Observations by David Robertson, 12/1/23
The change in investor sentiment the last few weeks has been breathtaking. From deep, dark depression and excessive misery to hair-on-fire exuberance, the tables turned quickly and violently. Let’s take a closer look …
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Liquidity and the rally ($)
Two parts of the November rally fit with the liquidity story. First, some of the assets rallying hardest contain echoes of the 2021 bull market, when liquidity was also on the rise. Cathy Wood’s tech-focused Ark Innovation ETF is up 33 per cent this month; bitcoin is up 10 per cent (despite the most important crypto institution paying $4bn in money-laundering fines); and the Nasdaq has outperformed the S&P 500, on the back of the Big Techs. Second, fund flows are up across the board.
This is a nice, succinct summary of market action for the last couple of weeks. Market goes up, crazy stuff goes up the most, sounds a lot like liquidity driving the rally.
The narrative driving this is that inflation has settled down, the Fed will soon start cutting rates, and that means stocks will be off to the races again. Some positive seasonality blends right in to this narrative.
What also blends in is rapidly declining volatility. The oft told narrative is the market is complacent, and there is truth in that. There is another explanation too, however. Kris Sidial cites two other reasons for declining volatility:
1) The re-emergence of the short vol trade. This continues to be one of the largest factors we are watching right now as this continues to build in large size. It’s not mom and pop selling 0DTE that is causing index vol to be suppressed. There are large money institutions that are switching their portfolio allocations in the face of rising interest rates.
2) When we speak to allocators, we get asked, “who in the world is selling this stuff? [volatility]” Behaviorally, why would anyone not sell this stuff? For the last four years people have been able to sell vol, close their eyes and make money hand over fist. Rate hikes leading to declining stocks, sell vol. Mini banking crisis, sell vol. Extreme move in rates, sell vol. Why wouldn’t these trades continue to gain AUM? They have had great risk adjusted returns in the face of macro economic uncertainty.
Selling volatility is a profitable trade and therefore accrues more assets under management. More assets have a bigger effect on suppressing volatility. Volatility goes down, asset prices go up, and financial conditions improve. Financial conditions improve, spending goes up, and inflation goes up.
This positive feedback loop vastly complicates the Fed’s job and in doing so, has the potential to destabilize markets. It does so by amplifying the effect of Fed policies. Just as soon as the Fed signals less strident monetary tightness, volatility selling kicks in and amplifies the signal. In order to gauge the Fed’s intentions, it is important to disentangle this important, complementary dynamic because it does not appear as if the Fed is accounting for the effect of volatility selling in its communications.
Two other markets that have been affected by the change in sentiment are Treasury bonds and gold. The 10-year Treasury yield has dropped over 70 bps in a month and a half. At the same time, gold has perked up and is hitting all-time highs above the $2,000 mark. These are big moves in important markets.
Biden-Xi Summit Won’t Save a Declining Relationship ($)
(h/t Shannon Brandao on Substack ($))
[“t]he People’s Republic of China is a Leninist state run by a party that believes the struggle for power is unceasing and unforgiving.”
“Know that, and you’ll know what yesterday’s meeting between President Joe Biden and Chinese leader Xi Jinping does and doesn’t mean. It does mean that Xi, like Biden, has good tactical reasons for talking. It doesn’t mean that China is any less determined to overtake the US as the country that sets the terms of global order — or that any amount of dialogue can change that fact,” he wrote.
A hint of thaw in the new cold war ($)
China is also attempting to take advantage of a split within the Biden administration, says Matt Turpin, a US-China expert at the Hoover Institution. Treasury secretary Janet Yellen favours a sounder economic relationship, he says, while national security adviser Jake Sullivan and his camp are focused on trying to shape the international environment around China in ways that would put pressure on the regime. “Beijing prefers the Yellen approach,” Turpin says.
The Xi/Biden meeting the week before Thanksgiving indicated a welcome thawing of relations between the two countries, though it is also true both parties had “good tactical reasons for talking”. As such, we’ll just have to wait and see if the meeting leads to a more sustained detente or not. Bloomberg suggests, “Not”.
Another dynamic that has become evident in regard to China/US relations is that there are two different factions within the Biden administration. The Jake Sullivan faction views China as a strategic rival to be actively managed, if not contained, and the Janet Yellen faction which favors friendlier, economic-based ties.
This is interesting, if not especially surprising. For one, it is hard to provide clear communications either externally or internally when the administration is squabbling with itself. For another, the Yellen approach seems at odds with the broader political position of the Biden administration of being more pro-labor than pro-capital and of defending the country against China’s repeated transgressions.
