Observations by David Robertson, 9/3/21

Observations, insights, and implications to help navigate the ever-changing investment landscape.

Welcome back!

It’s hard to believe the summer is already over, but here we are.

I hope you have a great holiday weekend!

Let me know if you have comments. You can reach me at drobertson@areteam.com.

Market observations

MEME stocks - bitcoin's biggest enemy?, Aug 31 2021 at 07:44 ($)

https://themarketear.com/premium

The comparison of meme stocks to bitcoin is interesting. Both are incredibly volatile. Often, they move in opposite directions, but not always. It’s almost as if in combination they provide a suitable playground for high-risk frenetic traders.

With stimulus checks a thing of the past and pandemic unemployment benefits running out, it will be interesting to see if this corner of the market continues to make headlines. My guess is much of this will gradually settle down.

Labor

Mistreatment of transport workers adds to supply chain pressures ($)

https://www.ft.com/content/998762ed-d58e-4c13-9242-3ac183bc9e57

“Millions of workers who have kept trade flowing should have been afforded the care and respect shown, rightly, to doctors, nurses, police officers and shop workers. Despite the efforts of industry, this has not happened nearly enough. Instead, facing increasingly harsh working conditions, the most important links in the supply chains — people — are beginning to crack.”

“Truck drivers sleep in their cabs for two weeks at international borders. Some pilots fly thousands of miles without being allowed to leave their cockpits. Seafarers are stuck on ships far beyond their tours of duty — up to 18 months in some cases — never setting foot on dry land. Many are leaving the sector, deepening its paralysis. At current rates, merchant shipping alone will see a shortage of 75,000 officers by 2025.”

The supply chain problems being experienced now are mainly the culmination of problems that have been brewing for many years. As the jobs have become progressively less desirable, the supply of operators has become something of a ticking bomb. Older operators are just doing their time until retirement – and there will be a wave of retirements. Younger prospects have no desire to enter a field with such adverse working conditions.

Higher pay is part of the answer but better working conditions are arguably even more important. As such, transportation firms are going to need to re-imagine many of their positions in order to keep things rolling along.

Homeschooling reaches critical mass

https://www.axios.com/homeschooling-pandemic-critical-mass-013e4f01-c962-4e38-8cb7-8079bb597540.html

“The number of U.S. kids who are homeschooled has nearly doubled during the pandemic.”

“Some parents have lost faith in traditional schools, others fear exposing their kids to the coronavirus — and the broad exodus could further weaken America's struggling public education system.”

A new report indicates “Nearly 2.6 million kids have switched from traditional school to homeschooling since the pandemic began” and according to census data, “more than 11% of U.S. households are now homeschooling.” In other words, homeschooling is no longer an activity way out on the fringe.

Taking the issues of transportation labor and homeschooling together, it is easy to see there are trends in place that will significantly affect labor supply. In transportation, the jobs need to be reformulated in order to attract enough people. In homeschooling, each incremental adoption prevents one parent from working outside the home, at least on a full-time basis. These are just a couple of changes working to systemically reduce labor supply.

Housing

The return of evictions

https://www.axios.com/eviction-renters-landlords-tenants-housing-market-f243c493-e0c4-49c6-ae13-3a6b555066ec.html

“Nearly all American renters can now be evicted, for the first time since March 2020 — and a white-hot housing market is making eviction much more attractive for landlords.”

“Pre-pandemic, evictions tended to run at a rate of about 1 million per year. Since the pandemic hit, various federal and state moratoriums have brought that number down sharply, by about 60%.”

When the pandemic started, I voiced several concerns over what would happen to the housing market. From that time the answer has been basically, “nothing”, but not because the downside was overstated. Rather, the downside was just deferred. That is changing now.

In addition to evictions restarting, supplemental unemployment insurance is also expiring. One of the most important points here is these challenges will now be affecting consumer sentiment and economic growth again. It’s hard to imagine there won’t be some period of time to digest these changes or that there won’t be pockets of notable disruption.

From a bigger picture perspective, this is a good thing. As these emergency measures are removed, we can better gauge the true status of economic activity. Much as with the case of reduced labor supply, I suspect we will find some important things have permanently changed.

Economy

This graph from https://themarketear.com/premium certainly puts fiscal policy in perspective. After massive wads of money were spent in 2020 and 2021 to offset the pandemic, fiscal infusions are scheduled to massively decline beginning next year. It’s hard to see how the return to more normal fiscal spending won’t be felt across the economy.

Emerging markets

Emerging economies cannot afford ‘taper tantrum’ repeat, says IMF’s Gopinath ($)

https://www.ft.com/content/873ca2e8-63d2-40dd-842d-5409169166fa

“[Emerging markets] are facing much harder headwinds,” she [Gita Gopinath, chief economist of the IMF] said. “They are getting hit in many different ways, which is why they just cannot afford a situation where you have some sort of a tantrum of financial markets originating from the major central banks.”

