A discussion about inflation and interest rates…Also a bit on one of my favorite talks, why bonds aren’t smarter than stocks!
- Using the Overton Window and Occam’s Razor to help investors look at how Covid and inflation will impact the market in 2022.
- Why IWM could outperform SPY after lagging by 13.5% in 2021.
- Looking at energy prices as the main driver of inflation and why they look set to stay elevated.
- How global quantitative easing is keeping inflation from showing up in the bond market.
Published on Seeking Alpha
Went over some market thoughts, equity duration and some S&P technical analysis.
“What doesn’t kill me makes me stronger” is a well-known saying from the 19th century philosopher Friedrich Nietzsche which also provides a very constructive way of looking at life, the economy and markets in light of the Corona virus (CV) pandemic. In fact, Nietzsche’s own self-described “motto” was a rather optimistic Latin phrase which translates to: “With a wound, spirits soar and virtue thrives.” While a discussion of Nietzsche and metaphysics is well beyond the scope of what we are working on here, it is nevertheless encouraging to take comfort in these uplifting phrases and to appreciate a philosophical approach to the unprecedented situation that we, as people and investors, face. With the economy and markets having been upended by the government mandated shutdown of all non-essential businesses and “stay at home” policies across the country, we are facing the first ever self-inflicted recession. Since the problem we are facing is health-based, it elicits significantly different reactions from different people. This is why we saw the spring-breakers down in Florida who were taunting the virus versus the elderly or those with existing health conditions who are afraid to leave their homes, and then everyone else who lies somewhere in-between. Because of this, we can’t just follow the typical recession and bear market playbooks. This time, it’s especially important that investors think for themselves and outside of the box. So, by taking an approach that questions the information, its sources and why people are having different reactions to this situation, we can formulate a view that is based on logic and rational behavior instead of hysterical emotion.
Given that we are dealing with a situation which strikes at the heart of some people’s greatest fears, behavioral biases can become even more prevalent in the information presented to the public and in how people interpret that information. While death is universally feared by all rational people, not everyone has the same fears. Some people have a fear of flying but no problem using public bathrooms while others enjoy flying but are afraid to have direct contact with any surface that could potentially have germs. Even though fact based arguments can be made that should diminish either fear, that’s not how the human psyche works when it comes to biases elicited from those fears. With that, we can take some solace in there being at least one familiar element in this situation, which is that there are markedly differing views on the same subject for investors to choose from. And to borrow an old Wall Street expression, that’s what makes markets.
With the understanding that some level of bias is present in any work as every author forms their views through their own lens which has been shaped through their own experiences, we can still sift through vast amounts of research to find that which seems most rational and has a common sense approach to it. However, we need to be aware of not just biases but also the technical validity of the research. Fortunately, as investors we are accustomed to working with data and models and are very aware that slight changes to model inputs can have significant changes to the output. In financial modeling, we have the luxury of using existing asset prices as a sanity check on any model output so that any egregious variance can be deemed a “modeling error” and cause a reassessment of the inputs. Conversely, when public policy makers and health professionals are dealing with analyzing a new virus, it’s very easy to become prone to modeling errors since there is no reliable context. Then, the modeling errors can be compounded by behavioral biases and the psychological stress of having to make immediate and significant decisions on an unfamiliar situation. All of which when combined can result in inappropriate decisions.
Back in early March when the CV situation turned from being just a China story into a global pandemic, the first widely recognized hospitalization and death estimates came out of a study from Imperial College in the UK. The study gained immediate notoriety with its shocking prediction of a possible 2.2 million deaths in the US from CV. Closely following that study was one from the University of Oxford that took a significantly different view which proposed the virus as having already been significantly widespread and that the mortality rate was actually very low. Given the actual results that we now have, the Oxford study was clearly more accurate and also reconciles well with what has occurred in the New York City metro area (NYC). In fact, when we combine actual NYC virus results with recent research from MIT which focuses on the subway system as being a primary source of virus spread and data out of UCLA which Governor Cuomo alluded to last week on how the virus can live on plastic and steel surfaces for up to 72 hours, we can form a rational and science-based view of what has happened, and more importantly, on what can happen going forward. Therefore, if we take the subway and surface research in the context of average daily subway ridership of 5.4 million people, it stands to reason that there is a significantly higher amount of positive cases in NYC than the 156,000 currently reported and a significantly lower mortality rate. This is an important aspect of the data that doesn’t get much coverage in the media most likely because it doesn’t stoke fear. That said, should the high infection, low mortality thesis continue to play out, that is exactly what will produce a V shaped recovery.
Since the Imperial and Oxford studies, the US has been getting its guidance from the University of Washington based Institute for Health Metrics and Evaluation (IHME). Even the IHME has seen its own projections be considerably off from what has actually happened. In early April, the IHME had a range of 100,000 to 240,000 predicted deaths which has now been revised down to 45,000 to 124,000 deaths. The IHME revisions are partly the result of an input error with respect to the March 1 start date used for their estimates. Based on the unrestricted travel from China that happened until January 31, it’s likely that CV was spreading unchecked throughout the country since at least January and probably earlier. In which case, an earlier model start date would have produced results more in-line with what really occurred.
