Observations by David Robertson, 5/6/22
Another Fed meeting, another anodyne press release, and a furious rally after. Then a complete reversal the next day with perhaps some hints of forced selling. Is it time to start thinking about summer plans instead? Regardless, have a nice weekend and Happy Mothers Day!
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One interesting phenomenon in the market is the ongoing back-and-forth tension that drives stocks up … and down. With sentiment measures decidedly negative and liquidity clearly worsening, it is fair to ask what forces keep coming in to drive stocks up? The answer stated clearly in the tweet above is, “RETAIL HAS NOT CAPITULATED”. A number of stock enthusiasts are still working from the playbook that the path to fame and fortune is betting on stocks. Good luck.
There are a couple of excellent threads on commodities here that are worth considering. A key subject is anticipating the consequences of a world in which currency reserves are a lot less safe than previously assumed. For governments and central banks, this means finding alternatives to currencies, such as gold, and finding ways to increase internal demand. For companies, this means stocking up on inventory and hoarding commodities.
My reaction is this is a very useful framework, but it will take time to really come into play. Companies, by and large, are still in the mode of “getting back to normal” and have not changed mindsets in a significant way yet. Outright outages of important commodities will do that and I strongly suspect are coming.
By the same token, it is not easy for exporting countries to reconfigure their economies by stimulating higher internal demand. If it were easy, these things would have been done years ago.
THE GRANT WILLIAMS PODCAST: Episode 31 Mike Rothman, Cornerstone Analytics ($)
I don’t really know when you’ll get a big move, but I will say this, I’ll venture a perspective here, and it is based on my observations over a fairly long period of time, which is what tends to finally get policy to move. Doesn’t always happen, but the tendency is when availability becomes an issue. People will bitch and moan about paying more for something, but they go a little bots when they can’t get it. That’s when you start thinking about policy responses that might change the equation.
So, commodities present a real catch-22 here. I still think the long-term prognosis is positive - there won’t be enough supply. I also think Paulo Macro’s thesis has a lot of merit and the hoarding of commodities by companies and the reconfiguration of growth models by exporting countries is not yet discounted by markets.
On the other hand … the Fed has a clear imperative to lower inflation and it has infinitely more capacity to accomplish that objective by reducing demand than by increasing supply. What comes first - massively reduced demand or actual outages of key commodities like oil that send prices flying? What serves US policy goals better - lower demand leading to lower inflation or stock outs that provide the impetus and political cover for change?
It may be a trick question; the answer could be, “Both”. Lower inflation in front of midterms would be a nice talking point for the Biden administration. At the same time, stock outs would cause people to “go a little bots” and demand policy responses. Whether those policy responses would be helpful or not is an entirely different question.
China's Leadership Is Prisoner of Its Own Narrative
Freight traffic volumes in the Shanghai metropolitan area plunged by 81% year-on-year in the first three weeks of April. Jiangsu province recorded a drop of 30%. Nationwide, freight volumes in April are down 15% year-on-year. There are currently no trains running between Nanjing and Shanghai; the authorities in Nanjing are so riddled with fear that they won’t allow any traffic. In Guangdong province, China’s economic powerhouse, freight volumes have plunged by 17%, even though there is no lockdown.
Until the 20th Party Congress, which will take place later this year, they will stick to the Zero Covid policy. President Xi wants to be confirmed for a third term, so he cannot change his narrative this close to the finish line. The president has maneuvered himself into two dead ends at once: He can’t change his Covid policy, and he can’t change anything about his friendship with Wladimir Putin.
These comments from a veteran China observer (and resident) feature a number of bits of “truthiness” that collectively form a chilling account of current conditions. Things have gotten to the point where “people are genuinely afraid of the virus”. Further, leaders who can observe the counterproductive effects of policy have their hands tied; “they can’t use this knowledge to bring about policy change” before the Party Congress later in the year.
As a result, April data are likely to produce a “real shocker” and growth for the year “will be below 4%”. Supply chains in China are “so tightly knit that lockdown measures in one place have ripple effects on other regions. Consequently, “China is losing its credibility as the best sourcing location in the world.” Yowza! Add a strong US dollar and widespread supply shortages and China is dealing with quite a slate of serious issues.
