Observations by David Robertson, 8/26/22
I hope everyone is enjoying the end of the summer and getting a chance to relax or do something fun. I’ll be taking a much-needed break next week and will return on September 9. As always, let me know if you have questions or comments at firstname.lastname@example.org.
Finding good sources of information is a never-ending challenge with a constantly changing dynamic. For example, I have found it interesting that Twitter over the last couple years has become one of my sources of consistently higher-quality insights.
Sure, there is all kinds of garbage, there are ads, and there are all kinds of distractions … but there are also a lot of smart people sharing their views and highlighting useful articles and research that I may have otherwise missed.
Partly as a result of this phenomenon, and partly because news flow has remained fairly slow at the end of the summer here, I thought I would try a tweet-o-rama this week. The majority of the items below center around tweets that I found interesting, timely, and relevant. Here goes …
Jim Bianco has been making this point for some time now: Cryptos are acting like a high beta stock index and serving as a leading indicator. The relationship is continuing to hold and continuing to prove useful.
I’m not sure why this is the case, but I’m guessing it has a lot to do with crypto being very significantly influenced by liquidity. In other words, when money comes into the system or goes out, crypto seems to be one of the first stops. Regardless, the message from crypto now is that stocks have quite some way to correct.
Another observation is central bankers are meeting at Jackson Hole this weekend and Jerome Powell is scheduled to be speaking Friday morning. While investors will be waiting to hear commentary as to whether the Fed has “pivoted”, these affairs are much less occasions to jawbone tactics in a certain direction than to provide higher level strategic thinking about policy.
In that regard, the two biggest points in my mind are QT (quantitative tightening) and the array of tools to maintain financial stability. As QT is set to ratchet up in September, it would useful to hear a progress report from the Fed and what it has learned along the way. To that point, if QT does start causing things to break, it would be good to know what remedial actions the Fed might bring to bear. An awful lot of commentators are assuming the Fed will capitulate at any sign of stress and reverse QT into QE. I think that is a lazy (and dangerous) assumption. Let’s see.
Pretty much since the mid-1990s, the business community has been obsessed with technology and the mind-blowing possibilities it can enable. However, as Google’s experiment in doing away with managers in 2002 demonstrated, all kinds of things unravel pretty quickly without oversight and traffic control. In short, and as the tweeted message corroborates, good managers matter a lot.
After several years of chasing dreams ostensibly enabled by tech and funded by cheap capital, I get the strong sense that good managers are going to start getting recognized and appreciated (and paid) again for all the valuable things they do. After all, it is the managers who have the responsibility to actually get things done.
I did my stints at small entrepreneurial places when I was younger and the message of this tweet resonates. While it can be exciting to work for a startup, you also make a lot of sacrifices - some if which you don’t appreciate until later.
For example, just about any learning or training you get has to be done on your own initiative and your own dime. Large companies often have formal training programs that are useful both for developing skills and one’s career path.
Of course, a major problem with large companies is the lack of urgency and impetus to innovate. Entrepreneurial companies have these in spades.
The challenge then is not a choice of one or the other but how to leverage the best of both environments. If you want to change the world and do something that matters, neither extreme will get you there. If you have such ambitions, you will almost certainly need to fulfill part of them outside of work.
There’s no doubt that consumers are feeling the pinch of higher prices. As the tweet above indicates, 2/3 are making adjustments to manage expenses. While it is tempting to look at evidence like this and start the timer for how long it takes for recession to arrive, the story is more complicated than that.
A recent synopsis of retail conditions in the FT ($) included comments from Walmart executives that described “back to school backpacks flying off the shelves even as it [Walmart] had to slash prices to clear excess stock and its poorest customers traded down from beef to beans”. The “conflicting anecdotes” were described as “a Rorschach test of economic interpretations”.
There are two major takeaways here. One is consumers have different views on amd experiences of inflation and therefore are incorporating it into their budgets at different rates. The second is this is causing a lot of noise in observations of consumer demand. The good news is that people are actually adjusting rather than just hoping inflation will go away.
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Michael Pettis is always worth following in regard to China and emerging markets in general. One main point here is there are two main layers of government debt in China - local and central government. This is important because the incentives for the two different entities are often misaligned.
This causes problems because it introduces obstacles to the process of managing debt and it also creates moral hazard. If the central government comes in to rescue one local government, there will be less incentive for others to be frugal.
Ultimately, as Pettis suggests, the central government is likely to take control, but it will be an interesting process to observe. This process is also likely to unfold in plenty of other geographies eventually, not least of which is in the US.
Fed Balance Sheet FAQs
The Fed’s Treasury portfolio continued to grow even after QE due to principal adjustments from TIPS … The Fed’s $370b holdings of TIPs has been gradually adjusted higher due to elevated inflation. That growth in turn shows up as small but steady increases in its overall Treasury holdings.
