Observations by David Robertson, 8/23/24

It was fairly quiet in front of the big Jackson Hole meeting of central bankers later in the week. Nonetheless, there were still plenty of things to reflect on before the summer ends.

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

Market observations

Stocks have rebounded strongly and bonds have been strong too in what appears to be nirvana for financial assets. Jim Bianco addresses the potential contradiction between financial asset performance and fundamental conditions in a nice thread:

About 100% of the world assumes that Fed rate cuts are bullish for bonds. They are unless they lead to too much stimulus and higher inflation.

Both civilians and pros are betting that Powell will use his J-Hole speech on Friday to outline an easier policy that will rally bonds but not cause an uptick in the economy and/or inflation.

The FT’s Unhedged letter also picked up the same peculiarity and responded:

I asked Unhedged’s go-to rates trader, Ed Al-Hussainy of Columbia Threadneedle, to explain how it is that interest rates can be signalling a softening economy, while spreads and equity prices are only slightly less gung-ho than they were a month ago. His reply: “greed”.

Economy

In the best of times, “rules” regarding the economy have only so much predictive value. The economy changes, patterns of business change, regulations change, and before you know it, the old rule doesn’t indicate the same thing any more. When the economy is in the midst of a major transformation, as it is now, old “rules” can mean very little.

That is why the graphic below from @MikeZaccari by way of @SoberLook is so on point: Leading Economic Indicators, yield curve inversion, and the Sahm rule have all been good indicators of recession but are currently not working as they have in the past.

This isn’t to say there aren’t indications of economic slowdown, there are. Unemployment is picking up (but still low). There are multiple signs of stress on consumers. Bankruptcies are up.

On the other hand, the GDPNow forecast is currently 2.0 percent. That is nowhere near recession territory. As the FT’s Unhedged ($) letter reported, stocks are within a whisker of all-time highs and credit spreads are near lows.

In addition, as John Authers ($) reveals, M&A deals are pretty healthy. Even excluding the recent $36B Mars-Kellanova deal, “total transaction value [is] climbing to its highest since February with volume little-changed”:

For good measure, private equity doesn’t seem to be slowing down either. Industry bellwether, KKR, is doing just fine, thank you.

While industry commentary right now is focusing almost exclusively on aspects of the economy that can get worse, there are also elements that can get better. For instance, business inventories have been worked down. Any hint of increased demand, or perhaps even just a rate cut, would compel manufacturers to crank up production to restore depleted inventory.

In addition, as I mentioned in Observations (6/7/24):

the population eligible to receive supplemental security income (SSI) is set to increase significantly from several million people to 41.9 million [on 9/30/24) … The end result is … There will be more money flowing to US consumers.

Add in some miscellaneous handouts and targeted loan forgiveness and it looks to me like the economy could be humming along pretty nicely by election time. This isn’t to say humming uniformly, but humming nonetheless.

Politics

The Pandering Problem ($)

https://thedispatch.com/newsletter/gfile/the-pandering-problem/

Politicians pander all the time, promising nonsense they can’t possibly deliver under our system of government, thank God. That’s because the rules say that no matter what a president promises to do, once elected he has to—or at least is supposed—get approval from Congress and the courts. Promise all the fattened missionaries—or gibbeted billionaires, exiled illegal immigrants, or gelded Supreme Court justices—you want, the president can’t do that stuff without following the rules. 

Pandering, like populism, eschews making arguments or debating costs and benefits, in favor of immediate gratification. Republican democracy relies on leaders committed to persuading people on a course of action with facts and logic. Populist pandering skips all that. It replaces statesmanship with vibe-marketing. 

What is Dumb May Never Die ($)

https://thedispatch.com/newsletter/gfile/what-is-dumb-may-never-die/

What Harris is proposing is probably smart politics. Dumb policies are often the bleeding edge of smart politics. For starters, as the New York Times notes, this crap polls well with swing voters, and progressive groups are hot for the idea as well. Tell any politician that a policy idea simultaneously placates the base and appeals to swing voters, and they will perk up like a cat when it hears a can of tuna being opened.

With the Democratic convention this week and the revelation of at least some elements of economic policy by the Harris campaign, it’s a good time to evaluate the ideas that are out there.

The first point is there is lots of pandering on both sides, so neither side is more or less guilty than the other. Indeed, in the context of an electorate that is mostly unable and/or unwilling to have a civil debate about the merits of policy issues, it should be expected that pandering would be the campaign tool of choice.

The second point is that pandering is not necessarily a bad thing. Since institutional rules require approval from Congress or the courts to implement policies, there are significant constraints on the types of pandering that can result in real policy actions. In short, a lot of claims are just hot air. That said, pandering can serve as a marketing instrument, not unlike a focus group, which can inform campaigns about what voters want.

