Observations by David Robertson, 5/12/23
It was another busy news week. With most of the economic and market news being mixed, strong directional views increasingly reveal more about the self-interest of commentators than market insight.
As always, if you want to follow up on anything in more detail, just let me know at firstname.lastname@example.org.
This chart from @SoberLook ($) reveals a couple of important points about artificial intelligence (AI). One is the uptake of ChatGPT (one implementation of AI) has been far faster than a whole slew of other “tech” services. It’s not just hype and fake accounts; people are using it.
Another point is the potential for truly valuable contributions to the economy. The vast majority of other services highlighted are mainly forms of entertainment. Potentially fun, sure, but not the stuff that makes an economy stronger.
ChatGPT by contrast, is already proving itself incredibly useful for coding, language calibration, basic research, creative assistance, and lots of other activities we humans often spend a lot of time being “stuck” on. It may not literally be a “flying car”, but figuratively it’s close. It is the manifestation of technology many of us have been waiting for. Unfortunately, it’s quite useful for bad guys too.
Why homebuilders have rallied ($)
Obviously we were wildly wrong [about the thesis to short homebuilders at the beginning of the year], but what about, exactly? We were betting on a margin-crushing recession that has not arrived; mortgage rates have fallen a bit from their peaks, too, which has helped the homebuilders. But what we really misunderstood was how the very fast increase in mortgage rates would affect the industry, and in particular the relationship between the markets for new and existing homes.
There are some good lessons in this [so far] bad call on home builders. Yes, the logic of higher rates negatively affecting home values and therefore home builders is sensible. No, it has not worked year-to-date. Yes, yet another unexpected consequence of the rapid rise in interest rates has distorted markets.
These are harrowing times for all types of investors. Try to pick a stock or a sector and unexpected consequences can completely upend your investment idea. Try to lay back and just let the market do its thing and you set yourself up for big underperformance in the future.
It’s enough to make about anybody feel stupid a good chunk of the time … and that’s the lesson. If it is virtually impossible to call many parts of the market correctly, then the main play should be defense. Maybe after enough money-losing propositions investors will figure this out.
All year, through this range-bound market, crude prices have been driven overwhelmingly by speculative capital movements in and out of oil-linked futures and options contracts. While many likely feel that this is normal given the outsized discussion of speculators, I feel that this level of market control is, in actuality, quite rare and speaks to both low effective liquidity in the market and a lack of pressing fundamental drivers to force us in a counter-vibe direction.
These comments by Rory Johnston in regard to oil also speak to the broader commodity markets in general. Indeed, several different commodities are being driven by “speculative capital movements” that create a great deal of volatility and put a huge premium on timing.
As such, it has also been extremely difficult for long-term investors to get comfortable incorporating commodities into their portfolios. While they make sense as protection against inflation, it is very difficult to take on the short-term risk. Maybe we just need some more “pressing fundamental drivers” to make things easier.
THE WORLD IS NOW FACING A TOXIC TUG-OF-WAR BETWEEN STICKY INFLATION (SPURRING A STUBBORNLY HAWKISH FED) CAUSING A DEFLATIONARY NEGATIVE FEEDBACK LOOP INTO OIL DEMAND THAT MAKES IT MORE LIKELY FOR CHINA TO DEVALUE; THIS IN TURN SPURS A GEOPOLITICALLY AND ECONOMICALLY MOTIVATED OPEC+ TO DEFEND OIL, THEREBY STOKING INFLATION AGAIN.
NOT ONLY DO I THINK CNY HAS NO SHOT AT SUPPLANTING USD, BUT I VIEW DEVALUATION OF CNY AS A NECESSARY BUT NOT NECESSARILY SUFFICIENT CONDITION TO CURTAIL GDP SLOWDOWN FOR CHINA.
More great analysis by Michael Kao. In the midst of so much noise about “de-dollarization”, it can be easy to overlook the far bigger and more imminent challenge of China maintaining the value of the yuan.
While there are a lot of moving parts to this geopolitical puzzle, it is interesting to note that China’s Covid rebound has been far less vigorous than many have expected. While air travel within the country has been strong (Americans had pent-up travel demand too), other consumption trends have been meager.
For example, Axios reports, “Sluggish imports into China suggest that domestic demand in the People's Republic continues to struggle”. In addition, @INArteCarloDoss points out, the “big issue is Asian refinery margins and run cuts”. Iron ore is down and overall inflation is dropping to very low levels. None of these are the kind of things that happen when demand is strong and growing.