Emerging markets often experience a kind of bullwhip effect whereby they perform disproportionately well when times are good and disproportionately badly when things turn south. This makes the whole valuation case for emerging markets at least partly a function of timing.

As Gopinath points out, this isn’t a really great time for emerging markets as “they are getting hit in many different ways”. For example, as trade has become more global, the orbit of emerging economies around the US has become even tighter because of their dependence on the dollar.

If the Fed is in a bit of quandary over when to taper, the conundrum is felt many times over in emerging economies. Many of these countries have large amounts of debt so any rate increases could be extremely harmful to growth. At the same time, many of these countries are also experiencing significant food inflation. The bottom line is there are few good options. There is a reason emerging markets look cheap.

China

China Evergrande Says Construction of Some Projects Has Stalled, Warns of Possible Default ($)

https://www.wsj.com/articles/china-evergrande-says-construction-of-some-projects-has-stalled-warns-of-possible-default-11630412380

“Cash-strapped China Evergrande Group said work has been suspended on some of its real-estate projects after it delayed payments to its suppliers and contractors, showing how the developer’s financial troubles have spilled over into its business operations.”

“Global investors that hold Evergrande’s bonds have pushed prices of its debt securities below 40 cents on the dollar, indicating they see a high likelihood of default. The company is China’s largest junk bond issuer, and had borrowed aggressively onshore and offshore to fund its rapid expansion in recent years.”

In what has become a well-rehearsed routine, a company in China gets itself deep into financial trouble and concerns creep into the market. Given the countless times companies have been bailed out at the eleventh hour, however, there is very much a “Boy who cried wolf” aspect to the whole thing.

Will this time be different? We seem to be getting close to finding out. Evergrande has warned of possible default and the Chinese government seems to be taking a much harder line on these situations. It is not an exaggeration to refer to it as China’s “Lehman moment”.

When a major default finally happens, whether Evergrande or some other entity, it is hard to imagine it won’t have a jarring effect on other Chinese businesses and global investors.

ESG

So, I was cleaning out some old books over the weekend and came across this entry on the “Environment” from the World Book Science Year from 1982. The article informed readers “The availability of a safe and adequate supply of drinking water became a major area of environmental concern in the United States in 1980 and 1981.” The passage even included a snarky cartoon about acid rain.

One point is environmental concerns have been around for a long time, the basis for ESG is nothing new. Another point is a great deal of progress has been made over time. After all, who complains about acid rain anymore? This doesn’t mean there aren’t plenty of environmental problems that can and should be addressed, but nor does it mean concerns should always be stated in apocalyptic terms either.

Commodities

The initial take on Powell’s performance at Jackson Hole was positive. As the graph shows, inflation beneficiaries bolted during and immediately after the speech. The interpretation was a deferred taper would be positive for commodities and cyclical stocks. But there is another interpretation …

Oil - bye bye, Aug 26 2021 at 16:18 ($)

https://themarketear.com/premium

"+10% CL [crude light] price gains over 3 days, open interest actually lower, volume scraping the 30-day lows...certainly looks like a dead cat bounce or as we like to call it at MPAS.... a conviction bye! "

Along with the INFL ETF, oil also popped last week. It is tempting to attribute the action to a resumption of the reflation trade, but The Market Ear has a very different interpretation: This was a late summer, low volume, dead cat bounce. In other words, nothing to see here.  

Monetary policy

In an admittedly light news cycle, it seems all anyone can talk about is Jackson Hole and parsing Powell’s statement one way or another. To this point, John Authers made the interesting observation that “Powell is presenting the decisions on tapering asset purchases and raising interest rates as entirely separate.” The idea that “a taper is imminent” can now cohabit mental space with the “reassurance that rake hikes aren’t.”

While the Fed’s predisposition towards tightening policy is certainly relevant for investors, it looks right past what I believe is a much bigger issue which involves the machinations around the debt ceiling …

Lee Adler’s Liquidity Trader, Thursday, August 26, 2021 ($)

https://liquiditytrader.com/index.php/2021/08/26/link-corrected-qe-still-100-of-treasury-issuance-but-coming-change-crash/

“The Treasury is rapidly exhausting its cash as it continues to pay down T-bills. At this rate, it will run out of cash at the beginning of October. Congress will be forced to raise the debt ceiling.”

“Once the Treasury begins to issue new debt, it will be on top of this gigantic wave of corporate supply. It won’t be pretty.”

The debt ceiling is a bigger issue because it is entirely outside the control of the Fed and because it has the potential to massively complicate the task of metering money supply. As the Treasury works down its cash, incremental liquidity enters markets. As it works cash back up, incremental liquidity leaves.

In addition, economic progress will also be an important variable. As Adler assesses, “the Fed can only taper if the Federal deficit is shrinking”. This means employment and tax revenues will be critical, if hugely understated, factors driving the proclivity to taper. Add in a few pinches of intense political rhetoric and you have a recipe for some pretty wild volatility over the next several months.

