Observations by David Robertson, 6/7/24

As I have been working my way through news and research lately I have noticed a distinct lack of substance. As a result, I’m going to change tack a bit this week. The dearth of substantive news provides an opportunity to take in the bigger perspective so I will focus more on a high-level view of the investment landscape. 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

The week kicked off with another performance by GME which almost doubled overnight based on another social media post from Roaring Kitty. While the stock settled down during trading hours, it still finished up over 20%. As Almost Daily Grant’s (Monday, June 3, 2024) put it, “The proliferating popularity of lottery-ticket trades likewise illustrates the current speculative fervor.”

A number of commodities got a good beat down on Tuesday. The proximate cause was weak economic data in the form of ISM manufacturing and JOLTS (employment) data. Evidence of weakening economic growth sent the 10-year bond racing higher and the yield plummeting lower. Stocks did worse than underlying commodities. Love was in the air for bonds and some tourists in commodities got flushed out.

New all-time highs were reached in stocks on Wednesday on the basis of Nvidia’s continued rise and the assumption that weak economic data will accelerate rate cuts. For the time being it looks like investors are seeing what they want to see in the data.

Also of note, the Mexican peso got hammered after the landslide election win by Claudia Sheinbaum. This is important for a number of reasons not least of which is the fact MXN (the Mexican peso) has been a prominent component of carry trades. Themarketear.com ($) reports: “Borrowing in JPY and ‘yielding’ the MXN has been a popular trade for a long time. The trade just experienced a massive loss yesterday”. These are the kinds of events that can blow up hedge fund pods and ripple across the financial waters.

Politics

Chartbook 287: After the verdict: American money and Donald Trump

https://adamtooze.substack.com/p/chartbook-287-after-the-verdict-american

The other version of this Trumpian diagnosis of crisis is more cynical. Rather than insisting on Trump’s innocence, it argues that America is a swamp shot through with quid pro quos, deals, evasions, routine and not-so-routine illegalities etc. Trump is a player in this swamp. He openly boasts of avoiding tax, as far as he possibly can. But, Trump is just one player amongst many. Joe Biden and his entourage, like the Clintons before him are all “crooked” too. Everyone “in the know” understands these facts about American life. Everyone who is anyone “plays the game”. The crisis consists in the fact that Democrats in a sanctimonious fashion are choosing to victimize Trump, and weaponize the law against him whilst overlooking the peccadilloes of their own side.

Does the felony conviction not put them [donors] off you might ask? Perhaps. But most Americans, especially rich Americans, regards the courts, part through experience and part through lore, not as neutral places for the finding of truth or justice, but as arenas of “lawfare”. If Trump lost a battle, it is time to rally around and to make doubly sure that he wins the war.

The reality of American wealth and power is … banal. The conspicuously consuming celebrities and jet-setting cosmopolitans of popular imagination exist, but they are far outnumbered by a less exalted and less discussed elite group, one that sits at the pinnacle of the local hierarchies that govern daily life for tens of millions of people.

This piece by Adam Tooze reveals a number of interesting tidbits about the political environment. First off, he highlights America as “a swamp shot through with quid pro quos, deals, evasions, routine and not-so-routine illegalities etc.” I think there is a lot of truth to this.

From the neoliberal policy bias that left US workers with a raw deal to the moral hazard of supporting banks in the GFC to the carry regime enabled and strengthened by the Fed’s Quantitative Easing, policy bias has been less about effectiveness and more about what those in power get out of the deal.

This ethos of “deals and evasions” has pervaded more than just the political environment and is widespread throughout society. Worse, “Everyone who is anyone ‘plays the game’.” This makes the behavior contagious and normalizes the justification of questionable means in the pursuit of desired ends. In short, it creates a toxic permissiveness that persistently erodes society’s moral fabric. For better and worse, this is the political and economic environment in which we live.