Interestingly also, for all the talk of poor relations between Saudi Arabia and the US, Saudi has been anything but overtly friendly to China. Commentators have rushed to highlight Saudi’s snub of the US through OPEC’s production cuts but have failed to mention that China is OPEC’s largest customer. As Rory Johnston highlights, “China is the largest single destination for OPEC+ crude exports, with all but one of China’s top suppliers (Brazil) counted among OPEC+’s ranks”. If OPEC production cuts are a snub, then, they are a snub to its biggest customer - China!
This reality reveals a more complex universe of potentialities than is normally presented. For example, what if OPEC is not so much snubbing the US or China, but is operating unilaterally, in its own best interests? One can go even further: What if OPEC banded together with other natural resource-producing countries? After all, OPEC formed as a defense against colonialism and imperialism. This could every bit as interesting as the China story.
As to China and the US, while much is made of the competition between the two, they are both so important to global growth that it is in nobody’s interest that the other side should fail miserably. An uncontrolled devaluation or deflationary spiral on either side would present a global risk, not just a local one.
In the meantime, both sides are ratcheting up the heat of rhetoric. Politically, it makes sense for each side to have a “bad guy” enemy in order to coalesce public opinion and distract attention away from domestic troubles. However, such moves also create something of a self-fulfilling prophecy which increases the odds of conflict - and lots of unintended consequences.
On the other hand, there have also been some signs of amelioration. Lu Shaye, an ambassador to France, was recalled to Beijing after making some incendiary comments. George Magnus characterized the move as a sign China may want to “stabilize” the relationship. In addition, national security adviser, Jake Sullivan, recently met with top Chinese diplomat, Wang Yi, for two days. The discussions were characterized by the FT as “candid, substantive and constructive”.
In sum, this feels like the early chapters of an epic global transition. The temperature may get dialed up or down at times, but something big is happening. Best to keep this on the radar.
Thanks for reading Observations by David Robertson! Subscribe for free to receive new posts and support my work.
Back in the heydays of zero interest rates and the Fed put, investors learned to associate market declines with financial instability. They also learned to associate financial instability with Fed easing. As a result, instability was good because it forced the Fed to become even easier in its monetary policy.
This history is making for some hard-to-break habits. For example, after Powell extolled the virtues of monetary policy that is consistent with financial stability during the FOMC press conference last week, Steve Liesman from CNBC complained on Twitter that bank stocks continued to decline afterwards. The inference was that if bank stocks go down 2%, it must be an indication of instability - and therefore a condition for the Fed to ease up.
Methinks Mr. Liesman doth protest too much. As @Stimpyz1 highlights in a follow-up, “Financial stability and bank equity prices are not the same thing”. This is correct. As a result, modest stock declines do not warrant massive monetary policy responses. This has changed. Get used to it.
This is going to take some getting used to for a lot of people. It will be harder for CEOs to obtain a “Get out of jail free” card. It will also force financial sector analysts to treat company-specific risks much more seriously. Finally, it will force investors to develop a more sophisticated playbook than just buying the dip (BTD).
One of the surprises in the market, to me anyway, is how little attention the debt ceiling is getting. Yes, it has been mentioned a few times and yes, a few people are running around like their heads are cut off screaming it will be the end of the world. All told, however, the story is taking a back seat to inflation and to China.
Perhaps it will take a while longer for the story to flare up. Perhaps people have become inured to the issue. Perhaps people are just tired of hearing the same old crap.
Regardless, while I don’t think “catastrophe” is the most useful depiction of possible consequences, I do think investors should have this on their risk radar. For one, there is quite a bit of potential for an extended ordeal, which of course would extend the period of uncertainty. For another, the range of possible outcomes and unexpected consequences is massive. All this and VIX has been residing in its lowest range of the year.
The CPI report came out on Wednesday and was pretty much in line with expectations. As a result, stocks shot higher by about 80 bps out of the gates but quickly pulled back to a more modest gain. By itself the report was not enough to change any opinions. On Thursday, however, weaker than expected PPI and higher than expected new jobless claims supported the view that inflationary pressures are slowing.
Been hedging around the pivot? Don't stop now
The almighty shock of Covid-19 has made it very easy to be wrongfooted … But with the shockwaves still moving through the system, it seems odd to bet with quite such confidence that inflation will be back under control two years hence.
This piece by John Authers highlights two important issues. One of those is the highly unpredictable consequences of Covid-19 and its shockwaves. The other is the high level of confidence investors have that inflation will quickly come down despite the inherent uncertainty of the environment.
John Hussman addressed the same issue in a recent tweet noting that “the only recessions that brought core PCE inflation below 3% within 24 months were also recessions that started with core PCE inflation below 3%”.
I continue to believe inflation is underpriced (both in magnitude and duration) by markets and will eventually cause a great deal of disruption in financial assets. The longer the Fed keeps rates about where they are, the harder it will be to maintain the illusion the Fed will be the white knight to come riding in and save the markets.