Investment management

A tiny sniff of fear ($)

https://www.ft.com/content/8d2ea578-04d2-449d-ab8a-55202cc455f0

“I moved into an ESG focused role a few years ago . . . and even I am aghast at the current trend. The market seems to have lost its collective mind, failing to maintain any realistic connection to what makes sense and what doesn’t. I’ve often thought about how to stand up and say ‘hang on a second’, but in my role the risk of being ostracised is pretty uncomfortable.”

Robert Armstrong from the FT posted this quote from “a person who runs ESG investments at a global asset manager you have heard of”. I found it interesting because the sentiment is completely consistent with my experience at a global asset manager you have heard of.

Namely, being associated with such a firm certainly provides a lot of access to information – both formal and informal. Of course, for analysts like me, this can be a very attractive benefit, but it comes with an underappreciated cost. When you work for a large asset gathering firm, the priority is on gathering and retaining assets, not on managing them in the best possible way.

It took me a while to figure this out even while I was working in that system, so I have plenty of sympathy for those who have never experienced it so directly. However, it doesn’t change the gap between the perception that many the leaders of large asset management firms express valuable insights about managing money and the reality that they are often just cogs in a giant machine of asset gathering willing to say what they need to in order to keep the money rolling in. In this sense, they are probably paid more for what they know but do not say publicly.

Capital markets

Demographics mean the fall in interest rates is far from over ($)

https://www.ft.com/content/3f199380-3d78-44bb-b856-4a0e3214c741

“In one of the papers presented at the virtual Jackson Hole Fed conference over the weekend, the Chicago professor Amir Sufi presented new research that suggests rising inequality weighs on interest rates even more than ageing demographics.”

“The mechanism by which inequality can cause falling interest rates is well known: rich households have a higher savings rate, so when they get a bigger share of total income, overall savings go up. More saving relative to investment pushes interest rates down.”

“Sufi and his co-authors note that savings rates vary far more by income than they do by age, and that even among the US baby boomers, the top 10 per cent by income saved more than earlier generations while the other 90 per cent saved less. That suggests inequality was a bigger factor than demographics.”

This paper by Atif Mian, Ludwig Straub, and Amir Sufi (MS&S) has gotten a lot of attention and rightly so. It is important on many levels but most fundamentally in helping better understand the conundrum of persistently low real rates. The conclusion that inequality is a bigger factor than demographics is bound to cause some fireworks. To that point, Robert Armstrong does a nice job summarizing the political implications …

The rich get richer and rates get lower ($)

https://www.ft.com/content/256acf1b-5bbb-475b-9df3-6d0b3a59389a

“A further note. I think if MS&S are right, the political implications are particularly nasty. Inequality, in their view, is self-perpetuating, with the feedback loop running through low rates. Excess savings of the rich depress rates; low rates push asset prices up; the rich get richer still. Many governments are engaging in monetary policies that, in all likelihood, make this flywheel turn faster. For how long are the people who sit outside this wealth machine — a majority of voters — going to tolerate this?”

One point is this is likely to put a lot more pressure on the Fed. It is also likely to put more pressure on Congress since it was the impotence of Congress during the financial crisis that empowered the Fed to be as aggressive as it has with monetary policy. I have been amazed at the level of ambivalence toward counterproductive public policy – but that may be changing.

Another more subtle point is the insight from the analysis derives from higher resolution analysis of the data. The potential causes of excess savings become more visible when viewed through the lens of multiple income buckets rather than as one homogeneous mass. This creates a pathway for economic analysis to be much more insightful and the potential for public policy to be much more nuanced – and effective.

Implications for investment strategy

The last couple weeks of summer are always a period of reflection for me. Markets are quiet, volume is low, and even if stocks are moving, it normally doesn’t mean much. In contrast, once things start up after Labor Day, the news cycle can quickly cause one to lose the plot line – and the plot line is what matters most for long-term investors.

This fall, most attention is on when the Fed tapers, but I think that is mostly a red herring. The Fed is unlikely to taper unless tax receipts miraculously jump up and that is unlikely.

What is much more likely is a potpourri of events that can collectively pummel the recovery narrative. The resurgence of Covid globally, slower growth in China combined with tighter financial conditions, vulnerable emerging markets, reduced Treasury issuance, lower fiscal spending, and reduced labor supply are just the topics covered in this letter that can put a crimp on growth and increase volatility.   

If any or all of these factors come to pass, the greatest area of vulnerability will be commodities and cyclical stocks. I am watching and waiting for a selloff in these stocks to provide a more attractive entry point. I still like the longer-term supply dynamics, but the potential for near-term demand weakness needs to get discounted first. Getting this mostly right will do far more for long-term performance than guessing on the Fed’s next move.

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