Observations by David Robertson, 11/12/21
PPI came in hot on Tuesday and CPI came in hot on Wednesday which finally paused the amazing fall run up in stocks. Investors now have some raw, non-transitory inflation data to digest in order to establish longer-term expectations.
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Themarketear.com ($) captured the crazy market action through the week as well as anyone. On Sunday:
“Retail is extremely active, and they love punting options. Below are a few stunning facts via Goldman's Scott Rubner:
1. single stock option notional (140%) now exceeds single stock shares notional
2. over 70% of options traded have an expiry of two weeks or less (more in the 2,3,4 day range)
3. $904bn (Thursday stock option notional). This is largest single stock option notional traded of all time.”
"Traditional investing rules are being thrown out (NVDA; ~$750bn company going up 12% in a day, TSLA adding $350bn of mkt cap in a couple of weeks, BBBY going up 65% after hours on earnings, CAR 29 sigma move in a day).
“In this options driven market, the smart guys aren't in charge.”
And on Wednesday from Robert Armstrong ($) at the FT:
“The S&P has (i) reached new highs each of the past eight trading days, tying the longest streak since 1964; (ii) risen 17 of the last 19 trading days, a feat surpassed only once in 90-plus years, and (iii) for only the second time since 1950, taken less than a month to rebound from twin fragility shocks.”
Investors looking for some solace may see good news in the fact that nobody else seems to know what is going on either. Other than that slim piece of optimism though, the interpretation is mainly negative: Things are running out of control and either and this is exactly the kind of situation when things can break in unpredictable ways.
Wednesday was quite a day with the S&P 500 down .82%, the ten-year Treasury yield up 8.94%, and the US dollar index (DXY) up a huge 1.00%. Obviously, something started shaking the market’s otherwise calm demeanor. Zerohedge reports:
“And just in case the Fed is still unclear what is going on, this is the market - nearly a year before the Fed has to hike rates - tantruming and making it clear that it will not buy paper anywhere close to current levels if the Fed indeed abandons its QE commitment and subsequently hikes rates. Brace for far, far uglier auctions in the coming months from a market that is now fully habituated to getting everything it wants from the Fed.”
"Unprecedented Liquidity Pressure" - Chinese Property Stocks Crater As Kaisa Misses Payment
“Kaisa's troubles come amid concerns about a deepening liquidity crisis in the Chinese property sector, with a string of offshore debt defaults, credit rating downgrades, and sell offs in the developers' shares and bonds in recent weeks. Meanwhile, amid the confusion over the outcome of the current solvency scare, the Chinese property market continues to lock up and we reported earlier this week that China’s top 100 developers saw new-home sales fall 32% from a year earlier in October, after a similar slump in September.”
With all eyes on US stock market gyrations, China’s real estate market has escaped notice. This is too bad because details are trickling out and thus far, they are not good. Not only has contagion spread through the entire real estate sector, but it is also reducing transaction activity and pricing.
The big question is, “How long will this be allowed to go on?” On one hand, the established playbook is to increase liquidity in order to prevent a massive deflationary spiral. That path requires a great capacity to accept moral hazard, however. Given that Xi seems to have a preference for constraining moral hazard and associated corruption and has the power to allow a controlled demolition of the overleveraged property sector, it’s hard to say how long weakness in Chinese real estate might go on.
At the very least, investors cannot buy the dip with the same confidence they do in the States. I suspect there will be a lot more pain than investors are accustomed to.
Xi Jinping goes full 1984
"Who controls the past, controls the future; who controls the present, controls the past."
“That slogan laid out the Party's sinister ploy to entrench itself in power by rewriting history in George Orwell's classic novel 1984. And it's what the ruling Communist Party now wants to do in China, where ‘Big Brother’ Xi Jinping already oversees an authoritarian techno-surveillance state that in many ways exceeds the intrusion of Orwell's dystopian future.”