I touched on this subject last week because there has been a lot of confusion around the subject and because that confusion is causing a lot of observers to mistakenly characterize the Fed’s balance sheet reduction efforts as MIA. That is not true.
This piece by Joseph Wang is a good explainer from someone who knows the details. By the way, this is also the kind of subject that reveals a big weakness of Twitter (or any social media): There are a lot of grouches out there who don’t know the details and yet still feel compelled to jump to conclusions and propagate misunderstandings. Thank you Joseph for setting the record straight!
This is going to be an area to keep an eye on. The more a situation evolves to a zero sum game in which larger “slices of pie” must come at the expense of others (because the pie is longer growing), the more individual competition heats up and the more top-down allocation procedures increase in importance. I suspect we’ll be seeing a lot more rationing of resources and the priorities are almost always established according to political expediency, which may but often do not correlate with economic growth.
Consider this a friendly reminder that governments are likely to get heavily involved in formulating the allocation parameters for many scarce resources. This is way of using power and will be used to promote political objectives above any others.
This little tidbit reveals clearly and concisely why analogues are problematic as analytical tools. It is also timely since analogues have become fairly common in market commentary. They fail to be very useful because they can tell whatever story you want them to.
What analogues can do, however, is provide perspective. By illustrating how a certain pattern has actually completed in the past, it is easier to envision that possibility in the future. As such, analogues are much more communication devices than analytical ones.
There are a few major points to highlight in this excellent thread by @UrbanKaoboy. First, the strong US dollar is central to the stress in the global financial system. Second, there are a lot of overvalued assets all over the world - which presents a lot of risk. Third, these factors, combined with other problems, create conditions ripe for geopolitical conflict.
The Asian Financial Crisis 1995-98: Birth of the Age of Debt, by Russell Napier
This historical journey through the Asian Financial Crisis is a great history lesson, has many parallels with the landscape today, and dovetails perfectly with Michael Kao’s analysis above.
One of the big lessons is liquidity is a powerful driver of asset prices. While liquidity often falls outside the purview of many analysts, it is often the key factor behind what is often perceived as “mysterious” price appreciation or depreciation.
Another lesson is currencies involve political tradeoffs and those tradeoffs are made by politicians who have personal agendas. As a result, it is inherently difficult to handicap responses to and consequences of currency crises. If everything were so well managed, there wouldn’t be a crisis to begin with.
Finally, currency crises involve capital movement and the operating principle is “where there is smoke there’s fire” often applies. In other words, once things start going downhill, lenders and asset managers immediately start assessing who else might be affected and pull money from those targets as well. These are the makings of contagion and vastly increase the downside risk.
An important point to keep in mind in assessing these various phenomena is insofar as most are “macro” forces, they often fall outside the normal field of vision of retail investors and advisors. This creates another dynamic to contagion: It often happens in phases. The first phase is when institutional money figures out the problem and gets out of Dodge, and the second is when large masses of retail investors get fed up with the situation and finally bail out as well.
Implications for investment strategy
Strategic Allocation white paper by John Hussman
Two popular approaches for long-term investment planning are “target date” strategies that set allocations to equities and fixed income based on the number of years until retirement, and “fixed allocation” approaches that invest a constant percentage of assets in stocks, bonds, and money-market securities, with little or no variation.
The striking feature shared by these approaches is that the amount invested in stocks, bonds, and other securities has absolutely nothing to do with investment valuations or prevailing market conditions; even if the securities being held are profoundly overvalued or undervalued relative to historical norms. Indeed, the assumptions made by investors and pension funds about likely future investment returns are often set based on average historical returns, even when prevailing market valuations are nowhere near the valuations that produced those historical returns.
Advocates of index funds often make the case for their low cost - and this is a fair point, to a degree. The tradeoff that comes with low cost, however, is complete inattention to prevailing conditions. It is investing as if the right clothes to wear throughout the year are those that are appropriate for the average temperature for the year. Never mind you’ll be freezing your butt off in winter and sweating it off in the middle of the summer.
That’s what allocation strategies based on averages do - they use average returns over long periods of time to construct allocations. The only problem is prevailing conditions can vary considerably, just as temperatures vary considerably in different seasons. As a result, allocations based on long-term averages can turn out to be horribly inappropriate when prevailing conditions vary considerably from long-term average conditions.
This is the case today. Excessive amounts of debt globally, eroding demographics, diminishing liquidity, and prominent vectors of geopolitical conflict, all in the context of broadly overvalued assets, make today’s investment landscape about as far from “average” as imaginable.
The implications are fairly intuitive. Investors with long-term “average” allocations will fare poorly and those with allocations based on “prevailing conditions” are set to be much better protected. The only real question is, who is prepared to adapt to a different environment and who will cling on to the past?
Thanks for reading Obervations! I hope you have very nice Labor Day weekend!
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