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Observations by David Robertson, 9/1/23
Well, this is it - Labor Day is finally here! I hope you have a great, relaxing, fun, and enjoyable long weekend!
As always, if you want to follow up on anything in more detail, just let me know at firstname.lastname@example.org.
Jerome Powell essentially reiterated at Jackson Hole last week what he has said dozens of times before. Stocks went up on Friday and through the week. @Barchart captured the mood well:
On the same note, the JOLTs report came out on Tuesday and showed noticeable incremental weakness in the labor market. While still a long way from actually being weak, it does look like the labor market is turning.
The interesting observation is the 10-year Treasury rallied hard and the US dollar fell significantly on the news. While the direction of the moves make sense, the magnitude is wholly out of proportion with the information content of a single report. Increasingly it appears, economic news is not so much something to be assimilated into a longer-term view but rather serves as a toggle for short-term directional bets.
China revealed a number of moves this week, primarily in regard to stock trading and the real estate market, in an effort improve sentiment and invigorate the economy. While stocks did respond, at least initially, the moves are trivial relative to the scale of the problem. The article below by Michael Pettis came out a little over a year ago but provides terrific context from which to understand China’s economy policy challenges.
The Only Five Paths China’s Economy Can Follow
But it’s a mistake to view China’s growth in terms of whether it can or cannot achieve a particular GDP target. China’s GDP growth is not a measure of the country’s economic output and performance in the same way the statistic is for other major economies. China’s GDP growth target is an input decided by Beijing at the beginning of the year. Its fulfillment depends on the extent to which the economic authorities are able and willing to use the country’s resources and debt capacity to achieve the required amount of economic activity.
To simplify matters, a better economic outcome for China is not more GDP growth but rather more genuine growth and less inflated growth, whereas a worse outcome is the opposite. In that sense, whether or not China achieves a GDP growth target that exceeds the economy’s underlying genuine growth only reveals how determined Beijing is to achieve that level of economic activity, and how much debt it is willing to allow and how many resources it opts to sacrifice, to achieve a politically acceptable level of economic activity as measured by GDP.
One of the first things that jumps out is China’s GDP does not mean the same thing as US GDP. In Pettis’ words, “China’s GDP growth is not a measure of the country’s economic output and performance in the same way the statistic is for other major economies.” Rather, the target is set by Beijing and then is achieved using whatever resources necessary. As with so many things Chinese, they just don’t translate directly.
Another notable insight is the scale of China’s economic challenges. Pettis methodically reviews each of the major potential policy responses. In doing so, however, he also reveals the shortcomings of each. He concludes, “In my opinion, domestic financial conditions are such that China is still unlikely to have a financial crisis or a sharp economic contraction. It is much more likely, in my opinion, that the country will face a very long, Japan-style period of low growth.” Coming from an excellent economist and long-time resident of China, I’m not sure why more people don’t take this perspective more seriously.
A final point is the Chinese treatment of GDP is not entirely different from the US. While the US does not establish a top-down target for GDP, it absolutely deploys both fiscal and monetary policy to periodically nudge GDP above sustainable levels. As a result, GDP in both countries is, to a greater or lesser extent, a distorted measure of economic performance. As such, investors need to calibrate for the level and sustainability of distortion in order to evaluate long-term market impact.
The West Is Losing Control Over the Gold Price
For about ninety years, up until 2022, there was a pattern of above-ground gold moving from West to East and back, in sync with the gold price falling and rising. Western institutions set the price of gold and bought from the East in bull markets. In bear markets the West sold to the East. For more information read my article: The West–East Ebb and Flood of Gold Revisited.
If we zoom in on the period from 2006 through 2021 the main reason for Western institutions to buy or sell gold was the 10-year TIPS rate, which reflects the 10-year expected real interest rate (“real rate,” in short) of US government bonds … As we will see below, the TIPS rate, UK net gold import (positive or negative), Western ETF holdings, and the COMEX open interest were all correlated to the price of gold. Until the war in Ukraine broke out late February 2022, that is, and things started to change.
This piece provides some useful background on the gold market as well as insight into how it is changing. A big point is that different groups purchase gold for different reasons. In a very general sense, Western buyers acquire gold for relative investment merits, as indicated by real interest rates. Eastern buyers acquire gold more as a store of value to protect wealth against currency debasement.
