Observations by David Robertson, 11/18/22
Observations by David Robertson, 11/18/22
Even though the midterm elections are over, there is still as much uncertainty as ever. I’m going to take a break for Thanksgiving next week but will be back early in December. In the meantime, let me know if you want to follow up on anything at drobertson@areteam.com.
Market observations
Arguably the most prominent observation of the week was the massive turnaround in the market after the CPI report last week. Zerohedge ($) quoted Charlie McElligott as having “run out superlatives able to describe the scale of the cross-asset ‘momentum shocks’ experienced since the light MoM Core CPI print Thursday”. Clearly, the report did a major job on a lot of shops that were stopped out of trades and forced to dramatically reposition.
While much of the trading activity has essentially been a reset of trends that had continued through a good part of the year, that doesn’t mean things have settled into a nice little state of equilibrium. As this tweet from @KobeissiLetter highlights, there are an awful lot of cross-asset relationships that don’t make much sense right now.
Politics
With rising house prices and now rising mortgage rates, the qualifying income has risen from USD50,000 to over USD90,000 in two years.
The problem of course is that real incomes in the UK have not risen since 2007. Asking more rent from people that have not seen a wage increase in 15 years seems politically toxic to me.
Russell Clark mixes and matches data from the US and UK here, but his overall point is a valid one: The combination of increasingly unaffordable houses (and rents) and very low real income growth means housing is becoming a big political issue. As such, it is an area that is vulnerable to wealth and income redistribution through public policy.
While it is important to not read through to rent control too literally, it is useful to beware the prevailing winds of public policy. Interestingly, Clark points out that China is a useful leading indicator because policy can be implemented much more quickly with its centralized, autocratic government.
In the US, with both Democrats and Republicans trying to better appeal to workers, the potential for some kind of action on housing costs is much higher than it otherwise would be. Further, several labor disputes will create all kinds of opportunities for politicians to weigh in on the shape and nature of resolutions. The broad outcome of these issues are likely to shape politics (i.e., labor vs. capital) and economics (higher labor costs = more inflation) for years to come.
Economy
T1 Alpha Sit-Rep: Tuesday, November 15th
https://mailchi.mp/9cd68a44d81f/market-sit-rep-november-15th-2022-color-us-skeptical
What immediately jumps out for us is the cumulative downgrade through 2024. In the February survey, expectations for global GDP growth over the '22-24 period were for 11.4% over the next three years. Today, that number has been lowered to 8% cumulative. These are huge numbers. To put it in oil terms, that's roughly 3.3MM barrels per day of consumption that will not occur.
With so much focus on the Fed, on rates, and on politics, declining economic growth has not received the attention it deserves. Cumulative growth expectations for the ‘22-24 period have dropped from 11.4% to 8% and this is a pretty big deal.
One of the big implications regards oil demand. As tier1 points out, the decline in economic growth projections amounts to about 3.3mm fewer barrels per day of oil demand. In a market in which a few hundred thousand barrels of oil per day one way or the other can dramatically upset the market’s balance, these are big numbers.
Oil
Elements: Oil's brightest market (11/14/22)
https://www.bloomberg.com/account/newsletters/energy
Petroleum demand in the world’s third-largest oil consumer [India] has been growing faster than anywhere else in 2022, rising by more than 400,000 barrels a day. That’s equivalent to more than 20% of the total global increase.
Three factors help to explain that resilience. First, a fast-growing economy: India is set to post the second-strongest expansion among the Group of 20 this year, behind only oil-rich Saudi Arabia and well ahead of China. Second, New Delhi has capped retail fuel prices, insulating the public from the impact of $100-plus oil on the wholesale market. And third, the government has turned to Russia for petroleum, benefiting from the discounts offered by Moscow — at times as much as $20 a barrel — to keep its oil sales flowing.
A good point is made here in that India matters to incremental oil demand. While most of the focus tends to be on China and the US, India can also move the needle.
The big question is how sustainable is this demand? Part of it is chicken and egg: Is the rapidly growing Indian economy needing more oil or is cheap oil driving faster growth? Relatedly, how long can the government continue to subsidize retail fuel prices? Further, how long can India continue to reap the benefits of significantly discounted Russian oil?
