Observations by David Robertson, 7/1/22
Wow - what a quarter and first half of the year! We enter the third quarter with a lot of uncertainty and a lot of unresolved issues. In other words, don’t expect the drama to let up any time soon. In the meantime, however, I hope you have a great 4th of July!
As always, let me know if you have questions or comments at email@example.com.
One of the more interesting phenomena throughout the first half was the continued enthusiasm for speculative buying, even in the context of suffering multiple beat-downs. The exemplar of this category has been the ARK innovation fund (ARKK). Despite being down 58% year-to-date (as of 6/30/22), the fund has “garnered net inflows in each of the past eight trading days, totaling $639 million” according to Almost Daily Grant’s on Monday, June 27.
One observation is it’s almost as if different sets of investors had totally different interpretations of the facts on the ground. Hmm. Another observation is that after 15 years of encouragement from low rates and a Fed backstop, it is going to take a lot more than a couple of bad quarters to tame speculative frenzy.
On the economic data front, the PCE (personal consumption expenditures) was the most anticipated number. May came in at 6.3% which was the same as April’s print and therefore an anticlimactic report. The inflation narrative is not settled.
The other piece of economic data of note was initial jobless claims which came in nearly equal to the prior week but clearly showing an upward trend. As such, the recession narrative is winning out as the key driver for the time being.
The polycrisis we are in the midst of, is fast-moving, complex, heterogeneous, interconnected, explosive. One comfort, at least intellectually, is that we are in it together. If you are feeling confused and overwhelmed you aren’t on your own. No one is outside the current conjuncture. There are different vantage points, with different perspectives, but no single point and no single theory that encompasses our reality and provides an absolute point of view.
Specifically, we have never seen such a combination of already rapid inflation and rapidly slowing growth with elevated financial vulnerabilities, notably high indebtedness against a backdrop of surging house prices.
Adam Tooze raises several important points in this wide ranging piece. A big one is emphasizing just how unique and unprecedented current conditions are. The problem in dealing with unprecedented conditions is there is no, well, precedent to provide guidance. While various historical periods can provide some useful perspective, the range of possible outcomes is huge.
Another point is the slowdown is coming fast. This is the difference between being in a car when the driver eases off the gas pedal and when the driver slams on the brakes. The violent deceleration is likely to cause its own set of problems.
Finally, none of this is easy to analyze or manage. As Tooze puts it, “if you aren’t puzzled you don’t get it. This isn’t your common or garden slowdown. Admitting to disorientation is a sign of honesty and realism.” In other words, beware scenarios that are simple or straightforward.
As we try to calibrate the speed and depth of the slowdown, this reminder by Albert Edwards is helpful: The year-over-year change in fiscal stimulus is going to be negative all year which means doing nothing will leave a significant headwind to growth.
Importantly too, this is not a surprise. I highlighted the phenomenon of slowing fiscal spend back in the 9/3/21 edition of Observations - and it is playing very much as expected.
By the same token, this tweet from Tavi Costa provides a good reminder of what to expect in regard to the trajectory of corporate margins. As costs go up, margins will come down. In addition, at some point, companies will need to decide between lower sales or even lower margins. That is likely to be a defining moment for stocks.
China’s middle-class angst ($)
The new buzzword for Chinese people sick of being locked down is ‘runxue’: the study of leaving the country completely
The runxue phenomenon highlights that ordinary Chinese are deeply frustrated. Their day-to-day freedoms hinge on the results of mandatory Covid-19 tests, often taken every 48 or 72 hours. Their minds are occupied by the immediate risks of strict quarantine in state-run facilities, separated from their families, as well as deeper anxieties over job security and falling household incomes as the economy teeters on the edge of recession.
China seems to retain a certain mystique with a number of investors that involves a belief in its persistent ability to grow. This belief survives despite factors such as rapidly aging demographics, a massive debt burden, a broad restructuring of its real estate industry, heavy dependence on imported energy, and a regime of strict lockdowns for Covid.
As is often the case with foreign or unfamiliar venues, it is useful to observe what the locals are doing. In China, increasingly, people are trying to leave the country. As the FT puts it: “They don’t feel like there is a future with the repressive political atmosphere and weak economy. They’re voting with their feet.”
