Observations by David Robertson, 7/7/23

I hope everyone had a happy (and safe) Fourth of July! I’ll be taking a break next week to put out the Market Outlook piece and Observations will return on 7/21.

As always, if you want to follow up on anything in more detail, just let me know at drobertson@areteam.com.

Market observations

Ben Hunt sums up current market conditions as well as anyone with this one tweet:

The BBBY bankruptcy auction finished today, and total proceeds were ~$35m (BBBY IP + Baby IP) against billions in outstanding liabilities. Equity is officially worthless. And yet 16m BBBYQ shares traded today and still $230m mkt cap.

In other words, given the results of the bankruptcy auction, BBBY is demonstrably worthless. No option value, no hope that things turn around. Worthless. And yet, people are trading those worthless shares at a price that reflects $230M of value. This is worse than gambling; at least with gambling your odds of winning are greater than zero.

Another great observation regarding the yield curve by Ben Hunt appears in this tweet:

The replies here that are still focused on the inverted yield curve as a recession ‘signal’ are just baffling to me. The curve is inverted because everyone believes that the Fed has beaten the inflation problem. Inflation reacceleration is max pain trade for this market.

Two points here. One is that Hunt is right; for all the attention placed on the inverted yield curve as a leading indicator of recession, investors are missing another possible interpretation - that the expectations for permanently moderating inflation are wrong.

The second point is it is not very hard at all to make a case that inflation will re-accelerate. For one, the base effects of CPI suggests a break in the downward trend soon. CPI in June 22 was unusually high, so when that rolls off, the annualized CPI will come down. However, the number in July 22 was actually negative. As a result, there is a good chance the July 23 number will be higher which will mechanically cause the last twelve months CPI to show an increase.

The argument for re-accelerating inflation extends beyond simple base effect mechanics though. The ADP report on Thursday showed strong employment growth and annual pay increases of 6.4%. This is a point Matt Klein also picked up on. By his analysis, “what matters most are wages”. He goes on to say, “The bad news—at least for those who want inflation to return to pre-pandemic norms—is that nominal wage growth has been remarkably stable”.

Wages data is also very consistent with personal consumption expenditures (PCE) which the Fed places a great deal of emphasis on. PCE has remained in the mid-single digit range on an annualized basis. While none of this points to a lurch higher in inflation, nor does it suggest “the Fed has beaten the inflation problem”.

Oil

Rising cost of money leaves oil trade more vulnerable to shocks ($)

https://www.ft.com/content/8cb4e47e-ae81-49da-a193-accd3a6ddc7c

However, oil demand has been anything but weak. In the year to date, official data from government agencies and analyst OilX show global oil demand has grown by 2.5mn barrels a day year on year, exceeding our forecast by 0.3mn b/d.

We believe an under-appreciated culprit is the higher interest rates that have increased the cost of capital just as fears of a global recession lead businesses to reduce inventories.

Very interesting observation by Amrita Sen in the FT on oil. In trying to understand the relatively low prices for oil, demand does not seem to be the issue. Supply, however, is distorted by higher interest rates - because those higher rates create a disincentive to store production.

As a result, there appears to be a market pushing towards a breaking point. Demand is continuing to be strong while days of supply keeps going lower. As Sen concludes, “The market is on thin ice.”

Real estate

The narrative wars are flaring up in the commercial real estate sector. The latest salvo has been a declaration of stability and selectivity based on the headline price of the 245 Park property sold by SLG. Sure, low quality properties are having trouble, the narrative goes, but prime properties are holding their own.

Leave it to Diogenes (aka legendary short seller, Jim Chanos) to disabuse investors of this misperception:

And here we have Evercore pointing out that after the necessary redevelopment/re-leasing costs of over $300M, the cap rate on the $SLG 245 Park deal is 5.4%, not 4.0%. $SLG itself currently trades at an implied 6 cap.

As is so often the case, the devil is in the details. Much as nongaap earnings are often used to flatter corporate results, so too can real estate terms be used to flatter the deal “price”. These are the times when analytical work pays off by differentiating between headline value and economic value. Hint: Economic value is lower.

China

While the US and Europe continue to contend with inflation, China is increasingly facing deflationary pressures. The graph below from @SoberLook shows producer prices declining and consumer prices on the way to declining.

It is interesting to see the material contrast in pricing pressures between West and East, though arguably not too surprising. China would have had a problem restructuring its massive and over-indebted real estate sector anyway, but weak consumer demand is exacerbating the problem. There is no silver bullet to solve these problems and they are likely to hang around for many years. Price pressures are one way to keep score.