The most likely answers are “Not forever”. Regardless, India will be an important variable in the oil demand equation, but not a game changer.
This will be helpful to keep in mind as the oil market will be subject to a number of pressures over coming months that could tip the scales one way or the other. Declining global growth estimates, the future trajectory of Chinese growth, diminished supply help from the Strategic Petroleum Reserve, and still-constrained industry supply growth will all play a role in determining oil prices. The most that can be said for now is there is a very wide range of possible outcomes.
Inflation
Very nice thread by @GordonJohnson19 here. The main point is the “miss” in the CPI report last week was due partially to a periodic adjustment in health insurance. This is an excellent example of many points I have made in the past.
One is any single data point should not be relied on too much. This is pretty much common sense but especially so when there are lots of moving parts and lots of noise in the data.
Another point is these “adjustments” to economic data seem to be fitting a pattern of being unusually beneficial to the incumbent administration. This isn’t to say government statisticians are intentionally cooking the books, but it does suggest they use their discretion regarding adjustments to considerable effect.
These are points explained beautifully by Ben Hunt and Rusty Guinn in several pieces over the last few years including “Heeere Comes Lucky!”, “Wage Inflation Isn’t Coming. It’s Already Here.”, and “The Icarus Moment”. “Lucky” digs into inconsistencies in unemployment claims from back in 2013. “Wage Inflation” from 2021 discusses inconsistencies in wage and price reports. “Icarus”, written in 2018, provides the best high-level context from which to interpret government data:
What if I told you that both of these wage growth numbers were misleading abstractions of what they claimed to be? What if I told you that you’ve been whipsawed by a cartoon, and you’re going to be whipsawed again?
What I AM saying is that this systematic error was clearly visible and known to the BLS, which is staffed with very smart people, and they could have fixed it if they had wanted to. The BLS adjusts raw data all the time, and there are obvious statistical adjustments that could be applied to this obvious systematic error. But the BLS chose not to fix it, or rather they chose to allow the Employment and Training Adminstration to continue making these egregious errors.
So, this stuff is still going on big time. Systematic errors develop, biases appear and eventually get corrected or adjusted, but only at a time that is most convenient. As such, it should go without saying that investors should take government data with a grain of salt. We can go even further than that though:
As investors, I think we must take a profoundly agnostic perspective on capital markets. That means that we don’t trust anything we hear or read. That means we ask WHY we are being told something with as much or more attention as we ask WHAT we are being told.
Investment landscape I
T1 Alpha Sit-Rep: Friday, November 11th
https://mailchi.mp/ef1ddee263d7/market-sit-rep-november-11th-2022-5-day-with-a-starting-vix-below-30
Needless to say, our overall conclusion remains the same -- we are playing games with tools that we do not yet understand. 0dte options and levered ETFs (and passive) all contribute to the same phenomenon: an increasingly inelastic risk market. Small changes in demand or supply are driving historically unseen price moves.
Short but sweet analysis of the historic market moves a week ago. The bottom line is very short options (0 days to expiry) and levered market exposure are playing big roles in increased market volatility.
One point is this is increasingly becoming a case of the tail wagging the dog. Low liquidity combined with highly speculative behavior is driving big swings, not important changes in fundamentals. As a result, it is important for long-term investors to be aware that while conditions are conducive to wild swings, at this point there is little information content in them.
Investment landscape II
The graph above provides a good indication of just how difficult the market has been this year. CYA, the ETF developed by Simplify Asset Management is “designed to create a highly convex payoff during severe equity market selloffs”. To a large extent, it has accomplished this. The graph shows a clear pattern of CYA zigging when the S&P 500 zags and as recently as September 30, posted a modestly positive return - which would have been a nice offset to the S&P which was nursing its biggest losses of the year.
But then things changed and less than two months later, CYA is down over 40%. To a certain extent the decline is overstated since the ETF is designed as a hedge against tail risks and not a standalone portfolio. The fact remains, however, even with a big rebound since the end of the third quarter, the S&P 500 is still down in the mid-teens percent - and the hedge is down a lot more.
