Observations by David Robertson, 9/13/24
There has been a lot of chop in the markets - let’s take a look at what’s going on.
As always, if you want to follow up on anything in more detail, just let me know at drobertson@areteam.com.
Market observations
The big data release for the week was the consumer price index (CPI) which came in at 0.2% for the month and 2.5% for the year. While the annual number has been progressing in the right direction (i.e., down), the monthly numbers actually show a reversal to modestly accelerating inflation. Specifically, the headline monthly numbers were 0.0% and -0.1% in May and June; in July and August they bumped up to 0.2% each month. In addition, the core number hit a monthly bottom in June at 0.1%, but increased to 0.2% in July and jumped again to 0.3% in August.
Once again, there was enough to feed both sides of the inflation debate. However, the latest increases are making it a lot harder to claim absolute victory over inflation. This is especially important in the context of extreme positioning in the direction of low inflation. If the CPI numbers continue edging up through the remainder of the year, a big shift in positioning is likely to occur.
One of the things we haven’t been hearing nearly as much about lately is AI (artificial intelligence). No wonder, since the middle of August the stocks have been underperforming. They have rebounded in the last couple of days, but have yet to regain anything like their former swagger.
Another trend that has quietly shifted direction is the path of the US dollar (as captured by DXY). After a pretty steep drop off since the end of June, DXY bottomed on August 27 and has been creeping up, erratically, since. If this continues, look for associated moves in rates and commodities.
Finally, the presidential “debate” on Tuesday proved these events are more about exchanging barbs than actually debating policies. Take from it what you will, but we learned virtually nothing about how either candidate will deal with the heap of challenges that will fall in their lap on day one.
China I
The steady drip-drip of bad news from China continues apace. Growth is stalling and deflationary pressures are spreading. Worse, China’s economy is much larger and more important to global growth today than the last time it hit the skids. The Economist published two articles that provide useful perspective.
The Chinese authorities are concealing the state of the economy ($)
The steady contortion of official statistics seems designed to obscure news that might embarrass the government. For instance, in mid-2023 a professor at Peking University said publicly that there were 16m young people without jobs who did not feature in the unemployment statistics because they had stopped looking for work. If they were taken into account, the professor asserted, the underemployment rate for youth would be over 46%. Within a month the NBS stopped issuing data on urban youth unemployment altogether. Then in January it began publishing an “improved and optimised” figure, which also happened to be far lower. Academics and journalists have had relatively little to say on the subject since then.
Meanwhile, the data that are made public are ever less consistent with the experience of firms and investors on the ground. The official numbers show that the GDP growth rate has reverted to pre-pandemic level, despite the moribund housing industry and low investment in infrastructure. This is a risible claim, says Logan Wright of Rhodium Group, a consulting firm. “The broader problem is simply that the GDP data have stopped bearing any resemblance to economic reality,” he explains.
While data from China has never been especially good, investors adapted by either discounting the data quality or offsetting it with growth prospects. Since the beginning of its real estate downturn, however, data has gotten much worse and public policy towards information transmission has become much more restrictive. No longer do data “bear much resemblance to economic reality”.
This pattern is familiar to long time fundamental analysts: Reduced disclosure at a company serves as an important warning signal. The reason is there aren’t many good reasons to conceal positive information. Normally companies (and other organizations) trip over themselves to promote anything that is positive. As a result, if they are doing just the opposite of that, it must mean the news is bad.
Reduced disclosure causes its own set of problems though. With less information available, it’s not clear leaders have good information from which to make public policy decisions. In regard to China, the Economist notes:
The gradual strangulation of information about the economy is not just vexing for foreign investors and economists. It also raises the same question that Mr Zhao did in his censored article: on what basis do Mr Xi and other senior officials make decisions about how to manage the economy?
The answer is almost certain to disappoint. The dearth of information suggests economic policy has little basis in facts. Even if it was based on facts, there is certainly a perception of capriciousness and/or ineptitude. It’s hard to tell what officials will do or when they will do it.
As a result, the dearth of information is vexing for everyone - investors, economists, and importantly also - consumers. That leads to yet another problem …
China II
China is suffering from a crisis of confidence ($)
According to the National Bureau of Statistics, consumer confidence collapsed in April 2022 when Shanghai and other big cities were locked down to fight the covid-19 pandemic (see chart 1). It has yet to recover. Indeed, confidence declined again in July, according to the latest survey. The figure is so bad it is a wonder the government still releases it.
Some analysts think that China’s gloom reflects deeper problems, beyond current economic circumstances. Adam Posen of the Peterson Institute for International Economics, a think-tank, has argued that faith in China’s policymaking was shattered by the pandemic lockdowns, as well as by abrupt regulatory crackdowns on some of China’s most celebrated companies. In both cases, officials cast private prosperity aside in pursuit of other goals.
