Observations by David Robertson, 9/16/22
With most people back at work after summer vacations and back to school preparations, a number of tensions in the market are receiving heightened scrutiny. The persistence of inflation, the persistence of the Fed’s monetary response, and China’s real estate melt down, among others, are all significant threats to still-high stock valuations. It promises to be an interesting fall. As always, let me know if you have questions or comments at firstname.lastname@example.org.
The biggest news of the week was an unexpectedly strong CPI report on Tuesday. I say “unexpectedly” because the S&P 500 sold off by 4% and the Nasdaq sold off by more than 5% indicating a lot of investors were caught off guard.
So, one observation is market expectations for inflation still seem too benign. While the headline CPI number came down incrementally, all of the worrisome core and sticky components rose. As John Authers noted in an excellent summary of the report, each of the Cleveland Fed’s “trimmed mean” inflation rate, the Cleveland Fed’s “median” inflation rate, the Atlanta Fed’s “sticky” price inflation rate, the classic “core” measure that excludes food and energy, and the Services Excluding Energy Services indicator, increased in the period.
Another observation is the marked disparity between stocks and bonds as revealed in the chart from themarketear.com ($) below. Bonds have clearly been affected by high inflation and rising rates through sharply rising volatility. Stocks not so much. While stocks are down for the year, the relatively sedate level of volatility suggests things might start getting more interesting before too long.
One of the many consequences of exceptionally low interest rates was the low cost of capital made available to leveraged investors like private equity firms. Not surprisingly, these companies used their financing advantages to compete with families in buying homes in many areas of the country. The result was to push home prices up even higher (and faster) than they otherwise would have gone.
Now, with rates going up, the financial proposition for private equity ownership of single family homes is marginal. Further, since that ownership is leveraged, there is a distinct possibility the selloff will not be measured or orderly. Just like there was a big “push” on the way up, it is fair to expect a big “pull” on the way down.
One redeeming factor to this phenomenon is private equity buying was not uniform across the country. As a result, while certain communities will likely bear a disproportionate impact, it is less likely to be a country-wide phenomenon.
Mining's uncertain future ($)
Chile’s rejection of a proposed new constitution is being welcomed among investors as the least bad outcome, with the peso set to strengthen and equities ready to climb. An idealistic, maximalist document born of 2019’s social upheaval, the charter would have come with dangerously vague environmental and other burdens in particular for miners — plus onerous spending demands for a government that can ill-afford them.
This is a healthy reminder of the many dimensions of uncertainty that exist for global commodity miners. It is easy to forget when times are good and the environment is stable for an extended period of time.
The constitutional referendum in Chile highlights not just the ongoing political uncertainty, but also the real possibility of nationalization, widespread issues with water rights, and mining taxes, among others.
This all increases the level of difficulty with investing in commodities. Just as supply and demand conditions suggest higher prices, those higher prices often generate incremental uncertainty.
In the best of conditions, it is a huge challenge to distribute the spoils of natural resources equitably. When economies are weak, food prices are high, people are disenchanted, and governance is weak, the range of possible outcomes is massive.
This is another great thread by Michael Pettis that addresses the specific progression of financial distress in China at one level, but also generalizes the “process” of financial distress at another level.
A major point is distress migrates in stages. What can appear as an unbelievable string of bad luck is, rather, a fairly predictable progression that eventually spreads far and wide. As a result, there is also a “self-reinforcing” element of financial distress that makes it extremely difficult to reverse.
These insights by Pettis help explain why the restructuring of China’s economy is taking so long (every process of financial distress takes a long time) and why it is not fair to expect a sudden and complete recovery.
Lots of news from Ukraine this week and most of it good for Ukraine and the West. While it is always difficult to cut through the “fog of war”, and misinformation abounds, the theses presented by @PeterZeihan and @gummibear737 are striking for their implication: The US is setting up for not just success, but potentially spectacular success in the Ukrainian conflict.