China has always been an enigma to Americans who have historically projected their own value system on the Middle Kingdom. As the CCP’s inner sanctum convened this week, Xi Jinping plans a “broad revision of China’s historical narrative”. In other words, he is going full George Orwell.
As Gzero reports, this won’t be just some “anodyne internal document” either. The historical revision will “influence everything in China — from foreign policy, to what's taught in schools or shown on TV and in films, to what constitutes the ultimate crime of disloyalty to the party — for an entire generation, if not longer.”
The bottom line is this is a massive display of raw lust for power. One consequence is that it will have vast potential to challenge assumptions about how China works. Another is that it invites a huge array of unintended consequences. In short, it will be hard to rule out many possible outcomes. For example, I wouldn’t be at all surprised if China takes a much more aggressive stance towards Taiwan after the winter Olympics.
THE GRANT WILLIAMS PODCAST, Episode 20, Julian Brigden, MI2 Partners, NOVEMBER 09, 2021 ($)
“… the inflation prints that I see are ginormous. I was just looking at... No-one noticed today, Eurozone PPI went to 16%. Sweden’s already at 18%, 45 year highs for the second time in two months …”
“We actually wrote this piece called The Man Doth Protest Too Much, and we went through and we took the Fed’s own data and just went, ‘Wrong. Wrong. Wrong. Wrong.’ And he’s doing the same thing again, because I think he’s really trapped.”
The main point Julien Brigden makes in this interview is that the Fed has pumped all kinds of money into the system and now it is really beginning to flow into the real economy and create inflation. Since these dynamics take time to unfold, he expects inflationary forces to get much worse.
One point to take away from this is that the Fed is in a terrible position and really cannot speak the truth about inflation. As a result, it is up to investors to observe and assess on their own – and all the data point to significant inflationary pressures.
Another point is that low long-term rates seem disconnected from the significant potential for higher inflation. There are several possible reasons for this phenomenon, but my leading candidate is that long-term rates discount the potential for inflation because underlying growth is so low. This underappreciates the potential for inflation to be much higher and more persistent not because of high growth, but because of high costs and lower efficiency. In essence, policy choices, not organic demand growth, are creating inefficiencies that cause prices to go up.
Insofar as this is the case, there is enormous potential for investors to get burned when inflation continues to rage higher and the political costs of not raising rates outweigh the costs of allowing higher rates thrash the prices of financial assets.
“A structural change in the plumbing of the banking system is dampening the impact of monetary policy and may even make rate hikes inflationary.”
“The primary impact of Fed hikes will likely be through the financial channel. Every hike reduces the market value of fixed income investments, with the losses transmitted more broadly through the (often leveraged) portfolios of investors. The good news is that the ‘reverse wealth effect’ channel has a reliable record of subduing inflation by tanking all commodity prices.”
In another extremely readable, somewhat technical, and incredibly insightful analysis of monetary policy, Joseph Wang describes how the Fed’s go-to play of raising rates to control inflation isn’t going to work the same way this time around. In fact, raising rates could even make inflation worse. This should put to bed any notion that the Fed is in control.
Perhaps worse, the most likely way rate hikes would be felt is through the reduction in value of fixed income securities. Since these securities also serve as collateral for repo transactions, the Fed is extremely unlikely to allow rates to go up too much for fear of seizing up that market. As a result, it is fair to expect more inflation for longer.
FANGs Are Getting Fatter on Falling Bond Yields ($)
“Higher concentration [of an index] logically makes it harder for an active investor to beat the index. Doing so requires taking a large holding in companies that are already strong and, at present, highly valued. The momentum of indexation exacerbates this. When an index becomes more concentrated, more investors buying into passive, from active, distributions will at the margin mean putting a higher proportion of their money into the dominant stocks, and thus increasing their dominance.”
One of the little discussed aspects of passive fund management is that it does better relative to active management as holdings become more concentrated. Since holdings have become more concentrated, passive funds have had a strong tailwind relative actively managed funds.
