Observations by David Robertson, 6/21/24
For a quiet summer week with little data and a holiday in the middle, there was still actually quite a bit going on. Let’s take a look.
As always, if you want to follow up on anything in more detail, just let me know at drobertson@areteam.com.
Market observations
Momentum continued to be the dominant factor this week with artificial intelligence remaining the key theme, and really the only theme. Importantly, however, breadth in the market is actually decreasing. This suggests for all the hoopla surrounding AI, the good news is not making it to the rest of the economy, at least not yet.
One of the reasons for the narrow leadership, and the continued rise of major US stock indexes, is the flows of capital into US markets from other countries. As Michael Howell points out, “Momentum investing is driven by capital flows. Look there for the explanation and that is a USD story.”
Brent Johnson, who has long advocated the same concept in the form of his “milkshake” theory, posts an illustration:
In short, for all the shortcomings of the US dollar (USD) as a currency, it is still better than all the other fiat currencies. As a result, money flows into US asset markets at least partly as a currency hedge.
On the topic of foreign markets, France remains very much in the news ahead of its election. As the marketear.com ($) reports, “France has gone from the most preferred European overweight to the biggest underweight in a month.” This reveals two interesting insights.
One is the surprise election in France gives an indication of the types of events that can cause capital to flow elsewhere. Another is how rapidly the investment landscape can be thrown into upheaval. France went from a significant overweight to a significant underweight in less than a month, all due to elections being called. This is a good example of the type of fragility that permeates most capital markets at the moment.
Finally, Japan’s monetary policy direction is gradually becoming clearer. Baufinanciaphaster relays comments made by BOJ (Bank of Japan) Governor Ueda: “Reduction in JGB purchases will be in considerable volume, will be decided immediately at the July policy meeting after consultation with market participants". Things are getting real in Japan.
Credit
French Kiss ($)
https://www.yesigiveafig.com/french-kiss
Like the late 1990s, credit quality is increasingly perceived as a function of equity market value. In the late 1990s, creditors were eager to lend to aggressively spending ISPs, CableCos, and telecoms because their equity values suggested a large margin of safety. We are here again.
So we are now seeing indications that DEMAND for credit may begin to lose a key pillar, while the SUPPLY of credit is being pushed higher by looming maturities.
There are a lot of good insights in this piece for those interested in the mysteries of the credit markets. For those satisfied with the tl;dr, the message is simply that we are in another boom whereby credit markets are supported by inflated equity valuations. Those valuations help create the appearance of security of credit, but in actuality serve to mask its fragility.
The issue is even more acute now as both supply and demand for high yield credit is changing for the worse. On one hand, “high yield issuance has begun to rise as tight credit spreads and a looming maturity wall have encouraged new issuance”. On the other hand, “Like the precursor to the GFC, the risk has become the risk-free rate — high yield issuers simply cannot afford issue new paper at higher yields”.
Clearly, there will be losses on loans that cannot be economically refinanced and clearly, those problems will start being realized at a large enough scale to matter this year. The main questions are, “When, and to what extent, do authorities step in to cushion the decline?” Unless there is a major threat to the functioning of the Treasury market, I suspect investors will be surprised at the newfound discipline. After all, putting a brake on rapid debt accumulation was the objective to start with.
Housing
Here’s an interesting take on housing from Gunwale Capital:
Everyone thinks the housing market is up 50-100% since Covid, but that is based on an abnormally low number of transactions. Most owners are sitting there thinking they have this massive amount of equity they can unlock whenever they want because 2 houses in their neighborhood
Have traded in the last 12 months at ATH prices. I think people are waiting for the first FED cut to put their house on the market as they think value increases when that happens, and instead what we are going to see is more houses come on the market than expected, all at once.
A few of those sellers will actually need to sell as they held out too long and will start offering their houses at lower and lower prices and it will cause a cascading effect. Put another way, i think high rates have caused the market to seize, and the values most are using as
Benchmarks for pricing will turn out to be a mirage when the market starts functioning again. And just like there is a feeding frenzy now in the market, there will be a buyers strike when things turn back on as people will “wait for a lower price.”
This is a very interesting hypothesis that also dovetails with a couple of assumptions I find to be useful: Covid and the policies to deal with it are still causing significant disruptions in the economy and those disruptions are causing a lot of counterintuitive relationships.
On the first point, much higher mortgage rates combined with still-high home prices are causing the number of transactions to fall considerably. Many fewer transactions mean poorer price discovery which means “market” prices are a poor representation of real underlying value.