This is not what I would call a leading indicator for a big burst of growth. Rather, it is yet more evidence of the enormous headwinds China is going to be facing for years to come.
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Banks and finance
With an explicit lender-of-last-resort, it would be difficult for a funding squeeze to escalating like it did in 2019, even if the current large pool of marginal private cash lenders slowly dwindles over time.
Where unsecured markets dominated in the past, the reference rates in a Eurodollar 2.0 world are set onshore by dealers and arbitrageurs in secured markets with explicit policy backstops and highly centralized clearing and custody. By creating a full rates curve using HQLA securities and nearly frictionless netting, the Treasury repo market has completely overhauled how the price of money is set.
One of the points I have made several times over the last few years is to highlight the important ways in which banking has changed. This Substack post provides a nice overview of the changes.
It important to be aware of the changes for a couple of reasons. First, there are a lot of people who took a few Econ courses a few decades ago who think they have a better understanding of banking than they do. Many changes in regulations, public policy, and money market operations have rendered much of that learning obsolete. It’s not anyone’s fault; it’s just a reality that things have changed a lot more than many people realize.
This is problem is exacerbated by the fact the Fed and other policymakers often speak in terms of those antiquated principles. This can lead to a lot of misunderstanding.
The good news is with some fairly recent Fed interventions it is much less likely “we see a repeat the 2019 repo spike.” So, at least for now, repo is a less likely suspect for the thing that breaks.
The bad news, however, is money markets and the banking system continue to evolve and many aspects remain untested by crisis. All we really know is “when we do arrive at a new normal it will be very different from 2018 or 2007 or any other time in the past.”
Throughout his concurrence, Kavanaugh maintained a laser-like focus on what he sees as the justices’ limited role in answering the profound questions before them. “The issue before this Court … is not the policy or morality of abortion. The issue before this Court is what the Constitution says about abortion,” he wrote. “The Constitution is neutral and leaves the issue for the people and their elected representatives to resolve through the democratic process in the States or Congress—like the numerous other difficult questions of American social and economic policy that the Constitution does not address.”
“Because the Constitution is neutral on the issue of abortion, this Court also must be scrupulously neutral,” he continued.
But that’s [the decision to overturn Roe v. Wade] not the end of the story. Not by a long shot. The two sides of the great American divide are now staring at each other and asking, “Now what?”
“Now what?”, indeed. I am going to take a chance at mentioning an extremely polarizing issue for the purpose of highlighting what I believe to be an increasingly important phenomenon: The continued deterioration of our government institutions. The first quote is from The Morning Dispatch and the second is from David French.
When I peal away all of the drama and partisanship from the Roe decision, I see two contradictory realities. First, on a strict basis of interpreting the Constitution, the original Roe decision probably went too far. Second, on a practical basis, the Roe decision provided an important protection for women and a protection that most of the country wants regardless of how infrequently it is actually used.
In other words, if the primary argument against Roe is overreach, then how should representation of the citizenry be weighed? Consider a slightly different situation. The Fed is a central bank and as such really has only one job - to maintain stable prices. However, it also has also received a mandate to ensure maximum employment. Is this overreach by the same standards? Absolutely!
So, why are these organizations [the Supreme Court and the Fed] burdened with responsibilities that rightfully should fall to elected authorities, i.e., Congress? The reason is, in my opinion, Congress has been shirking its responsibility for years. When Chuck Schumer called the Fed “the only game in town” in regard to dealing with the GFC, he was effectively acknowledging that Congress was abdicating its responsibility.
There is an analogy with the business world. Often conditions are too dynamic to assign strict responsibilities and job descriptions. In order to get things done you need people who step up to do those things regardless of whose “job” it is. The world isn’t a perfect place, but it doesn’t need to be. On the other hand, what you don’t need is people saying, “That’s not my job”.
What I observe and interpret is that as our elected officials have become progressively less able to contend with major problems. The consequences of that failing have been mitigated to a large extent, however, by others backfilling, even though it wasn’t technically their “job”. Now that the Supreme Court is proclaiming a woman’s right to abortion is not it’s job, it is breaking a tradition of admittedly imperfect process, but at least functioning policy.
What it is also doing, however, is exposing the withering inability of Congress to tackle meaningful issues. While I believe the Supreme Court erred in failing to consider Roe in a broader social context, the greater failing is with lawmakers who repeatedly fail to invest their authority to represent the people of this country. As a result, the Roe decision represents, as much as anything, the continued deterioration of current institutions to govern.
