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Observations by David Robertson 9/17/21
Back for another week of “Observations” and there are plenty of things to observe. Inflation is probably the biggest topic but there are plenty to go around – so let’s dig in.
Let me know if you have comments. You can reach me at email@example.com.
Just like we are starting to get some glimpses of a change in the weather, so too are we getting some glimpses of a change in the market environment. The prior week extended the number of consecutive losing sessions for the S&P 500 to five. Beginning on Friday the 10th, on three consecutive days, futures pointed to a strong open only to immediately and persistently lose ground during the day.
The obvious point is something is different here – this is a different trading pattern than we have seen most of the year. The following comments from Zerohedge suggest the cause may be diminished retail activity …
Is It Time To Buy The (Monthly Cycle) Dip?
“But, as SpotGamma specifically notes that the reflexive bid that usually arrives on each and every dip has been absent these last few days.”
Collapse In Retail Investor Euphoria Points To "Imminent Correction", Vanda Warns
“Maybe it is because the S&P is at all time highs, or because retail euphoria has shifted to cryptos which have vastly outperformed even the most perky meme stonks, but as Vanda Research which tracks traffic on retail trading platforms and industry-wide order flows, the scale of retail interventions is getting smaller. This, according to the firms strategists, raises the chances of more serious declines if big investors continue to retreat.”
“While we have seen a pick-up in ETF buying this week, the magnitude has been a little underwhelming relative to previous selloffs,” Ben Onatibia and Giacomo Pierantoni wrote. “This diminishing appetite to support the equity rally raises the odds of a larger selloff if institutional investors continue to sell.”
The Market Ear has also been hypothesizing about the atypical weakness and one reason (among several possible reasons) is already-high equity allocations …
Looking for pockets of "stretched" ($), Sep 15 2021 at 04:00
“Half of the funds Morningstar track are running a high equity allocation vs history. Chart shows number of multi-asset funds with equity allocation above their 90th percentile (110 US funds, 174 European funds)”
It’s very hard to tell if the retail bid is fading or not. Several other accounts indicate retail money is simply flocking to the brightest shiniest objects of the moment. On that account, cryptocurrencies and IPOs are more attractive for pure volatility.
Regardless, the flow of money into stocks is an important ingredient for keeping prices elevated. Odd trading behavior the last couple of weeks suggests there may be some disruption to these flows. Since this has the potential to be an important inflection point, it will be helpful to keep a closer eye than normal out for new developments.
“In any event, based on the present set of conditions in the U.S., my expectation is that the SARS-CoV-2 pandemic will rapidly subside in the weeks ahead.”
“[F]rom an economic standpoint, investors seem to have little appreciation of the extent to which trillions of dollars in Federal pandemic relief funds have supported the economy, and the contribution that these deficits have made to household savings, corporate profits, and the financing of record trade deficits in recent quarters. Even the deficit contemplated in existing budget legislation comes nowhere near replacing this impact. So a recovery in the private economy will have to pick up the slack just to hold steady.”
As befitting a section on economics, there is both good news and bad news. The good news is it looks like we are past peak for the delta resurgence. One might not guess this from all the political squabbling, the re-introduction of restrictions in many areas, or the sense of resignation that has emerged after several false calls in the past. However, the math of vaccinated people and people who have already been infected massively reduces the vulnerable population. We can start planning seriously for life after Covid.
Ostensibly, this is also extremely good news for the economy as well. In many respects it will be, but as John Hussman rightly points out, improvements in the private economy will need to more than offset the massive influence of Federal pandemic relief funds in order to post any incremental improvement. Unfortunately, this isn’t likely to happen for a number of reasons. As a result, the market will be left to decide which is better, an economy that grows on its own or one that is massively aided by government largesse.
A quality theory of Treasuries ($)
“Thomas Sargent, an economist at New York University who won the Nobel Prize in 2011, points out that before the 1940s, Congress used to design every new debt issue in detail — terms, duration, amounts. All new debt had a specific purpose. ‘You could use this bond to reschedule debt,’ he says, ‘this bond to pay for things’.”
“Starting in the early 1970s, the Department of the Treasury began to establish a clear calendar for auctions, and by the mid-1980s had built an accounting system that made it easier to trade US debt securities … The goal was to make it more attractive to buy Treasuries, and lower borrowing costs. It worked. But it also completely divorced the act of appropriation — what the money is for — from the act of borrowing.”
This is an interesting little piece of history, of which I was unaware, that helps explain a great deal about the current debt situation. Because the issuance of Treasuries has become something of a machine-like process, there is no longer a link between debt and what it is used for. This is also a point discussed and expanded upon by Ben Hunt in “The Long Now, Pt. 4 – Snip!”.
