Observations by David Robertson, 4/8/22
It was a topsy turvy week that started off strong and then turned south. Soon companies will start reporting on the first quarter and what they are seeing coming into the second. With such a dramatic change in the commodity environment, it promises to be a very interesting season of conference calls. Let me know if you have questions or comments at drobertson@areteam.com.
Market observations
Stocks entered the week with some residual momentum from the week before but that changed quickly on Tuesday when the Fed’s Lael Brainard spoke and re-affirmed the intention to raise rates. She also clarified the desire to start materially reducing the size of the Fed’s balance sheet by selling Treasuries.
The whole exchange has something of a farcical quality to it - like that of a parent scolding a child who knows all-too-well the parent almost always acquiesces. “This time I really mean it!”
Just like kids usually have a sense of what a parent’s breaking point is, so too the markets are sensing the Fed might actually be serious about carrying through with the tightening plans it has communicated. 10-year Treasury yields immediately spiked above 2.5% and continued rising.
Since Treasury yields are going up, so are mortgage rates. Gordon Johnson did a back of the envelope analysis in the tweet below. This probably overstates the situation a bit, but still, wow is right!
Economy
Any driver on I95 knows the phenomenon. You are cruising along, trying to make good time going from point A to point B. Just as you seem to be making good time, you see nothing but brake lights in front of you and have to hit the brakes.
This is pretty much what is going on with the economy right now. Employment is cruising. People are busting to get out and get away after being cooped up for two years. But the Fed is aggressively tightening conditions and all those “pent-up” savings are getting burned up. It is so frustrating sitting in traffic when you are trying to get somewhere else.
Public policy
The Biden Admin announced plans for a sustained release of 1 million barrels of oil per day from the SPR over the next six months, by-far the largest such release in history.
A combination of spot selling and future refilling (if committed today) could flatten the curve and enhance the price signal received by US shale and other non-OPEC producers, but it remains to be seen if the Biden Admin is planning or even positioned to pull it off.
In the Blind Spot on Tuesday (Elon, Oil futures, Off balance sheet affairs) ($)
https://the-blindspot.com/in-the-blind-spot-on-tuesday-elon-oil-futures-off-balance-sheet-affairs/
Most of the stuff I previously wrote about the topic in FT Alphaville was during the deflationary period of 2010-2011. The arguments were focused on having the Fed intervene in commodity futures to flatten energy curves so as to dampen speculator effects, which at the time were incentivising contango hoarding and over-investment relative to current demand.
While it’s true that neither the cbank or the government can print commodities, the most powerful thing they can do is guarantee future market demand for any commodities produced from investments undertaken today. And this, ultimately, is what the market needs to correct imbalances as quickly as possible and what banks need to de-risk lending to commodity traders so that trade does not seize up today.
Based on what I have been reading recently it seems like disparaging the Biden administration for whatever it does has become a national sport. While I am no apologist for the Biden administration’s policies, I think it is counterproductive to criticize reflexively rather than thoughtfully.
As Rory Johnston rightly points out, a case can be made for doing exactly what the White House is doing with SPR - withdrawing reserves by selling high. Indeed, this is one-half of a strategy a commodities trader would pair with buying future deliveries today at a lower price for an almost risk-free arbitrage.
Of course there are caveats regarding technical and logistical issues and the Biden administration has not communicated any such coordinated effort. The main point, however, is the SPR absolutely could be used in a public policy effort to stabilize supply and demand imbalances, reduce speculation, and increase incentives for long-term investment in energy infrastructure. Let’s not automatically dismiss such interesting possibilities.
Geopolitics
Russia’s War Is the End of Magical Thinking
In the three decades since the end of the Cold War, the world was mostly stable enough to allow leaders to concentrate on pursuing and preserving economic opportunities—not only for pork producers but for all kinds of companies, small and large … Right now, more disruptions of the global economy look likely as Shanghai and other parts of China lock down yet again to control the virus. But the losses triggered by the war in Ukraine—and the speed at which they’ve been incurred—are unprecedented.
The geopolitical stability of the past three decades produced too much magical thinking by governments and companies alike.
