One of the fun books we read our kids is “Where’s Waldo” or “Where’s Wally” which is the original and British version created by Martin Handford. I used to spend much time with my kids trying to find that little guy, and we had a lot of fun doing it. I miss those days, and hopefully, in the future, I will do the same with my grandkids.
In the context of the market, at least for me, Waldo is clear as to what is really going on. It can sometimes feel like with so much going on all at once, it is hard to pinpoint what really matters. As I wrote earlier in the year, the picture remains as murky as a Florida Everglades swamp, with all sorts of dangerous critters lurking. My approach when writing this piece is not to outline whether there is a tradable near-term bottom, as Tommy Thornton does a great job with that. Rather, I am trying to define whether there is a material change to the broad macro investing paradigm that the market is not currently pricing. Last year, I spewed much verbiage on things like the inflation debate – because I thought doing so would help readers find Waldo and prepare their portfolios. I saw inflation/stagflation as highly problematic because the bulk of marginal allocations going into high speculative long-duration assets amidst very low rates and seemingly endless liquidity. I posited that should that picture change, those assets were likely to get hammered – and they have.
At present, I see seven clear and present dangers:
1. Crisis expansion from Ukraine outward including cyber
2. Sanction risks cascading through to counter-party risks (see Gavekal below)
3. Stagflation/recessionary risks on growth and earnings
4. Excess positioning in equities and possibly credit due to financial repression
5. Fed/CB policy errors
6. Interconnection/Economic Inter-dependence in the absence of trust – Democracy vs Autocracy
7. Broad change in post-WWII US-led trade and monetary order, globalization.
So, if the material risk coming into this year was normalization of Fed/CB policy and tightening of liquidity given inflation concerns, we now have more existential questions that make not only finding Waldo difficult but also predicting what dangers his movements might unleash. As with the pandemic, most people just wanted to get back to their lives as it was. Same thing for investors. Hard to see that magically going back to pre-invasion mindset anytime soon.
So, “there is a lot going on in markets” would be a massive understatement. War rages on in Ukraine bringing untold suffering, death, and destruction, and NATO nations doing much to help support the Ukrainian military and risking further escalation. As predicted prior to the invasion, commodity markets already severely backwardation – a sign of tight supplies – have become more so. Commodities like Nickel – a key component for EV batteries – have traded to $100K on the LME, and trading has been suspended. Volatility is elevated, corporate spreads are widening out, FRA-OIS spreads are as well, the US Treasury curves continue to flatten, inflation remains high, and yet, the equity markets in the US – in spite of the first weekly outflow in 10 weeks (and biggest ever outflow in Europe) – continue to hold above the lows that were set last month.
My personal stance continues to be very defensive, even though I am up around 5% this year because I just don’t see this Ukrainian situation suddenly becoming clearer, and even if it does, there are issues and questions behind it that I need more clarity on before being bolder. Once again, we are in short gamma land still (see charts for SPY and QQQ), movements are extreme and headlines can turn a positive day negative in a hurry. This is not to say there is no money to be made being bold, but structure your trades intelligently, adhere to risk management principles, and if it is not working as you expected, get out.
Things that caught my attention this past week:
Scenarios for War and Peace:
This is all way above my pay grade, but I find this analysis by historian Niall Fergusson to be insightful.
Fwiw, I do find the Biden Administration ratcheting up economic sanctions, willing to send physical military hardware support, but making a definitive choice about No Fly Zone to be curious. Nobody wants WWIII, but nobody wants Cold War II, global influence blocs that are on different operating platforms either. Even if we have no intention of sending troops, why tell that to Putin who controls the skies and is bombing cities and civilians at will.
The Flows:
The one bit of positive information is that the buyback bid (see below) continues to be very strong and the weekly flows seem to tell the right picture in terms of curve flattening, less capital market activity impact on financials, movement into energy, materials, and mega-sized into commodities, and largest ever outflow from European equities (financials getting hammered there). But, if we add equity length from last year to the equally torrid pace we were on this year, it’s still a sizable exposed position relative to recent history – and it could reverse.
The last major inflationary period:
I like pictures because they are good starting points. When I looked at this picture below, my immediate thoughts were that real returns to equities from buying and holding was awful You can do the math, but I got something in the order of about 2% per annum nominal for the SPX, and an annual CPI around 6%, so -4% real. The average CPI from 1959-1965 was below 1.5%. But, bad things can happen quickly, and they did, just like they are happening now.
What don’t we know?
Well, a lot. I saw this table a few weeks ago from Morgan Stanley and thought it was a reasonably useful rubric for investors. I can wax on about any of the 7 risks I see above, or build schematics and decision trees to define how this might all play out, but given the perturbation is large, very hard to analyze and price, and there is no immediate silver bullet that brings us back to a clearer pre-invasion investing paradigm, it is safe to say there are a lot of unknown unknowns, which is why I think caution is warranted.