Brendan Greeley raises a very interesting question. If we were to do a thorough accounting, it would be clear that “not all Treasuries are the same, because they don’t all buy the same things”. Insofar as that is the case, we might start getting different answers as to what debt should be issued and what debt should be disavowed.
For example, Greeley asks the provocative question, “Are we selling Treasuries to lower taxes for favoured constituents?” It’s hard to avoid the distinct possibility this is true. While this is hardly a mainstream issue at the moment, it certainly has the potential to provide a great deal of fodder for political arguments at some point.
Inside Democrats' tax-hike menu
“House Democrats will consider as much as $2.9 trillion in tax hikes for the next 10 years — mostly on the extremely wealthy and corporate America — as they scramble for ways to pay for President Biden's $3.5 trillion infrastructure and social spending plan.”
“A draft proposal from the Ways and Means Committee, which ricocheted across Washington on Sunday night, previews epic fall fights between Democrats and some of the best-armed lobbies in America.”
It was all fun and games when the coronavirus pandemic provided the plausible pretense of an “emergency” that was used to unleash trillions of dollars of unfunded spending. In the absence of such an emergency, the pressure to actually fund spending is higher.
Now, the reality of paying for all of these plans is hitting the public square across the forehead in the form of tax hikes. What was once considered a nice pipeline of further economic support is becoming a calculation of what the net benefit is, or at least what can get passed in light of significant political resistance. Given much more modest expectations, it is hard to see realistic fiscal spending plans as incredibly stimulative relative to the pandemic spending.
Endgame Begins: Evergrande Hires Bankruptcy Advisors As Furious Investors Protest Imminent Default
“In a filing on the Hong Kong stock exchange on Tuesday, Evergrande which was busy trying to convince angry Chinese mobs that they will get their money and/or apartments and that it has no plans of default, the company all but conceded that a bankruptcy is imminent when it said it has hired notable bankruptcy advisors Houlihan Lokey and Admiralty Harbour Capital as joint FAs to ‘assess the firm’s capital structure’, a well-known euphemism of ‘prepare to file for bankruptcy.’ And just so there was no doubt as to what is coming next, the company said if it’s unable to repay debts on time or get creditors to agree to extensions or alternative arrangements, it may lead to cross-default.”
More bad news came out Thursday as Zerohedge reported, “Evergrande Suspends Trading In All Bonds”.
The financial noose around Evergrande keeps getting tighter and tighter. Michael Pettis, one of the most authoritative voices in emerging markets and financial distress, posted an informative tweet thread in regard to yet another Chinese conglomerate in trouble:
The bottom line is many people do not really understand how financial distress affects behavior and “how it systematically forces worse outcomes than expected.” I don’t expect a Lehman-like seizure of the financial system, but I do expect this to be an iconic turning point with far-reaching consequences.
One thing that is changing is China’s leadership of the emerging markets category. After long being an important driver of emerging markets returns, China has recently become a drag. It started with regulatory clamp down on some big tech companies, but the effort has broadened considerably and now is also including the allowance of real financial distress.
As the graph below shows, emerging markets ex China have been outperforming emerging markets since about March. If these trends continue, the fundamental case for investing in China will need to be completely re-evaluated and the effort of investing in emerging markets will likely need to become much more selective.
“Perhaps more worrisome is the fact that the PPI pipeline shows this is far from over as Intermediate goods prices are still roaring and have yet to filter through top the end-product...”
We have heard reports of increasing costs from PPG and MMM which seem to corroborate the PPI report. As I have mentioned before, companies have a number of levers to pull to temporarily avoid having to raise prices. The confluence of data suggests we are at that point and now costs must be passed on. It will be very interesting to observe the degree to which prices rise or margins decline.
This Is No Knockout Win for Team Transitory ($)
“This is how the core (excluding food and energy) annual change in the consumer price index has compared with the 10-year Treasury yield since 1980, a period that goes back to an era where the Fed under Paul Volcker was fighting serious inflation:”
“How unusual [is the incidence of inflation rising above the 10-year Treasury yield]? In the last 60 years, something like this has only happened twice before, during the oil spikes of 1975 and 1980. In both cases, it didn’t last long.”
John Authers goes into a fair amount of detail to suss out the cases for persistent vs. transitory inflation after the CPI report on Tuesday. Once again, the distinction boils down to semantics that distract from the bigger issue.
A key point is despite a number of supply chain issues easing, several indications of inflation are still pointing up, and this result is no longer the result of large moves across a narrow set of products and services. Further, there are several indications housing inflation has been deferred and will catch up in future periods.
Of course, important deflationary forces, not least of which is excessive debt, have not gone away either. This means the stage is being set for a mighty game of tug-of-war between inflation and deflation.
