Thursday, December 1, 2022

Soft (ish) Landing Interpreted

Chairman Powell yesterday confirmed the Fed will slow the pace of its interest rate hikes from 75 bp to 50 bp.  Though it was expected, his statement created a strong relief rally in all markets, which chose to focus on that part of his statement, instead of these:

  • The Fed will keep hiking to a level higher than previously targeted
  • Inflation is expected to remain high for longer, necessitating a restrictive policy well into 2023 or further.  His reasons include structural shifts, such a demographics and changed employment patterns post COVID.
  • He expects a soft(ish) landing for the economy, rather than a deeper recession.
How do we interpret his pronouncements? For me, it's this: inflation will last for years and won't revert to 2% soon, or ever, and the economy will be weak(ish) for the foreseeable future.  In my book, that's called stagflation, though not the same as in the turgid 1980s.  Putting it in numbers, I expect inflation around 5-6% and real GDP growth around 0-1%.  

What does this mean for markets, assuming Mr. Powell is correct? For one, the yield curve inversion will soon reverse course and become more normal/flat around 5%.  For another, a period of near zero economic growth will hit equity valuations by lowering P/Es going forward.

Looking at real GDP growth for the last 70 years (chart below) we can observe a change in the nature of US economic activity. During 1950-80 the economy was highly cyclical, with frequent recessions and booms. During 1980-2000 there were fewer boom-bust cycles and a more consistent, albeit lower, level of economic growth.  Finally, from 2000 onward the economy was much more consistent, except for the Great Debt Crisis, though average growth was even lower. In percentages, average growth has declined stepwise from approx. 5% to 4% and now around 2.5%.


If our future is even mildly stagflationary, where should equity P/Es be? For perspective, here is a chart going back to the 1980s when they averaged around 12X.  Versus today's 17x, a reversion to 12x implies a 30% correction ON AVERAGE.  Of course, markets overshoot, and during long, drawn out bear markets they can also become despondent, so I would not be surprised to see multiples as low as 7-8X.

Chart: Yardeni Research

High inflation, high(er) positive real interest rates and near zero growth are very strong headwinds for equities, particularly "growth" stocks that do not pay consistent dividends. 

Wednesday, November 30, 2022

Be Careful What You Wish For

 Seems like everyone in markets is hoping for a recession so that the Fed will stop raising rates.  They point to the yield spread between 10 year and 2 year Treasuries as an accurate predictor of recessions.  The spread is now at its most negative in 40 years, and a quick glance at the chart below confirms that a yield inversion accurately predicts recessions (grey areas in the chart).


From a fundamental perspective, it makes sense to expect a recession.  Sharply higher prices for consumer essentials like energy, housing, food and transportation means that disposable income is curtailed for other expenses such as clothing, electronics, vacations, dining out, etc.  So, yes, a recession is more likely than not.

But, "markets" had better be very, very careful what they wish.  For one, squeezing available incomes and raising unemployment in today's America is downright dangerous.  The middle class has evaporated, replaced - mostly - by the working poor;  and they cannot afford to see their incomes eaten away by inflation, because they simply cannot make ends meet living paycheck-to-paycheck.  Labor actions are already in the works where unions still have a toehold, but if this negative income/expense balance continues for much longer there will be serious social trouble.  At the very least, expect higher wage demands even where there is no unionization.

The government/Fed's record breaking largesse during COVID via QE helicopter money is now long gone, spent away on the likes of FAANG-type services and punting on scams like meme stocks, cryptos and NFTs.  Moreover, the Fed has - finally - started to drain the excess liquidity at the rate of $95 billion/month.  Not fast enough to kill inflation quickly IMHO, but this is money that will be increasingly "missed" from the economy.


Americans' Savings: Easy Come, Easy Go

Bottom line: I don't think this will be a recession like all others.  It won't be the quickie down-and-up of old but a shallower and more prolonged affair, possibly marked by social unrest and political upheaval. Markets: Beware what you wish for!

Fed Update:  Mr. Powell confirmed that rate increases will moderate from 75 to 50 bp and sent markets into a strong relief rally.  He also, however, pointed out that structural changes in the economy, demographics and employment patterns mean that inflation is now more difficult to bring down quickly, requiring restrictive policies for a longer time. He thinks that a “softish” landing is possible, rather than a deep recession. Another name for it? Mild stagflation…




Monday, November 28, 2022

Is The US A "Safe Haven" Or A "Powder Keg"?

