Observations by David Robertson, 9/27/24

It was a fairly quiet week overall but as we edge closer to the election, there is plenty to discuss. Let’s dig in.

As always, if you want to follow up on anything in more detail, just let me know at drobertson@areteam.com.

Market observations

For all the monetary hubbub this week, stocks only barely eked out gains through Thursday. While the prospect of progressively lower rates is clearly sparking some speculation, overall follow through has been quite modest so far.

One of the news items that clearly affected markets was that of Saudi Arabia hinting that it may start increasing production. The FT ($) reports: “Saudi Arabia is ready to abandon its unofficial price target of $100 a barrel for crude as it prepares to increase output, in a sign that the kingdom is resigned to a period of lower oil prices, according to people familiar with the country’s thinking.” Oil was down about $3 in the midst of a sea of green everywhere else.

As a reminder, Saudi Arabia has been absorbing a disproportionately large share of OPEC+ production cuts and apparently has had enough of that unfair deal. Even though oil demand has been holding up fairly well, it’s hard to get very excited about oil when supply starts creeping up again. That said, inventories are also low. All told, a good setup for some volatility in the oil space.

Finally, here’s a fun fact in the precious metals space delivered by Marin Katusa: “Move over Costco, Amazon is coming for your precious metals sales. Now selling 1 oz silver eagles for $50!” This is especially interesting because gold and silver coins normally come with a commission/premium in the mid- to high-single digits — which often serves as a deterrent to would-be buyers. Apparently the 56% at Amazon is not a problem though!

Economy

Uncertainty about the economy abounds with “doomers” seeing recession right around the corner and optimists seeing nothing to worry about. Thus far, the doomers are dominating sentiment as interest rates are falling and the Fed has jumped into action. As usual, Bob Elliott provides a masterclass on what is going on. The tl;dr:

There is a big divergence between surveyed confidence measures for the US consumer and their actual activity. Yesterday's confidence numbers were just another example of gloomy consumer surveys, but when you look at behavior, spending growth remains pretty good.

One of the more important, but less-heralded economic phenomena is the degree to which consumer surveys deviate from actual reported behavior. I have mentioned this several times now and there are several reasons, but a big one is political partisanship. Surveys of consumers whose political affiliation is different than the president report the economy as being worse than it is. Despite the evidence the economic surveys “have degraded in quality,” markets still place a great deal of weight on them. This creates “a pretty big divergence in the sentiment readings relative to actual economic activity.”

This divergence causes at least three big problems. One is that it also distorts the Fed’s view of economic conditions. As a result, it is fair to assume the Fed is making policy based on an overly negative view of the economy, and of employment in particular. Another problem is that investors are likely making the same error insofar as they are taking their cue from the Fed.

Finally, the political bias in economic perception is indicative of just how unwieldy the political environment is. Regardless of how effective any president might be in steering the economy, half the population will not see it as such. As a result, the policy bias will always be to do more than is necessary — and that is inflationary.

China

Early in the week China reported a new stimulus program. The initial reaction was positive with Chinese stocks popping. It sent a number of mixed messages though.

On the positive side, it was a large, multifaceted program, not a series of small fragmented tweaks that don’t amount to much. This is a good indication China is getting much more serious about stanching its decline. In addition, much of the focus of new liquidity provisions was on supporting housing and stocks, the declining value of which has severely undermined confidence.

On the negative side, the measures were all liquidity-oriented and did not include any fiscal stimulus. As a result, they fail to address the single biggest problem in China’s economy which is deficient consumer demand. This failure raises a big concern: Will China ever address weak consumer demand directly through fiscal support? Perhaps this big liquidity provision is just the latest, desperate but wrong-headed, attempt to stave off decline with the wrong tools?

On Thursday, China followed up with a pledge of intensified fiscal support. As the FT ($) reported, however, the policy statements “did not provide figures for the proposed fiscal stimulus, or whether it would exceed existing plans for long-term central government and local government issuance this year.” In short, it was more bark than bite.

Given the overall effort, there is a good chance Chinese equities will rally for a while. Given the continued failure to address the core underlying problem, however, it’s hard to say how much of a sustainable boost these new programs will provide. If policymakers don’t produce credible responses to the country’s economic woes, markets will challenge them again.

Monetary policy

With the starting gun of interest rate cuts being fired, now the challenge is to map out the path of cuts. Or is it? As Robert Armstrong asks in his FT newsletter ($),

What if the central bank rate policy is always a meaningless or near-meaningless sideshow in economies and markets? What if policy rates are … mostly epiphenomenal — that is, accompanying important changes, rather than causing them?

