Observations by David Robertson, 5/24/24
Observations by David Robertson, 5/24/24
It was a fairly quiet week for financial news as people started checking out early for the upcoming holiday weekend. As a result, this week’s post will be shorter than usual.
In the meantime, I hope you have a happy and relaxing Memorial Day weekend!
As always, if you want to follow up on anything in more detail, just let me know at drobertson@areteam.com.
Market observations
The market started off the week somewhat in limbo. With benign developments already fully priced in (e.g., rate cuts, inflation target), there was little impetus to drive significant movement.
Last week ended in auspicious territory with the VIX volatility index sporting an 11-handle which was the lowest since November 2019. VIX dipped into that territory again this week. While perceived uncertainty is quite low, that’s not the only thing going on.
As Mike Green highlights, “it looks like our friends the 0dte [options with 0 days to expiry] are the driver”. He notes that rather spending significant premium to hedge a specific event risk, “a hedger can now buy a low-priced single-day option”. Consequently, “the demand for crash puts and the trading of them has collapsed at the VIX tenor”. The result is the types of options used to calculate the VIX are now used less frequently (due to the emergence of 0dte) and thus the implied volatility is lower.
While there is nothing nefarious about this per se, it does mean historical VIX readings will be higher, all else equal. It also means current low volatility readings could be misinterpreted as being indicative of low risk.
In addition, financial conditions (from @SoberLook) have been getting progressively easier and are at their loosest since the meme-crazed days of 2021.
Nonetheless, storm clouds are on the horizon. The US Leading Index (from @SoberLook) has been persistently weak and is at its lowest level since the depths of Covid.
At very least these factors create the appearance that financial conditions are gradually being loosened so as to keep the economy hanging on. If and when those financial conditions actually tighten up, it’s not hard to imagine that things could get pretty ugly pretty quickly.
Credit
One of the market’s mysteries over the last year or so has been tightening credit spreads. The expectation from rate increases, which started about two years ago now, was that business costs would go up and that would slow the economy down and that would increase credit spreads. Didn’t happen, at least not yet in any systemic way. The FT’s Robert Armstrong ($) provides some nice perspective based on his conversation with Jim Grant:
When I spoke to Grant last week, he put special emphasis on the fact that many companies, faced with debt maturities, now have more options besides refinancing at a much higher rate (or defaulting): payment-in-kind agreements, debt exchanges, amended loan agreements. “We have perfected and institutionalised the means of procrastination.” But delay does not solve problems. If rates stay high enough for long enough, they will do “substantial damage” he says. And there are signs of rising stress already: rising bankruptcy filings, credit deterioration at several business development companies, declining interest coverage ratios, and so on.
One point, then, is the financial system has evolved in ways that delay the effects of interest rate hikes. Debtors now have more options than just “refinancing at a much higher rate” and can therefore forestall financial disaster. Most of this represents secular changes in the financial system and therefore should not be discounted as uniquely Covid-related.
A major implication, of course, is that monetary policy works differently than many of us had assumed. If the transmission of rate hikes to the economy is much more gradual than in the past, then the “long and variable lags” of monetary policy effects are even longer and more variable than in the past.
Importantly, just because higher rates haven’t significantly impinged upon economic growth yet, doesn’t mean they won’t. As long as rates stay near current levels, the expectation should be for “substantial damage”. The only issue is timing.
I especially like Grant’s characterization that “We have perfected and institutionalised the means of procrastination.” This is a good way of putting it. We have been much better at putting off problems than actually solving them.
This habit of procrastination is true for more than just the credit market; it is also true for public policy. Since debt problems have not yet been solved, but only forestalled, we can expect “substantial damage” on that front as well. While I continue to think that is unlikely during an election year, I think it will be hard to avoid next year.