A couple of weeks ago in Observations I referred to an FT column in which an expatriate former director of a Russian company exclaimed, “Nobody I knew expected Putin would actually invade!” There could hardly be a better representation of the type of magical thinking highlighted in the Foreign Policy article above.
Oftentimes good fortune is a matter of perspective as much as anything. Indeed, the mistake of magical thinking in regard to geopolitics provides a useful and timely heads up to investors.
More specifically, Edward Alden points out how many people and organizations have become “perfectly calibrated to a world in which nothing bad ever happens.” For investors, this has been manifested by the Fed repeatedly stepping in to support markets to prevent bad things from happening.
Those times are over, however. With widespread supply disruptions and persistent inflation, the Fed no longer has the freedom to support markets at any sign of weakness. The result is shaping up, just like it is in the realm of geopolitics, “to be a great risk recalculation.” Investors who heed this early warning will be able to avoid a lot of unnecessary pain.
Currencies
Money, Commodities, and Bretton Woods III
https://plus2.credit-suisse.com/shorturlpdf.html?v=51io-WTBd-V
Central banks have it easy when it comes to policing the prices of money in the nominal domain, but not when it comes to policing prices in the real domain of commodities … Central banks are good at curbing demand, not at conjuring supply.
It used to be as simple as “our currency, your problem”. Now it’s “our commodity, your problem”.
Bretton Woods II served up a deflationary impulse (globalization, open trade, just-in-time supply chains, and only one supply chain [Foxconn], not many), and Bretton Woods III will serve up an inflationary impulse (de-globalization, autarky, just-in-case hoarding of commodities and duplication of supply chains, and more military spending to be able to protect whatever seaborne trade is left). “and resource inequality cannot be addressed by QE…” “…you can print money, but not oil to heat or wheat to eat.”
Zoltan Pozsar made a name for himself by disentangling the plumbing of the financial system in the GFC at a time when virtually no one else was paying attention to such details. Now he is making waves by applying his deep expertise to commodities and the implications of the war between Russia and Ukraine. The punchline is to expect a lot more inflation.
The main reason for this is central banks are simply not able to do anything about commodity shortages. Further, while an enormous belief system in the ability of central banks to save markets has developed over the years, Pozsar is exactly right to identify this experience as conditional. In a broadly deflationary environment, central banks could act with few negative consequences. In a supply constrained inflationary environment, the equation completely changes. The power of central banks to control the price environment has radically diminished.
As Izabella Kaminska states in an excellent complementary analysis ($), “We need to understand the details of commodity trading because the rules of the game are changing, and these changing rules will affect the price level, the level of interest rates (OIS), FX rates, and, in due course, OIS–OIS bases.” While there are all kinds of possible outcomes, the really important takeaway is that “the rules of the game are changing”.
Monetary policy
Inflationary forces spell long-term trouble for central banks, warns BIS head ($)
https://www.ft.com/content/e17f3abf-b0c0-4855-8b0f-8d0fa5a26872
Carstens said the “adjustment to higher interest rates will not be easy”, pointing out that households, companies, investors and governments have “become too used to low interest rates and accommodative financial conditions, also reflected in historically high levels of private and public debt”.
“It will be a challenge to engineer a transition to more normal levels and, in the process, set realistic expectations of what monetary policy can deliver,” he said. “Nor will the required shift in central bank behaviour be popular.”
BIS is often thought of as the central banks’ central bank and often serves as a thoughtful foundation of what monetary policy should look like. In this short piece, highly regarded Agustin Carstens says what most central bank heads have trouble saying plainly themselves: Inflation is going to be around for a while and rates have to go higher to deal with that. Things will be harder for everyone.
For those who have a tough time hearing that message, Bill Dudley shouted it out for those in the back: “If Stocks Don’t Fall, the Fed Needs to Force Them”.
Investment landscape
Corporate bond markets are shrugging off the global worries ($)
https://www.ft.com/content/2ea215eb-c359-4a72-830a-1ecdd575b969
One [convenient adage that works some of the time but not always] is that stock pickers are optimists and bond investors are pessimists, making the bond market a better predictor of future distress.