Politics

You Keep Using That Word ($)

https://thedispatch.com/newsletter/gfile/you-keep-using-that-word/

Procedural liberalism is fundamentally about curtailing the use and abuse of “arbitrary power,” as Burke and Locke would say. The idea that the president can assert the power to reward constituencies with taxpayer dollars without any congressional or constitutional authorization is a form of monarchical or authoritarian thinking. Progressives would recognize it instantly if Donald Trump had announced that he was forgiving the car loans for every American who uses a pick-up truck for a living, on the unstated assumption that they tend to vote Republican. Never mind that such a policy would probably be fairer and less regressive. 

This is a nice little exposition on political philosophy from Jonah Goldberg at the Dispatch that I found interesting for two reasons. One is it provides very interesting background on political theory that helps decipher some of the uses and misuses of political labels in today’s environment. Another reason is it highlights a vector that is becoming increasingly bipartisan: The “use and abuse of ‘arbitrary power’”.

If we examine an issue like the forgiveness of student loans, one can make the case it is good public policy (though I don’t agree) and one can certainly call it a good political move for Dems. However, it is also a use of arbitrary power. Simply re-frame the argument in Republican terms and the abuse is clear for all to see.

The point here is not to pick on one political side versus the other. Rather, just like the issue with corporate power I discussed in last week’s edition, I find the few lines along which Democrats and Republicans are both gravitating to be important portents of the future political landscape.

Geopolitics

Chartbook 224 The Wagner uprising and the centrifugal force of war.

https://adamtooze.substack.com/p/chartbook-224-the-wagner-uprising

As to the question of the state and the monopoly over the legitimate use of violence, Wagner was obviously in a grey zone. On the one hand it was deniable. On the other hand it was an open-secret that it was endorsed and backed by Putin himself, which gave it a status in a sense higher than the regular military. It was an exception defined by the sovereign and defining his sovereignty.

The serious problem this kind of organization creates is less the question of legitimacy than the rivalry between different militaries, especially when the going gets rough and it is not victory, but the responsibility for defeat that has to be apportioned.

In a system that has become reliant on an individual leader to act as arbiter between rival factions, the ability of a force made up of a few thousand troops to threaten the capital demonstrates the chaos that could unfold once Putin is gone.

Some interesting comments here from Adam Tooze on the Wagner uprising in Russia that provide some broader historical and geopolitical perspective. The picture Tooze paints is one of an inherently fragile power structure in Russia. With Putin as the sole “arbiter between rival factions”, it sparks the imagination to consider what might happen without him, or even with him if his grip loosens.

Tooze also rightly suggests the implications span far beyond Russia’s borders. The cracks that are beginning to appear in Russia’s political order could easily metastasize to other parts of the world. As Tooze concludes, “Modern wars generate massive and violent centrifugal forces. We should not be surprised if this is just the beginning.”

Public policy

Michael Pettis being about as clear as one can be on China trade policy:

Setser is right. The important point is not that the US is hypocritically doing what it criticizes China for doing. It is that in a world in which some countries engage in mercantilist policies that result in large, persistent surpluses, the rest of the world must...do the same or see the erosion of its manufacturing capacity. As we should have learned in the 1930s, beggar-thy-neighbor is always an escalating process.

As is so often the case, the politics surrounding important issues like China trade policy can become entangled with, and massively distorted by, narratives that elicit emotional responses. This causes harm by misdiagnosing the underlying problem and therefore also misdirecting ideas for public policy cures.

Michael Pettis has been clearer and more consistent on this topic than anyone else I know. The underlying problem is weak domestic demand in China. Because demand is weak, production must be exported elsewhere. Because the US dollar is the global reserve currency, the US plays a large role in absorbing China’s excess production. Because the US absorbs so much excess production, it must accept either higher deficits and debts, or higher unemployment.

The bad news is the China trade issue still incites a lot of emotional, and not very thoughtful responses, which vastly complicates policymaking. The good news is the underlying problem is fairly straightforward and the policy options fairly limited. In other words, it’s not an especially difficult problem to solve as long as the political capital exists to do so.

Investment advisory landscape

Nice observation by Andy Constan in this tweet:

I'm surprised more isn't being written about the 10% annual carry drag on 3x levered ETF's in both directions.

He references the tickers TQQQ and SQQQ but the point is widely applicable. When rates are zero, the incremental cost of leveraged funds is trivial. When rates are higher, the costs of leveraged funds get big fast - to the point of very significantly impairing net returns.

A bigger point is there are a lot of funds that get marketed that are just bad deals for investors. The problems are often centered around exceptionally high cost structures, but can also relate to unusually high risks relative to fairly pedestrian returns. The bottom line is, there are a lot of crap funds out there. It pays to figure out what you are getting.