With such frightening data that was originally predicting a collapse of the healthcare system, it’s understandable that the decision was made to temporarily shut down the country. Thankfully, we are seeing with each passing day that the actual CV results have not been anywhere near as dire as what was predicted. It has been these results that have allowed some states to begin lifting restrictions and start returning to some sort of normalcy. Unfortunately, it still may be quite some time before the 26 million people and rising who filed unemployment claims over the last 5 weeks get back to work. Even with reopening, the CV has caused such substantial changes to life and work that we really don’t know what the business landscape is going to look like when the country fully reopens. This is where Nietzsche’s motto “With a wound, spirits soar and virtue thrives” comes into play.
Since the shutdown started, we have seen the most significant job losses in accommodation and food services, retail trade, non-essential healthcare services, manufacturing and temporary workers associated with these and other sectors. Compounding the job losses is the lack of visibility for when people can get back to work. Thankfully, we have numerous government programs that are in place to help mitigate the financial pain being felt by all these people, but that will not be enough to revive the animal spirits of the economy. The question that investors and media are trying to answer is, what will the economy look like when the country is open again? The truth is no one really knows for sure because of all the variables from state to state. And, until a vaccine is developed, there is a part of the population that will not be comfortable without social distancing guidelines in place for anything that they do. This means that the end result could be businesses redeveloping themselves to serve a given risk tolerance of a particular clientele. As the anti-shutdown protests have shown, there is a segment of the population that has assessed the health risks and is comfortable without stringent social distancing guidelines. There is also a view in the scientific community, as discussed above, that the virus isn’t nearly as deadly as what was predicted and is actually something similar to an influenza virus. Thus, once the business community has worked through the various reopening guidelines, the free market will be in control again and consumers will vote with their wallets as to what is acceptable for them. Given the move in equities from the March low, it’s clear that investors are already pricing in a benign economic outcome.
Where we could see spirits soar and virtue thrive is in the changes that have come about because of CV. The recent shortages we experienced of medical supplies and other basic goods has shown how vulnerable our country is to foreign powers as a result of decades of offshoring manufacturing processes. It has been a testament to American ingenuity that our corporations were able to quickly retool existing facilities to produce the lifesaving equipment that our country and the world desperately needed. It has now become a matter of national security to rebuild domestic supply chains for essential goods. That rebuilding will be a renaissance of American manufacturing that will bring back jobs to areas all across the country and rejuvenate the economy’s animal spirits. People will argue that increased domestic supply chains will lead to inflation, but that may not be the case. Thanks to technology like open source software, 3D printing and the Internet of Things (IoT), new manufacturing processes can be developed with lower costs and higher productivity than what existed before. Since we have an administration that has already shown its support for domestic industrial development, the economy is set up to absorb the job losses that have resulted from the shutdown and potential changes in consumer preferences. So, amidst all the hysteria that the virus has caused, we know that by taking a data focused and open minded approach to what is happening, we can see that it’s not just spirits that are set to soar, but the economy as well.
Marco Mazzocco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG. Marco has no positions.
“That’s what makes markets” is an old Wall Street expression that describes how different perspectives of buyers and sellers come together to facilitate trading throughout capital markets. And just as perspectives of value vary for any given asset, so do perspectives on the economy. What shapes these views is an analysis of a number of different economic metrics which are framed by the analyst’s own personal biases. With there being so many different metrics available and with everyone having their biases, it’s easy to see why there are so many different views on the economy at any given time. However, there are two fundamental elements of any developed market economy that rise above biases and whose strength or weakness determines the economy’s overall health, and those elements are employment and consumption. To quote Keynes from his seminal book, The General Theory of Employment, Interest and Money, which dealt with the symbiotic relationship between employment and consumption, Keynes stated, “Consumption, to repeat the obvious, is the sole end and object of all economic activity.” With the idea that sustained consumption is the goal, it’s interesting to think that Keynes may have found the current US economy with its services and consumption based model to be the ideal economy. So, with market turbulence driven this past week by soft manufacturing and services data but coupled with strong employment data, we find ourselves once again facing economic crosscurrents. When facing these crosscurrents, it becomes critical to focus on the basics like employment and consumption and to also understand what is driving the negative data. Because, when we look at the soft manufacturing data from last week in the context of its own historical fluctuations and along with the strong employment and consumption backdrop, we see that the economy is in good shape and not falling into recession as financial media would have one believe.
Looking first at employment, we got another solid month of job growth in the September nonfarm payroll report from Friday. With the unemployment rate falling to 3.5%, a level not seen since 1969, the case for being at full employment has clearly been made. September job creation also saw a continuation of growth in the services sector and further refinement of services jobs into more sustainable and higher wage professional and business services (PBS) positions.
