Observations by David Robertson, 5/20/22
It was another crazy week with stocks holding in fairly well until some fireworks went off on Wednesday. I’m ready to take a much-needed break next week and will resume with a new edition on June 3. In the meantime I hope you have a terrific Memorial Day weekend! Let me know if you have questions or comments at firstname.lastname@example.org.
Stocks forged out decent gains last Friday and into midweek this week on the back of collapsing volatility. All that was lost on Wednesday, though, after markets got a chance to digest earnings reports from both WMT and TGT. BTDers made valiant attempts to turn things around on Thursday with many of the more speculative names, especially those related to crypto, making big gains.
The bad news on Wednesday lingered, however. Revenue growth was decent but clearly reflected a shift to food and essentials at the expense of discretionary items. Margins also came down due to higher expenses across the board. It’s hard to tell what was more disappointing - that neither company expected such intense margin pressure or that both expect enough of it to continue to bring down guidance materially for the rest of the year.
These data points from the big box retailers are where the rubber hits the road with inflation. Higher costs can be absorbed by and shuffled through the system for a while without presenting too much of a problem. The end of the line has come though and that problem is now leaking out to consumers - and they are reacting by cutting back.
China continues to be an interesting indicator for market psychology. While it has been an important engine of global growth for a long time, that growth derived from credit and investment and as such, was never a sustainable model. The real estate sector started collapsing last year under the pressure of tighter credit and the entire country is now also suffering from significantly more expensive commodities. Nonetheless, people are still surprised when China’s growth fails to meet expectations.
There are certainly plenty of excuses to go around and the zero-Covid lockdowns are a big part of that. The main point is that China’s growth trajectory has changed and investors need to adapt to that reality. This is going to be a very long slog with no “all-clear” signals in the foreseeable future.
One of the ongoing market puzzles is figuring out how it will take before the Fed starts easing again. With stocks and bonds both down solidly for the year, pain is already being felt. In addition, investors have been conditioned to a Fed that has an extremely low threshold for such pain. As a result, many prognosticators are suggesting the Fed will relent with its tightening program in short order.
Such a view understates two important factors. One, which I have mentioned several times before, is the extremely politicized nature of inflation. This isn’t about what the Fed wants; it is about what the Fed must do to serve its masters - and the Biden administration needs inflation to come down.
Another factor is that a strong dollar currently serves the geopolitical interests of the US. A strong dollar puts even more pressure on Russia and China and therefore provides leverage in the battle for national security. If the Fed were to signal easing and the dollar weakened, it would undermine that effort.
Interestingly, though the Fed rarely gives much of a nod to happenings outside of the country, Powell explicitly acknowledged “geopolitical events” in an interview last week:
“There are huge events, geopolitical events going on around the world, that are going to play a very important role in the economy in the next year or so,” Mr. Powell said on Thursday. “So the question whether we can execute a soft landing or not, it may actually depend on factors that we don’t control.”
My read on the comments is that Powell is distancing the Fed from potentially adverse outcomes - and this is an important change. Since the GFC, the Fed has been happy to project an image of omnipotence. Whatever the Fed wants the Fed gets and investors had better get in line.
Now, the Fed is rebranding its role as a mere pawn on a geopolitical chessboard. This sounds a lot like Fed is realizing many aspects of inflation are well outside its control and needs an excuse. This is an important signal that inflation is likely to be more problematic than most investors are currently assuming. It is also a signal geopolitical realities are likely to be a better guide to handicapping Fed actions than its behavior over the past twenty years.
Another way to phrase the change in direction of monetary policy is as a return to less interventionism. Much of current policy was established in the throes of the GFC. At the time political feuding created gridlock on the fiscal side and by default left monetary policy as “the only game in town”. Now, with far less concern about spending from either side of the aisle, it is time for fiscal policy to re-take the reins of leadership from monetary policy.
The good news on this front is that policymakers seem to be very sensitive to helping voters cope with various hardships. The bad news is the policy ideas are almost uniformly horrible. A number of politicians have recommended vouchers of some sort for gas but that would only further increase demand without increasing supply. California is proposing cash payments to help home buyers and politicians in the UK and Australia have promoted the idea of allowing home buyers to borrow from their retirement funds to purchase a house.
The common thread in nearly all the proposals to date is that they aim to use money to ease consumer hardships, but in doing so worsen the conditions that caused those hardships to begin with.
As lamentable as this is, it creates important second-order effects that investors need to consider. Given the renewed prominence of fiscal policy, will such policies make problems better or worse? How might midterm elections change the odds on various policies? Will severe problems, such as outages of gas and/or diesel, need to occur to provide the validation for politicians to finally make difficult tradeoffs?
The outcomes for all of these are uncertain and subject to change over time. As a result, the investment opportunities in affected areas, whether it be commodities, housing, or other, is going to be very uncertain as well. The main message is that I am currently being very cautious in allocating risk to such sectors. The secondary message is I am keeping my eyes peeled for changes in conditions that might significantly improve the odds.
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Gold has been weak lately but not nearly as weak as it could be given its historical relationship with real rates. This is an issue I have addressed several times in the past. Gold typically does better when real rates are falling and worse when they are rising.