Another interesting point raised is the notion that a number of very wealthy people regard the courts “not as neutral places for the finding of truth or justice, but as arenas of ‘lawfare’.” I think this is also true, although I don’t think it is remotely a monopoly of Republicans (see Sam Bankman-Fried, the product of two Democrat law professors). The main point is there is an audience of people who very much want to preserve their status of being above the law, or at least insulated from it.

Finally, there is an important insight regarding the “less exalted and less discussed elite group” referred to as the “American gentry”. These are people who are not billionaires, but they are very wealthy. Further, their occupations don’t require exceptional skillsets such as engineering wizardry, visionary entrepreneurialism, or humanity-saving efforts. Nope, the “majority of the country’s 140,000 Americans who earn more than $1.58 million per year” are comprised of “Car dealers, gas station owners, and building contractors”. I think this goes quite a ways in understanding why “The reality of American wealth and power is … banal”.

Oil

One of the more notable market moves this week was the decline in oil. The OPEC+ meeting over the weekend was the most obvious catalyst. As Rory Johnston summed up in his Commodity Context Substack there were both puts and takes:

OPEC+’s production policy announcement on Sunday, June 2 contained multiple both bullish and bearish elements—while the immediate balance outcome is modestly bearish given only a Q3 extension of the latest tranche of cuts followed by an explicit plan to begin winding them back, the guidance puts the producer group on an inherently more sustainable path. Furthermore, the producer group made considerable progress on addressing ongoing challenges to group cohesion and communicated the details—at least after the immediate meeting day dust settled—in a far more coherent and transparent manner than we’ve seen out of recent meetings.

In the short-term, Johnston describes the outcome as “modestly bearish” since continued support of existing production cuts seems to be wavering. That seemed to be just enough to push some speculative interest out of the trade as it forestalls the day when demand sustainably exceeds supply. The vibe from commodities trader Alyosha is, “Capitulation is finally underway in crude and with it, product cracks and product front spreads could be making seasonal lows, soon.”

A couple of implications derive from this. First, lower product cracks suggests gas prices could be coming down over the summer and that would create a very visible (but also very limited) indication of moderating inflation. Second, oil prices are closely associated with economic growth and with downward pressure on oil prices, there will be a natural assumption global economic growth is slowing down as well.

That said, I strongly suspect this short-term weakness in oil has mostly to do with OPEC+ and the release of speculative positioning. As a result, it would be unfair to interpret the downward move in oil as a read into slowing growth.

Investment landscape I

The market feels like it is stuck in a kind of purgatory waiting re-engage in a new narrative to follow. Artificial intelligence is still getting headlines, for sure, but is rapidly losing dominance as a market-moving force. Rather than providing play-by-play commentary on the mainly trendless activity going on then, I think this is a good time to take a step back and take in some perspective.

My sense is the directionlessness of the market is largely due to an unsettled view on long-term interest rates. One side argues that the cumulative effect of rate hikes is increasingly impinging upon the economy and it’s only a matter of time before growth slows down and inflation with it. This view has been boosted by a weakening GDP outlook, weak ISM numbers on Monday, and falling oil prices.

The other side of the argument is that long-term rates are likely to go higher. This view is predicated on the notion that rates have been artificially suppressed ever since the Fed started Quantitative Easing during the GFC. A simple normalization of rates to their historical relationship to GDP and inflation would put a 5-handle on long-term rates. Further, with the likelihood of continued significant federal deficits, large quantities of Treasury bonds will need to be issued. In the context of a shrinking audience for Treasuries, higher yields are likely to be needed to meet the onslaught of supply.

Until this debate gets resolved with some certainty, there is likely to continue to be a back and forth between the competing theories. Until then, here are some discussions to illuminate the analysis …

Investment landscape II

Jim Bianco: Rate Hike on Deck

https://www.macrovoices.com/1315-macrovoices-430-jim-bianco-rate-hike-on-deck

But one of the things I think that'll drive those yields higher, is expanding real yields. If you look back prior 2009, say, from the 1980s to 2009. What was the average real yield? It was around 2%, meaning that whatever the inflation rate average during that period, interest rates averaged 2% above that. As I talked about with R* [the neutral interest rate] a second ago, I thought we would get 1% above the long run inflation rate of 3%. But ultimately, I think real yields might not even stop at 1%, They’ll go to 1% now, but ultimately, they might go to something approaching what we saw pre financial crisis at around 2%. So we're going to continue to get this push up in yields.

