Observations by David Robertson, 3/18/22
Fighting in Ukraine continues as does volatility in markets. If you are waiting for all this to just be over you are going to be disappointed. You will be better off adjusting your expectations instead. Let me know of questions or comments at firstname.lastname@example.org.
A number of interesting oddities have emerged over the last week or so. The most discussed one was the closure of nickel trading on LME for several days. Most of the story has been reported now but the incident is an important indicator. One player was allowed to take (and maintain) a huge position that went bad. That underwater position also threatens the banks that lend to it. The trading was allowed to continue until losses, if realized, could also endanger the exchange. Not good.
LME finally reopened on Wednesday but immediately closed again after reaching the down limit of 5%. Same on Thursday. To be continued.
In other news, American Banker reported the assets of problem banks jumped in the fourth quarter report from the FDIC, the bank regulator. By these standards (according to Investopedia), a bank appears on the list if it is “on the brink of financial insolvency”. In addition, the FDIC judges that the bank has “financial, managerial or operational weaknesses that threaten its continued financial viability”. In other words, a fairly large bank is running short on capital and may need to be taken over by FDIC.
A third interesting oddity occurred with the volatility ETF, VXX. In the midst of high volatility last week, Barclays suspended creation of new units. It’s another instance of when the going gets tough, markets just stop.
The bottom line is these are the types of things that almost never happen when the market is functioning well. The takeaway is the tide is rolling out and we are starting to get glimpses of who might be swimming naked.
Commodities have been incredibly volatile this year and even more so the last few weeks since the war broke out in Ukraine. Notably, oil bounded to nearly $130 before retracing almost all the way back to its pre-war price. In addition, this crazy activity happened after the price had already risen more than 50% over the last year.
One point is the environment has become highly uncertain. This means extreme price volatility and high dispersion of plausible outcomes. It also indicates this is a terrible environment in which to act impulsively.
Many of the short-term changes also affect the long-term case for commodities. I have been fairly supportive of that long-term case for commodities and Peter Zeihan highlights many of the key ingredients below. The main point is commodities had a big headwind for 30 years and now that is reversing to a tailwind.
THE GRANT WILLIAMS PODCAST, Peter Zeihan, MARCH 12, 2022 ($)
So all of the fertilizer, all of the oil, all of the natural gas, all of the bauxite, all of the nickel, all of the iron ore all of the copper, all of these things that the Russians used internally within the Soviet empire, they were dumped on international markets and they continued to dump them for 30 years. It’s one of the reasons why inflation has been so tame around the world for so long. We were coasting on the leftovers of the Soviet industrial giant. Well, now we get to do all that in reverse in a year.
Along with that major reversal, however, also comes the potential for fundamental disruption of global trade and finance. The war in Ukraine has changed the equation. With possibilities such as additional sanctions, capital controls, price controls, rationing, demand destruction, disorderly deleveraging, and counterparty risk, among others, now far more visible than just a few weeks ago, the case for commodities has become a lot more complicated.
Joe Biden’s indispensable leadership ($)
Still, the administration’s diplomacy has in three ways looked impressive by any measure. Mr Biden has a tendency to prevaricate. Yet his Ukraine effort has been decisive. Having predicted Mr Putin’s invasion months ago (in what looks like a big success for American and British intelligence), the administration began corralling nato’s response long before either its members or Volodymyr Zelensky, Ukraine’s brave leader, considered the war likely. And it has done so with quiet relentlessness—drawing on the top-notch diplomatic expertise that Mr Biden has assembled in Tony Blinken, the secretary of state, Jake Sullivan, the national security adviser, and William Burns, the director of the cia.
During the Afghanistan debacle, the professionalism of such figures looked perversely like a liability. Former staffers and diplomats, they appeared to lack the necessary political heft to force Mr Biden onto a better track. But on Ukraine their expertise has told. Mr Blinken has won especially good reports, re-establishing the primacy of civil diplomacy over the sabre-rattling Mr Trump loved. But the Biden team appears to be working in unison, as is illustrated by a third and more surprising attribute, its creativity.
The administration’s bold use of intelligence to counter Russian misinformation was an early illustration of this. Its successful effort to curb Russia’s access to its foreign reserves and energy markets is another. “It’s fair to say we’ve stiffened some spines,” says a senior administration figure.
I am far too cynical to attribute too much success to any political effort but I have to admit the Biden administration’s diplomatic efforts in dealing with Russia, Ukraine, and Europe has been extremely effective thus far. A situation that was setting up for yet another round of Russian aggression and the West rolling over has taken on a completely different tone. While much remains to be resolved, it is clear Putin has not only been thwarted, at least for the time being, but has also been significantly weakened.
The debt that pleasure owes to power ($)
This is a political moment, but no less revealing as a cultural one. It is a reminder that the lifestyle for which I bang the drum in this column — and which finds its highest expression in Europe, where you can visit another country for lunch — relies on its opposite. It relies on uniformed men and women and the backstop of coercive force. Passing off a large part of that burden to the US doesn’t make it less true.
The quality of European living depends on more than direct physical security. There is an implicit subsidy at work, too. The paid leave, the clean cities, the high social minimum: Europe funds these things, in part, with the money it saves on defence … If the continent is going to tool up and remain a “lifestyle superpower”, it will face trade-offs that it has fudged since the end of the cold war.
Janan Ganesh addresses one of the more important underlying issues of the Ukraine conflict: It has arisen from the “fudging” of trade-offs since “the end of the cold war”. It is time to reconcile these accounts and it is fair to ponder who has the moral authority to take on such a challenging task. So far, German Chancellor, Olaf Scholz, is a front runner due to his notable U-turns on security and energy policy, though those positions undoubtedly relied largely on US influence.
