Observations by David Robertson, 9/9/22
Whew - back in the saddle after a very nice week off. I hope everyone enjoyed the long holiday weekend as well. It’s looking like we will have another crazy, news filled fall so let’s jump in. As always, let me know if you have questions or comments at firstname.lastname@example.org.
After drifting up through the better part of August, yields on 10 yr Treasuries spiked higher on the first day back from the long holiday weekend. Tuesday’s closing yield of 3.34% is a full 2% higher than a year ago and showing no signs of plateauing.
This is important to watch for two reasons. First, higher rates mean a higher cost of capital which means lower discounted cash flows. In short, higher rates will punish long duration assets such as long bonds and tech stocks.
In addition, and as I have noted in the past, the 60/40 stock/bond portfolio works under the condition that rates remain low. As long rates creep up to the 4% threshold, this assumption is increasingly at risk. If and when that happens, the correlation between stocks and bonds tends to increase which means the two major asset classes no longer diversify against each other. When that happens, investors will be no longer be as able to smooth out market volatility and therefore will be vulnerable to bigger swings than they have experienced over the last forty years.
Another noteworthy happening during the week was the dramatic fall in the price of oil. Rory Johnston shows the inventory increases that set the market off in his tweet. We’ll have to wait and see, but it certainly looks like oil is catching down to other commodities in pricing in slower global economic growth.
Another useful observation came from the tweet below (h/t Jesse Felder from The Felder Report). It illustrates bear market losses are not distributed evenly through the course of the bear market, but rather tend to be back-end loaded. This makes sense as the biggest losses tend to occur when investors who had been holding out hope for improvement finally capitulate and throw in the towel.
Vast corporate profits are delaying an American recession ($)
But this [Fed rate increases, reduced capital spending] is all being done from a position of considerable strength. Aneta Markowska, an economist at Jefferies, another bank, says the Fed may ultimately be forced to induce a recession to curb inflation, but adds that it will have a fight on its hands, in part because of the resilience of profit margins. “It’s like a Mike Tyson economy,” she explains. “It’s a lot stronger than you think, and it’s going to take a lot of work to take it down.”
There are several bits of evidence pointing to a weakening in the financial health of US consumers. Increased credit card use and anecdotes from retailers count among them.
In a broader context, though, the economy is still pretty healthy. Of course, it is just a matter of time for higher rates to really bite and it is fair to expect higher energy and power costs to eventually make their way to the US. For the time being, however, companies look pretty healthy.
In sum, I expect economic news will continue to be very mixed - which also means the economy is not likely to fall off a cliff any time soon - and the Fed will have to remain vigilant.
UK and the Eurozone
I can’t say the same thing about Europe. The economic pain of higher energy and power costs, as Jim Bianco reports, “has ALREADY happened”. The pain is quantified, but has not yet been distributed to the ultimate bag holders. Much of the pain will fall on consumers and businesses, but much will also be laid off on to taxpayers.
This will cause major problems for a couple of reasons. One is the significant sovereign liabilities taken on will put downward pressure on currencies. Further, there is a good chance there will be more to come.
Maybe the adversity will be enough to coalesce political capital around better, more sustainable energy policy. Or maybe, big declines in standard of living and capricious wealth redistribution will enflame populations. Regardless, status quo is the least likely scenario.
Finally, these issues are almost certainly coming to the US as well. It will take longer and probably won’t be as severe. But they are coming.
Just about this time last year, the Chinese real estate company, Evergrande, missed a payment on debt and the investment world was thrown into a tizzy as to whether the event marked the next “Lehman Brothers” or was a non-event to be looked past. I wrote posts here and here in Observations at the time.
A year on, the answer is clearer: Evergrande was neither the next Lehman Brothers nor a non-event. Rather, it marked the beginning of a uniquely Chinese restructuring away from overbuilt industries to those that are more productive and strategic and ultimately into a more sustainable growth model.
Part of this same restructuring has been a reckoning of bad debt that has been a long time coming. Given the broad authority Beijing has, this has not resulted in a total collapse of the real estate sector, the banking sector, or anything else. At least not yet.
What it has resulted in is a weakening yuan. The weakening has occurred despite China’s efforts to keep the currency stable. The reserve ratio adjustment mentioned above is just one of those efforts. Since China is highly unlikely to allow its currency to float freely, it will either need to support the currency or eventually devalue.
In other China news another wave of lockdowns has affected cities that comprise an aggregate of 35% of GDP. This is another area that has been hard for investors to figure out. Many have assumed China’s zero-Covid policy just wouldn’t last long or would suddenly go away. Despite policies that seem unconscionable to Western minds, the beat goes on. What also goes on are negative ramifications for global supply chains and global economic growth.
Despite the capacity of the country to shock, investors are beginning to figure one thing out. China remains the marginal consumer of many commodities and therefore represents a major factor in commodities markets. If its demand is down, prices are coming down.
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As long as we’re on currencies, it is also worth considering the Japanese yen, shown here in percentage moves relative to the dollar. This is the currency of the third largest economy of the world and a clear industrial leader. And its currency is down over twenty percent since the end of 2020. What gives?
At one level the currency weakness reflects the expectation the Bank of Japan will continue its yield curve control efforts for the foreseeable future. In other words, “Damn the torpedoes!” is the thinking in light of the rapidly eroding currency.
At another level, this seems to be reflective of an “Asia problem”. After all, it’s not just the yen that’s been weak, but also the Chinese yuan and the South Korean won. The regional currency weakness brings to mind the Asian Financial Crisis of 1997 and 1998. Fortunately, a number of lessons can be drawn from that experience in Russell Napier’s book by the same name.
