Observations by David Robertson, 3/31/23
Observations by David Robertson, 3/31/23
Aaaand … it’s over? After getting all in a tizzy about banks, investors calmed down this week. We’ll see how long that lasts as fixed income markets are still jittery and first quarter earnings are on deck.
As always, if you want to follow up on anything in more detail, just let me know at drobertson@areteam.com.
Market observations
As bank problems started bubbling to the surface a few weeks ago, interest rate volatility (MOVE) rocketed higher and stock volatility (VIX) jumped a bit. As the problems cleared this week, VIX fell back into its normal range but MOVE remained elevated.
In fact, the relationship between the two has now reached an extreme not experienced since the GFC. One of the lessons I learned during the GFC was to pay more attention to fixed income and credit markets. I strongly suspect that applies here as well.
If there is any wonder as to why the stock market has held up as well as it has, look no further than the big five tech stocks. Amidst all the turmoil, they have been viewed as safe havens. One point is the market ex the big five is looking decidedly lethargic. Another point is if the big five cave in, it would be a big problem - and there are reasons to believe this can happen (see below).
Banks
Brace for Volatility, But Banks Are Looking Better
This means that trouble for banks in the the eurozone — whose rickety structure makes any crisis harder to quell — and especially in China could create far greater economic damage. The following chart from the Institute of International Finance shows that as of 2019, bank lending to the private sector was equivalent to gross domestic product in the eurozone, but barely half of GDP in the US. Apart from China, note that the UK also has particularly elevated exposure to its banking system, and that Japan is more bank-dependent than the eurozone. Countries least dependent on their banking systems include Egypt and Mexico:
One of the outcomes of the banking problems the last few weeks was the US dollar (USD) got weaker. On first glance this makes some sense. Liquidity provided to rescue banks could understandably be perceived as coming at the cost of fighting inflation. Further, reduced confidence in the US financial system could also weigh on the dollar. Most simply, real yields based on the 10-year TIPS have come down.
If you look a little deeper, however, and consider the US bank problems in a broader global context, these worries about USD make no sense at all. Let’s compare with Eurozone banks. For starters, Eurozone banks actually had to deal with negative rates, not just the low rates in the US. As a result, there is more duration risk.
Secondly, Eurozone economies are confronting higher inflation than the US and have a lot more commodity risk. Also, as can be seen from the chart above, private lending is far more important to Eurozone economies than to the US. Credit contraction will be harsher. Finally, there is still every indication the Biden administration is engaged in conflict with China and Russia and is using USD as a tool in that effort.
All of this severely undermines the case against USD. It may take a little while to play out, but all the pieces are there to be seen. Betting against USD due to relative weakness at US banks looks like a fool’s errand.
Management
One of the responses to the SIVB debacle has been to assign blame. There was gross mismanagement. The Fed screwed up by raising rates too much. Regulators failed to do their job. Some bad actors instigated the bank run by effectively yelling “Fire” in a crowded movie theater. Customers and investors fled banks largely out of financial illiteracy, further compounding the uncertainty. Yes, yes, yes, yes, and yes.
But so what? People screw up; what’s new? Since I often discover insights by looking at situations from different perspectives, I was intrigued by a tweet by Maxfield on Banks which highlighted comments from M&T Bank in its 2021 message to shareholders:
With a lack of loan demand during the year, many peers chose to invest a greater proportion of their excess cash into investment securities. It is notable that during the year, we chose to avoid following suit given the historically low rates of interest that did not seem to compensate us for the risk that rates might rise in the future.
In short, MTB was in exactly the same situation as SIVB at exactly the same time, and made very different decisions. MTB recognized rates were historically low and “did not seem to compensate us for the risk that rates might rise in the future.” The risk of higher rates was right there for anyone, indeed everyone, to see.
I suspect we’ll be seeing a lot more instances like this and not just in the banking industry. Now that there are real costs associated with aggressive decision-making and lax risk management, the consequences will be much more visible. Not everyone blithely chases short-term returns.