So, it will be important to get some clearer sightlines on the administration’s direction. Sullivan’s policy is wide reaching and no doubt some toes got stepped on with its implementation. It could be a short-term concession was made to the Yellen faction to ease some hurt feelings and promote the short-term goal of re-establishing communication with Chinese leadership at the same time. Alternatively, the recent tilt toward China could signal a more lasting thaw in relations. I lean towards the former, but we’ll just have to wait and see. Either way, it will have implications not just for geopolitics, but also for the economic landscape.
As I continue to evaluate the environment for inflation, it strikes me that two mistakes are often made in the analysis. One is to focus too much on demographics as the driving demand factor. For example, the inflation of the 1970s and 1980s was driven largely by the enormous cohort of Baby Boomers reaching the age at which households are normally formed. This created a bolus of demand for housing and consumer products.
Demand can be driven in other ways though as well. For example, lower income consumers tend to have a higher marginal propensity to consume. In other words, they spend what they have because they don’t have that much.
This introduces the possibility that demand could be driven by policies that reduce inequality. Get more money into the hands of people who will spend it and guess what, they do - and it drives the economy! I think this is happening. Insofar as it is, it means that a policy direction that continues to favor labor over capital is also likely to be inflationary.
Another mistake regarding inflation is to focus too narrowly on short-term changes in consumer prices and not nearly enough on the longer-term trends towards fiscal dominance. Longer-term investors are not materially affected by a CPI reading coming in a tenth of a point higher or lower than expected. However, they will be affected by excessive fiscal spending that eventually gets monetized. This story is a lot less exciting day-to-day, but a lot more important in the long run.
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China’s internal economic and financial imbalances create challenges for the rest of the world, but policymakers in the major economies can shield their societies from (most of) the potential harms if they choose to do so. The trick is to use government borrowing and spending capacity to preserve private sector balance sheets, full employment, and the domestic industrial base.
The overwhelming dominance of Chinese producers in specific critical goods gives the Chinese government leverage over others. While this leverage is tempered by China’s own dependence on certain imports, the Chinese government is doing its best to create asymmetric dependence through a combination of self-sufficiency, diversification, and stockpiling. The democracies should learn from China’s approach by making their own societies more resilient while ensuring that China remains dependent on imported goods beyond just food and energy inputs.
One of the very big economic problems over the past twenty-plus years has been the remarkably weak growth in real earnings for workers over most of that period. Across a wide swath of industries, companies competed with cheap imports from China (and other countries) - and adapted by constraining growth in compensation.
While this problem has increasingly gained attention on the political front, it has only fairly recently been properly diagnosed. As Michael Pettis and Matt Klein lay out convincingly in their book, Trade Wars are Class Wars, large and persistent trade imbalances are caused primarily by insufficient demand from countries with large trade surpluses. As a result, policy responses such as tariffs, while often popular politically, do virtually nothing to address the underlying cause, and therefore nothing to solve the problem.
One point is the Pettis/Klein framework seems to be gaining traction in policy circles. This is encouraging because it actually addresses the core problem. In addition, to the extent these ideas become integrated into public policy, it also bodes well for labor in the ongoing labor vs. capital tradeoff.
Investment landscape I
Just before Thanksgiving news came out that Jim Chanos was closing down his hedge funds. Chanos made his name as a short seller with Enron, but he hasn’t slowed down. He also called out Chinese residential real estate as “The most important asset class in the world”, which I highlighted five years ago. Through his career he accumulated a long and varied list of wins in the face of markets that had an incredibly strong bias towards going up.
That Chanos, perhaps the most skilled short seller out there, is closing down speaks to the character of the markets today. It’s not that there aren’t plenty of bad business models, dishonest and/or incapable management teams, and overleveraged balance sheets; it’s that in the context of lax regulatory oversight and easy financial conditions it is hard to earn returns high enough to justify the risk. Even though monetary policy has tightened, speculative sentiment continues unbridled. As a short, you can be right on the analysis and still lose money.
Nonetheless, it is interesting Chanos chose this time to close down. As Russell Clark notes ($), “To make money in short selling you really want to see bankruptcy.” With all the clamoring about rising interest costs and weakening credit, one would think the potential for bankruptcies is increasing. Does Chanos see something others don’t on the policy front? Or, has he just had enough?
Either way, yet another one of the great investors has decided to opt out of the business of running a hedge fund - and that says something.
Investment strategy I
One of the relevant debates for investment strategy is the projected demand for US Treasury bonds. Many historical sources of demand are waning just as supply is increasing as a result of persistently high deficits. One take has it that yields will have to go much higher to attract buyers. This is partly true, but not completely true.
It is important to understand here that the rules for public policy are different than those for you and I. When the rules suggest an untenable position for policy, then the rules get changed. Indeed, this is exactly the plan for US Treasuries. For example, higher capital requirements for banks are likely to impose greater ownership of Treasuries.