On the second point, normally one would expect asset prices to rise when the discount rate falls. But that’s only relative to good price discovery to start with. If you start with inflated prices and pent-up selling (excess supply), then the effects of better price discovery could easily swamp the effects of lower rates.
Now do the same for stocks, private equity, commercial real estate, venture capital, and on and on. I certainly don’t think rate cuts are highly likely to cause a big selloff in assets, but I do think it is a distinct possibility. Interesting.
Geopolitics
Trade is rapidly moving up the ladder of important subjects in the both the political and geopolitical realms. While I have reported on the issue numerous times, this thread by Michael Pettis captures the complicated reality in a fairly simple construct:
Every country will insist that its trade partners are behaving unfairly and acting disruptively, but, as Joan Robinson explained in her famous 1977 essay, "In the beggar-my-neighbor scramble for trade during the great slump, every country was desperately trying to export...its own unemployment. Every country had to join in, for any one that attempted to maintain employment without protecting its balance of trade (through tariffs, subsidies, depreciation, etc.) would have been beggared by the others."
This neatly fuses a couple of issues that are often confused. First, while comparative advantage is one potential cause of trade surplus, another potential cause is the “export of unemployment”. They have very different implications.
When countries like China “export unemployment”, it really forces every trade partner to join in erecting barriers for fear they will end up being on the short end of the unemployment stick. This explains why trade policies can be so emotional (because they touch on economic security) and why they can be so contagious (because they spread geopolitical insecurity).
The bottom line is don’t expect trade issues to suddenly or magically disappear unless the root causes are addressed and dealt with. There is no silver bullet.
Politics
WHY ARE YOU BUYING BONDS? ($)
https://www.russell-clark.com/p/why-are-you-buying-bonds
But simplifying the political maths, we can just look at the changing voting power of baby boomers. Baby boomers are defined as people born from 1946 to 1964. In the UK, that gives us a group 14.4mn people. In 1979, when Thatcher was elected, they were 26% of the population. They are now 21% of the population, and falling in numbers everyday. In other words, their relevance as a voting block is now in decline. Politically, it was impossible to ignore their wishes from 1980s onwards. From 2024, the baby boomers need to scrap with everyone else.
Sure, this is based on UK numbers but the dynamics are the same: The Baby boom generation that changed consumerism, economic growth, politics, and everything else it came into contact with is now on the decline. As a result, the generation’s influence on all those aspects of society will be on the decline as well.
According to Neil Howe, one of the defining traits of the Baby boom generation is a penchant for risk-taking. The formative experience of boomers (in general) was that of growing up in a post-war world that was growing AND that absolutely did not want to relive the horrible experience of war. The sky was the limit in terms of opportunity and the chance of things going horribly wrong was negligibly small. Not surprisingly, this environment encouraged risk-taking. I suspect lots of competition with other boomers fueled the same tendency to take risks.
Those tendencies manifested themselves in an ethos of an intense drive for growth and little concern for consequences. Politically, they manifested in policy programs like neoliberalism and the favoring of capital over labor.
As the boomer generation declines, then, so too will support for such political tendencies. Further, due to the extreme degree to which boomer tendencies have been expressed, an increasing amount of backlash is emerging in younger generations.
For example, the practice of growing at all costs has resulted in an enormous burden of public debt, a great degree of environmental damage, and an extremely high level of inequality. Not only are these liabilities being unfairly thrust on future generations, collectively they significantly undermine the American Dream.
So, as boomers decline in political influence, and the pushback from younger generations increases, it is fair to expect “pro-boomer policies to be reversed”. This has less to do with Republican or Democrat political positions than it does with changes in longer-term societal preferences. I suspect this will become increasingly evident after the US presidential election, regardless of who wins.
Monetary policy I
From a high level strategic perspective, I think it is fair to say monetary policy is essentially rigged. I mean in the sense that it is “heads I win, tails you lose” for asset owners. Of course, this is a nearly perfect illustration of the ongoing political tug-of-war between “labor” and “capital”. For the last forty-plus years, capital has been winning and labor has been losing.
One of the ways monetary policy has supported capital is through excess liquidity. Indeed, during and shortly after Covid, liquidity served as a powerful indicator for markets.
More recently, however, liquidity has leveled off even as stocks continue to run. Robert Armstrong reported ($) at the FT reports:
Focus first on the federal liquidity proxy, the mid-blue line, which is the sum of all the other components. It peaked at about $7tn at the end of 2021, driven up by the Fed’s bond buying (the dark blue line), and fell to $5.8tn by early 2023, as the Fed let bonds roll off its balance sheet and absorbed liquidity with reverse repos (the green line). Since then, federal liquidity has ambled sideways, as rapidly declining repos have released cash, offsetting a smaller Fed balance sheet and a rise in the Treasury general account.