Every time there is some sort of global upheaval in markets or geopolitics the US benefits from a stronger dollar and a rally in Treasury bond prices.  It has been thus for decades, as the US is viewed as a safe haven for capital from all over the world. 

Is this view still valid?

In my opinion, no it is not.  The US should no longer be taken for granted as a safe haven;  instead, it should be viewed more as a risk factor than anything else, a powder keg that could potentially blow up spectacularly. This is not a recent development, it has been a long time in the making.

  • For one, it was the US itself that caused the Great Credit Crisis in 2007-10.  Yes, there were other economies that followed the same unsound path: loose money, substandard lending practices, real estate excesses and unbridled securitization of loans and derivatives.  But, it was the US that was the main culprit and it was the US that subsequently "printed" trillions to save its banks, brokers, funds and insurance companies from default - well, most of them anyway. The deleterious effects of that massive QE are still with us, even if the even more massive COVID era QE has far outdistanced it.
  • The US is now amongst the most highly indebted nations in the world, with public debt to GDP at 121%, an enormous increase from just 30% in 1980.  The debt ratio has accelerated the most during the Great Debt Crisis (see chart below), precisely because the government "saved" the private sector banks, investment banks, etc. by assuming their debt - foolishly, in my opinion.


  • Going back further, the US economy has become emasculated, wasting away its manufacturing muscle by shifting it abroad, mostly to China.  As I said before, manufacturing is the fountainhead of all technology, of all high value-added economic processes. According to the Bureau of Economic Analysis, US manufacturing now accounts for 11.5% of GDP, down from 27% in 1960.  Crucially, manufacturing employment is now a mere 7% of total, down from 30% in 1960.  US manufacturing leadership is now limited to aircraft (Boeing) and military equipment.  Not good.
  • The loss of manufacturing jobs has all but eliminated the solid American middle class, creating a socio-economic chasm between the working poor and the ultra rich.  The political consequence of this divide are becoming apparent (Trump/MAGA) and dangerous (storming of the Capitol, rise of the far right).  Unthinkable previously, the US can no longer be considered a politically stable nation.
  • As is common in nations, societies and economies that are losing their leadership edge, financial speculation in the US has increasingly replaced healthy, productive economic activity.  American tycoons are now mostly owners and top executives of hedge funds, investment banks, and until recently, all manner of crypto/NFT firms.  That's not a healthy sign, it marks an economy that makes money from trading paper, instead of innovating and producing. 
  • One final observation: a sure sign of an Empire in decline is that its supremacy is increasingly challenged by second or even third rate powers, who would never dare do so before. Iraq, Venezuela, Afghanistan, North Korea, Turkey and, of course, Russia are nipping at Uncle Sam’s heels with increasing frequency, if with questionable success. But the mere fact that they are doing so speaks volumes.
So, yeah, the US is no longer a safe haven in my book.  And unless American leaders wake up soon, they will end up wondering why the proud nation has become a has-been.

Sunday, November 27, 2022

That’s Oil Folks


The recent slight drop in inflation caused a wave of optimism that we are out of the woods. All markets rallied and the Fed decided to slow down the pace of raising interest rates.

But, let’s take a closer look at the constituent parts of inflation, shall we? The following chart from the WSJ tells it as it truly is: the drop in inflation came 100% from lower energy prices. Core inflation remains mostly unchanged and high, and so does the food component.


To make this clear, here is another chart: energy price inflation came down from 42% yoy - the highest in 40 years - to a more manageable 17.5%.


And why did energy prices come down in the US? Because the government released an unprecedented amount of oil from the Strategic Petroleum Reserve, increasing local availability of cheaper oil to domestic refiners thus lowering gasoline prices from $5.00 to $3.60 per gallon. Gasoline is the largest component of energy CPI thus… lower overall inflation.


This unprecedented drawdown in the SPR is not sustainable, of course. If continued at October’s rate, America’s strategic reserves would empty completely in a mere 17 months. In fact, there are signs that the drawdown is slowing down in November - after the midterm elections, of course. Now, if I were of a suspicious nature I would say that lowering gas prices and inflation was a political ploy designed to shore up the Democrat’s showing in the midterms. 

One way or another, we will soon be back to normal (whatever that is), the oil drawdowns will cease and the SPR will need to be filled up again, reversing the downward pressure to an upward one.