Read through the thread and you end up with Russia crippled as a geopolitical foe, which allows the US to focus on containing China, all of which is done at relatively low cost, and which leaves the US in a dominant economic position. It’s like winning the lottery of strategic geopolitical goals.
Of course this is a non-consensus position, and of course, there is potential for serious escalation. However, the hypotheses fit the evidence well. As such, it is important to at least consider the possibility they are right.
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Lost innocence ($)
Whatever happens to inflation in the next year or two, a lot of volatility in the price indices is a certainty. Repeating what Unhedged has written before, there is no such thing as high and stable inflation. Even if inflation declines from here, the decline will not be smooth.
Observations by David Robertson, 4/30/21
The main one [point] is that the volatility of prices is also an important factor, not just the direction. Any business or consumer making decisions must evaluate not just direction of prices, but also timing. Being too early or too late to a big pricing move can be more destructive than being wrong on the direction of the move.
The first quote above is Robert Armstrong of the FT describing inflation after the CPI report on Tuesday. The second is me describing inflation almost a year and a half ago.
One big point is inflation is not a uniform or easily characterized process. Although this has been knowable for quite some time, large swaths of investors nonetheless prefer to learn lessons the hard way. This is why stocks sold off on Tuesday and why the same thing is likely to happen many times over again until the message finally hits home.
Another point is that rising inflation, starting from very low levels, tends to be good for companies. This corroborates the exceptionally good financial performance of public companies over the last year.
As inflation sets in, however, it starts having a more pernicious effect. With higher prices crimping consumer budgets, companies run out of space to raise prices without also reducing demand. As a result, higher prices start eating into company margins. Next stop on the inflation train: Earnings misses and lowered guidance.
Countries do not control their own currencies ($)
The paper’s [“Rethinking Monetary Sovereignty: The Global Credit Money System and the State”] authors, Steffen Murau of Boston University and Jens Van ‘t Klooster from the University of Amsterdam, believe that the dominant definition of monetary sovereignty is Westphalian — nation states create and control their own money. But like Carlo Cipolla’s medieval rulers, governments now actually issue very little currency on their own. They have some influence over the rest of the system. But it is limited, even in a more closed financial system like China.
Traditional theories of money present central banks as the creators of currency, but they’re really more like currency shepherds, nudging banks back and forth.
Every once in a while I come across an article that makes me smile - for its insight, perspective, and its ability to pull together various threads into a coherent thesis. This is one of them.
There are a handful of commentators who regularly discuss the Eurodollar system. This is an important endeavor and I have commented on it several times in the past (here and here, among others). It is an arcane subject, however, and often escapes notice as a result.
What Greeley accomplishes brilliantly is to provide the context from which it can be appreciated why such arcane details are important. For example, the general theory of money, at least the one that has been taught in colleges and universities for decades, focuses on commercial banking as the source of money growth. This view, however, is incomplete at least, and misleading at worst.
Probably worse is the fact that this is the language policymakers use to explain monetary policy. Either policymakers don’t fully understand money themselves or are being intentionally deceptive in their communications. Neither possibility bodes well for good outcomes.
It is this point that Greeley focuses on: “as the authors point out, there is no such thing as a dollar, just dollar-denominated credit assets. Then we ask what the US wants to accomplish with those dollars, and whether it’s working.” Sounds like a reasonable place to start.
What we are getting, however, is a continuation of fuzzy beliefs about what dollars really are. As a result, it is very difficult to judge what monetary policy is or is not accomplishing.
Since shortly after QT began I have been tracking progress on the Fed’s balance sheet that it reports every Thursday afternoon. A number of others are doing this too which has led to a fair amount of confusion as to how well the Fed has been performing on its commitments.
In general, the Fed is on track and is ramping up QT this month. So one major point is the decline in liquidity is about to get worse.