Arguably the most important actions by the Fed are the least discussed - the program of quantitative tightening (QT) that kicked off in June. The program is designed to reduce the Fed’s balance sheet that was bloated by QE and in doing so, promises to reverse the liquidity infusions of that effort.
For those keeping score at home, the Fed updates its balance sheet once a week with the H.4.1. report. Since yesterday’s report is for the week ending 6/29 it will not include any end of month roll offs. As a result, we’ll have to wait until next week to see if the Fed is on track.
Recession rally? ($)
A better way to understand things, suggested by Ed’s [Al-Hussainy] comments and proposed, for example, in a recent paper by AQR’s research team, is that it is not the level of inflation, but uncertainty about inflation that drives the stock bond correlation. The key thing that happened in the 1990s that matter is that inflation uncertainty, not just inflation levels, went way down.
A dot plot has been making the rounds lately that shows the correlation between stocks and bonds turns positive when Treasury yields get in the neighborhood of 4-4.5%. As Unhedged reports, it may well be the uncertainty about inflation indicated by higher rates that drives the correlation, not the level.
After such a long stretch of not just low volatility, but almost unimaginably low volatility, this is a useful point to keep in mind. Uncertainty dramatically increases the degree of difficulty of forecasting and the consequences of making bad forecasts.
In regard to investment planning, greater uncertainty means regimes may be much longer or much shorter than in the past, guiding metrics may go much higher or lower than in the past, and entirely unprecedented things may happen. Hopefully you are getting the picture: It’s going to be hard to home in on anything with much certainty.
Implications for investment strategy
As rates continue to go up and stocks continue to go down (mainly), a number of investors are wondering if it is time to get back into bonds. This is exactly the issue taken up recently by Alf Peccatiello in a Substack post. He uses three questions to help frame the decision:
Is the momentum of growth slowing?
Is the momentum of inflation slowing?
Are Central Banks giving us the green light to buy bonds?
On one hand, the framework is a useful one because it forces one to envision how things might change. On the other hand, the framework is incomplete in that it does not consider the relative attractiveness of stocks or cash in relation to bonds. I also think his discussion of question #3 focuses far too much on the expected effect of rates on economic growth and not enough on the supply/demand consequences of quantitative tightening (QT).
So, point one is that it is far better to have some kind of decision-making framework than none at all. Point two is while bonds are looking incrementally more attractive at higher yields, that is hardly where the evaluation should end.
Point three incorporates a prominent theme of this edition of Observations: Uncertainty has gone up a lot and that complicates all investment decisions. If one’s assumption is that inflation has been annoyingly high for some time but the Fed is on the case and will bring it down in due course, then I agree, bonds are looking more attractive. But those aren’t my assumptions.
Rather, I expect the Fed to continue being behind the eight ball in its fight with inflation. Inflation will remain persistently high because raising rates will do little to resolve the main causes of inflation which are excessive money supply and insufficient supply of key resources. Due to the lagging effect of Fed policies and its obviously incomplete knowledge of inflation dynamics, there is a very good chance its moves will precipitate either continued inflation - or deflation - or both.
John Authers ($) considers the consequences of stubbornly high inflation:
At this point, obdurate inflation, forcing rates up to 4% and beyond, definitely isn’t priced in. At the macroeconomic level, the most painful surprise over the second half of this year would be for inflation to stay sticky.
In addition, Mohamed El-Erian ($) extends the logic further:
There is another equally possible alternative [to the Fed hiking rates only to be forced to reverse due to the threat of recession], if not more likely and more damaging economically and socially: A multi-round flip-flopping Fed.
This is a world in which policy measures are whipsawed, seemingly alternating between targeting lower inflation and higher growth, but with little success on either. It is a world in which the US enters 2023 with both problems fuelling more disruption to economic prosperity and higher inequality.
In sum, I believe the evidence points to a Fed that is not in control of inflation. I agree with Authers this is not priced into the market now and I agree with El-Erian that the potential for a flip flopping Fed is significant and would be quite harmful. As a result, I am still very cautious on stocks and still not inclined to seriously entertain incremental allocations to bonds.
Thanks for reading!
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