One lesson is tail hedges are expensive protection in this environment of “controlled demolition”. The reason is tail risks are largely being underwritten by the Fed in order to ensure “financial stability”. In other words, there is no longer a “Fed put” to provide a floor for market indexes, but there is a “Fed stability put” to protect against situations that could lead to instability.
The good news is the chances of a financial “accident” are lower than presumed when the Fed started tightening. The bad news is, the Fed’s program of controlled demolition distorts common hedging methods and lacks transparency. The combination makes hedging a still-overvalued market much riskier than it should be.
Monetary policy
Ten Fed members were on the schedule to speak this week which created all kinds of opportunity to clarify the Fed’s position given the market’s huge reaction to last week’s CPI report. The result was … pretty much a nothing-burger. It’s not that Fed speakers didn’t say anything, it’s that they didn’t say much that was new.
The lack of meaningful push-back to the market’s rebound (with the exception of Bullard on Thursday) suggests the Fed is mostly OK with the move. This sounds a lot like the point I made two weeks ago in the “Monetary Policy II” section: The way to break the Fed put is to … allow periodic rallies in stocks. This course has multiple benefits including dispersing selling pressure so as to reduce the chances of a financial accident and giving some time and space for foreign allies to absorb the burden of a strong US dollar.
All this said, there is still very much a need to reduce the size of the Fed’s balance sheet through Quantitative Tightening and to stay on top of inflationary pressures. Don’t get too accustomed to the intervening relief.
Cryptocurrencies
Amidst the immense quantity of verbiage spilled this week over FTX and cryptocurrencies in general, I will limit my comments to what appear to be the lasting impacts. As @EpsilonTheory points out above, “What changed this weekend is that crypto-related investing of any sort now presents career risk to CIOs of institutional pools of capital”.
@biancoresearch corroborated this view by saying, “Anyone acting as a fiduciary for other people's money long crypto after today loses their job should the price go lower, more failures, and/or hacks”.
While it can seem quaint at times, industry standards of fiduciary duty and ethical behavior are there to protect investors. Further, that protection can serve as a competitive moat in an environment of uncertainty and malfeasance. Since crypto is now going to be relegated to a niche investment class that institutions and other fiduciaries will have to avoid, it will open the door for gold to play a bigger roles as a protection against fiat debasement.
Implications for investment strategy
Unhedged: Higher rates (and hubris) killed FTX ($)
https://www.ft.com/content/e9d820bf-35f0-4129-a67a-50f81079bde3
Bob Prince, co-CIO of the macro hedge fund Bridgewater Associates, thinks that markets are overpriced. Risk assets have discounted higher interest rates, he believes, but not the sharp decline in profits that those rates will, in time, bring about.
“We are in a unique economic environment, unique in the last 30 years, unique in relation to direct experience for most people. We are in a monetary-induced inflation, leading to a tightening of monetary policy, which is likely to lead to a period of stagflation,” he told me. “It’s an excess of money chasing goods, and the consequence is higher prices. It’s not an overheating economy.”
Both of these communications touch on the same issue: We are now dealing with a different kind of market than the one of the last thirty years. During that time, markets were moved mainly by credit growth and liquidity, not so much by economic growth. Markets took off not when economic growth improved, but rather when central banks signaled looser monetary policy. This made watching the Fed and other central banks for clues about changes in policy a useful exercise.
The game has now changed, however. We are moving back to a historically more normal relationship between economics and monetary policy, one where economic growth is the primary driver of markets. This will have important implications.
One of those implications is that earnings are going to matter more. With higher rates and higher materials costs, the record profit margins companies have posted will start to decline. Increasingly, this will be reflected in market prices. Relatedly, investors will eventually figure out that the exercise of watching the Fed for signals will be a lot less productive than monitoring the business and financial conditions of companies in which they invest.
This process will take time and won’t happen in a straight line. While it is likely to result in poor performance for a lot of stocks, it will ultimately be a very good thing to have stock values that are more reflective of underlying economic value.
Note
Sources marked with ($) are restricted by a paywall or in some other way. Sources not marked are not restricted and therefore widely accessible.
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