Pegged currencies can be a big problem because they subject an economy to a monetary policy derived somewhere else. While China’s currency isn’t pegged, for example, it isn’t free floating either.
Another problem is there are several channels by which contagion can occur. Regional economies tend to be interdependent because they are their own biggest trading partners - due to proximity. Similarly, cross-boarder banking is common which makes credit risk contagious as well. Japan may not be the main problem, but it is certainly vulnerable to infection.
A new ingredient to this Asia crisis is the unfriendly nature of the relationship between China and the US. In the late 1990s, the IMF and the US both played important roles in capitalizing and stabilizing the region. This time around, there is little reason to expect the US to come to China’s aid. As a result, it certainly looks like Asia is heading to a deflationary crisis. If China goes, it will be hard for Japan to remain unscathed.
Public policy 1
Grant’s Interest Rate Observer, September 2, 2022 ($)
The real budget-buster is the administration’s proposed student-debt forgiveness plan, which would extinguish up to $20,000 in student debt per borrower. College-related borrowings summed to $1.59 trillion on June 30, and the Penn Wharton brains trust estimates that President Biden’s proposal will produce $519 billion in writeoffs, with $468.6 billion of forgiveness in the first year.
In classic Grant’s fashion, it investigates a policy, puts numbers to paper, and reveals what become clearly negative consequences. Add the cost of student loan forgiveness to the deficit of $984 billion already expected and the potential cost of a recession on the horizon and you get to a place where the country must continue to increase its borrowing from already high levels. At current rates about double that of the average for existing debt. Ouch.
So, interest rates will increase which will further push up borrowing costs. A worse than average recession, new spending bills, or subsidized energy costs like what Europe is facing today, and we will fall into a vicious cycle of more borrowing = higher borrowing costs = more borrowing.
Fortunately we aren’t there yet, but it is coming unless something major changes. When it does, markets will pivot violently and launch a new and very different investment landscape - as described in the tweet above. This is my base case right now, but I don’t think it will happen until after midterm elections.
Public policy 2
Fascinating! Amidst a record-setting heatwave California sends out a text when its electric grid approaches the breaking point. Almost instantaneously demand falls taking the grid out of an emergency situation. Is all it takes for substantial compliance a timely and direct text?
Almost certainly, conditions matter. The imminent threat of a blackout was both credible and timely. But the situation begs the question of why more general requests tend to be ineffective. No doubt, future studies will be done on this, but the potential for more effective and efficient public policy and behavior modification is enormous.
Two themes regularly top my thinking about the investment landscape. The first is inflation and how narratives about it are likely to play out over the next few years. The second is the increasingly ugly political environment.
I still believe inflation will be above the Fed’s wished-for 2% for an extended period of time which makes it an extremely important variable to monitor for portfolio management. However, I also believe short-term conditions are pointing to lower inflation.
The big decline in oil prices and the additional lockdowns in China during the week combined to lower near-term expectations of inflation. Neither the draining of the Strategic Petroleum Reserve and tight monetary policy in the US nor the persistent lockdowns in China are sustainable policies, however. Once China holds it party congress and the US holds its midterm elections this fall, the political need for such draconian policies will diminish.
At some point, I’m currently guessing 6-12 months out, the realization of structurally constrained supply of many commodities will become unavoidable and inflation will be truly off and running.
This promises to make politics even more toxic than it already is. With consumers in Europe confronting electric power bills ten times higher than last year one can wonder how public policy could have gone so wrong as to allow this to happen. By a similar token, many US consumers are wondering how the Strategic Petroleum Reserve can get drained for nothing more than a short-term, one-time benefit of cheaper gas prices.
While I cannot conscientiously defend either of these positions, I do have some sympathy for government officials who must manage scarce resources on one hand and appease incorrigible consumers on the other. People want stuff, they want it cheap, they want it now, and they get ticked off and blame government if they don’t get served according to expectations.
So, when resources become insufficient to meet those expectations, what are governments to do? There is very little hope of modifying behavior. You can fudge the figures for a while. At the end of the day, though, the rubber hits the road and people realize they aren’t going to get what they want.
As I work through these issues in my head, I am growing increasingly sympathetic to the wretched set of options we are facing in so many policy arenas. Not because I think this is a good thing, but because I don’t think most people will change their behaviors or consumption habits, or make other sacrifices, unless and until it is blatantly obvious there are no other choices and everyone else has to deal with it too.
I wish it were otherwise. And I wish policy roadmaps could be established to gradually transition from one set of conditions to another. But I don’t see that reasonable approach as viable in today’s social and political environment.
Insofar as this is a decent read on things, we’ll be facing a number of crises and shortages and outages in coming years. I don’t think any will create catastrophic conditions in the US, but that doesn’t mean it won’t get extremely unpleasant at times.
Implications for investment strategy
As my expectation of a continued bear market remains intact, the challenge for investors is to determine what to do about it. Here, the old adage about encountering a bear in the woods applies: You don’t really need to outrun the bear; you just need to outrun the slowest person you are with.
In a similar way, investors don’t need to “outrun” the bear market. Indeed, setting an expectation of avoiding all harm from a bear market is too high a goal and can easily prove counterproductive.
Rather, a more useful and practicable goal is to try to escape as much harm as possible. This means you don’t need to get the timing exactly right and you don’t need to micromanage your portfolio through the working day. But you do need to make sure you aren’t exposed to too much risk and you do need to avoid major drawdowns. Sometimes, you need to reassess old investment approaches.
Of course, that may be easier said than done as bear markets present all kinds of tempting opportunities to jump back in just before things head south again. The main thing is to remember during bear markets, the odds are against you. That means it is better to focus on playing defense than offense.
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