Now, keep in mind, a lot of people are really struggling with what this means if we're going to have big real yields. And if we're going to have higher nominal rates, like in the 4% or 5% or 6% range for long term interest rates, they're still have a mindset of 2010 to 2020. That if into rates go above 2%. That that's bad? Well, it depends on why interest rates are going up. But if we're in a higher nominal growth world, we're in a 2% inflation, you know, 2% to 3% real growth world because the government is just spending so much money and plus inflation. That's actually normal interest rates. That's actually nothing to get worked up about. You would like to have back down at 1% or 2% interest rates for long term interest rates, like we had from 2010 to 2020. That's a different era right now. So I do think we should expect to see higher real rates.

The “different era” of which Bianco speaks highlights a critical element of the debate about rates. If you believe the neutral rate of interest is 2.5%, which is what the Fed is still promoting, the you are expecting quite a few rates cuts to get there. If you believe, as Bianco does, that the neutral rate is in the 4s somewhere, then you are only expecting a few rate cuts because we aren’t that far off neutral now. As Tom Porcelli, PGIM Fixed Income’s chief economist described in John Authers’ letter on Thursday, “It’s really normal for longer.”

Another point Bianco makes is in regard to the dominance of the S&P 500. As he points out, in the minds of most investors, there is little reason to consider alternatives to stocks or “safe” assets. Given the experience since the GFC, why would they think about anything else?

Now, you asked me about precious metals, and I'm answering about the stock market and the reason why I'm answering about the stock market is why would I get myself all worked up about $2,400 in gold, when I can buy this thing that only goes up, and that the guy with the unlimited printing press will make it go up when it doesn't go up. So why would I think about anything else? And that's where I think we're stuck with domestic investors right now. They're so mesmerized in the stock market.

Investment landscape III

THE END GAME EP 50 – LE SHRUB ($)

https://www.grant-williams.com/podcast/the-end-game-ep-50-le-shrub/

So just to keep it simple, so Freddie Mac made an application to the FHFA to offer secondary mortgages to its clients. Now, to keep this simple, if you have a mortgage with Freddie Mac, you can borrow up to 80%, an additional mortgage. So it’s like an equity release mechanism for people, but you don’t have to refinance your first mortgage, so you just add on top. Which is very elegant because now if you’re a boomer and you own a house, you go and get a consumer loan unsecured, you’re going to pay a much higher rate, so you can go to Freddie Mac and borrow it at a more sensible rate.

And this whole thing could release about $1 trillion worth of consumer spending power to the homeowners. And if you add Fannie on top, if Fannie does the same, that’s another trillion. So you’re talking about 2, 3 trillion dollars that could get unlocked of consumer spending power.

And the second thing that, again, no one is talking about, which, again, I’m not in the US so I’m not sure if I’m missing something, but I don’t see it mentioned, is the supplementary security income. So basically, the expand expanded the definition of households that qualify for supplementary security income to include households that are now receiving SNAP payments, which is Supplementary Nutrition Assistance Program.

So here’s the numbers. So right now in the US, 7.4 million people receive SSI, so the supplementary security income. And on average, that’s like $650 a month. But on the other side, 41.9 million people get SNAP payments. So that’s 12% of the population gets SNAP. So basically right now, this is going to get implemented September 30th, right now you’re going to have five times more people that can get a check of the SSI.

One of the arguments I made in the Outlook piece at the beginning of the year and have been making for some time is that concern about weakness in the economy is overstated because “modest real economic growth is basically a policy objective”.

As I stated then, growth “is being nudged along with help from fiscal spending”. That spending can be formal or informal. We have all heard of the CHIPS Act and the Inflation Reduction Act, but the informal measures count too. On this subject, Le Shrub revealed a couple of important developments.