As Porky used to say - almost - “That’s Oil Folks!”




Friday, November 25, 2022

More On The Creaking Treasury Bond Market

In a recent post I pointed out that liquidity in the secondary market for US Treasury securities is at the lowest point in years, creating serious problems for dealers, traders and the Treasury itself.  I did some more data mining in SIFMA  and came up with the chart below.

You can see that the average daily volume in all Treasury securities (bills, notes, bonds, TIPS) as a percentage of all marketable Treasuries outstanding (ie excluding those held in the Social Security accounts) is at the lowest level ever.  The big drop in activity came about after the Debt Crisis in 2008-09 and has been falling steadily since.

This drop in activity is very worrisome, particularly now when the spike in inflation has led to sharply higher interest rates and an increase in new bond issuance to cover higher budget deficits and debt service payments/refinancing.


Why did activity drop in the secondary market?  Partially, it is due to the sharply higher amount of bonds held by central banks, particularly the Fed, which now owns 6 times more Treasuries than in 2008.  Such holdings don't trade, so the percentage traded has come down - but this can't explain everything.

Amount Of Treasury Securities Held By The Fed

Something else is going on… it could be the near zero interest rate environment that held for such a long time sapped all desire to trade - there was very little price volatility for years on end. Also, investors had no reason to sell their older higher coupon bonds since they could not replace them.

No matter the reason, low liquidity and low volume is troubling and could create serious problems for the government’s finances.



Inflation and Wages - A Follow Up

Following up on yesterday's post on how inflation is eroding the buying power of the average American and European wage earner and the upcoming strikes in key sectors like rail, mail, education and health.

It has been decades since unions flexed their muscle - indeed, unions have become emasculated. In the US private sector only 6.1% of workers are unionized today, a far cry from almost 35% in 1960.  The primary reason is the de-industrialization of the US/West, particularly after China became the world's factory.  I am certain that this shift of production from West to East (it started with Japan, remember?) is one of the stupidest socioeconomic decisions made by all Western leaders, bar none. Pardon the "stupid", but as a trained engineer I understand very well how production drives R&D advances and quickly leads to technological supremacy.  Lose your technological edge and you destroy your high value-added economy and your prosperity - period.

The loss of manufacturing jobs emasculated the entire middle class, now but a shadow of its former glory.  And along with that, has come the rise of populist politics, and politicians promising to Make America Great Again.  It is happening everywhere: in the US, France, Italy, Brazil, Austria, Poland, Hungary... it is no accident that Germany, the only Western economy still boasting a large and solid manufacturing base, has not fallen victim to populism - at least not yet.

It was a matter of time, then, that something would give and social unrest would follow.  Soaring inflation and loss of real income is now threatening to throw the West into a vicious cycle of social unrest.  It is no accident that Russia/Putin is taking advantage of this situation, hitting Western economies in their soft underbelly: energy, food and transport.  And it is still early in the game.

What should the West do? Here's a list, from immediate actions to longer term:

  1. Substantially raise minimum wages - at least to cover inflation.
  2. Do everything necessary to kill inflation immediately: raise interest rates at least at or near inflation levels AND get rid of excess liquidity ASAP.
  3. Promote saving instead of spending. Pressure banks to raise deposit interest rates.
  4. Raise corporate taxes, enforce minimum tax policies and invest the proceeds in alternative energy technologies, public transport, technical education and R&D.
  5. Provide serious incentives to bring factories back. Perhaps impose trade/import restrictions.
  6. Promote "buy local" policies, with tax incentives.
  7. Seriously evaluate the consequences of getting rid of WTO, replacing it with bilateral/multilateral trade agreements. 
If the West - and by West I mean 70% USA, 20% EU, 10% Japan - does not act immediately, it will fail spectacularly and suddenly.  There is no time left for navel gazing.

 


Thursday, November 24, 2022

Real Wages Eroding Fast, Strikes On The Horizon

With inflation running hot in the US and Europe, labor unions are preparing massive strikes not seen in decades.  

US railroad employees are set to strike next month, though the federal government will likely step in and impose labor terms, as it has the right to do in order to prevent the economy from grinding to a halt (40% of all goods move by rail and many commuter trains use private railroad tracks). In the UK rail workers are also set to strike in December, joined by university professors, teachers nurses and mail workers.

Can you blame them? In the US consumer inflation is rising much faster than pay raises, resulting in negative real wage growth (see chart below).  