A third point is that it is extremely difficult to handicap policy direction, especially before the election. In order to do so, one needs to not only pick the presidential winner, but also the Congressional winners - in order to understand the balance of power and policy preferences. In addition, one needs to pick the ways in which the winning administration chooses to apply its political capital, while also estimating risks to that capital. While there is value in thinking through the scenarios, it is extremely easy to overestimate the probability of specific outcomes.

That said, it is not wholly useless to analyze political statements. As Goldberg explains, the actual substance of pandering “matters less than the optics”. He continues:

Harris wants to boost the impression that she “cares about people like you.” Whether it can work is of secondary importance to signaling that she cares about the problems of ordinary people.

So, to an extent, pandering can reveal a broader sense of inclusion and representation.

Finally, one of the things I will be keeping a close eye on is the degree to which the parties make meaningful commitments to wage earners, at the expense of capital interests. To date, both parties have been inclined to use the stock market as a measure of political success, even as it comes at the expense of working people. But this seems to be changing. As Russell Clark puts it:

To make an incredibly obvious point, rampant asset inflation, rising income inequality, the perceptions of being in corporate pockets is now  a VOTE LOSER … For me, its easy to see that “good” politicians (i.e. those that know how to win elections) - will avoid any austerity, and start going after corporates for more tax and wage increases.

To be sure, Clark’s views seem to be based on what he is seeing outside of the US more than inside, but it still applies. My view has been that the election is interfering with timing: The Democrats have been walking a fine line between wanting to provide more support to workers and being extremely careful to prevent inflation from picking up meaningfully before the election.

Regardless, if Clark is right about the political pendulum swinging toward labor and if it happens that this trend takes off more meaningfully in the US, the political, economic, and financial environment will be very different than what markets are currently pricing.

China I

China steelmaker Baowu warns over severe and prolonged industry crisis ($)

https://www.ft.com/content/41c9fa0d-9b3e-48d4-b4b4-bb8f8863c0e0

The steel industry “winter” was likely to be “longer, colder and more difficult than we expected”, said Hu Wangming, chair of China Baowu Steel Group, yesterday, according to a company statement concerning its recent half-year results.

The warning by state-owned Baowu suggests that the latest crisis will be even more severe. The sector has been ravaged by weak real estate demand and industrial production. These have created a glut of steel that has driven down prices, leading to losses at mills.

Chinese steelmakers have been turning to foreign markets, exporting the most in the first half of 2024 in eight years, but face barriers as tariffs go up to protect industries.

There have been a number of accounts of how weak China’s economy remains and this is just one example from the FT. Steel has been an especially important industry in China given its foundational role in the country’s industrial development.

Two things happen when cyclical industries turn down. One is there is vicious fight for market share, usually through lower prices. Another is a desperate attempt to unload excess supply anywhere, including shipping it abroad. As a result, China’s economic woes are also likely to land on foreign shores.

China II

On the issue of trade, China’s numbers have been increasingly inconsistent. As Brad Setser reports, “The gap between China's customs surplus (measured at the order, verifiable based on counterparty data) and its BoP [balance of payments] goods surplus in q2 (now based on an internal survey, not verifiable) was almost $90b in q2 alone”. Obviously, this shouldn’t happen.

His conclusion, stated in a related post, is “China's balance of payments data used to be better than the rest of China's data. Now it is close to crap. A bit sad, really ... SAFE appears to have been politicized”.

In another thread, Setser explains the phenomenon from a high level:

The enormous gap between the story in the current account data and the story in the customs data is basically a function of an adjustment China made to its balance of payments methodology in 2022, which has reduced its surplus via statistical means ...

He then lays out the implications:

This debate basically is the difference from concluding that a China that relies on exports to grow its way out of a real estate slump is a global problem and concluding that, well, there is nothing interesting to see in the global balance of payments.

So, it appears as if China is intentionally under-reporting its export data in order to create the impression it isn’t exporting as much as it is, yet this is not obviously so to many people. There’s nothing like a healthy dose of uncertainty to keep inquisitors (and rivals) at bay.

China III

While uncertainty is often treated as a uniformly bad thing in the West, it is viewed differently in China. According to the Economist ($):

To a striking extent, today’s Chinese diplomats manoeuvre like Red Army guerrillas, warily avoiding crises that might trap and entangle China, while staging quick, showy wins. China is a superpower with global interests. But it is run by the same Communist Party that survived the Long March by picking battles and staging strategic retreats. Remember that history and China’s opportunism makes more sense.

The Chinese instinct to see both risk and opportunity in chaos often confounds both diplomats and analysts. This is especially relevant in the context of China’s economic headwinds. As Michael Pettis explains, public policy in China has more to do with pragmatism and opportunism than with dogma:

While analysts have argued that China couldn't have a fiscal transfer aimed at stimulating consumption because Xi was ideologically opposed to such transfers, I've argued since March that we would likely see one in the 3rd or 4th quarter of this year. The reason was not because of any ideological shift, but because I did not see any other way to achieve the GDP growth target.

We will have to wait and see if Pettis is right, but if he is, a lot of people will be wrong-footed on global growth in the last months of the year.