Of course, this works both ways. As holdings of passive funds become quite large, especially due to factors other than fundamental improvement, they also become increasingly large liabilities. When, for whatever reason, sentiment begins to sour on such holdings, an active manager has to do little more than avoid the most egregiously overvalued and significantly weighted holdings to outperform. Easy peasy.
Inflation surge fuels negative real interest rates for leading economies ($)
“The surge in inflation is leaving the world’s leading economies with their lowest real interest rates in decades, as central banks delay any abrupt tightening of the extra-loose monetary policy used to help weather the coronavirus crisis, arguing that the recent rise in prices is transitory.”
“In the US, where nominal interest rates are near zero, real rates stand at around -5.3 per cent. They are at -3 per cent in the UK and -4.6 per cent in Germany, according to Financial Times analysis.”
One of the important aspects of the current investment environment that is often underappreciated is what sustained negative real interest rates mean for investors. In short, real rates are the benefit investors derive from the act of investing. When real rates are positive, investors benefit from the “natural wonder” of compounding. When real rates are negative, investors suffer persistent erosion of the purchasing power of their assets.
The implications run deeper, though, and fundamentally affect what it means to succeed at investing. For example, historically investment success has meant performing better than a benchmark or some other comparable portfolio. The index goes up, you go up more, and that is “winning”.
It is that mindset of winning, however, that makes negative real rates so dangerous. When real rates go negative, it is tempting for investors to try to keep “winning” by going progressively further out on the risk curve – by buying stocks. While that can defer the pain for some time, it can’t change the reality that the odds are stacked against investors and savers.
As a result, the most useful message to take from negative real rates is that expectations should be reset. Returns will be lower. The proposition of investing is more about preserving wealth rather than expanding it. It is more about defense than offense.
Once this reality is accepted, it becomes much easier to make appropriate tradeoffs. Chasing extremely risky, low probability bets starts looking incredibly foolish rather than temptingly lucrative. Big bets start looking more like flirtations with disaster rather than valid opportunities. Most importantly, small losses of purchasing power that allow one to fight another day become a pretty reasonable standard of performance.
Implications for investment strategy
With inflation persisting at much higher rates than in the recent past and many inflation hedges getting bid up substantially, I spend the better part of my research and analysis time assessing tradeoffs between quality of inflation protection and the price for that protection. The easiest answer to this puzzle has been gold and gold miners since they have barely moved despite having significantly improving fundamentals.
Beyond that, things get a lot tougher. The traditional argument is that stocks also provide a meaningful hedge against inflation since quality companies can always raise their prices. There is absolutely truth to this, but the question is, “How much should one pay for that functionality?” John Hussman just published the following graph which is essentially a price to sales multiple for the entire economy:
As he reports, “This measure is now 50% above levels that were never seen in history prior to last year.” While that certainly comes across as excessive, the more concrete translation is an expected return of the S&P 500 that lags Treasury bonds by “about 8% annually over the coming decade”. In other words, if Treasury bond yields are zero over that period, stocks will lose 8% per year.
There are several big implications that arise from this. For one, as unattractive as bonds may appear in light of persistent inflation, stocks appear far worse at current valuations. Any potential inflation protection has long since been more than priced in. For another, if you are tempted to catch some of the feverish temperament in stocks, be well aware of the fire you are playing with, especially if the allocation is for any kind of long-term portfolio.
A deeper underlying question is, “What is safe?” If the desire to catch the wave in stocks is an effort to defray the increasingly visible rise in cost of living, that ship has sailed – so stocks can’t be considered safe. Further, it is clear that inflation will erode the purchasing power of bonds – so they aren’t safe either.
The answer lies in perspective. At current valuations, financial assets are extremely unlikely to retain the purchasing power implied by current prices and inflation levels. So, in a sense, there is no “safe”. The sooner investors figure out that investment success will mean losing less purchasing power than others, the sooner they can avoid the futile distractions of chasing markets and focus on the more productive course of diversifying among real assets.
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