Commodities
One point is the last year for oil has been “pretty friggin spec-y”. In other words, there has be a high level of speculative interest driving prices as opposed to fundamental data. This corroborates my hypothesis that the existence of too much money continues to enable a great deal of speculative activity.
Another point is this situation is common for commodities in general. Not only do supply and demand imbalances cause massive price swings, those swings get amplified even more by speculative activity. The result is an asset class that can be very tempting, and yet very off-putting at the same time.
Building a Better Commodities Portfolio
https://www.aqr.com/Insights/Research/White-Papers/Building-a-Better-Commodities-Portfolio
Commodities have tended to be particularly strong diversifiers during periods of rising or volatile inflation.
Because each commodity has unique supply-and-demand characteristics, commodity sectors are less correlated than equity or fixed income sectors. If diversifying across global equity markets is valuable, diversifying across commodity sectors is even more valuable.
Just in case there was any doubt about the potential usefulness of commodities in an investment portfolio, AQR puts that to rest by demonstrating their value over time. Importantly, that value shows itself the most during “periods of rising or volatile inflation”.
Another big point is while individual commodities tend to be incredibly volatile, they tend to be even less correlated than stocks are with one another. As a result, there is a great deal of value in diversifying across multiple commodities. This offers clues as to how to derive the most benefit from commodities. While pursuing an individual commodity can be exciting and hugely profitable, it can also be incredibly volatile and difficult to time.
The answer is to diversify commodities to the greatest extent possible. While there aren’t a lot of options for non-accredited investors, there are some and just about any effort is helpful.
Technology
There is still lots of talk and lots of excitement about artificial intelligence as more people get a look at what ChatGPT and other AI services can do. While I have a natural affinity to new technology, I have also been burned enough times so as to be sensitive to over-hyped claims. Based on my early impressions, ChatGPT and its ilk have a ton of potential for good, but also quite a bit of potential for distraction.
One impact will be to vastly improve access for most people to the world of knowledge. Historically, that access has come through the role of “reference librarians”. Whether you do the work yourself, or hire someone else to do it, it has taken time and effort (and often money) to find out what you need to know.
ChatGPT almost completely replaces that functionality. Insofar as it does, it plays a similar role to that of the graphical user interface (GUI). Prior to GUIs, computers were hard to operate and required very technical knowledge of commands and attention to syntactical details. They were the domain of the few tech types. With GUIs, almost anyone could deploy the processing power of computers.
ChatGPT is the GUI for knowledge. Insofar as it is, there will obviously be a lot less need for people who do that for a job. Junior analysts, research assistants, paralegals, marketing analysts, coders, etc. can largely be replaced by something cheaper and more reliable. That’s deflationary.
Further, to the extent these types of functions can be replaced, the big tech companies lose many of their competitive advantages. They were busy building huge engineering teams but now everyone has access to the equivalent of a huge engineering team. Combine the rapidly changing competitive environment with threats to globalization, increasing antitrust scrutiny and the evisceration of many venture capital startup customers, and there is a lot of hurt that can befall the big tech companies.
Will the potential of AI be realized? The record of tech over the last ten to fifteen years has not been especially impressive. A great deal depends on the applications. Will it be used more for entertainment or more for productive purposes? There’s a ton of potential for both. The value is likely to be most noticeable in applications that manage scarce resources.
Economy
Amidst all the clamor about the damage being caused by Fed rate hikes, Bob Elliott makes a useful observation: The economy is still in pretty good shape. This being the case, combined with the fact the US economy is pretty resilient anyway, prompts another useful observation from KKGB Kitty: “not one single event will topple the US economy. There needs to be a combination of factors and changes in underlying sensitivities happening at same time to topple it over.”
For better and worse, the US economy will be facing multiple headwinds this summer. As KKGB Kitty points out in another post: “Going into q3, the resolution of the debt ceiling will come with fiscal tightening, re-build of the TGA, excess savings would have run-off and unemployment will move quickly above 4%”.
