“We believe the effects of the troubles in the subprime sector on the broader housing market will be limited….and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system…” Ben Bernanke 2007
“Businesses and consumers widely report upward pressure on prices and wages. Inflation at these levels is, of course, a cause for concern. But that concern is tempered by a number of factors that suggest that these elevated readings are likely to prove temporary.” Jerome Powell, Aug 2021.
When I was on the sell-side at firms like JPMorgan and Credit Suisse, ran large businesses for them. I made some good calls and some bad ones. I hired and worked with some incredible people, and I think I built really good teams. I spent a fair bit of my time trying to understand how the market was evolving, what customers wanted, and trying to position our assets to optimize our share of the wallet. It is standard stuff. One of the biggest challenges – and largely because these were businesses where the assets (people) were mobile and the costs of turnover/disruption were material – was to make strategic choices that I knew would have people impact and loss of jobs.
What’s funny about all of that, is that when I first started managing businesses after moving to London in 2006 for JPMorgan, it was because I was generally perceived as a no-nonsense, bottom-line-oriented heat-seeking missile, who did not suffer fools gladly. I was focused on performance, productivity, and skill sets that were a cut above to develop points of differentiation with clients. But, I was also pretty sharp-elbowed, and I needed to find ways to sandpaper those edges down if I was going to be made a Managing Director. In 1998, despite my title as Global Head of Distribution for Currencies, Commodities and Emerging Markets Europe, my promotion was put off a year because some people found me “inscrutable, intimidating, and dismissive.” Almost 25 years later, I shudder to think how true those criticisms were, and even proud that I did the learning and introspection needed – with the help of an executive coach – to pierce the ceiling to MD.
On Wall Street, you not only need to be cold-headed and warm-hearted generally to move up the ladder, but also have a lot of finesse in how you manage situations. People won’t follow you if they don’t trust you or predict how you will act, and your managers won’t keep you in the role unless you improve results and position the business to perform regardless of the market environment. What can happen, and it happened to me, is that because I was so focused on one dimension, in this case being the good people manager, I did not act quickly enough as the e-commerce wave hit our businesses. Cold-headed Dave would have seen the writing on the wall, shifted means of distribution, and invested heavily in e-commerce. Warm-hearted Dave felt constrained to make tough choices that would impact people. We managed through it all, but I missed a golden opportunity trade to add scale via electronic means.
When I look back at it, my misgivings were no different than many others in business, investing or policymaking, that just fail, for whatever reason, to size up important secular shifts. Very often, there are good reasons why such happens. We are all a reflection of our experiences and our decisions. Nobody is as clear/cold-headed in making decisions, particularly when the weight of their actions will impact other humans. Add into that institutional inertia, political realities, execution risks, this is a recipe for sub-optimization, to put it mildly. There are reasons why many firms and careers have been disrupted and it is almost always because they were too slow to adjust and adapt.
This brings me to the opening quotes above. Both Ben Bernanke and Jerome Powell have been at the helm of the Fed through some of the most unique periods in economic history. Unlike myself, their decisions had/have exponentially greater impact, and they operate under intense scrutiny and pressure. Their institution is held in high regard, politically independent, and is staffed with extremely bright and committed personnel.
So, given that, how did they get things so wrong? Isn’t it their job to make sure that they are prepared for such events don’t cause widespread pain? How much of Bernanke’s comments were just trying to be soothing vs malpractice? Did he lack the operational savvy to prevent $1 problems from becoming $100 ones? How much of Powell’s comments were wishful thinking based upon the last 25 years of benign inflation, institutional bias toward employment, and his lame-duck status? We don’t know the answers for sure, and in reading Bernanke’s book “The Courage to Act” it is clear he didn’t connect the dots. For Powell, I think he’s not being an economist probably hurt him, and having stronger internal views on the subject matter. I view him as a risk manager, who played the odds, was impacted by institutional inertia, and got it wrong. In fact, I think as the language from the quotes below shows, he is still walking a tightrope, holding out hope that he does not have to be too aggressive. He represents the view that this can all be worked out – and been flat out wrong.
Here are two Powell quotes from an NYTimes article today from Jeanna Smialek,
Here is a good piece from Larry Summers on how wrong the Fed (and market) have been. and here is a Twitter thread that calls Powell’s thinking of reaching inflation targets given current fact patterns as the “immaculate disinflation.”
Things that caught my attention this week:
Asset Allocation:
As I have been saying, I expect the movement toward more regionalization and geo-economics to play a larger role going forward. That is a big shift. Merrill’s Private Client Group had a good chart called FAANG 2.0, but the acronym has a different meaning than before.