All that said, as I laid out in a blog post earlier this week, evidence suggests the Ukraine/Russia conflict will morph into a much broader war. To that point, be careful out there.
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While some traders interpreted China’s move to ease financial conditions Wednesday morning as a positive, the longer-term situation still appears seriously troubled. This story from Zerohedge provides a good rundown of the problems. It starts with widespread Covid lockdowns and covers crashing markets in stocks, offshore bonds, and property, among others.
Further, lest anyone think China problems are too remote to affect the US, the lockdowns are affecting important manufacturing operations for China as well as several ports. With Apple being the dynamo driving the US market, this will be a big test.
All that said, China’s markets rebounded dramatically on Wednesday following supportive comments from leadership. While this certainly helps reverse the short-term freefall, it doesn’t solve any longer-term problems either.
While credit has been weakening since last fall, the pace has quickened noticeably this year. Below is the high yield bond ETF, HYG, over the last year. That selloff, however, only represents part of the problem …
The China rout($)
The point is that there are few instances where the Vix is that high [as it is now] while spreads are as tight as they are right now.
There is a very high probability that a few months from now Vix and the high-yield will no longer be as radically misaligned as they currently are. That makes it intriguing to consider a bet on a closing of the gap . . . A more normal spread, with the Vix at current levels, would be something on the order of 775 basis points, Fridson reckoned.
As Marty Fridson lays out, the adjustment in high yield is only just beginning. Historically, high-yield has moved in tandem with volatility, but has lagged the increase in volatility this year. As high-yield catches up, expect spreads to widen further.
Credit is also getting dinged for collateral problems. This week the bonds of the commodity trading groups (Trafigura pictured) collapsed due to concerns about being able to cover margin calls.
The evidence spells out a rapidly deteriorating environment for credit. This is especially notable given the Fed’s still extremely accommodative monetary policy and the fact that it just started raising rates this week. As is often the case, credit is the space to watch for those wanting clues to the stock market.
The FOMC had an eventful meeting this week in which it finally raised rates by a quarter point. In line with past patterns, stocks were up strong before the meeting, as much as 1.7% for the S&P 500. By the time of the press conference at 2:30, virtually all of those gains had evaporated. During the press conference, almost all of those gains came back. It’s hard to read too much into the roller coaster behavior.
In terms of information content, there was little that was especially new or insightful in the release or the call. The Fed seems to be taking a position of “slow and steady wins the race”. The only thing of moderate interest was commentary suggesting balance sheet contraction could begin as soon as the May meeting and will likely be faster than the last effort at contraction.
The whole process is kabuki theater. While inflation is an important issue, waiting until it’s way too late and then slowly raising rates is not going to solve the problem. It’s ridiculous.
What does matter is how the Fed is going to return monetary policy to some sense of normalcy without having the whole overleveraged financial system blow up. It’s a giant game of financial Jenga and the tower is already leaning ominously. Since no plan has been discussed publicly, it is fair to assume there is no plan, or at least no serious plan. So, most likely we are on a path to some kind of disorderly deleveraging.
The Fourth Turning, by William Strauss and Neil Howe
During the Crisis, the American economy will experience the most extreme shocks to asset values, production, employment, price levels, and industrial structure in living memory.
Expect the worst and prepare to mobilize, but don't precommit to any one response. It is typical of an Unraveling for a society to be complacent about the threat of war—and to expect that isolation, diplomacy, massive superiority, and simple goodwill can keep it (and the world) out of serious trouble.
When I first read this book over ten years ago I was immediately impressed by its almost magical ability to make sense of a lot of things that had mystified me for years. The premise is that history moves in cycles about the length of a human life span and these cycles have regular patterns. The Fourth Turning, the last phase, is a period the authors describe as one of “secular upheaval, when the values regime propels the replacement of the old civic order with a new one”.
One takeaway is that such a momentous event can be hard to see from the perspective of day-to-day events. It is only when we zoom out, over a broader expanse of history, that the broader patterns are much easier to see. Another takeaway is that those patterns suggest we will experience “the most extreme shocks … in living memory”. Better strap in.
A final takeaway is that while the foreseeable future will be extremely challenging, it will eventually open into a new cycle that will be immensely rewarding. It is crucial for long-term investors to appreciate these forces so they can make it through to the other side.
Implications for investment strategy
Almost Daily Grant’s, Tuesday, March 15, 2022
Raging inflationary pressures and imminent policy tightening have proved an unpleasant backdrop for the ubiquitous 60% bond and 40% stock portfolio construction, as a Bloomberg Index tracking that allocation has absorbed more than a 10% loss so far in 2022. That puts the gauge on pace for its worst annual showing since 2008.
The road ahead may prove even rockier, if one asset manager’s expectations prove accurate: GMO’s latest seven-year asset class real return forecast, released on Feb. 28, pencils in annual returns of minus 4.8% and minus 4.2% for U.S. large- and small-cap equities, with U.S. bonds losing 3.9% per annum on a real basis through 2029.
After a tough quarter for 60/40 funds, it may be tempting to write it off as just a bump in the road. That dismissive stance, however, misses an important reality: The last forty years have provided a uniquely advantageous environment for 60/40 strategies and those times are now changing.
The expected returns from GMO’s forecast are very sensible. For a 60/40 blend, they imply future real returns of -4.4% per year.
This will be especially harmful to retirees. For one, their spending power will be eroded significantly and persistently. For another, few have negative returns built into their financial plans; this will be a harsh surprise. Finally, most will not have the ability or willingness to re-enter the work force to supplement their diminishing assets and income.
While there are certainly no magical solutions in a very difficult investment environment, there absolutely are things that can be done to mitigate the damage. The earlier investors figure this out, the better.
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