Not only has gold buying shifted from West to East (with particularly “strong private demand in Turkey and China”), but the purchase group has also expanded to emerging market central banks. With this change in purchase patterns, so too have the primary motivations changed. No longer are real interest rates such a dominant driver. Increasingly, wealth preservation in countries with weak currencies and central banks adapting to an evolving financial system are even more important drivers.
This change in market conditions could have a material impact on gold price. As Fred Hickey spells out:
Computer algos, which dominate daily gold trading in the West, don't do well when variables change (such as this shift in gold buying). Their (regression-based) models are backward-looking. When Western investors (or their models) figure this out - Up & away!
Meanwhile, Western computers trigger gold sales (including shorts -see my earlier COT tweets), based upon the old rules (sell gold on rising real rates, TIPS correlation, U.S $ strength etc.). But this time gold has held up (it's usually smashed on heavy West selling/shorting).
In sum, gold is often a wild and crazy market so it is futile to try to understand every little zig or zag. That said, gold does a good job of preserving wealth over long periods of time and has very low correlation with other assets. This means it’s a good portfolio diversifier. It also looks like gold may be setting up for a step-function increase in price. This means it doesn’t make sense to get too cute about timing purchases.
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As I mentioned last week, there was an opportunity for Fed chair Powell to step beyond the familiar territory of monetary policy in his Jackson Hole speech. While stability in capital markets has provided necessary cover to continue raising rates, the continued climb of stocks threatens to over-extend itself and become susceptible to instability. It was a good opportunity to talk down the recent strength in stocks. He didn’t take it.
Indeed, the comments were mostly notable only for their familiarity. There were just two elements that stood out to me. The first was an emphasis on uncertainty. Yes, the environment is uncertain, but coming from the Fed chair seemed to suggest a subtext: The central bankers are scared. They are scared partly because the underlying conditions fall way, way outside of anything their models can reliably deal with. They are also scared of getting blamed for anything that goes wrong.
The other element that stood out was an emphasis on caution. My read is that Powell would rather make an error of omission than one of commission. This is typical of central bankers. General inaction is far less likely to suffer political castigation than specific action.
This should not be comforting to investors. At a time with multiple risks and cross-currents, geopolitical tensions, and potentially path-dependent outcomes, what is needed is someone who can act and act decisively. Sometimes it is what you don’t do that can kill you. It should not comfort anyone that one of the economic “firefighters” is afraid of fire.
THOSE WHO FAIL TO STUDY HISTORY ARE DESTINED TO OUTPERFORM ($)
One reason that US stocks continue to do well is that the magnificent seven have done a great job in pushing back government initiatives to tax them more, or to break them up (in stark contrast to China). But one day, politicians will have to choose between taking on corporates, or being voted out of power. And if there is one thing politicians love more than money, its power.
One thing investors in global markets, especially emerging markets, seem to understand so much better than those focused on the US alone is the preeminent role politics plays. Sure, economics can play an important role for periods of time, but only to the extent it also serves the interest of politicians. As soon as the politics change, so too do the rules.
Russell Clark makes an excellent case that a large part of the success of the magnificent seven stocks is essentially due to tax avoidance. As such, it is a deliberate act to deprive the country of resources at the expense of everyone else. To date, no one has cared very much. As the budget gets squeezed progressively harder, however, something will eventually have to give. I think Clark is right that eventually, “politicians will have to choose between taking on corporates, or being voted out of power”.
One point is the sweetheart tax deals many large corporations currently enjoy are unlikely to survive an extended economic downturn. There will almost certainly be a large scale reallocation of wealth and this time corporations will be the givers, not the takers.
Another point is the issues of inequality and corporate power are increasingly bipartisan. As a result, it will be very interesting to see if one party or another can dominate these positions without breaking apart, or if a new party can capture this political ground. If so, it could provide the basis of some pretty important transformations not just of politics, but of society as a whole.
Treasury Issuance is what really matters
John Comiskey has done great work in detailing the Fed’s Quantitative Tightening (QT) program and now he is extending that work to Treasury issuance. This is especially timely as large Federal deficits combined with the effects of the debt ceiling standoff are forcing issuance numbers up. As I have written before, these forces have significant implications for liquidity.