In a sense, it shouldn’t be too surprising that confidence in China is falling given the harsh turn of events over the last couple of years. Years and years of strong growth and ever-increasing wealth (largely in the form of a real estate boom) did a lot to boost confidence. The last few years of declining growth (and real estate values) and episodes of extremely restrictive public policy did a lot to erode that confidence.
Again, extrapolating from financial analysis, when disclosure is reduced, it is hard to maintain the same degree of confidence in a venture. Not only does uncertainty increase, i.e., you don’t know what you don’t know, but you are invited to imagine the worst that could happen.
In a general sense, when people don’t have a good understanding of what is going on, the most natural reaction is to hunker down. Across an economy, that means less activity and less spending.
This is likely to present an awesome challenge to China’s policy makers. Confidence is like reputation, it takes years to build and only moments to lose. It will be a long, uphill battle to recreate the conditions upon which that prior confidence was based.
In the meantime, as Michael Pettis notes, food inflation is imposing yet another challenge: “China's CPI was up 0.4% in August (versus up 0.5% in July). This might seem a good sign that domestic demand is rising, but in fact most of the price increase can be explained by food shortages driving food prices up. Not a very helpful number.”
Clearly, rising food prices in the context of deflation elsewhere puts even more pressure on the erosion of confidence. Further, food inflation is an especially ominous indicator since it can trigger political instability.
Eurozone
The story through the latter part of the summer was the Olympics and weakening growth in the US. Now that the Olympics are over and people are back in the office, news is coming out about the Eurozone. It’s not good.
Javier Blas highlighted Mario Draghi's report on European competitiveness. In short, Draghi noted, “High energy costs in Europe are an obstacle to growth”. By itself, this is not especially informative, but given the source, it illustrates a significant escalation of an enduring problem.
Izabella Kaminska picked up on the same report and was even more emphatic about its importance. Her highlights included “Europe is facing existentially threatening stagnation - symptoms ignored for too long. ‘The situation is worrisome’,” and “Draghi calls for ‘radical change’ which is ‘urgent and concrete’.”
John Authers followed up with the broader message Draghi’s report conveyed:
Draghi inveighs that the EU lacks focus, is wasting its common resources such as huge potential collective spending power, and doesn’t coordinate where it matters. Having put its monetary systems together a quarter-century ago, there’s still no coherent fiscal system. That means no chance to link industrial and trade policy in the way the US and China do.
One point is this sounds like “burning platform” kind of stuff coming from one of the Eurozone’s leading statesmen. It’s not just passing remarks from another bureaucrat. Another point is the listed weaknesses are not new developments. The Eurozone was fortunate to sidestep the most dire consequences of Russia’s invasion of Ukraine at the time, but it never solved its structural shortcomings. Now those payments are coming due.
A final point is despite all the concern in the US about its economy, problems are far worse elsewhere. This is likely to jolt the US dollar higher and increase the spotlight on the Eurozone as a source of trouble for some time.
Investment landscape
Neil Howe: A Collision of Financial, Social & Geo-Political Crises All At Once?
https://adamtaggart.substack.com/p/neil-howe-a-collision-of-financial
This interview is a good application of Neil Howe’s concept of a “Fourth Turning” to today’s problems and challenges. The part of the conversation that jumped out for me began at about the 42 minute mark and discussed declining birth rates.
As Howe mentions, “historically, people had kids to take care of them in old age”. Now, however, Social Security and Medicare are a big part of the care package for older people. That practice reduces the need to have children for old age support, but it also introduces a significant generational disparity in how public money is spent. As Howe puts it, “we subsidize the cost of growing old, but privatize the cost of raising kids”.
With such skewed incentives, it shouldn’t be surprising the birth rate keeps falling. Unfortunately, it keeps falling as the country’s finances become increasingly encumbered. When a severe crisis/”Fourth Turning” does arrive, it will demand sacrifices from the entire population. The wealthy will be taxed, but others will have to make sacrifices in a more direct way. In order for that to happen, they will need to have an incentive to do so.
Howe suggests this is the point at which public policy is likely to become much more inclusive - and much more family friendly. Just as the GI Bill in 1944 gave veterans and their families in World War II a reason to make sacrifices during the war effort by agreeing to help with education, housing, and employment after the war, so too will a new public policy program be needed to provide incentives for young families to build a future by equalizing the distribution of income.
The kicker is this new spending program will need to be enormous, i.e., on the same scale as Social Security and Medicare combined. Since that total spending will dwarf any reasonable intake from taxes, government will need to inflate away its liabilities. This is one of the reasons it is so important for long-term investors to have a robust plan for hedging inflation.
Investment strategy I
At the end of August, Russell Napier ($) put out a newsletter entitled, “Why Financial Repression is Failing, Why The Risk of Deflation is Growing & The Consequences For Investors” and this week he followed up with a Zoom meeting on the same subject. His thesis is “the risk of deflation will soon outweigh the risk of steady or higher inflation”. He lists the cause as insufficient growth in broad money.