Landscape I

I’ve been reading Matt Stoller’s book, Goliath, on corporate power and the historical roots of anti-monopoly sentiment in the US. Reading through the vast involvement of financiers like JP Morgan and Andrew Mellon and the concentrated businesses of US Steel, Standard Oil, General Electric, and Alcoa, amongst others, in the 1920s has clear parallels with the last fifteen years. Namely, the power was often in stark contrast to public opinion. Stoller writes:

In May of 1929, four progressive senators fulminated that Mellon “control[s] some of the most gigantic financial operations in the world,” that “most of the products of these corporations are protected by our tariff laws, and Mr. Mellon has direct charge of the enforcement of these laws.” He should be disqualified from holding his office, they wrote, because of the law against the treasury secretary having an interest in the business of trade or commerce. “It would perhaps be impossible to find in the United States a single citizen who has a greater interest in the business of trade or commerce.”

In the “boom days” of the Roaring 20s, however, “these arguments hadn’t worked”. When times were good, there just was not enough support to prosecute malfeasance. After the crash of 1929, however, the “true cost of cynicism and self-dealing” was revealed. Stoller concludes, “Mellon’s political shield, a vibrant prosperous economy, had been shattered”.

It seems to me a really good time to start making some lists of people and companies who, in the event of a downturn, may lose their “political shield”.

Landscape II

BofA: dumb, or just unlucky?($)

https://www.ft.com/content/ff5e8b5a-0742-4e1e-964d-62447b476ee0

Two years ago, I wrote a piece for Unhedged called “B of A buys tons of bonds, JPMorgan does not”. The piece pointed out that both banks had enjoyed a huge inflow of deposits, far exceeding attractive lending opportunities, and had decided to use the cash very differently. Between mid-2020 and mid-2021, Bank of America added $470bn of mortgage-backed securities and Treasuries, hoping to capture a bit of additional yield. JPMorgan, on the other hand, mostly just let the cash accumulate. 

At the time, BofA CEO Brian Moynihan emphasised his team was not wagering on interest rates … JPMorgan, on the other hand, said it was timing the market and betting.

This “compare and contrast” lesson from the FT’s Unhedged letter provides insight into the differences between BofA and JPM, but also illustrates one of the major challenges for virtually all investors today: Whether you like it or not, you are increasingly being forced to make bets.

While many investors followed the Fed’s lead that interest rates would stay low until inflation got up to 2%, what both failed to take into account was the effect of massive fiscal stimulus during the pandemic - combined with policy measures that constrained supply. Effectively, the Fed forced investors to follow its lead (or get run over) even though other (bigger) forces were also at work.

This is what happens when the policy intervention dial gets turned up to “High”, as it has. Investors have to make bets which policies will win out, what effects those policies will have, and what the intended and unintended consequences might be. This is anything but a stable, steady as she goes kind of investment landscape.

Asset allocation

One of the really important things to keep in mind in regard to asset allocation is what the motivations and incentives are of the big asset pools - like big pension plans. Stimpyz gives us a peek on Twitter:

"If we can get 5% risk free in UST and then buy private credit that is senior to the equity we currently hold as a primary asset class (by definition it is senior), then why would we want to own stocks at all?"

Imagine you are the manager of a big pension plan. Your targeted rate of return is 7-8%. You can get 5% risk-free and 7-8% in slightly riskier credit, but without having to take on the much higher risk of stocks or alternatives at all. What would you do?

It’s a no-brainer. You would sell all your stocks (and probably private equity and venture capital and hedge funds, and real estate, etc.) and load up on credit. In doing so, you would massively lower the risk of your portfolio and also massively lower the risk of getting fired due to underperformance.

Now, imagine what happens to stocks (and private equity and venture capital and hedge funds, and real estate, etc.) when those big pools of money start selling? No bonus points for guessing “Down”.

Implications

I have always argued there is enough room in the world for both active and passive investing. There are advantages and disadvantages to both and the relative impact of each of those depends on the environment.

The post-GFC environment was dominated by low rates and the ascension of monetary policy. This created an incredibly beneficial environment for passive investing.

Now, after a major pandemic, the resurgence of fiscal policy, and the emergence of inflation, the environment has changed dramatically. The universe of possible outcomes has expanded significantly, as has the number of geopolitical flashpoints.

While I am loathe to suggest that people who do not have any time and energy to put into investment research should pursue a more active approach, I am also loathe to pretend I don’t see some pretty big opportunities to sidestep big risks and to take advantage of upcoming displacements. This is when active investing gets fun!

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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