One of the clearest links to the resurgence in stocks last fall was a modest change in Treasury policy. Although the Treasury announced only a very small reduction in the amount of long-term bonds it planned to issue, the signal was huge: The Treasury would not stand for 5% yields on the 10-year Treasury.
CrossBorder Capital explains what is happening: “Janet [Secretary Yellen] is duration managing US debt by shortening tenor of calender. Banks are buying = monetization.” So there you go, it’s just liquidity provision by a different, less visible means. A case of moving the goal posts, if you will.
What does all this mean for investors? For one, no monetary official wants to be accused of causing the party to stop so it is unfair to expect any kind of courage in preventing things from going too far. In addition, monetary policy typically follows politics. As a result, as long as capital continues to prevail politically, monetary policy will remain loose.
All that said, there are signs that the regime of easy money is approaching its twilight. Politics is changing and labor is unlikely to be satisfied with platitudes while assets rage higher. In addition, the room for maneuver in monetary policy is rapidly diminishing. The costs of excess liquidity are becoming more widely appreciated and the room to forestall increased issuance of Treasury bonds is rapidly running out. Also running out are the days in which investors could simply follow monetary policy as a guide to making money.
Monetary policy II
As investors have been basking in the monetary nirvana of lower inflation readings and decent economic growth, a couple of inconvenient truths emerged this week. First, the CBO (Congressional Budget Office) updated its forecast for the federal deficit for fiscal 2024. That estimate was $1.5T in February but is now $1.9T. Oopsie. Ed Bradford succinctly evaluates the consequences: “More UST auctions coming our way”.
Second, news came out that Japan’s fifth largest bank, Norinchukin, intends to sell $63B of US and European government bonds by March 2025 (h/t Zerohedge). The goal is to stem losses from bets on older vintage low yield bonds. For one, the amounts are large enough to matter. For another, this will further increase supply challenges at a time of already rising issuance. For yet another, it could induce a “run” on US and European government bonds from investors trying to front run the selling from Norinchukin.
I think both of these are big deals that will fundamentally change the complexion of government bonds markets going forward. Norinchukin is not the only bank with underwater Treasuries on its books, not by a long shot. There will be others. As selling pressure increases, the pressure for yields to go up will also increase. It’s only a matter of time before those higher long-term bond rates will impinge on growth.
That said, I also don’t think there is a big chance of a financial crisis. Respective monetary authorities should be fairly well aware of where the problems are and are committed to doing “whatever it takes” to preserve the smooth functioning of their government bond markets. Messy, yes; disaster, unlikely.
Investment landscape I
I have mentioned the challenges of illiquidity (in this case, liquidity is the ability to sell without materially affecting the market price) before but JustDario provides a nice update in this post:
US Pension funds status chek
Cannot get out of US Treasuries because under water
Cannot get out of MBS and CMBS because under water
Cannot get out of Private Equity (sorry WSJ, but this was an open secret really)
Some large ones already borrowed debt already to meet pension payments
Invested heavily in obscure Hedge Funds
They are the main investor in the unregulated, but now beyond hundreds of billions size, “Buy Now Pay Later” loans (article below)
Narrator 1: Mag7 at nosebleed valuations is what’s “saving” their investment portfolio so far - fyi
Narrator 2: Insurances are dealing with similar problems
Narrator 1: Oh dear
In short, more and more of the go-to pension fund and insurance company investments cannot easily be sold for cash. This usually isn’t a problem when it’s just a single security or a small asset class. Unfortunately, the problem is metastasizing across several large asset classes.
This usually results in one of two different scenarios: Either there is a forced sale of illiquid assets that causes prices to collapse, or there is a bailout by a public entity. Banks were bailed out in the GFC because they were considered critical to the functioning of the financial system and are deeply interconnected. Insurance companies and pension funds are considerably less critical and interconnected.
Implications
One of the hardest things for an investor to do is to reduce stock holdings and then proceed to watch those stocks go up - and up! However, just about anyone who has actively invested for any length of time (e.g., several years) knows two things. One is trying to sell at the very top is a fool’s errand that normally results in losses, not even greater gains. Relatedly, another is that if you don’t know exactly why a stock (or the market) is going up, you’re not going to know exactly when to sell it.
I get the sense an increasing number of investors are getting uncomfortable with the investment environment but just can’t bring themselves to reduce holdings when stocks are still going so strong. Unfortunately, this creates the conditions where a sharp decline can happen completely out of nowhere and with no specific catalyst. I’m getting an uneasy feeling the probability for such an event is increasing.
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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