Is the Fed walking into a trap?:
DataTrek put out information last night, that appears to suggest that the Fed – after making a policy mistake by not hiking last year and stopping QE (reloading the gun, so to speak) – is in a very tough spot in terms of hiking rates given where BBB credits are trading and also where the VIX is trading. For a market that believes the Fed has its back – and it certainly has – having the Fed punt on rates, for now, might be a relief. But, for a country and bloc that may be in an existential crisis against autocracy, who also want to diminish the role of the US in their affairs and supplant $ hegemony, pivoting or equivocating again by Powell could be a negative as it reveals some concern about growth, and perhaps weakens the dollar at a time where such could feed through to more commodity inflation. My take would be that raising 25 is going to happen, as it is already in the market, and let the situation unfold. Nevertheless, DataTrek’s analysis is certainly interesting below:
Is the US market still too sanguine?
Both of these charts seem to indicate that the market believes this Ukraine situation will blow over soon enough and that growth and earnings will be fine.
But, Mike Wilson at Morgan Stanley believes that their Equity Risk Premiums are too low given the amount of volatility we are seeing in the market, and that dividend payout ratios are low given companies know they have been over-earning. Wilson is expecting SPX 3840 by April.
Can China and the RMB threaten US$ supremacy?
I had a lengthy missive last week about whether the shifts we are seeing in the global trade and monetary system could in fact be the beginnings of a wholesale movement away from $ supremacy. I don’t count that out, and Zoltan Poszar at CSFB has a piece about this that I was able to find via this tweet. https://twitter.com/TheBondFreak/status/1501182910120013825 which given his Fed and monetary plumbing expertise, is well worth reading and food for thought. His primary point is this crisis, seen most acutely in commodity markets where Russia (+ Ukraine) are critical players, is like the 1973 crisis on steroids and could have far-reaching implications, including for OTC commodity derivative, exchanges, and of course wider systemic issues.
He then goes on to suggest that there is a role for China to play to support the Russian commodity market and develop a commodity-backed RMB that would be a part of Bretton Woods III.
Now, my immediate thoughts are that he is right about “money” not being the same, but hard currency systems have their issues, and China is away from being a globally benevolent actor, with strong legal / contract/property rights, that has deep and liquid markets and a convertible capital account. This tweet from George Magnus perhaps speaks to the challenges China faces, with or w/o commodity backing.
As I read through this – which I largely agree with – I also wanted to do a bit of homework on Triffin’s Dilemma, which arose when Belgian economist Robert Triffin wrote a book in 1960 called “Gold and the Dollar Crisis: The Future of Convertibility” that while early, was prescient in predicting that eventually, the US would have to close the gold window. But, the basics of the theory are as follows:
As we can from the chart below, Triffin was a bit early, but correctly noted persistent C/A deficits in the $ convertible to Gold system prior to 1971 was going to be a problem, and it was. He was wrong about deflation, however.
From NBER working paper written by Michael Gordo and Robert McCauley:
The piece is a pretty quick read and not very technical. But, it doesn’t easily accept some of the “anachronistic” points often associated with the dilemma and it doesn’t draw any conclusions and takes pains to suggest the dilemma was concerning because it could cause deflation.
The wider point is that the US-$ is by no means the only reserve currency (see below), but the Euro, represents 80% of reserves. Keynes’ Bancor or SDRs or some other format that clarifies roles and responsibilities are regularly discussed, like an international Taylor Rule. But, like the Taylor Rule – which would have the Fed Funds rate tied formulaically based upon inflation and today would equate to 7-9% – similar rules tied to correct imbalances in a world where private and official capital flows freely – would have disruptive effects. We have at other times in history – see Maastricht – have supranational rules drive domestic affairs, only to see rules disregarded. Such is the history of the gold standard, where countries disregarded it during times of war and other financial distress. China – which despite being the world’s second-largest economy and a large player in global trade – still does not have an open capital account, and manages its currency and flouts WTO rules routinely to ensure current account surpluses. The US$ (or the Euro) are held as reserves for particular reasons, mainly to do with the need for liquid and safe assets. There is no doubt that requires careful management of other country holdings, and yes, it is a part of the reason I think the Fed and fiscal authorities should be very careful going forward. But, I am still not buying the notion that Russia and China (plus other autocratic nations like Iran) have great cards to play at this point, or that the sanctions enacted by major CBs to freeze reserve assets, etc. is the wrong call.
Just tonight (Tuesday), we saw more saber-rattling as Russia is threatening export restrictions to unfavorable nations, while the US commerce secretary warned of China providing too much aid and comfort to Russia. “Chinese companies that aid Russia could be shut down…US could essentially shut down semiconductor manufacturing international corporation or any Chinese companies that defy US Sanctions.”
Analog for the week
Head Scratcher of the Week
I get it. ARKK has gotten hit quite a bit, and Cathie is ubiquitous out marketing her views and themes. Maybe some believe these super-duration plays will be in favor as rates come off and growth slows further. If she were a hedge fund, she’d already be out of business.