Observations by David Robertson, 2/24/23
There wasn’t a lot of notable action in stocks except for Tuesday, but it does feel like suspense is building. This is the part of the movie where the dramatic music starts getting progressively louder. I don’t know what the outcome will be, but I’m pretty sure it won’t be “business as usual”.
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The holiday shortened week got off to a rough start as stocks fell 2% and the yield on the 10-year Treasury jumped almost 7 bps. It is now knocking on the door of 4%. VIX jumped from its sub-20 close the prior week to finish over 23. Interestingly, a number of inflation-sensitive stocks such as BTU, CCJ, WY, and JOE got hit hard, as well as inflation and natural resource funds like INFL and GRHAX.
Interestingly, one of the things that has changed recently is expectations for inflation. The chart below from @SoberLook shows a period late last year and into early this year that justifies Jerome Powell’s description of “disinflation”. No longer. The last several weeks show inflation expectations creeping back up. This score is not settled.
Add another phenomena to the ranks of “permanent changes from pandemic”. Not only did retail investors increase market participation by a step function during the pandemic, recent evidence suggests the trajectory continues to move up. It’s hard not to draw a parallel with sports betting and crypto. While far from conclusive, there certainly is the appearance of increased participation in sanctioned forms of gambling.
This is an interesting observation I hear almost nobody talking about. The bottom line is just as the pandemic has distorted a lot of economic data, much of that data is also less reliable due to substantially lower survey participation. One takeaway is to recognize these kinds of distortions are typical of turning points. Another takeaway is to take individual data points with a grain of salt.
When house prices were skyrocketing in 2021, a great deal of that was attributed to incredibly low mortgage rates and significant demand from Millennials. While this was all true, the big honking marginal buyer was Wall Street funds. Such funds did not exist fifteen years ago and as such, have provided a big push on the demand side.
Now, that story is reversing big time. Residential property funds are extremely sensitive to cost of capital and therefore are one of the groups who suffer with much higher rates. Not only is a big buyer largely exiting the market, but eventually these funds will need to sell properties to provide liquidity - and that will hit prices.
As @nickgerli1 concludes, “My prediction is that Wall Street will begin liquidating houses in mid-2023. Starting in markets like Phoenix and Vegas. Because that's where rental vacancies are surging the most. Meaning it's less profitable to be a landlord.”
While this is likely to cause some notable price pressure in certain geographies where residential property funds have been active, it is less likely to be a nationwide phenomenon like in the GFC.
One of the more prominent narratives regarding China is it opened up the liquidity spigots last fall to supercharge growth coming out of Zero-Covid policies.
Although this is possible, by the telling of @michaelxpettis, this interpretation seems misplaced. A better interpretation is to recognize the high level of debt at the local government level and the increasing difficulty of rolling that debt over. In short, China’s local governments are facing a solvency crisis.
Pettis elaborates: “As it becomes increasingly worried about repayment risk, Beijing will at first force local governments to try to come up with new ways of refinancing their unrepayable debt, but ultimately the only ‘solution’ will be to recognize and allocate the losses.”
As a result, liquidity infusions from the central government take on a very different character. In this context, they primarily serve the purpose of mitigating the deflationary impact of local government debt going bad.
As such, China’s current liquidity provisions parallel Quantitative Easing (QE) measures by the Fed after the GFC. Those measures did not provide economic stimulus so much as fill the giant hole of money destruction created from the collapsing shadow banking system. These are emergency measures to keep the ship afloat, not big growth initiatives.
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China’s former foreign minister visits Moscow as US President Biden visits Ukraine. Shortly after, Putin gives a speech announcing its withdrawal from the START arms reduction treaty. Kinda hard to imagine this was all just a coincidence.
At very least, tensions between the US and China and Russia appear to be heating up. As such, these recent events also appear to confirm the thesis of a broader geopolitical conflict between the US and the West, and Russia and China.
As a result, baseline expectations should be for more sanctions, less trade, and further pressure on other countries to pick one side or the other. Economically, it is fair to expect more supply problems, a stronger US dollar, and (at least) another round of higher goods inflation.
Investment landscape I
I’ve written quite a bit about how the economic and investment landscape is uncertain and how there are a lot of cross-currents. I’ve also talked about how the consumer seems to be in pretty good shape while higher interest rates are seriously threatening certain business models like asset-based securitization. This thread from @PauloMacro provides one of the clearest ways to pull these same ideas together into a cohesive narrative.
He describes it as a 2-speed economy. “First we have the financial economy that relies on interest rates - this economy is totally fuct. Here you have the recession in Wall Street, PE/VC/tech, hedge funds, CRE/office, even some housing/auto — basically anything that needs a rate.”
He goes on: “Then there’s the real economy which is screaming out of control. Hand out stimmies, cull a few million from the workforce, and then layer on COLAs…that economy is the real world not the nominal world — and it is hot.”
One point to make is the “2-speed economy” helps to explain a lot of the variance in outlooks. Interest rate junkies think the world is falling apart - because their world is falling apart. At the same time, the real economy seems to be doing fairly well because it is doing fairly well.