The first point is a detailed one, but a good one to keep in mind. Comiskey reports the “Fed will fail to reach the UST QT cap of 60b in June 2024 and again in September 2024.” It’s good to keep in mind because there have been a lot of bad takes on QT from people who don’t do the detailed work Comiskey does. When the Fed does fail to reach QT cap for Treasuries later in 2024, informed investors will know this is a coincidence of timing and not any fundamental change in policy.
The bigger point is the increasing share of Treasuries with three months or less to maturity:
We are in the midst of a significant rise in the level of outstanding ultra short remaining time to maturity treasuries (3m to maturity or less). Significant to the tune of an ~52% increase in outstanding volume from 5/31/2023 to 12/31/2023 rising from 3.081T to 4.68T, ~1T more than the previous high in September 2020, and more than double the pre-covid norm.
Comiskey reports this could be “nothing more than a reflection of the significant growth in treasury issuance combined with the Treasury’s temporary flood of bills vs. coupons over the last 6 months of 2023”. If this is the case, high levels of ultra short remaining time to maturity Treasuries will likely normalize once coupons, aka longer-term Treasury bonds, fund a larger portion of the deficit in 2024.
This highlights competing forces on yields. Insofar as coupons play a bigger role in 2024, there will be greater supply - which should force prices down - which should force yields up. However, Treasuries with 3m or less to maturity “are pretty damn money like”, and therefore “its probably a good idea to consider that there may be more ‘liquidity’ lurking out there then meets the eye”.
Excellent point. While there is certainly good reason to expect downward pressure on liquidity, there is also “shadow” liquidity that could prove to be an offset. If I had to guess, and it is a just guess, this lurking liquidity looks like a bunch of fire engines gathering on the landing strip in case the incoming plane has a hard landing and emergency crews are needed.
An important feature of the policy environment currently is that monetary policy is focused squarely on fixed income, not stocks. Indeed, when stocks fell through the first three quarters last year, it was largely due to the rebalancing of funds with both stocks and bonds. As bonds sold off on rate hikes by the Fed, funds had to buy bonds and sell stocks to remain in balance. In other words, the fall in stocks was an indirect consequence of rising rates.
The next phase of monetary policy looks to be a period of retaining short-term rates at or near current levels. The effect will be to gradually, but persistently, tighten credit conditions. As time passes, more and more companies will need to refinance and will need to do so at higher rates than existing financing. This has been evident in real estate, startup funding, private equity, and other assets, and will become progressively more so.
This kind of credit tightening is a battle of attrition. The longer it goes on, the tighter the noose gets. The main point is credit troubles to date have largely been overlooked and/or glossed over. This is about to change and is likely to become much more visible in the final four months of the year. As a result, credit is likely to be the next victim of tighter monetary policy.
This leaves the prognosis for stocks as an open question. On the positive side, there is not any clear impetus to induce selling. Further, a policy playbook of controlled demolition makes it very difficult to short stocks.
On the negative side, stocks are still wildly overvalued and therefore have the potential to fall a long way. A big question remains as to the yield on long-term Treasuries. If rates go up, that will eventually hurt stocks, but if they go down, it would help them. Finally, another open question pertains to how much deteriorating credit will affect large institutional balanced portfolios and therefore how much rebalancing (buying more bonds, selling stocks) will need to occur. Either way, this is likely to be a dominant theme through the end of the year and into next.
The summer tends to tamper down risk perception. It’s a time when many of us look forward to some well-deserved time off. It’s a chance to get away from the routine and forget about troubles for a while. Further, the solid performance of stocks since the end of May has given no reason for concern.
None of that should be taken as a signal that risks have dissipated, however. With short-term rates remaining at higher levels, credit conditions continue to tighten. The resumption of student loan payments and discussion of a UAW strike provide a great deal of potential for disruption. Speaking of potential for disruption, there is a good chance there will be a government shutdown this fall. On top of it all, higher supply of longer-term Treasuries in the fourth quarter could cause long-term rates to go up, just as economic growth is slowing down. I won’t even start in on geopolitical problems.
None of this is to say we should expect Armageddon. It is to say, however, investors should not expect a continuation of the fairly placid market environment of the summer. Primarily, we should start to see more evidence of credit problems - and the way those permeate through the economy and financial markets. They will start taking their toll and we’ll just have to wait and see whether the problems remain relatively contained or whether they cause more systemic problems. Either way, it’s probably a good time to tune down risk exposure.
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