Monetary policy

As investors anxiously await the Fed’s starting gun for rates cuts, it’s worth thinking through what the implications will be. Surely, lower rates will lower interest costs to indebted companies and individuals. Perhaps even more importantly, the first rate cut will be taken as a signal that many more rate cuts are to come and that credit conditions will continue to ease.

However, as Cost of Leverage posted in a short thread on X, rate cuts are not an unambiguous good:

One fact - lower Fed Funds means lower fiscal transfer via IORB, RRP and TBills. In the case of IORB and RRP it is being paid out without being funded as a result of the Deferred Asset Account.

So, lower rates will be beneficial for debt holders, but will be harmful for savers. The net effect will depend importantly on the degree to which private credit increases. That, in turn, will depend importantly on expectations for future rate cuts and future growth.

Further, the Fed can change, modify, or adapt its policies at any time. This possibility gained additional currency on Thursday when the Fed’s Jeffrey Schmid indicated there was room to further adjust the central bank’s balance sheet, both in terms of size and duration.

This presents an interesting possibility. On one hand, short rates may be used to send a signal of easing while on the other hand, a stronger form of Quantitative Tightening (QT) could tighten financial conditions.

Interestingly, this possibility aligns nicely with Bob Elliott’s excellent analysis of monetary policy. According to Elliott, “this has been an *income-driven* expansion, not a credit & money driven one like they've [Fed governors have] known”. As a result, he argues it would be more effective in this environment to transmit monetary policy through higher long-term rates, i.e., QT, than through short rates. Given the name of the symposium is “Reassessing the Effectiveness and Transmission of Monetary Policy,” it looks like he knows something the Fed is just now figuring out.

Gold

Despite turmoil in stocks, gold has been making new highs with regularity. I haven’t written much about this largely because this is exactly what I expected. In the January outlook piece I wrote:

As the prospect of financial repression becomes increasingly imminent, so too does the prospect of fiat currencies losing their value. This is exactly when gold provides a valuable hedge. This is a bigger concern for China than the US right now, but it’s just a matter of time. It looks to me like gold is right on the doorstep of a long bull market.

Short-term, the decline in the US dollar has added a tailwind to an already strong trend. As a result, I wouldn’t be surprised at all for gold to take a breather in the not-too-distant future.

That said, I think we are still extremely early in a long-term trend for gold. One way to look at gold is through the lens of stocks. As John Authers ($) reported this week,

Gold at a record also casts the stock rally in a different light. Gauged in dollars, US stocks are at or near a record. In gold terms (how much gold it would take to buy the index), the S&P 500 is exactly where it was in August 1971. The significance of that date, picking up from yesterday’s newsletter, is that it was the moment when President Richard Nixon severed the dollar’s link to gold.

The equivalence of gold to stocks since 1971 is mind boggling to a lot of investors. Just poke around X to find examples of stunned disbelief.

The chart indicates two important phenomena over that time period. One is that stocks didn’t so much grow on the back of tremendous economic growth as inflate on the back of monetary debasement. This reality significantly changes the role stocks play in a portfolio.

A second phenomenon is that stocks were only able to achieve equal performance with gold through the process of valuations rising from historical lows to historical highs. It is fair to expect those valuations to revert to more historically normal levels. In this sense, stocks are like Wile E Coyote whose Acme jetpack runs out just as he shoots over the cliff’s edge, while gold is like the Road Runner who keeps on going his merry way. Beep beep.

Investment landscape

Last week I focused on the carry trade and its implications. Since then, stocks have rebounded further than would be indicated by a carry crash, so it’s worth looking into why that happened. Cost of Leverage covers the subject succinctly on X:

All beta is short vol, all short vol is beta See today’s translation below - spot on Who bailed out VIX, I mean beta, i mean $SPX last week? The drug dealer (options market makers). It was not investors You have been warned

Point one, “all beta is short vol”, is that stocks move because flows of money go into or out of funds that short volatility. That is all. There are not material fundamental drivers.

Point two is that at the height of the turmoil on August 5, the turnaround was not caused by investors buying the dip. It was caused by options market makers. This is a source that cannot be relied upon in future turmoil.

Point three is the same fragility that facilitated the selloff earlier in August absolutely still remains. Nothing got resolved. This tremor was simply a precursor for a bigger event to come.

Implications

While it may not feel like it at the time, I firmly believe we are right on the doorstep of two major changes to the investment landscape.

First, so much focus has been placed on the Fed and when it will start cutting rates that attention has been distracted from monetary policy in China and Japan. Both economies are struggling under the burden of excessive debt. Both will require looser monetary policy in order to manage those debt burdens. Both are very likely to implement policies that will reverberate around the world.

Second, I expect the slow transition from pro-capital to pro-labor policies to continue. That will confound a lot of analysts by being fairly popular among voters. It will also present a significant headwind to asset prices that will manifest in many different ways. This will be shocking and extremely frustrating for investors who don’t or can’t see the bigger picture.

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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