Another point to make is the real economy is doing fairly well because of stimmies, pandemic work restrictions, COLAs, and student loan deferments, among others. These are all manifestations of fiscal policy/public policy, not monetary policy. As a result, the rate of growth in the real economy is largely being determined by the administration, not the Fed. This is a big change from the landscape before the pandemic.
Investment landscape II
Steven K N Wilkinson provides a useful, high-level analysis of the investment landscape in a recent Substack post. In doing so, he incorporates some thinking by Russell Napier which helps reconcile many of the vastly different interpretations of current conditions. Wilkinson explains:
In Russell’s world view there are two competing forces. What is left of free markets wants deflation, and a giant reset of a bankrupt system. The free markets want to purge the system of bad players, and zombie businesses. This amounts to debt deflation, and what would amount to the largest debt deflation in history.
But dead set against this deflation is the State, be it that of China, or North America, or the UK, or the euro zone, or Japan. The economic attitude is the same, irrespective of geography. The State cannot survive entrenched deflation. The State has to inflate. Hence QE, TARP, ZIRP, NIRP and a thousand other mindless acronyms that betoken the new China syndrome.
This explains a lot. Why are there such different views as to whether conditions are inflationary or deflationary? Because those views are predicated on one’s assumptions about the key economic driver: Is it free markets or is it the State?
I have to admit to being in the free market camp for a long time. Partly this was based on the experience of observing what actually happened in US and Western markets and part was based on my belief as to what was “right”. In my mind, history had clearly proven free markets as the driver of better outcomes.
This is true to an extent, but only insofar as likely outcomes do not pose a threat to the State. This is a crucial caveat. The problem is debt deflations do just that - threaten the State. In anything other than powerful autocracies, debt deflation is an express ticket to lose power. As a result, inflation it is.
Investment landscape III
Grant’s Interest Rate Observer, FEBRUARY 24, 2023 ($)
“There’s a mass extinction event coming for early & mid-stage companies,” Tom Loverro, a general partner at v.c. firm IVP, tweeted on Jan. 31. “Late ’23 & ’24 will make the ’08 financial crisis look quaint for startups.” To be sure, Loverro noted, v.c.-backed firms raised a lot of cash during the 2020–21 bacchanalia and many cut expenses during last year’s selloff.
One of the great beneficiaries of Quantitative Easing in general, and the abundant liquidity provision during the pandemic in particular, was the venture capital world. Now, with Quantitative Tightening in place, the brakes have been firmly applied to that rocket ship ride.
That doesn’t mean the ride is over … at least not yet. With a lot of excess cash raised and firms adapting to the new financial environment by cutting costs, it will take some time to fully deplete the coffers. That time is coming, though, and when it does, it is likely to be widespread and painful.
Headed For The Tail
Given that higher bond yields can impact corporate profit margins with a lag, we observe an even stronger relationship between the Baa corporate yield and the S&P 500 operating profit margin one year later. With a Baa yield of 5.6%, the implied profit margin is closer to 9% than the recent 13%.
No. The drivers [of S&P 500 profit margins] are wholly pedestrian, macroeconomic factors – primarily labor and interest costs. Both have been depressed over the past decade, and they are no longer at such extremes.
A couple of good points here. One is higher bond yields translate into higher interest payments. Another is it takes time. As a result, it is pretty easy to see that there will be persistent pressure on operating earnings from higher interest payments. This will continue to be a headwind and is unlikely to go away.
In addition, labor costs have been unusually low by historical standards. If labor costs begin normalizing, and there is clearly evidence this is starting to happen, then analysts can add those to the growing pressure on operating margins as well. In short, regardless of what you think about top line prospects, it is going to be very hard for companies to eliminate these two cost pressures. Operating margins are headed down.
Both landscape frameworks, the “2-speed economy” thesis and the “free markets vs. the State” thesis, solidify my thesis for inflationary pressure. In doing so, they also highlight the difference between inflationistas and deflationistas. The facts are not the main source of disagreement. The main source of difference is the assumption about which force ultimately prevails - free markets or the State.
These landscape frameworks allow some important implications for investors to be clarified. For example, the “2-speed economy” indicates it is not appropriate to treat the economy with one broad brush. Instead, the real economy and the financial economy are tracing very different paths. Investors should take note and align their portfolios accordingly.
Another implication is it will take time for things to play out. It is not a “speed bump” that causes a bit of a jolt and then it’s over. Since much of the financial economy is financed with bonds, the negative effects of higher interest rates will not take effect until those bonds need to be rolled over. There will be a lot of dead funds walking - funds that will not be able to get refinanced, but do not have debt due yet. Just because there aren’t fireworks yet doesn’t mean serious problems are not brewing.
It will be interesting to see how the inflationary and deflationary forces prompt public policy. At some point, as uneconomic financial constructs fold under the weight of higher rates, debts will go bad and money will be destroyed. This can create a vicious feedback loop as it did in the GFC. Fear of this may explain some of the Fed’s acceptance of looser financial conditions.
Will monetary policy be more selective in offsetting debt deflation once it starts? Will there be better coordination between monetary and fiscal policy? How will the tradeoffs be made if debt ceiling discussions and geopolitical conflict also threaten to impinge upon economic and financial resources?
Of course, these questions are mostly imponderable, but certainly suggest the potential for a great deal of volatility coming up. For long-term investors that means playing defense first and playing offense opportunistically.
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