Inflation
The Inflation Outlook Is Getting Better, But Also Worse? ($)
https://theovershoot.co/p/the-inflation-outlook-is-getting
The latest batch of U.S. data on spending, prices, and production suggests that inflationary pressures may be shifting (slowly) from services back to goods—despite weakening demand. If so, this would be a marked reversal from the dynamics of the past two years.
The vexing thing about this is that the pickup in input costs and the (mild) deterioration of I/S ratios have coincided with a substantial slowdown in consumer spending.
Two points jump out from this inflation update from Matthew Klein. First, Klein’s suggestion that “inflationary pressures may be shifting (slowly) from services back to goods” jives with my observation last week that “there is undoubtedly upside risk to food, energy, and goods”. This is what is coming out of objective assessments of the inflation numbers.
Second, the rising pressure on goods prices, especially as demand is looking relatively weak, suggests a different paradigm for inflation. The dominant paradigm has been that as long as economic growth and employment remain fairly healthy, it will be hard to get inflation down to target. Recent data suggests, however, goods inflation is reheating even as demand weakens. This suggests more of a stagflation (ish) paradigm and would require very different investment positioning.
Narrative landscape
One phenomenon worth mentioning is in the absence of very much market-moving data over the last week or so, many of the things that did get reported had more to do with narrative formation than information transmission.
Exhibit A is the Bloomberg article Ben Hunt posted on X entitled, “Sorry Inflation Doomers, We're Heading in the Right Direction”. First, this is a classic narrative structure whereby we are told how to think about inflation rather than being allowed to make a judgment on our own. Second, this depiction represents a change in the story line on inflation. No longer is it about sustainably hitting the 2% target. Now it is about “heading in the right direction”.
Exhibit B entails recent comments by Blackrock’s head of fixed income, Rick Rieder. In a recent interview with Bloomberg TV, Rieder made the case that “the Fed will need to cut interest rates to tame inflation”. Yes, you read that right. Now, cutting rates is the way to tame inflation.
Paulo Macro posted some choice comments on X reflecting his opinion of Rieder’s argument:
It takes a special kind of elite intelligentsia to suggest that rate cuts would ease inflation. An out-of-control externally funded fiscal deficit drove inflation skyward, inflation is now becoming embedded in expectations, and the “contrarian” position is that the central bank should be dovish to — tame inflation. Spiking interest payments that jack the Gini coefficient and raise inequality because the 0.1% collect rates while peasants pay them is not inflation. It’s Brazilification.
In both of these examples there are nuances that can be discussed and debated … but that is not why we are seeing them now. We are seeing arguments like these now because inflation data is not being permissive of rate cuts so storytelling needs to take over. Both narratives pave a path so that monetary authorities can lower interest rates regardless of what the data says.
One last comment is this is the type of thing I used to gloss over as an analyst. I would think this is just more crazy BS piled on top of other BS. I have learned, though, that statements like these are important to track because they are indicative of a changing narrative. And a changing narrative is what governments and other powerful people use to get their way when the data don’t justify what they want to do.
Investment landscape I
Artificial intelligence is still a powerful theme and its leading light, Nvidia, reported another quarter of strong sales and earnings on Wednesday. As interest in the theme grows, so too does its reach broaden into other industry groups.
In a teaser for a recent Substack post, Le Shrub wrote the following:
In Part 1, I wanted to get across that there are many ways to skin the AI-cat and invest in the AI theme through old economy sectors. For example, since publication:
the Tin price is +30%
Metals-X (our preferred tin play) is +60%
Nat gas is +65% (!)
Everyone is now talking about the impact of AI on Energy demand, the Grid and even copper demand!
This is a very fair point. Whether you believe in the astronomical potential for AI or are just following a trend, it is natural to figure out what industries/themes/securities are related and might also get caught up in the fervor.
One of these related industries is utilities. As the electric power needs to develop and train large language models becomes more widely appreciated, the expectation is that power consumption will have to go up which in turn will increase the revenues of utilities.