First, the prospect of Fannie Mae and Freddie Mac offering secondary mortgages creates an opportunity for consumers to convert a valuable asset (their home) into near-term spending capacity. This provides “an equity release mechanism” for people and does so at a very competitive interest rate.

Second, the population eligible to receive supplemental security income (SSI) is set to increase significantly from several million people to 41.9 million. Neither of these changes were the result of laws but rather administrative rule changes. The end result is the same: There will be more money flowing to US consumers. Based on examples like this, I have a hard time believing the economy is going to get very weak for very long.

Investment landscape IV

One of the more prominent views supporting the market is the belief that public officials will provide remedial liquidity if any glitch in the market appears. This view got endorsed last year when in light of 10-year Treasury yields touching 5%, Treasury increased the proportion of bills issued instead of risking further pressure on the longer-term bonds.

The short-term success of this maneuver has led some to wonder why this can’t be done indefinitely. To that question, Andy Constan posted an instructive thread on various scenarios for Treasury issuance. He concludes with the following message:

Debt crisises [sic] but nonetheless a political if less certainly an economic issue would be created if the Treasury made such a choice and then saw rates spike. Weak USD and volatile deficit is the reason why using bills is generally for emergencies only. At 5300 SPX we expect …

That the treasury will issue less than 25 % bills over the next two years

In short, bills are no miracle cure. They provided a one-time get-out-of-jail-free card for Treasury last fall, but that is all. Going forward, it’s going to be virtually impossible to avoid the negative effects of higher coupon issuance.

Investment landscape V

If these aren’t enough, there are other arguments for long-term rates going up as well. Michael Howell notes the "Most important price in financial mkts [US Treasury yield] is being distorted lower by 80bp!” In addition, as long rates in Japan continue to rise, the differential with those in the US continues to shrink and the incentive for Japanese savings to return home increases. That would mean Japanese money moving out of US stocks and bonds where it has been parked for years.

So, judging by this evidence, the question of whether long-term rates go up is not a matter of “if”, but a matter of “when” and “how”. As to the “how”, both Bianco and Le Shrub make mention of a “Liz Truss moment”. This was when in fall of 2022, newly elected Prime Minister of the UK, Liz Truss, presented a budget with significant tax cuts but continued spending. Investors judged the budget to be irresponsible and yields on gilts (UK bonds) blew out and disrupted global markets. In other words, if the deficit is not addressed at some point, there is likely to be some kind of disruptive move up in yields which causes financial markets to seize up - and it won’t necessarily take much of a push to get there.

As to the “when”, both Bianco and Le Shrub point to after the election in November, but not much after. That suggests the first quarter of 2025. I had thought that day of reckoning would come this year, but it’s understandable that efforts to clear the path for the election could forestall it for a bit. Regardless, that day is almost certainly coming, it’s just a matter of when.

Implications

As a result of the long-term rate debate, investors are stuck with a conundrum. On one hand, investors continue to have a great deal of confidence in the S&P 500 and why not? Authorities have exhibited time and again that supporting stocks is (or at least has been) a policy priority.

On the other hand, a nearly perfect storm of structural forces are pushing against financial assets and those forces cannot be kept at bay indefinitely. This puts investors on a collision course with fate.

That fate will be determined by two primary factors. One is sustainability. If we truly are approaching a Liz Truss moment, it won’t take much to tip the scales over. I suspect this is right. However, if officials can pull a few more rabbits out of their hats and investors don’t push back, the life of excess can continue.

The second factor is the direction of politics. If the trend towards favoring labor over capital continues to progress, their will be little sympathy for what happens to stocks or bonds. The favoritism to capital is especially pronounced in the US, however, and intense lobbying could impede the rate of progress for labor.

In sum, it’s still hard for investors to go against the grain by betting against the S&P 500. Nonetheless, long-term investors have a big incentive to avoid and/or manage the downside risk. The good news is the selloffs in commodities and industrial companies this week creates better entry points for those who are interested in their longer-term diversifying benefits.

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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