Real Average Hourly Earnings - Annual Percent Change

Lower/middle income workers feel the pinch much more, since a greater portion of their earnings go to buy essentials like food and transport where prices are rising faster than overall inflation: Food and beverages are up 10.6% and transport up 11.6%, while overall CPI inflation is up "only" 7.8%.  For them, wage erosion is closer to minus 5% - 6% instead of 3%.

Service workers in Amazon or Twitter may be laid off in droves without immediately causing an economic upheaval, but essential workers are a different matter altogether.  Expect more labor actions to surface in the immediate future.

Tuesday, November 22, 2022

It's Deja Vu (All Over Again)

 Very short post today.

The gut feeling I get from all markets these days is that I've seen it all before, specifically during 2007-08.

Back then the Debt Crisis started slowly at the very edge of the risk/credit/real estate spectrum, ie subprime loans for speculative type properties.  Some mortgage brokers started going under, then specialist mortgage lenders (remember Countrywide?) and - finally - the doodoo hit the fan all at once: venerable investment banks who had bought and securitized loans and derivatives went bankrupt or were bought/bailed out for peanuts, seemingly overnight. The Fed saved the day by providing massive liquidity in amounts that looked immense - back then.

Today, the "edge" of the credit/risk spectrum is in cryptos and their associated exchanges and lenders.  They are now going under leaving behind losses in the billions.  Since the financial system is highly interconnected, however, I'm waiting for the next domino to fall, and it won't necessarily involve cryptos.

Once the Risk switch is turned to the OFF position all manner of critters are going to be rushing for the exit doors.

Monday, November 21, 2022

COP27 Ends In Failure

The COP27 conference just ended in abject failure, as leaders failed to agree on the mitigation of emissions from fossil fuels and arresting global warming. Not surprising. God help us and our children, because global leaders won’t.

Below, relevant charts. 

Fossil Fuels Are 80% Of Our Global Energy Consumption


CO2 Emissions Have Risen 800% In 70 Years


Global Land-Ocean Temperatures Up 1C In 40 Years



Heat Map In 1950

Heat Map In 2022

All charts are alarming, of course, but the last one is particularly so.  It shows that Arctic temperatures are rising the fastest,  4C+ over average.  This means:

  • Polar caps are melting fast, raising sea levels
  • The Siberian Arctic tundra holds immense amounts of trapped methane near its permafrost surface. Methane is up to 80 times more damaging as a greenhouse gas and its release will act as the most powerful accelerant of global warming/climate change, much more than CO2.  It means that we may see climate and habitat disasters happen within years, not decades.  

Friday, November 18, 2022

The Most Important Market In The World Is Creaking

The stock market gets the glory (incessant publicity), but the most important market in the world is the bond market, particularly US Treasurys. Everything, and I do mean everything, is ultimately based on it. It hasn’t always been so, but ever since the abolition of the gold standard in 1970’s, and more recently the emergence of shadow banking and the effective abolition of bank reserve requirements has led to an explosion of debt. 

Yes… Sudden Debt…

Obviously, the proper functioning of the US Treasury market is of paramount importance: liquidity, breadth, depth, transparency and regulatory oversight are the cornerstones of any market and are taken for granted for Treasurys.  Lately, however, something is seriously wrong as the chart from a very important FT article shows.


Liquidity, measured as the amount of a single trade that can be executed without seriously moving the market up or down,  has deteriorated to dangerous levels at the very time that the size of the market has quintupled. In 2010 liquidity stood at almost $800 million and today at just $100 million.  As a ratio of the total market, liquidity has collapsed 97.50% from its 2010 levels. Another way to look at it: for a bond trader it is now 42 TIMES more difficult to execute trades in US Treasuries - in equivalent market size. 

In practical every day terms it's not as bad as that because a chunk of Treasuries sit at the Fed's balance sheet, around $5.5 trillion worth. Still, it's bad enough.  Furthermore, the Federal Reserve Bank is ultimately... a bank!  At the end, it too has to take into account how heavily exposed it is to its borrowers and how liquid is its portfolio.

As a bond market professional, this liquidity plunge is really scary.  It could create enormous price volatility in the market, a possible repeat of what we saw in UK gilts recently, but magnified many times over.  If it happens, it would necessitate the massive intervention of the Fed in the form of another QE, at a time when we need the exact opposite (QT).to tame inflation.