Another interesting pattern that has emerged, however, is the vast majority of the runoff in Treasuries has occurred in the segments of 1-5 years and 6-10 years. Interestingly, the quantity of Treasuries of ten years and up has actually increased since QT began.
This begs a lot of questions but the most obvious speculation to me is while the Fed does want to work down its balance sheet, it is also hyper-sensitive to the all important 10-year yield. In other words, it doesn’t want the 10-year yield to rise too far or too fast.
If this is correct, and it is an “if”, there are two important implications. First, there is a lot of pressure on the 10-year Treasury. After starting with a yield of about 2.84% when QT began in June, the yield is now in the range of 3.45%. How much higher might it be if the Fed wasn’t still buying? This suggests the pressure on yields remains upward. It is also causing problems for those who are expecting bond yields to remain low because of high debt and low growth.
A second implication is the Fed is actively managing the yield curve. Effectively it is implementing a “twist” in order to keep the yield curve flat. Again, “if” this is the case, it is important to acknowledge the intentional effort to distort market signals. Perhaps, the Fed is concerned even higher yields on the 10-year might send a signal of strong economic growth. Perhaps it is worried too fast of a move might “break” something in the financial system.
Either way, the message is rates are likely headed higher. As a follow up note, Treasuries greater than ten years finally did decline over the four weeks ended Wednesday. This helps explain the recent bump in yields.
Entering The Superbubble’s Final Act
Only a few market events in an investor’s career really matter, and among the most important of all are superbubbles.
My theory is that the breaking of these superbubbles takes multiple stages. First, the bubble forms; second, a setback occurs, as it just did in the first half of this year, when some wrinkle in the economic or political environment causes investors to realize that perfection will, after all, not last forever, and valuations take a half-step back. Then there is what we have just seen – the bear market rally. Fourth and finally, fundamentals deteriorate and the market declines to a low.
Jeremy Grantham is one of those investment legends that it just always pays to listen to. His vast experience, broad perspective, and native independence make him an invaluable resource for long-term investors.
The first quote contains two important truths. One is there are only a few market events that matter over the length of one’s career (or investment horizon). Of course, this can also be said of life in general. When it boils right down to it, most day-to-day stuff is not life-changing. But a few events, most of which involve change of some sort, do matter.
The second truth is the importance of superbubbles. The history of markets shows that markets do go to extremes, and sometimes super-extremes. These matter a lot to people who also happen to be at important junctures in their investment horizons. It is especially important to retirees who no longer have the interest, energy, or capacity to re-enter the workforce to compensate for investment losses.
In addition, the second quote highlights another important truth: bubbles don’t break uniformly or quickly, but rather transpire in stages. Further, there are recognizable patterns to these stages. While the presence of such stages does create trading opportunities, they are also useful to long-term investors as signposts that can guide longer-term exposure to investment risk.
Implications for investment strategy
Probably the biggest implication of having relatively few but massively important investment events over one’s lifetime is the need to pay attention when they come up. Partly this is a matter of preparedness (by being aware of changing conditions), partly it involves the ability to reassess expectations, and partly it involves an ability to change tack if a new direction is needed.
All of this highlights an often under-appreciated reality: While a large proportion of investment accidents occur because of wildly speculative forays, another large proportion of investment mishaps occur less dramatically as errors of omission. In other words, it is all-too-easy to let one’s investment portfolio run on autopilot into an environment it is not well suited to withstand.
This is truer today than ever as more and more portfolios are comprised of passive funds. Since these funds replicate market indexes they are considered “safe”. As such, they often receive a “hands-off” treatment under the assumption nothing needs to be done.
Such inattention is fine if one is very clear and comfortable with the potential swings financial assets can take over a market cycle. Unfortunately, the sensitivity of that perception often increases when assets go down. After a couple of tough quarters already this year, a lot of investors are starting to wake up to the real risks embedded in their “safe” portfolios (as illustrated in the graph of household net worth from @SoberLook below). And then they have questions.
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