The main distinction I have highlighted is that this relationship is only part of the equation. The other part is the actual level of real rates. If real rates are negative, gold is still attractive regardless of the direction of travel for real rates.
With real rates now just starting to break into positive territory the big question is does gold need to catch down to inverted real rates or has something changed? While I would not categorically rule out the possibility that gold falls to re-establish the relationship, I think the better argument is things have changed. Clearly, the Fed has taken on a mission of slaying inflation by raising rates, reducing asset values, and squeezing the economy.
This is a tactical mission, however. Given the country’s enormous debt burden, maintaining significantly positive real rates for any considerable length of time would lead to progressively more massive deficits. As a result, I think the gold price sees through this little intermission by the Fed to a longer-term regime of negative real rates.
I am seeing more and more reports trying to quantify the downside risk in stocks. Many seem to anchor around 20-30% selloffs and many calibrate the potential based on the distance from all-time highs. Many cite instances of individual stocks being down by 50% or more as some kind of indication the worst may be over.
These metrics are misleading for many reasons - which begs the question of where they came from. I suspect part of the answer is the Fed’s put normally kicked in at about the 20% level for the big market indexes. I suspect another part of the answer is forecasts of more than 20-30% losses sounds so extreme after such a strong bull market that they sound incredible to mass audiences.
In the absence of monetary (or other) authorities shepherding stocks in a certain direction, a much more useful benchmark is intrinsic value. In other words, the discounted stream of future cash flows is a good baseline estimate of where a stock should trade in a free market.
This model helps explain why many risky stocks have gotten hit so hard over the last year. They don’t have any cash flows to discount. Indeed, risky stocks are very similar to call options. If the company cannot create a certain base level of business value (the strike price) in a certain period of time (while financing is available), then the option expires worthless. This makes sense and is exactly what is happening.
The discounted cash flow framework reveals a couple more insights. One is that the total value is often very sensitive to the discount rate. As the risk-free rate continues to rise, valuations continue to come down. Another is that cash flows can change. In a time of peak earnings and the distinct prospects of both lower economic growth and greater regulation, it is almost a sure bet that many companies will be challenged to produce much, if any, cash flow growth in the intermediate future. The end result is that the downside potential for stocks is a lot more than 20 or 30%.
Probably the biggest single occupation of my strategic thinking about markets right now is war-gaming which particular investment problem is going to cause markets to break and potentially cause the Fed to change course. It reminds me of the cartoon races shown between innings at the ballpark between ketchup, mustard, and relish. Who will win?
One of the top contenders is over-leveraged hedge funds. As Kuppy lays out in the tweet thread below, there is often a pattern and timing to the way hedge funds unfold and that pattern is re-emerging. Think Tiger cubs.
Another top contender is high yield ETFs and more broadly any ETFs that are comprised mainly of securities that do not trade very actively. This is not a problem when inflows are steady and lots of companies are issuing new debt. It becomes a big problem, however, when money starts exiting, especially when it exits in big chunks. This creates the kind of forced selling that can rapidly crush prices.
A third contender is cryptocurrencies. While crypto does not immediately come across as a huge risk, they do have a lot of similarities to subprime mortgages and shadow banking in 2008. Crypto is large enough to matter, it is used as collateral despite often dubious underlying value, it is interconnected, and it largely flies under the regulatory radar. The potential for collateral value destruction and excessive selling pressure is substantial.
Of course, other contenders could also enter the race and the particular manifestations could take slightly different forms. It is also possible there will be several “winners”. In this case the situation would be analogous to the “little fires everywhere syndrome” that Mohamed El-Erian used to characterize emerging markets in the FT. So many options to choose from.
Implications for investment strategy
It is increasingly looking to me like the second quarter is the time frame in which investors start getting the message that financial assets are going to continue getting whacked and this is not just a short-term blip to ride out. The Fed is really going to continue tightening, Russia’s invasion of Ukraine is going to continue to fester, and China is not going to bounce back quickly. Add to the list commodity shortages which will both increase prices and might introduce instances of outages in places over the summer.
One important factor in this equation is how long the Fed waits to reverse course and how it does so. As I explained earlier, my judgment is that the Fed is taking a new path that prioritizes inflation fighting that will disappoint fans of its old path of keeping the markets happy.
The one modest caveat to that position is I believe the Fed will act if markets become disorderly, but I suspect it will apply a different playbook than in the past. Over the last twenty-plus years, the Fed’s solution to any problem was MOAR liquidity. This time around it will need to be far more surgical with any remedial programs. If several different problems were to cause the market to “break” all at once and in different ways, it would be incredibly difficult for the Fed to fix all of them without losing credibility on its mission to tame inflation.
All of this is going to take time for investors to digest and I am expecting something like the Kubler-Ross five stages of grief. We’re mainly in denial stage now with some anger creeping in. With inflation continuing relatively high and with the next big leg down in the S&P 500, we’ll slide firmly into the anger stage. Then it will be a long and arduous road to acceptance. Short answer: It’s nowhere near time to go bottom fishing yet.
Just for fun
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