IBM also recently announced it was restructuring its corporate pension scheme. Mike Green described the changes as potentially starting a trend to de-equitize pensions. This is interesting for several reasons. One is the plan would emphasize Treasuries over stocks. Another is this is a private plan that will be creating incremental demand for Treasuries, in addition to public efforts.
Finally, corporate pension plans were started back in the day as a way to attract workers in a competitive labor environment. Now, IBM is actively dialing back retirement benefits in what appears to be a move to discourage its workforce from staying on.
As to who will be buying all the new Treasury debt, Brent Johnson posted what could very well be the answer: “Just wait until the gov does the same thing with Treasury bonds and IRAs. Who will buy the debt you ask? You will…”
So, while the view that historical sources of Treasury demand are unlikely to meet rapidly increasing supply is right as such, it overlooks the likelihood of new sources of demand being developed.
On the other side of the equation, it is not appropriate to dismiss the increasing supply of Treasury debt as trivial either. The current mode of issuing disproportionate quantities of bills versus bonds cannot be a long-term solution without serious repercussions. Once bond issuance increases again, which it is quite likely to do, funds will need to come from other risk assets - and that will create steady selling pressure in those other assets.
So, the short-term reprieve in longer-term rates does not look like any kind of fundamental “pivot”. It looks a lot more like a “pause” to facilitate the development of new sources of demand for Treasury bonds. While this is good in the sense of reducing risk in the financial system, it is likely to prove very disappointing for traders betting on a long-term decline in Treasury bond yields.
Investment strategy II
How the young should invest ($)
That golden age [for investing] is now almost certainly over. It was brought about in the first place by globalisation, quiescent inflation and, most of all, a long decline in interest rates. Each of these trends has now kicked into reverse. As a consequence, youngsters must confront a more difficult set of investment choices—on how much to save, how to make the most out of markets that offer less and how to square their moral values with the search for returns. So far, many are choosing badly.
This creates two sources of danger for investors now starting out. The first is that they look at recent history and conclude markets are likely to contribute far more to their wealth than a longer view would suggest. A corollary is that they end up saving too little for retirement, assuming that investment returns will make up the rest. The second is even more demoralising: that years of unusually juicy returns have not merely given investors unrealistically high hopes, but have made it more likely that low returns lie ahead.
This article from the Economist does a good job of summarizing the challenges of the investment landscape for younger investors. In short, there are good reasons to believe the attractive returns of the past forty years are unlikely to repeat over the next forty. Investing is quite likely to be more difficult and less rewarding. It’s not fair, but it’s the hand that’s been dealt.
The implication is: “All this makes it unusually important for young savers to make sensible investment decisions. Faced with an unenviable set of market conditions, they have a stronger imperative than ever to make the most of what little is on offer.”
While this isn’t exactly unicorns and rainbows, there is good news. For one, there is more information and accessibility than ever before. Interested and curious investors have tremendous opportunities to learn, research, and analyze investments as opposed to just fielding sales calls from brokers. In addition, the same critical thinking and problem-solving skills developed in professional careers are largely transferable to the investment process as well.
Finally, the need to take a greater role in investing activities is probably a burden not a lot of people will welcome. However, once you get past the jargon and the sales pitches, many of the lessons of investing are broadly applicable to life as well. Then, sensible investment decisions just become sensible decisions.
As I’m sure you have heard by now, Charlie Munger passed away this week. What I appreciated most about Munger’s insights is they were almost always insights about life and thinking, that also just happened to be incredibly useful for investing as well.
The quote I apply most often is, “Invert, always invert”. This fits right in with my M.O. of always looking at things from different perspectives. Flipping ideas upside down, viewing transactions from both sides, and figuratively walking in another person’s shoes are all ways of doing this. They are not only ways of learning more about a situation, but of learning more about how to work productively with other people.
Another quote of his describes my liberal arts, generalist orientation: “I paid no attention to the territorial boundaries of academic disciplines and I just grabbed all the big ideas that I could.” Indeed, there are a lot of big ideas out there and they can be especially effective when mixed and matched.
Anyway, thanks Charlie for all the wisdom you have shared over the years. As he himself might say, keep on learning!
We haven’t even seen the worst (presumably) of the long and variable effects of monetary policy and the market is getting comfortable there won’t be any. That seems premature to say the least, doubly so given it doesn’t even take into account fiscal policy.
Indeed, one of the surprises of 2023 has been the strength of the economy which many had expected to enter recession. This time, however, recession has been avoided thus far without monetary and credit largesse from the Fed. Instead, recession has been avoided due to continued strength in fiscal spending, essentially a “fiscal put”.
It seems as if large swaths of investors have not yet picked up on this change in policy direction. Those waiting for the Fed to come in and save the day will be repeatedly disappointed. Those expecting inflation to durably decline will also be disappointed. Last but not least, those waiting for the economy to crash and burn will also be disappointed.
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