Modern Financial History Begins in 1998 ($)
“In theory, an increase in the price of raw commodities should eventually make its way to consumer products; over time, companies will find a way to pass on those costs, rather than absorb them. And in immediate terms, that's true: commodity price spikes lead to higher CPI readings, especially as energy costs either flow through directly (at the gas pump) or indirectly (through the cost of making or delivering just about anything). But something interesting happened in the 90s and early 2000s: commodities price spikes didn't get passed through to consumers. An old macro hedge fund letter I came across hypothesized that China was the reason for this disconnect: in a steady-state economy, raw materials are used to build a bit more capital that's a complement to existing labor, or to increase output (which uses more of that labor's hours). But in the 90s and especially the 2000s, the purpose of the marginal ton of iron or copper was to build things in China, where they were a complement to a large and cheap labor force. So higher commodities prices actually meant lower consumer prices, since the higher cost of components was offset by the lower cost of the people who turned those components into finished goods.”
In order to understand any phenomenon like inflation, it is important to have context, to understand what happened before that led to the current state of affairs. Byrne Hobart does an excellent job characterizing China’s growth model after the Asian financial crisis and describing how its excessive consumption of commodities paradoxically contributed to deflation.
Two important points derive from this insight. One, it is not just incremental inflationary pressures investors need to monitor. Rather, it is also important to observe the deflationary winds that are subsiding.
Second, as Hobart notes, “the inflation component … will likely be more volatile over the next few decades than before”. This makes it less a game “inflation” vs. “deflation” and more a game of active management and diversification with greater extremes. To that point, Hobart also notes, “And that means some of the easy diversification strategies will stop making sense.” True enough.
All of that said, it is only right to consider the other point of view, which Jeffrey Snider of Alhambra Investments does with a flourish. He caught a small, but telling, insight from a news item: “French container shipping group CMA CGM said on Thursday it was stopping all increases in its spot freight rates until Feb. 1, 2022, following a rise in prices this year”. While it is only one data point, price actions by companies with long-term capital cycles like shippers are often telling. Maybe, just maybe, economic growth isn’t as strong as many make it out to be.
Debt Ceilings & Interest Rate Floors
“As it turns out, the FOMC actually discussed in 2013 ways to skirt federal law and roll maturing US Treasury debt by one day at a time … Garbade’s timely history lesson published a year after the subject FOMC meeting was a not-so-gentle rebuke to the staff of the Fed Board in Washington. The Fed’s lawyers apparently advised members of the FOMC a year earlier that they could lawfully accommodate the Treasury’s cash needs.”
“If you subtract the GAAP release of bank loan loss provisions in Q2 2021 back into income, then the net interest income for the banking industry was below $120 billion or $30 billion below 2018 peak levels. MM [money market] funds are basically in the same boat. As and when Treasury market yields are significantly negative, look for pressure to grow on the Federal Reserve Board to come to the rescue of MM funds and banks. That ringing can just you hear in the background is the zero rate alarm. Sound for collision.”
Several good points are raised in this piece by Chris Whalen. The first, which I alluded to in the past, is when push comes to shove, the actions the Fed takes are not necessarily constrained by legality. The Fed may decide to shoot first and ask questions later. It may decide the ends (saving the world) justifies the means (breaking a few piddly laws). Or, as Whalen suggests, it may just act on bad legal advice. Regardless, the lesson is our conceptualization of what the Fed may or may not do under extreme conditions should not be limited by what we consider to be legal.
Another good point is the analysis of low rates on banks and money market funds. This is rarely discussed in polite company but one of the negative effects of persistent quantitative easing is it eviscerates business models that rely on the time value of money. Squash down rates too far and it becomes impossible to make money. As Whalen warns: “Few people inside or outside of the Federal Reserve fully understand the fragility of the current monetary construct.”
Implications for investment strategy
One of the mental models I have been using is to think of financial assets as a “net” that can be used to catch the extra money the Fed is infusing into the financial system. Since the process of quantitative easing uses banks as intermediaries, the vast majority of extra money ends up in financial assets. This explains a great deal about why stocks and bonds have performed so well since the Fed became very active in the financial crisis.
I believe one of the big lessons for future performance is going to be, “It’s not just what you do wrong that can hurt you, but what you don’t do.” In other words, inaction can be just as big a mistake as an active error. In a period with unsustainable excesses, lots of crosscurrents, and a great deal of fragility, the best baseline assumption is change will happen.
As change does begin to manifest across the investment universe, one of the worst positions will be those who continue to maintain or increase exposure to stocks. However, another very bad position will be static allocations to passive funds. Holders of cash will have opportunities, but those opportunities will be limited time offers as inflation becomes more pronounced. The big takeaway is it is a good time to be diligent and disciplined and ready to act.
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