher prices will be required to justify investment in new supply
Globalization, which increased specialization and increased efficiency, is slowing and appears to be partly reversing
Politicians are now in control of the money supply
The only politically acceptable solution to excessive debt is financial repression - and that requires inflation
None of this is to say there aren’t good arguments for deflation. There is too much debt and excessive debt inhibits growth. In addition, technology increases the efficiency with which goods and services are produced which puts downward pressure on prices. Also, China’s property bust is likely to be deflationary. Good arguments for sure, but hardly the last words in the debate.
At the end of the day, what really matters is what politicians need to do to stay in power. They have exhausted most methods. Increasing debt and kicking the can down the road has been mostly exhausted. Mispresenting debt and growth has also run its course. Now, the rubber is starting to hit the road because meager growth is becoming too big a problem to sidestep any longer.
The only real course left is to reduce the value of debt through financial repression - and that requires inflation. Anyone arguing for disinflation/deflation needs to explain how politicians can stay in power with persistent, nonpositive growth.
Now Comes the Hard Part
Very little confidence in the equity market has been shaken – yet. Consider the surveys from the American Association of Individual Investors (AAII). Sentiment – talk – is lopsided at 60.9% bearish and just 17.7% bullish. Portfolio allocations – actions – are an entirely different story, with an above-average 64.5% allocation to equities, nowhere close to the 40% equity allocations that AAII respondents reported at the 1990, 2002, and 2009 market lows. Put simply, investors are clearly becoming uncomfortable, but in practice, they continue to defend the hill of extreme valuations, in the apparent belief that whatever risk remains must be short-term in nature. “After all,” investors have been trained to repeat, “it always comes back.”
John Hussman makes a couple of good points in this selection. First, there has been an awful lot of commentary regarding how negative sentiment is. In many cases that is meant to indicate a positive for the market since sentiment extremes are more likely to revert than to become even more extreme.
Alas, this is just another case of wishful thinking. Unfortunately, while sentiment is negative, it doesn’t even remotely represent actual positioning. One thing unique to this particular bubble in risk assets is few investors have really believed in it. Rather, they have feared not being a part of it. Even when the stock market does go down, investors have learned, “it always comes back”.
As a result, a lot of investors are extremely uncomfortable here, as they should be. They are overly exposed to stocks, they don’t like the environment, but they have been conditioned to stay the course. That conditioning, however, was all the work of the Fed - which is now doing its level best to persuade investors to do exactly the opposite. This suggests a high probability of a “discontinuous” market move when investors finally work down their equity exposure to match their sentiment.
One of the great benefits of being an investor in these times is having easy (and cheap!) access to some really great investment talent. I find the insights and perspectives @PauloMacro and @UrbanKaoboy on Twitter especially helpful and @donnelly_brent, @MacroAlf, and @MrBlonde_macro all regularly provide fantastic content.
Each of these sources focus on macro trading, my opinion of which has evolved considerably over the years. I initially discounted it as mainly a gambling activity. Over the years, however, I have grown to appreciate many of the tools, disciplines, and insights of macro investing. In particular, knowledge and awareness of cross-asset relationships, open-mindedness, and attunement to change in general are all things that can benefit any investor.
These strengths are especially useful in the current investment landscape. Investors who get stuck in silos such as “stocks” or “bonds” or “US” often miss important developments. Investors who focus solely on finance and economics miss transformational political changes. Macro traders are often the ones leading the charge in identifying these important signals.
All that said, I think it can be all-too-easy for a lot of investors to fall for the allure of the swashbuckling macro trader and want to do the same thing. While I wholeheartedly believe there are a lot of really talented people that don’t fit into the big Wall Street firm prototype trader mold that can do very well on their own, I also believe it is really easy to underestimate many of the attributes that make such people special.
In short, great traders have a number of superpowers including being smart, curious, vigilant, focused, and dispassionate. None of these attributes is visible so they are easy to underestimate. Further, each of these superpowers needs to be complemented with a supportive environment. There isn’t room for distraction or procrastination. While trading is easy to aspire to, it is absurdly difficult for most of us to implement realistically.
The bottom line for long-term investors who do not have the capacity to fully devote themselves to trading is to take in the additional investing insights you can from macro trading, but to also be realistic about what you can implement in the context of your desired lifestyle.
Implications for investment strategy
While various disclaimers apply that ought to keep one from taking this too seriously, there are, nonetheless, some important points regarding investment strategy.
First and foremost, it shows passive investing is not a no-risk pathway to investment treasures. Passive fees are lower than active fees, but those lower fees also mean the decision to allocate to certain types of investments resides with the investor and/or advisor. In most cases, neither of these is a skilled allocator.
That brings up the second point. The concentration of funds at the top of the list are bond funds and international stock funds. Both of these are standard components of conventional allocation schemes. While the poor performance is partly an issue of timing, it also highlights the reality that no asset class is universally attractive. The purchase price and underlying conditions matter a lot.
Part of the weak performance of these funds is also reflective of a well-known investment dynamic: investors chase performance. People see funds doing well, hear about it from friends and neighbors, get jealous about missing out, and finally jump in right at the peak of the mania. ARKK is the poster child today but it can happen anywhere.
It should be noted that all of this is also true of mutual funds with similar strategies. The main point is passive funds are not risk-free. Another important point is the exercise of allocation is an extremely important aspect of investing along with security selection. If you want to succeed over a long investment horizon, you need access to both skillsets.
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