Carl E. Walter assesses the situation succinctly in the April 29, 2022 edition of Grant’s Interest Rate Observer: “That's the whole point. The whole point is that the whole place is mispriced.” And that is a very different assessment than can be heard from Blackrock, Goldman, Bridgewater or any of the large financial firms desperately vying for a toehold in China.
Big market declines are something we all know are a historical reality but can seem almost inconceivable in relation to our own future. The Market Ear ($) posted a chart of the current Nasdaq relative to the Nasdaq in 2002. The similarity suggests many of the same psychological components are involved. Bill Gurley’s tweet thread (below) is an excellent primer on the various phenomena that lay the foundation for this kind of breakdown.
A couple of the gems include “Previous ‘all-time’ highs are completely irrelevant. It's not ‘cheap’ because it is down 70%. Forget those prices happened” and “You may be shocked to learn that people want to value your company on FCF and earnings”. These lessons should be carefully studied by any analyst. The fact many have learned exactly the wrong lessons over the 13-year bull market run helps explain why the process of “unlearning” is likely to be long and painful.
Oh, and by the way, the Nasdaq chart above vastly understates the potential downside. By 2002, Nasdaq had already fallen by 61% from its peak. The graph above only captures the last bit of fallout after the big slide.
If you like qualitative commentary and anecdotes to help fill out the picture, Almost Daily Grant’s took a look at three Nasdaq victims (COIN, LCID, and HOOD) in its dispatch on April 29.
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A good way to think about what is going on here is this: Dollar super strength => mass eurodollar defaults => inter-state restructuring negotiations => mass “negotiated” redenomination/acquisition of a lot of dollar-denominated debt (most likely into CNY, RUB or crypto).
Once legacy US-dollar denominated debt is dealt with, US authorities will be tempted to engage in competitive devaluation to help encourage US exports and the reshoring of core industry from China and emerging markets to the West.
The US dollar has kept getting stronger and stronger. To an important extent the migration to safe havens makes sense in the context of geopolitical conflict and global uncertainty. There also seems to be more to it, though, as Izabella Kaminska points out. The situation has all the makings of the US using the strong dollar as a geopolitical tool. Applying leverage through a strong dollar “could open the door to some very interesting international negotiations in the months to come”.
If the dollar can be used as a foreign policy tool it is not too much of a foray into the world of tin foil hats to assume it could also be used as a tool to manage markets. A strong dollar would offset much of the pressure from higher commodity prices and incrementally reduce inflationary (and therefore political) pressure. It would also attract foreign money into US markets to help mitigate the potential for a disorderly decline. Harald Malmgren corroborates the view:
Russia's Natural Gas Strategy
All of this to a point, though. The Europeans are showing many signs of shaking off decades of inertia and wishful thinking when it comes to finally doing the hard work of weaning off Russian energy. We see this most clearly when it comes to updating oil transport infrastructure. Russia needs to move quickly before buyers like Germany can easily source alternative crude supplies, and before its own fields must be shut-in due to a lack of buyers. Which makes natural gas the last strategic link. Moscow must walk a narrow line between applying enough pressure to break the European alliance, but not so much that Germany and its neighbors become convinced to sever its energy dependencies on Russia.
This analysis by Peter Zeihan raises an interesting point: In order to attain its objectives, Russia must manage a delicate tradeoff that avoids applying too much pressure which would convince Europe to sever its energy dependence and not enough pressure which would fail to break the European alliance. It’s the proposition of a drug dealer: It’s best to keep them hooked so they keep buying, but not so hooked that they overdose and stop buying.
By the same token the West also has a delicate balance to maintain. It must stand firmly enough and unified enough so as to present a formidable deterrent. At the same time it must be careful to not go so far as to incite a much more aggressive response. Bottom line is none of this is easy, it’s constantly changing, and it is rife with the potential for errors to be made.
Judging by the Fed’s press releases on Wednesday there was little new information conveyed. The Fed raised rates by 50 bps as expected and announced plans to reduce the balance sheet as expected.