In January, the S&P 500 slipped into correction territory — defined as a move of more than 10 per cent lower from its recent peak. Meanwhile, high-yield bonds performed much better. The difference in yield on high-yield bonds and US Treasuries, a measure of the risk of lending to private companies versus the government, rose a little but remained well below any signal of distress. Why were credit investors not more concerned? Why aren’t they still?
One of the pressing questions of the day is why aren’t credit investors more concerned? After a couple of drawdown in stocks in the first quarter, high yield bonds moved but not by much, and certainly not enough to indicate any notable level of distress.
Going back to November of last year, a similar question was circulating in regard to long-term interest rates. With CPI remaining persistently high and the Fed very slow to react, long-term interest rates barely moved from unusually low levels. Rates acted as if there was nothing to see.
Fast forward to today and the 10-year Treasury yield is about 100 bps higher. At the time Russell Napier observed, “The market, in my opinion, is way behind on inflation expectations and is in for a nasty shock. So, things could change quickly.” He was spectacularly right.
Now, we seem to be in a similar situation with credit. Both cases seem to reflect investors being “perfectly calibrated to a world in which nothing bad ever happens”. Insofar as this is the case, credit is about ready to get a beat-down.
Investment advisory
With inflation persisting and financial assets wilting, advisors are going to be spending extra time re-assuring their investors that “this is just a bump in the road” and we just need to “stick to the long-term plan”. What should investors do when they repeatedly hear these things and yet their portfolios continue to underperform?
One thing that is easy to do is to keep asking, “Why?” Why do you think this is just a bump in the road? Why do you expect markets to turn around? This will reveal whether comments reveal thoughtful analysis or are mere platitudes. Often, they are the latter. Part of this effort can/should include seeking out other opinions and perspectives. A lot of people make a move when they realize they know more about markets than their advisor does.
Another thing to is to consider reducing risk by dividing assets among advisors; there is no reason why choosing an advisor should be an all or nothing proposition. Yet another is to outline an exit strategy in advance. It is always hard to sever a relationship and even harder to do so in the midst of adversity. Define ahead of time what you expect to receive and what would constitute a breach of that standard. Frequent and informed communication is normally a big part of that standard.
Implications for investment strategy
With regard to both [the question of supply chains and the power of the dollar] I am skeptical. My bet is that the current system has huge inertia and is tied down by gigantic network economies.
In any case, the challenge is to stand back from these dramatic vistas for the global economy and global finance and ask ourselves how powerful we think these trends actually are. What is the perspective of realism here?
It’s always a pleasure to read Adam Tooze for his balanced and thoughtful analysis. While I usually find his thinking very consistent with my own, the thrust of this piece seems to conflict with one of my deeply held beliefs. Specifically, he believes the “huge inertia” of current systems will leave the dollar-based financial system largely intact. As such, he also appears to be put off by efforts like those of Zoltan Pozsar to imagine very different possibilities.
Of course, Tooze has a point that radical changes happen rarely through history and he also is right that many pundits proffer dramatic stories more for the purpose of eliciting attention than for advancing solid analysis. That said, a developed world brimming with excessive debt and burdened by weakening demographics is exactly the kind of backdrop from which historic change happens.
Indeed, I would argue the dollar-based system has been stretched for a long time. We are where we are because we have kicked the can down the road, deferred costs, and redefined standards as long as we could to avoid dealing with the underlying problems. The US cannot continue to finance its overspending forever - without consequences. We’re reaching the end of the line.
While Tooze concedes that Pozsar’s effort to identify and grasp tensions in the dollar-based system are illuminating, he disparagingly compares the effort to science fiction. This where my radar goes up. I think efforts to conceptualize how things can change are crucial in enabling one to observe change as it happens. If your eye is not trained, you don’t see it.
I’ll go further. Being able to identify and act on change will be one of the biggest challenges, investment or otherwise, over the next few years. Those who cannot or will not imagine fundamental changes and adapt to them will get stuck using the wrong playbooks.
Note
Sources marked with ($) are restricted by a paywall or in some other way. Sources not marked are not restricted and therefore widely accessible.
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