I also questioned the usefulness of interest rate policy last week in regard to a note by John Cochrane, but the concept is not a new one. Michael Howell, for example, wrote in his 2020 book, Capital Wars, “the 2007– 2008 Global Financial Crisis (GFC) and the subsequent policy response evidenced that interest rates are not the main channel of monetary transmission.”

What does this mean for investors? For one, it means all the academic discussion about r* (r-star) and the neutral level of interest rates doesn’t improve our understanding of the investment landscape. In short, such discussions are mainly distractions from the things that are more important to investors.

It also means the vast majority of monetary policy statements are mainly kabuki theater; they are performances designed mostly for political posturing. More specifically, central bank statements are primarily made for the purpose of enhancing political narratives, i.e., the stories that justify what they want to do anyway, and not about informing effective monetary policy. Admittedly, this is a cynical view, but it is also the view that best fits the evidence.

What the Fed wants to do is to foam the economic runway with loads of liquidity. It wants to do this to do this to prevent/defer a meaningful economic slowdown, to enable a large slew of companies and investment vehicles to refinance at economic rates, and probably to tilt the election in favor of Kamala Harris. It is using relatively benign recent inflation reports to provide cover for this.

There are at least two big problems with this strategy, however. First, inflation is not dead; all the mechanisms that cause inflation are still in place. Large scale deficit spending, prospects for increasingly constricted supply, fairly strong consumer demand, the prospects for geopolitical conflict, or even a port strike, all suggest inflation could rip higher with very little incremental disruption.

Second, by starting the rate cut cycle with a 50 bp cut, the Fed is signaling that it will be very supportive of markets. While that signal will influence some behaviors, it is unlikely by itself to do much of anything to improve the economy. In such an event, the market would quickly and fairly completely lose confidence in the Fed.

Markets may already be sniffing out this possibility. The facts that gold is continuing to storm ahead and the 10-year Treasury yields are beginning to rise again, while stocks are not moving much, suggest the Fed may be losing its magic.

Politics

The Battle for Control of Congress Heats Up ($)

https://thedispatch.com/newsletter/morning/the-battle-for-control-of-congress-heats-up/

But downballot races are still very much in flux as the Democratic and Republican parties battle for congress majorities. Control of both the House and the Senate will come down to just a handful of contests, and how candidates in those contests run the final leg of their races will determine whether the 47^th president—whoever he or she is—has a rubber stamp or a meaningful check on the other end of Pennsylvania Avenue.

House race ratings from the leading election analysis shops—including Crystal Ball, the Cook Political Report with Amy Walter, and Inside Elections with Nathan L. Gonzales—put around 20 races in toss-up territory. Crystal Ball considers 19 races to be toss-ups. If Republicans won half of the tossups, either nine or 10, they’d retain their majority. But the group doesn’t believe that’s the most likely scenario. “In our own back of the envelope accounting of these races, our best guess is that the Democrats would do better than just splitting the toss-ups, putting the overall race for the House right on the edge of the 218 seats either side needs for the majority,” they concluded. “We continue to not see a favorite in the House.” 

This is a friendly reminder from the Dispatch that downballot races also matter quite a lot in this election — and they are also likely to be very close. A number of very close elections in contentious races is likely to invite a great deal of litigation. As a result, there is likely to be a period of uncertainty for some time after the election.

Even after the results get confirmed, there are likely to be issues. Close elections in politically polarized areas and accusations of unfairness and will undermine a strong sense of legitimacy.

Almost regardless of what the final results are, there are likely to be very thin majorities in both the House and the Senate. Consequently, small constituencies will have enhanced power to veto legislative actions. This will limit legislative ambitions meaning the greatest risk will be errors of omission, not of commission. Namely, the ability to respond quickly and effectively to emergencies will be constrained.

Finally, Janan Ganesh ($) raises another political problem — electorates in the West. As he notes, voters today “have passed through a human lifetime of peace and non-catastrophic economic performance since 1945. The ultimate result of that glorious feat is that we are harder to please.” As a result, “Starting around a generation ago, public opinion became less and less appeasable.” In other words, the political problem has at least as much to do with us as with “any governmental failure”.

I think this is mainly right. Insofar as it is, it suggests some real constraints on public policy. For one, excessively high expectations will prevent any real reform from happening. The political capital does not exist. For another, since there is no premium for good governance, there will be bad governance. This means policies will promote the short-term but at the expense of the long-term. Finally, this will continue until things blow up in a major event.

To be sure, I very much hope this is not the case. But it is the direction in which the evidence points.

Investment landscape

gallows humor

https://jj745.substack.com/p/gallows-humor

The carry trade was born in the 90s. The carry thesis is obvious. No one will say how big the carry is, but time is money and 34 years is a very long time. The BIS estimates the carry at $15 trillion. DB thinks it’s $20 trillion. The plunge in August was just 1 day, and the first and loudest voice to cry out in pain? Jamie Dimon.