This helps resolve some of the uncertainty about the economy. It’s sort of like a Schrodinger’s economy; it is both strong and imminently weak at the same time. Such an assessment is also consistent with the political cycle. If you are going to have a downturn, it’s best to have it in year 3 of a presidential administration. That leaves enough time for it to run its course and for the administration to “fix the problems” before the next election.
China
China’s economic rebound weaker than expected, warns Maersk ($)
https://www.ft.com/content/ef8cc881-eec4-4255-b969-6abaa3403dfc
China’s economic rebound is weaker than expected as consumers emerge “stunned” from pandemic-led disruptions and a real estate meltdown last year, according to the head of AP Møller-Maersk.
Vincent Clerc, the new chief executive of the world’s second-largest container shipping group, said, however, that trading volumes associated with the Chinese economy remained resilient with little sign of negative impact from US-led efforts to “decouple” from China.
Apparently, the experiences of Maersk in China run counter to a couple of the more popular theses on the country. First, the country is not rebounding strongly from its zero-Covid policy. Just as happened in the US and elsewhere, lockdowns had a big impact on consumers. Many of those consumers were deeply affected and now are in no place to pretend like nothing happened and quickly revert to their prior spending patterns.
Secondly, overall trade volumes are “resilient”. Despite a great deal of discussion about decoupling and various sanctions, there has been little effect on the overall numbers. It’s certainly the case this could become a bigger problem in the future, but that’s not where things are now.
Monetary policy
May we live in interesting times! One read on the diversity of expectations for Fed rate actions is it reflects a total failure of communication policy. However, it is also possible to read it as a feature and not a bug of policy.
After all, as Stimpyz points out, if the Fed is really intent on fighting inflation, it needs to be able to keep rates higher for longer. Further, it is far easier to accomplish that objective if stocks don’t fall very much. If stocks crash, it becomes virtually impossible for the Fed to keep the pressure up on rates. As a result, the relative resilience of stocks can be seen as an indicator of the Fed’s success in being able to continue fighting inflation.
Investment landscape
With lots of turmoil in the first quarter, stocks are actually set to finish comfortably higher. This benign outcome belies problems in other parts of the industry.
For example, the wild and unpredictable swings have almost certainly caught out hedge funds who often make very leveraged bets. In addition, the venture capital industry could see significant markdowns in portfolio companies due to greater scrutiny after the collapse of SIVB. Private equity is in the same boat.
Finally, structured credit is positioned to be a festering wound. Higher rates and upcoming refinancing needs imply imminent distress. Liquidity problems are likely to further propagate that distress. Widespread uncertainty can lead to contagion.
Finally, and probably most pernicious of all, since structured credit is almost entirely outside of the banking system, and because there has already been significant backlash against policies to preserve financial stability, these credit funds are unlikely to receive much sympathy from regulators or the public. Good luck.
Implications
The fallout from the last few weeks of bank problems brings a couple of important implications into focus for long-term investors.
First, while the proximate cause of the bank problems was liquidity, the longer-term consequence will be credit contraction. Banks will either keep savings rates low and continue to lose reserves, which will reduce lending capacity, or will raise savings rates and have lower profitability, which will reduce lending capacity. Either way, less lending will amplify the tightening of monetary policy.
Second, the way in which the credit contraction plays out is relevant. As Brent Donnelly points out, the path of credit contraction (acute or grinding) will have different implications for stocks, fx, and volatility. I tend to favor a third way. I see credit problems grinding away … right up until they become acute.
There are a couple of important implications for investors. One is it will be very difficult for stocks to do well as senior debt claims get downgraded and reduced in value. This creates conditions conducive to a big selloff in stocks later this year.
Another is the longer the Fed can keep policy tight, the less of a threat inflation becomes. This doesn’t mean inflation is going away, but on the margin it would be positive news.
Note
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