While there is absolutely truth in this, it is also not the whole truth. Indeed, just a couple of months ago we heard the laments of Warren Buffett in his annual letter about the increasingly unfriendly regulatory environment for electric utilities. He’s not sure utilities are a good investment any more given the increased uncertainty in the regulatory environment.
Another observation is that many of the areas Le Shrub lists are natural resources. While AI may certainly be driving incremental consumption of certain natural resources, it’s not the only driver. Recovering growth in China is a big driver and another is the anticipation of supply shortages.
One point, then, is a number of the exciting new growth industries look a lot like the old unexciting cyclical and value industries … because they are. Another point is that whether such industries are finally moving because of the boost from AI demand claims or because they are genuinely in a cyclical upturn isn’t incredibly relevant. Money is starting to move to them now and that’s what counts.
Investment landscape II
Mega cap tech stocks and artificial intelligence have been driving themes for the stock market not least of which is because they have dominated earnings growth and price appreciation. As powerful as those drivers have been though, there have also been other tailwinds for US stocks.
For one, high rate differentials and still-decent economic growth have kept money flowing into the US. That has also kept the US dollar relatively strong and therefore made US capital markets a relatively safe place for large investors to place capital. As Paulo Macro ($) describes in a recent Substack post: “Big pools of capital have been using US megacaps along with the bond market as a giant parking spot with an appreciating US tailwind for years.”
More recently liquidity has also been favorable as tax revenues temporarily suspended the need for Treasury to issue debt. Treasury came back to market this week with $220B in T-bills and $16B in 20-year Treasuries with little fanfare. Next week will be a bigger test with a slew of coupon offerings. Then we’ll get a better idea of what the market thinks of inflation and interest rates.
It’s not hard to imagine these tailwinds for US stocks may subside before long, and may even turn into headwinds. If more attractive growth appears in emerging markets or elsewhere, it may not take a lot for capital flow to reverse and start leaving the US. In addition, as Treasury issuance resumes more normal operations, it is pretty easy to imagine higher rates will be demanded and that those higher rates will impinge upon growth.
As a result, as attractive as the Magnificent 7 have been, and as strong as the S&P 500 has been, it wouldn’t take a big turn in fundamentals to cause a big turn in stock performance.
Implications
One of the great challenges for investors has been that the S&P 500 keeps chugging along despite its excessive valuation. On one hand, the consequences of that excessive valuation keep getting deferred and as a result, it’s hard to not be fully exposed. If you aren’t, you miss out.
On the other hand, the consequences of excessive valuation can’t be deferred forever and long-term investors have a strong interest in avoiding the losses/underperformance implied by those valuations. But … venturing outside of the S&P 500 has been fraught with its own perils.
In considering factors that could cause Mag 7 and S&P 500 dominance to change, flows of capital out of the US and higher long-term rates (that I mentioned above) rank at the top of the list. Yet another consideration is, at least somewhat counterintuitively, much higher economic growth.
Before interjecting with qualms about weak demand, consider first the potential for credit expansion. One of the unique aspects of recent growth in the US is that it has not been a function of private credit expansion. In fact, household debt service relative to personal disposable income (in aggregate) has not been lower in the last forty years than during Covid when many debts were in forebearance. It is nothing like the years preceding the GFC when it increased persistently to all-time highs.
So, if one had a notion to really light the economy on fire, like one might be compelled to do right before a big election, an easy way to do it would be to open up credit lines for households.
As Paulo Macro framed it:
The banking system is over-reserved, overcapitalized, and waiting in the wings (a function taken over recently by private credit/asset managers). As my man @qthomp points out, normalizing the yield curve is Chirstmas [sic] for banks and credit growth *explodes*.
In short, as painful as it has been to bet against the S&P 500, it looks like we are nearing a tipping point beyond which it will be painful to stay with the S&P 500. If and when that happens, there will be a lot of investors scrambling to figure out what’s going on.
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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