The BOJ held its overnight call rate at 0.25% last night. This is the BOJ’s Fed Funds. if the hiked it would have been dollar negative. Japan overall consumer prices rose 3% vs 3% as expected. However, JGB yields languish at 0.889% (BBG: cob 9/18). It is not a mystery why the BOJ needs to hike, however if they do, USD/JPY goes down. The carry (Yen) shorts would need to cover and sell USD assets (primarily stocks) to unwind and/or meet variation calls.   

This Substack snippet from Alyosha is packed with important insights and implications. For starters, the carry trade was “born in the 90s” and is somewhere in the range of $15T - $20T. That’s enormous! So, all the commentary arguing the carry trade unwind was over almost as soon as it started in early August is crap. It’s nowhere near over. It’s barely even begun.

It would be best to look at the severe dip in early August as a warning shot. That was a tiny little taste of what is likely to happen once the carry trade starts unwinding in size.

Another takeaway is the carry trade has been going on for a very long time — over three decades. The enormously profitable trade of borrowing in yen and investing in US stocks and bonds attracted a lot of capital to US markets which in turn helped drive prices up further than they would have gone otherwise. As a result, explanations for the exceptional performance of US assets over that period need to be recalibrated. Big tech, a fertile environment for innovation, and American exceptionalism probably all contributed to some degree, but capital flows from the carry trade were the dominant factor.

As Alyosha also highlights, the prognosis for continuation of the carry trade is not good. Japan is no longer in a situation in which it can suppress interest rates without consequence:

If the BOJ hikes it is bad for their  bonds. If they do not hike it is bad for their bonds. This is the BOJ’s dilemma. However, not hiking is worse because they cannot control the market. Therefore, they must hike.

Japan is a close ally of the US, so it is unlikely to barrel ahead with policy moves that would obviously subvert American interests. However, time is running out for Japan and at the end of the day, it must act in it’s own interest. I’m not sure the BOJ can pull off a rate hike after the last attempt failed, but it can repatriate capital. And then the carry trade would (will?) start unwinding in a big way.

Implications I

In order to make sense of the crosscurrents in the investment landscape going into the election, it helps to put some perspective on the policy environment.

For starters, all the attention is on monetary policy, not fiscal policy. Sure, there are things government can and will do to provide a boost going into the election, but they aren’t the kinds of wide-sweeping programs that can solve major problems or sustain growth for a long period of time.

For its part, monetary policy certainly has advocates. As Bob Elliott points out, “Every asset manager, corporate executive, and politician desperately wants an aggressive easing cycle to come and has for awhile, voices amplified by a media echo chamber.” This certainly can be positive for markets. As Paulo Macro ($) explains, “the reaction to massive rate cuts boosts speculation, animal spirits, CEO buyback ability (sorry — “capex  decisions”), subprime consumer borrowing/spending, and especially…asset prices, ie stocks and confidence.”

The question is — how good for markets — and for how long? The answer comes down to handicapping the effect of monetary policy (alone) on speculation vs. real economic growth. Put another way, and simplified, given only the signal of loose monetary policy, are CEOs more likely to spend money on share buybacks or investments in capital expenditures?

The FT ($) answers the question definitively, “Fed rate cuts should boost corporate America’s buyback binge”. Without a compelling reason to take incremental business risk, i.e., invest in capital expenditures, companies will take the low risk route to supporting their shares — by buying them.

As a result, looser monetary policy is likely to boost speculation. That means the S&P 500 should have a tailwind for a while as will cryptocurrencies and other speculative assets. The bigger question is how long speculative fervor is likely to last and will it be strong enough to bootstrap real growth?

Implications II

More sustainable growth will depend on both economic conditions and on government policy choices. In regard to conditions, there are a number of reasons to be at least somewhat optimistic. Lower interest rates will ease financial conditions for some. Some homeowners will be able to refinance. Most households have relatively little debt and therefore have the capacity to increase it if they wish. And, as Bob Elliott highlights, there are “Initial signs of nominal wage growth rebounding.” These all suggest the consumer remains fairly healthy.

The potential for additional help from government policy is attenuated by a couple of factors though. One is that new incoming president is likely to be handcuffed from implementing meaningful economic support for some time due to uncertainty regarding the results of the election. Another is that sustainable economic growth depends on consumer spending, but public policy in the US has long favored capital over labor. Will the new administration (finally) meaningfully support labor relative to capital? The answer will matter quite a bit.

These will be key items to monitor for long-term investors, but so will developments in Japan, China, and the Eurozone. Each country is going through its own challenges and any strategic decision by one will also affect the others.

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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