For markets, desperation is the new fear. Be afraid
The key jaw-dropping statistic from [Vrinda] Mittal’s paper is as follows:
Firms financed predominantly by the most underfunded public pensions experience a -5.2% annual change in labor productivity, as compared to firms financed by other investors which experience a +5.2% annual change. Firms supported by low quality PE funds face productivity decreases. The key mechanism is the notion of desperate capital, where the most underfunded public pensions allocate capital to low quality General Partners, and realize lower PE returns.
One of the key points in this piece by John Authers is that institutions are every bit as bad as retail investors at chasing performance and making bad investment decisions. Just because they are larger doesn’t inherently make them more competent or more sophisticated. Anyone is capable of making “seriously bad decisions on where to allocate capital” if the incentives are strong enough.
The bigger point, however, is that the long span of excessively low rates from the GFC up through the Covid pandemic created those strong incentives. As a result, it also caused a lot of performance chasing across a lot of different entities. We have already seen some banks fall victim to this. There will likely be more.
What Authers rightly points out is the problem is far broader. Pension funds faced the virtually impossible task of hitting unrealistically high return goals while earning virtually nothing from fixed income investments. In response, they chased private equity, venture capital, real estate, and other historically higher returning asset classes. They did so out of desperation, however, not enlightened analysis.
Authers’ conclusion is also apt: “If there’s a common thread to the investment world at present, it is tracing the impact of that desperation. It’s appearing in some unexpected places, and may not be finished.” This is absolutely true. It will take some time to clear out the rot, but it is coming. Don’t be surprised when it appears at a theater near you.
WHAT HAPPENED TO MEAN REVERSION? ($)
Mean reversion has been a part of the market since I started as a fund manager, but no longer it seems. Betting on mean reversion in the S&P 500 since 2018 or so has been a career ending move.
This is Russell Clark sharing one of his observations as a hedge fund manager: Mean reversion on the S&P 500 just hasn’t been working. Of course this is a major premise behind strategies such as the “value” style so that hasn’t been working either.
It is worth pondering the possible causes. Clark attributes corporate buybacks as a leading cause. I have mentioned Michael Green’s work several times that attributes the cause to the proliferation of passive investing which causes virtually all of the net inflows to stocks to be price insensitive. I have also mentioned the carry regime by which investors earn income through selling volatility. I suspect each of these has had an impact.
None of these causes, however, can be expected to persist indefinitely. Corporate buybacks slow and then stop when profitability declines. Saturation of equity markets by passive strategies cannot exceed 100%. Further, when unemployment rises, automatic 401(k) contributions will fall. Finally, carry regimes are inherently unstable and normally end with a crash.
As a result, long-term investors are left in a quandary. Is it better to continue holding stocks knowing the forces keeping them artificially afloat will someday end, or is it better to avoid that risk but not knowing how long it will take for a major correction? Much of the answer depends on one’s ability to anticipate the change and the availability of market liquidity when the time comes …
A key point to keep in mind, and one that I have emphasized repeatedly, is the market impact when selling starts. With large inflows still coming into stocks on a regular basis and with gates preventing significant selling at some large real estate funds, the price impact has been minimal.
As Andy Constan highlights, however, in the event significant selling pressure were to arise, the price impact could be large. This is true of stocks, Treasuries, and most financial assets. Further, it often doesn’t take a lot of incremental change to force that selling. Also, such conditions are often mechanical and therefore virtually impossible to throttle or reverse.
While this describes an important element of the landscape, it also has important implications for investors. Low market liquidity facilitates volatility. Think regional bank stocks over the last month. It is exceptionally hard to navigate these situations in the moment of disruption.
It is far better for long-term investors to be alert to the potential for volatility, be defensive while it persists, and to start looking for opportunities to implement when it is over.
Thanks for reading Observations by David Robertson! Subscribe for free to receive new posts and support my work.
Sources marked with ($) are restricted by a paywall or in some other way. Sources not marked are not restricted and therefore widely accessible.
This commentary is designed to provide information which may be useful to investors in general and should not be taken as investment advice. It has been prepared without regard to any individual’s or organization's particular financial circumstances. As a result, any action you may take as a result of information contained on this commentary is ultimately your own responsibility. Areté will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information.
Some statements may be forward-looking. Forward-looking statements and other views expressed herein are as of the date such information was originally posted. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time, due to numerous market and other factors. Areté disclaims any obligation to update publicly or revise any forward-looking statements or views expressed herein.
This information is neither an offer to sell nor a solicitation of any offer to buy any securities. Past performance is not a guarantee of future results. Areté is not responsible for any third-party content that may be accessed through this commentary.
This material may not be reproduced in whole or in part without the express written permission of Areté Asset Management.