Judging by the market’s response, the Fed reversed course and opened up the monetary spigots again. During the course of the press conference the dollar (DXY) dropped almost a dollar from its intraday high, the VIX dropped 9%, and the S&P 500 shot up 2.3% before logging even more gains before the close.
Clearly, there was relief rates weren’t raised by 75 bps and the delayed start to the balance sheet reduction probably gave some cause for celebration too. There were also clearly items of concern, however. Powell explicitly stated the Fed is better suited to address inflation by reducing demand than increasing supply. He also noted that stocks were one measure (though one of many) of financial conditions that were not in balance. Finally, he started the Q&A by stating “there is a path” for essentially a soft landing. Sounds like “I have a dream”.
In short, the Fed waited months to raise interest rates and blew a chance to get started right away on balance sheet reduction. In so doing it revealed a continuing tendency to tread cautiously. For the foreseeable future I expect this back and forth between Fed actions and expectations to continue. The main effect of excessive caution (i.e., lack of courage) will be higher and more persistent inflation.
One of the most popular investment “styles” is growth - and for obvious reasons - it is better to grow than not. Indeed, emerging markets are often highlighted primarily for their ability to grow at a faster pace.
One of the important lessons of investment analysis, however, is that not all growth is good; only profitable growth. The point being that in order to continue growing, a firm needs to continually reinvest in its business. In order to do that, it needs to earn a profit.
Unprofitable firms can grow but only so long as capital is forthcoming. In those instances, growth continues, but with each new increment of capital, pre-existing shareholders get diluted yet again. Alf’s example of China above is an excellent illustration of how unprofitable growth can fail (miserably) to benefit investors. As capital becomes increasingly difficult to source, a lot of investors are going to learn this lesson the hard way.
One of the current market puzzles is how sentiment can be so negative while stocks are holding up reasonably well. The tweet above sums it up nicely: A lot of investors don’t like stocks and have not liked stocks, but feel they have no choice. Bonds have had pitiful yields and are vulnerable to inflation. They grumble and groan but continue to own (stocks).
Another explanation is the proliferation of passive investing. A huge chunk of passive investors are fairly indifferent to market moves. They invest automatically through retirement plans in target date and similar funds and just don’t follow markets very closely. As a result, sentiment readings are probably biased to discretionary money and fail to represent much of the passive universe.
In order for markets to more clearly reflect negative sentiment, something so clearly awful would have to happen that would cause passive flows stop or reverse. That could include massive job losses or an environment clearly bad enough to compel large numbers of workers to go to the trouble of de-risking their retirement programs. The bar is high.
Ben Hunt from Epsilon Theory sent out a note last week by email that featured these comments:
The big trade around Skilling and Madoff wasn’t directly on their specific scams and frauds, but on what their specific scams and frauds showed us about systemic rot in the financial system. It’s exactly the same with Greensill and Hwang today.
The big trade is figuring out what happens when the squeezes and corners from insane hedge fund and shadow banking leverage come undone.
So, one point is that we are at the juncture of the market cycle when scams and frauds are surfacing. Another point, as Hunt highlights, is to observe what these scams and frauds reveal about hidden leverage. Don’t be surprised when frenzied deleveraging happens in places that are not in the headlines today.
Implications for investment strategy
One of the most important ongoing questions now is, “What will break in the markets?” Below is a list of nominees:
Credit spreads widen and companies start experiencing financial distress due to higher costs, higher interest rates, and refinancing challenges
Inflation continues at a high rate and undermines consumer purchasing power
Emerging markets are forced to restructure dollar-denominated debt
Major exporting countries like China, Russia, and Germany are forced to devalue their currencies
Something blows up in the shadow banking world due to devalued collateral
The European Union breaks up
Of course, the answer could be any of these, any combination of events, all of the above, or yet other possibilities. In addition, in order to navigate the landscape safely, it will be just as important to incorporate potential fiscal and monetary policy responses. In this capacity, it will also be important to consider not just economic, but also geopolitical goals.
The bottom line is a lot of forces are coming together all of which seriously threaten both stocks and bonds. The single best thing to do in the foreseeable future is to seek safe cover until the coming storm blows over.
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