On geo-economics, they made the following points:
On Uranium – which is a theme I have harped on for months (CCJ is my preferred vehicle to play this), note that Russia plays a critical part in refining Uranium for energy use, and that more needs to be done to eliminate that supply vulnerability in the US and Europe, as the WSJ reported. https://www.wsj.com/articles/u-s-rethinks-uranium-supply-for-nuclear-plants-after-russias-invasion-of-ukraine-11647941401
On the point of EVs, here is a very good chart from Michael Cemblast at JPMorgan Private Bank. As Tesla is getting bought hand over fist since the Fed meeting, it is worth keeping in mind a mental picture of the challenges faced for EV adoption relative versus other past innovations. And, this was prior to the situation in Ukraine and sanctions on Russia that adds further complexity to the glide path. Remember, TAM is one thing, and EVs are in a secular positive shift, so there is nothing wrong with the view that over time, EV adoption will continue. But, so is the rate of adoption (and imitation/competition). And, rate of adoption, in this case, requires many other infrastructure-related items, in addition, to changes in consumer tastes.
Flows:
As we can see, the flows keep coming into equities and commodities and out of bonds and money markets. From BAML.
What is interesting, is that, unlike prior crises, this one has seen more steadiness in terms of equity flows.
Goldman would have a somewhat different take as they continue to talk about a market with material sponsorship – ie. Buybacks – and also notes that while these events can cause large swings, they often reveal their worst downturn initially. Perhaps this explains the flow behavior noted above:
My take is that we were short-term oversold (nice calls TT) and that investors saw the Fed as very cautious and balanced as it tries to thread the needle for a soft landing. Perhaps the market believes they will not be willing or able to deliver on their hawkishness (see Dudley below). Not to mention, they appear to be moving along the path that is already priced, so no surprise = bullish. I am just not convinced that is the right read, and while I made a few bucks following some of Tommy’s calls, I think it is more of the same thrashing around in short gamma land (that we appear to have exited) as hard hit names and regions (Europe, China) spiked. The underlying conditions/challenges however have not shifted. As GS Investment Strategy Group notes in their piece entitled “Walking the High Wire”:
As I mentioned to a reader who emailed me this week, I think we are give or take 5% or so around the right prices – assuming revenue, margins, earnings perform up to snuff. As we go into earnings season, it is likely that the numbers are fine (GDP is still estimated at 3.5% for the year in the US). But, the stresses of cost increases can have EPS impacts. In fact, that is what the Merrill EPS model is suggesting as they are calling for EPS to turn negative by late summer.
Ukraine and Geopolitics
I did not want to get too deep into the dynamics of the Ukrainian situation this week – although I did think this piece from Nial Fergusson was very good. I listened to a few podcasts (Hidden Forces with guest Peter Zeihan), Merill’s Private Wealth Group with Ian Bremer, finished a book called “Putin’s World, watched a CBS Sunday morning interview with China Ambassador to US Qin Gang, and read the transcript of the Xi-Biden discussion, and all I can say is that I would be shocked if this situation magically disappears. Seems to me there are all sorts of new and difficult to handicap risks.
It is not worth going into the history of NATO, NATO enlargement, nor about how Russia sees itself on the global stage. All that matters from a markets perspective is that a. Russia is not going to stop its effort to take over Ukraine; b. There is potential for a mistake that enlarges the battle to NATO countries – an Archduke moment; c. Europe is going to feel some pain but is now acting as if there is an existential threat – ie. fiscal expansion; d. Sanctions are likely to expand; e. China is watching carefully, with their own challenges (see below) but appears to want Taiwan in the near(ish) future; f. There are no easy off-ramps that get us back to the world we knew.
And, on the situation with China, here are some comments from GS on their challenges.
The Yield Curve:
A few weeks back, I included a paper from an old Chicago professor named Campbell Harvey that talked about the yield curve and the quality of the signal it provides. Harvey focused on the 3m vs 10y curve and noted it was the better signal for predicting future recessions than say 2’s/10’s. So happens, Powell noted something similar in a comment this week.
And, the FT had this chart as well which shows that the current 3m v 10y curve still has low probability of recession.
Now, let’s take a step back. There are a lot of people in the markets that believe inflation will drop back down to the target (immaculate disinflation & discussed more in next section) and others that believe Fed can only get a few hikes in before a calamity takes place. Bill Gross mentioned as much. What the FOMC suggested from the dot plot, in subsequent conversations, and in the comments from Powell above, they are going to try. Summers would make the case that to arrest inflation, 10-30 year real rates need to go above the target inflation rate. Such can happen if both nominal rates head up and inflation heads down. As much as the Fed wants to engineer a soft landing, they have a solid economy, still loose financial conditions (see below), a strong labor market, solid household and corporate balance sheets, and an inflation problem which Ukraine does not help.
So, of course, they are going to attack the inflation problem, and while Powell’s language and action are still not decisive enough for my tastes, I think they are forced to face realities and do the hard work. Bill Dudley laid this out all very clearly on Feb 28th in a Bloomberg piece entitled “The Market Still Doesn’t Get How far the Fed Might Go”. He makes the following point:
In addition, there are other factors at work, including QT, occurring at a time of still very large Treasury issuance. So, for all the discussion about curve flattening, there is a lot of supply to get absorbed by private balance sheets. Here is an excellent piece by The Fed Guy where he lays out the case for steepening as the Fed normalizes the b/s to $6T, or $1T a year for the next 3 years.
