Observations by David Robertson, 3/25/22
While stonks were the story last year, rates and commodities are doing their best to steal the show this year. There is a lot going on and it’s easy to get overwhelmed, but it’s also one of those situations where doing nothing can hurt you the most. Let me know if you have questions or comments at firstname.lastname@example.org.
Interest rates started taking off last fall and have continued apace. As Powell spoke on Monday, he convinced markets of how serious the Fed is about raising rates and yields took off on an even higher trajectory.
The ramp up in rates rippled through financial markets and affected almost everything except stocks, which seemed oddly immune from the moves. At the same time, however, stock volatility went crashing down which explains a good chunk of the move in stocks. At this point, however, the divergence between stock volatility and bond volatility (https://themarketear.com/premium ($)) seems inexplicably wide.
This is a useful snippet from Julien Bittel on Twitter. After riding a nice wave of tailwinds following pandemic lockdowns, companies are now facing the double whammy of slowing growth and declining margins. There will be a broad representation of earnings misses and guidance reductions on first quarter conference calls.
Another thing to watch for is how companies cope with this adversity. Ben Horowitz distinguished between “Good times” CEOs and “Bad times” CEOs in his book, The hard thing about hard things. It’s true, leaders tend to perform much better in one environment than the other; exceptionally few do well in both. I suspect we will discover a lot of CEOs who were blessed with good times and will not be up to the task of managing through persistent adversity.
IEA calls for driving restrictions and air travel curbs to reduce oil demand ($)
The International Energy Agency has called for member countries to adopt “emergency measures” to cut oil demand in the wake of Russia’s invasion of Ukraine, including driving restrictions, lower speed limits and curbs on air travel.
The measures include cutting speed limits on highways by 10kph, which would save 430,000 b/d, reducing business air travel and taking trains instead of planes where possible. Working from home three days a week would also help cut oil demand, along with making public transport cheaper or even free.
For those of us of a certain age, reduced speed limits and alternative transportation bring back old memories. Now, IEA, the organization formed in the 1970s to deal with the 1973 oil crisis, is back at work identifying ways to reduce demand in a supply constrained world.
Some suggestions for conservation are sensible and some are silly, but the main point is we are likely to experience very real shortages in oil. The good news is people are very capable of modifying behaviors to adapt to different conditions. The bad news is it often takes a while to fully realize the fundamental supply and demand balance has changed. As a result, I would fully expect energy costs not only to spike, but for that spike to persist long enough to crimp global demand.
There are a ton of cross currents in commodities right now so it makes sense to review and synthesize the big ones. As I have reported many times before, the main trends are for longer-term demand trends to exceed supply which suggests higher prices will be needed to justify investment in new supply.
The supply/demand equation has been massively disrupted by the invasion of Ukraine, however, as supplies of many important commodities have been impeded in the short-term. Any forecast is complicated by the uncertainty of how much supply might be disrupted and for how long. Further, at some point demand will be destroyed due to higher prices. But the amount and duration of demand destruction is highly uncertain as well. Lots of moving parts.
As I have also noted before in Observations, the volatility of prices also imposes a cost. Volatility gets amplified when supplies run short and buyers over-order to ensure adequate supply. Volatility also gets amplified when key players run into financial difficulty. Both make it harder and costlier to run businesses and households.
The final point is that while commodities have rightly gained a lot of attention from an investment standpoint, the proposition for investing in them is far from an easy or obvious one. While there is a longer-term case to be made for commodities gaining relative to stocks for a significant period of time, in the short-term the signal to noise ratio is pretty low.
US liberals face a reckoning ($)
I know we journalists love to call everything a turning point. But it does feel to me as though the stresses that have been building in progressive cities for a while are coming to a head. The pandemic seems to have left residents more willing to express their frustration and more impatient for change. Normally, it’s not the done thing in a city like San Francisco to take positions that could be interpreted as insensitive to vulnerable populations like the homeless, or to racial minorities who are most exposed to a crackdown on crime. But these don’t feel like normal times.
It feels as though a number of things are converging right now to raise deeper questions about city governance.
As someone who has lived in big cities for over thirty years and thoroughly enjoys them, I have to agree with Richard Waters that it feels as though “the stresses that have been building in progressive cities for a while are coming to a head.” He focuses on San Francisco, but I can vouch for Baltimore and Philadelphia and there are many others.
While there has always been politics involved in governing cities, those politics often took a back seat to leaders who could effectively tackle common local problems. Today, the balance of power seems to have shifted more towards partisan politics and narrative creation and away from effective local problem solving. The many “stresses” Waters notes are simply the costs of this transition becoming increasingly visible.
Unfortunately, the problems in city governance are just one more symptom of the broader failure to be able to solve big problems. Until this gets fixed, there is little reason to expect significant improvement.
Couple the high probability of food shortages in many countries with excessive levels of debt and there are going to be problems. Unfortunately, the prognosis of an imminent humanitarian crisis does not seem like hyperbole. This is likely to get pretty bad in a lot of places.
Beijing has policy options. “China needs a welfare state befitting of its economic development. It needs to get serious about ending its dependence on coal. If it needs more housing, it should be affordable. All of this would generate more balanced growth. 5 per cent? Perhaps not, but certainly healthier and more sustainable … if you had to bet on a state which might actually have what it takes to break a political economy log-jam, which would it be? The United States, the EU or Xi’s China?”
With Chinese stocks crashing and then massively rebounding, a lender to Evergrande taking $2 billion in cash from the developer, and the potential for an acute shortage of oil, there could hardly be a better time for Adam Tooze to collaborate with Robert Armstrong and Ethan Wu on the policy implications for China right now.