It’s important to note that his long-term prognosis for higher inflation and financial repression has not changed. The only thing that has changed is now he sees a heightened chance of taking a little side trip to deflation on the way from here to there.
This has important implications for investors. For one, deflationary pressures will likely be negative for stocks. Earnings have been fairly strong but deflation kills demand. For another, short-term deflationary pressures would make bonds look attractive for some period of time, but would create a trap for longer-term investors insofar as higher inflation emerges later.
In order to monitor the progress of this little detour, bank credit will be one of the most useful variables to track. Signs that it is increasing will indicate faster money supply growth - which will alleviate deflationary pressures.
In the US, it will also be important to track the Fed’s Reverse Repo Program (RRP). This pile of money has served effectively as sequestered bank reserves. As a result, its rapid increase to $2.5T at the end of 2022 and decrease to the $300B range today has distorted typical M2 measures of money supply, making growth appear lower than it has effectively been. It has also, arguably, forestalled efforts to boost bank credit growth.
As it turns out, the RRP is expected to be effectively depleted by the end of the year. Once that happens, it will also be easier to juice loan growth without taking such a big risk on re-igniting inflation. However, the election will be held at about the same time and it isn’t clear what effect either party’s policies will have on money supply growth. For that matter, we don’t know what the Fed will do either.
So, while I have an enormous amount of respect for Russell Napier and agree money supply growth may be insufficient to fight off deflation, I have a hard time getting to the point that deflation is more likely than inflation in the short-term in the US. I will be wrong if economic and public policy paralysis continues well into next year.
Implications I
Oil has continued to get thumped down since the middle of August and it is easy to attribute the rationale to declining growth and deflationary pressures. Indeed, as Rory Johnston ($) explains, bearish positioning has been a driving factor: “Hedge funds and other money managers were massive net sellers of crude futures and options contracts over the past week-through-Tuesday”. Perhaps traders are expecting a deflationary bust as Napier outlines?
Certainly possible, but if so, that view of a deflationary bust is coming in the context of otherwise supportive fundamental data: “High frequency inventory data was mixed but leaned bullish”. Further, as Johnston notes, those bearish positions come with considerable risk: “It remains extremely likely that these positions begin to normalize to the upside over the coming weeks, providing explosive fuel to whatever fundamental trigger can finally pull the barrel out of its latest tailspin.”
Louis-Vincent Gave posted his take on recent commodity weakness:
Three possible explanations for the painful meltdown in commodities:
- Global growth is slowing hard
- China has hit a brick wall
- Someone (a trading house? A large hedge fund? An investment bank?…) has funded large commodity trades with JPY [Japanese yen] borrowing and is now being “tapped on the shoulder” [getting a margin call]
The recent strong daily correlation between the JPY and the oil price leads me to believe that it is the latter…
One point, not that we needed more affirmation, is that commodities are volatile. This means short-term moves always have the potential to disrupt longer-term plans. If you are going to invest in commodities, you need to be able to tolerate moves like this.
Another point is if Johnston and Gave are right in suspecting fundamental reasons for recent commodity weakness, then there is potential for a fairly violent swing in the other direction.
Implications II
With stocks being choppy of late and bonds being fairly strong, many investors are rediscovering the virtues of having bonds to offset stocks in their portfolio. Alf Peccatiello proclaims this as a “massive regime change in markets” and a “huge deal”:
But the big news for investors is that bonds have started to exhibit one of their key features again.
For the first time in a few years, bonds are acting again as a hedge against stock market drawdowns.
Consider me skeptical. For one, this renewed fervor for bonds is happening at a time when inflation expectations are as modest (complacent?) as they have been in over three years. You have to believe inflation has essentially been vanquished to load up on bonds here. I don’t believe that - and that sure wasn’t the message in the CPI report on Wednesday.
In addition, the following chart from The Daily Shot reveals Treasuries (and base metals) are pricing in much higher chances for recession than other assets. Believing that Treasuries are right on pricing and almost everything else is wrong strains credulity. A more credible explanation would be that bond prices have simply gone too far, too fast, and have priced in too much good news on inflation, much like what has happened with commodities.
One implication for investors is while there may be a short-term trading opportunity in bonds and commodities, there is little in the current environment to suggest a “massive regime change in markets” upon which to base decisions on longer-term asset allocation.
The longer-term view is still dominated by financial repression which is the practice of keeping longer-term bond yields below inflation. Obviously, this is value-destructive to bond holders.
There are two things to keep in mind in regard to the prospects for financial repression. First, no politician can afford to accept an extended period of outright deflation - they won’t get re-elected. As a result, the fairest expectation is that inflationary policies will emerge. Second, for long-term investors, the most relevant consideration is the enduring effect of the “medicine”, not the transient intermediary effects of the “disease”.
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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