And, to add some fuel to the mix, here is a piece from Guggenheim’s Scott Minerd who believes that the nature of this inflation problem is akin to the mid to late 1940s when the recipe for managing post-war inflation was left to the supply of money/credit. In that way, he cautions the Fed against using the FF rate AND QT, and rather focusing primarily on QT and letting the market drive short-term rates. Here is his logic:
Inflation dynamics – can we even reach 3%?
Included here is a piece from Jason Furman, who was a bit slower than Larry Summers or Mohammad El Erian to call out the dangers of recent policy choices, but generally very good at explaining the phenomenon.
And, here are two charts that I wanted to highlight from his piece. If you recall, I wrote about a great book called “Superforecasters” by Phillip Tetlock, which explains how truly difficult it is to forecast and that often, the best have extremely open minds, and are certainly not driven by institutional inertia and wishful thinking.
So, the first chart should come as no surprise that the community – consumers and businesses – that operate in the real economy are changing their expectations to reflect actual facts on the ground. Investors, forecasters, not so much. As Furman writes, the ability to get inflation down to 3% in the next 12-18 months would be quite a feat. And yet, investors, forecasters, are still expecting something below that.
This next chart shows that wage inflation, which Powell discussed in the above included Jackson Hole speech, is moving well in excess of productivity. Corporations do have the tools to manage through this, but over time, it should feed into margins pressures, which I have shown before are already high.
Other Tidbits:
Free Speech:
One of the good things about having pressing issues (and maybe keeping Russian disinformation off social media) is that some of the cultural issues become less discussed. But, here are 2 pieces about how free speech. Here and here. In one case, Yale Law School, protesters shouted down one of the participants from the Federalist society in what was billed as a civil discussion among competing narratives. In another piece, the University of Pennsylvania is trying to bring about dialogue, discussion, understanding, and empathy in a classroom discussion.
The New York Times editorial page had a separate piece on the matter, which acknowledged that those polled believed free speech is a problem across the country. . I have discussed how damaging polarization can be for making sound and durable decisions. If anybody believes that courteous and thoughtful discourse is too great a burden and that some are too triggered by hearing different views, maybe they should think about what it is like in Russia or China.
Banks
They are in the eye of the storm. Curve flattening + reduced deal flow + greater regulatory scrutiny on M&A is perhaps why financials are struggling. Not to mention, talent getting more expensive.
Analogue of the week:
This one is a bit different. I am not in any way suggesting that Ukraine has the capacity to defeat the Russians because the Russians appear willing to go scorched earth to reach their objectives. That they are willing to completely level property (see Chechnya, Aleppo) and target civilians, arrest Russian protesters, have stadiums full to listen to Putin spew nonsense, is all I need to see this will turn uglier, causing a food/starvation and immigrant crisis globally. All for what?
Anyhow, this was interesting.
WTF(s) of the Week:
SEC and Climate Change Disclosures: The SEC wants to put in guidelines for companies to reveal climate risks. Here is a piece from ex SEC Head Jay Clayton in the WSJ on the matter.
There was a great podcast by the University of Chicago (Capitalist) I listened to where they had a guest who runs a large PR firm, and it revolved around corporations moving out of Russia, and whether that was useful. PR guy made some points about how employees feel so disconnected from and have so little trust in government, that they act politically through their employers. And, that internal pressure, concern over reputation, and the relative unimportance of Russia overall to US business, makes CEO/Board choice to disband operations and assets an easy one.
But, to what extent will Russians not being able to go to McDonald’s really have on their actions? Well, not a lot. Climate change is the same deal. An important issue, but not so sure companies need to disclose this stuff and that the SEC should be barking down this tree when it barely does its job well as is. This is like trying to chop down a tree with a butter knife. It is better than nothing, but not the right tool.
Tariq Fancy – ex Blackrock Sustainable Investment Head – was on with Scott Galloway to discuss this, and he suggests this is a societal/large scale issue, and government should take the lead. In other words, Fancy believes all of this corporate greenwashing is marketing baloney. And Harvard Law School does not think too much of it either.
But, the WTF element is that Biden is trying to cut deals with repressive regimes to increase production of nasty fossil fuels while the SEC roles out these concepts, is pretty freaking weird. We just cannot walk the walk.
My second WTF of the week was the transgender swimmer who took some medals away from deserving women and also prevented some from participating in US Olympic Trials as this person took a spot in the top 16. I believe that all people should be treated with respect, but we don’t have men and women compete on the same playing fields, or boxers fight out of their weight class for good reason.
Anyhow, this piece by David French makes some good points about how we treat people as equals when they are not alike. Not sure there is an easy answer here. But, seems our collective common sense is twisted like a pretzel these days!