In a general way, I side with Armstrong and Wu. Tooze claims, “If you want to be part of history-making economic transformation, China is still the place to be.” Armstrong and Wu counter, “We just don’t see China as having any good options for maintaining strong growth.”
That said, I think Tooze asks the wrong question. This is not about betting on a state to break a political economy logjam. Solving these problems in the context of excessive debt levels, unfavorable demographics, and massively unequal wealth distribution does not involve minor policy tweaks. It involves a fundamental redistribution of wealth and a reformulation of the social contract. In other words, a history-making economic transformation can only come along with a history-making political transformation.
Such a political transformation will involve resolving the generational divide that has systematically biased policy choices. As a result, it will be a major test on the legitimacy of the state’s organizational structure.
Now, the better question is, which state can pull off a major political transformation without devolving into civil war? It won’t be easy for anyone, but I’ll take the US over Xi’s China or the EU.
Now That Powell Has Convinced Markets He Means It ($)
For two decades, inflation expectations have been “well-anchored,” in the central banking argot. Bond market forecasts for the next five years stayed below 3%, and for the next 10 years below 2.75%. Those thresholds, marked below, have now been decisively breached.
I have written before that an important part of the inflation equation is expectations. And, through last year, the Fed seemed relatively unconcerned about inflation - at least partly due to the fact that expectations were “well anchored”.
Fast forward to today and all that history is out the window. As reported inflation keeps pushing higher and still has not peaked yet, expectations are rapidly adjusting to the new reality. The Fed looks like it fell asleep at the wheel and indeed, it probably did.
What this means, is the Fed is now furiously trying to play catch-up in the inflation fighting effort. That means bigger, faster rate increases and significant balance sheet reduction (i.e., QT). What it means for investors is that liquidity is coming to a screeching halt and starting to reverse.
This will be an enormous headwind for the economy and for financial assets. The amazing rally that was brought to you by the Federal Reserve will now also be taken away from you by the Federal Reserve.
The Great Steepening
In the coming months a record amount of coupon Treasuries will flood the market even as demand for those securities appears to be faltering … This implies that non-Fed investors will have to absorb ~$2t in issuance each year for 3 years in the context of rising inflation and rising financing costs from rate hikes. Even the most ardent bond bulls will not have enough money to absorb the flood of issuance, so prices must drop to draw new buyers.
Anticipation of QT is already widening the spread between Agency MBS and Treasuries, but does not yet appear to affect Treasury prices. The supply and demand dynamics suggest that market may simply be slow to react. In that case, Treasury prices will also have to adjust downward, maybe by a lot.
As the Fed positions itself to start shrinking its balance sheet by selling Treasuries and MBS, it is important to understand how this will affect the landscape. The short answer is, “Treasury prices will also have to adjust downward, maybe by a lot.”
Of course, the other side of prices going down is yields going up, and we are already starting to see that in longer dated Treasuries. This will have a noticeable impact on investors holding a large proportion of bonds in their portfolio since the bond prices will go down. It will also accelerate the rise in mortgage rates both through a higher MBS spread and through rising yields on Treasuries. This will affect a lot of people.
For many years, the key to playing US markets correctly has been to buy the market when the corporate bond yields begins to fall. I show the KDP High Yield Index below, but you can use ETFs such as HYG or LQD for this as well.
My working assumption is that when food prices are rising, central banks will be less accommodating. Food prices have blasted through all time highs with the invasion of Ukraine.
Russell Clark addresses a couple of important points in this fairly short note. First, he identifies falling corporate bond yields as the main mechanism driving market returns the last several years. Many investors who took to buying the dip (BTD) as a strategy, have not realized that the success of BTD is not a successful strategy in itself but rather is contingent upon falling yields.
This is going to be of paramount importance as “Food prices have blaster through all time highs”. With rising food prices, we can expect rising yields. In short, since the conditions are flipped, we should now expect the opposite of BTD, i.e., sell the rip (STR), to be the better strategy going forward.
You wouldn’t know it by trading action through the week, but when rates go up, it creates a strong headwind for high duration stocks. The higher rates go up, the less cash flows generated far out into the future are worth. While the math is very straightforward, the market seems to be in a phase of slow motion realization. Paulo Macro is right, “large tech is dead”.
Implications for investment strategy
Why I should have listened to Garry Kasparov about Putin ($)
Kasparov warned that Putin was becoming increasingly authoritarian, isolated from the west and, as a result, likely to lash out at neighbours such as Ukraine in a dangerous way.
“I was stunned by the unwillingness of people [in the west] to hear these warnings, because I grew up in the Soviet Union and knew all about the historical events of the 20th century. I knew that you could have stopped Hitler in 1935 and 1936 and 1937 and didn’t. But I had so much outright rejection of what I have been saying.”
One point is that probability assessments are often more heavily weighted to recent experience than to thoughtful analysis. Another point is since thoughtful analysis takes considerable effort, beliefs and positions change less often than they should.
Another point is it is easy for errors to get magnified when leaders make these mistakes and propagate them through the airwaves and social media. Tett quotes an expatriate former director of a Russian company, “Nobody I knew expected Putin would actually invade!” When someone that close to the problem is so blind to it, there is an enormous amount of inertia to overcome in order to change minds. This was the obstacle Kasparov encountered.
This lesson is extremely useful for investors. Politicians, corporate bosses, journalists and the like all have a powerful ability to affect narratives on issues by virtue of having a large audience. That doesn’t make them right. Do your own analysis and supplement it with that of others who also think independently. With so many massive uncertainties there is no worse time to follow the crowd.
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