In addition to the gains in PBS, the leisure and hospitality services (LHS) sector also had strong gains for the month. Financial media is usually quick to discount gains in LHS jobs in a derogatory way as low wage / low quality jobs when what those gains really show are strength in consumer discretionary spending i.e., consumption. This strength is also evidenced in the strong earnings and guidance just announced by Cintas. Cintas’ primary businesses provide uniform rentals and facility services to the food services, hospitality, and gaming industries in addition to healthcare, automotive and others. Cintas had unadjusted/adjusted revenue growth rates of 6.7%/8.3% respectively, improved operating margins and raised the entire range of its revenue and earnings guidance. All of this helped send the stock to its all-time highs in September. When a company like Cintas, which has significant visibility into discretionary spending oriented industries, is comfortable raising its guidance, there is clear strength in those industries and by default strength in consumption as well. Then, just by looking at the most recent quarterly data of inflation adjusted personal consumption expenditures, we can see consistently positive growth.
Thus, by taking the employment data, Cintas’ earnings and PCE data, we can wade through some of those crosscurrents and see that healthy employment and consumption are acting as strong support for this economy.
Now, lets look at the weak manufacturing data last week which caused quite a stir in the market. The ISM manufacturing report posted its second month in a row of contraction with 9 of 10 of its subcomponents all with readings under 50. All around, it was a weak report. Commentary in the report was also downbeat, citing trade war and tariff related issues as weighing on demand and sentiment. All that said, the most important factor to understand here is that manufacturing accounts for just 11.3% of GDP, while services are 66.6% based on final Q1 2019 GDP data. Also, many of our manufactured goods like jet engines, industrial machinery and other high-tech goods are not substitutable so the downside here is fairly limited. Next, when we look at the history of the ISM report, we see that a month or even several months of contractionary data do not always lead to a recession. For example, if we use the most recent multiple month contractionary period which lasted from October 2015 through February 2016, we see that the data rebounded, and recession did not ensue. Looking through series history, there are 6 more instances of 5 consecutive months of contraction where recession didn’t follow until at least a year and a half later.
To put that in perspective, there were 11 official recessions throughout series history and 4 of them had expansionary months that preceded the recession start. The point of all this is to say that there isn’t a statistically significant relationship between two consecutive contractionary months and a recession. Therefore, we really need to let the data play out quite a bit more before extrapolating anything serious about the manufacturing part of the economy.
On the services side of things, the ISM Non-Manufacturing (NMI) report came in down from last month but still well in expansionary territory with a 52.6 headline reading. Unlike its manufacturing counterpart, the NMI had 9 of 10 components all in expansionary territory with some having actually ticked up from last month. The commentary also had some references to trade war and tariff issues but still had an overall positive tone to it. One remark stood out in particular:
“While Chinese tariffs are understandable, they are impacting our supply chain decisions. We are actively pursuing alternate sources for our China-based production. At this point, we have not passed on tariff costs to our customers, but we are evaluating all options.” (Other Services)
This comment lends itself well to the subdued inflation that we’ve seen since the tariffs were started and the overall low inflation we’ve had in general. It also goes to the heart of the trade war and what will ultimately bring China to the negotiating table, which is significant job and revenue losses from supply chains relocating. That said, going back to the strong guidance from Cintas, we could certainly see a rebound in the NMI going forward. Taking both ISM surveys in the context of hard data like weekly unemployment claims, it’s more probable that the recent downticks in the ISM data are more a function of natural month-to-month volatility, which is inherent in those surveys, than it is a true sign of a momentum shift. As weekly claims continue to show significant labor market strength in a near real-time frequency, a significant downturn in business activity just hasn’t happened yet.
All in all, we see that the underpinnings of the economy are solid. Unfortunately, the crosscurrents of trade wars and tariffs continue to batter the market. So, for now, we can rely on the resiliency of the services / consumption based economy to carry us through the storms. However, should the situation with China continue to escalate, we need to be vigilant and flexible with our investment positioning so that we don’t fall victim to Keynes’ most famous quote: “The market can stay irrational longer than you can stay solvent.”
Marco Mazzocco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG. Marco has no positions.
While mystery has always been a great seller to the masses in terms of books, movies and TV shows, it’s unfortunately also a top seller in financial media. We can see this with all the frenzy surrounding the dreaded inverted yield curve and this past week’s repo market mania. Both were events presented as mysterious and nefarious in nature, but when analyzed with some technical knowledge and common sense, both become perfectly explainable and are not actually harbingers of the next recession or crisis. In reality, both events are just a result of supply and demand for different assets in their respective markets by participants conducting normal business. So, by working through these “mysteries” and having the FOMC meeting behind us, we can now focus on the positive economic data that was out last week which is what will ultimately drive this market higher.
Looking at the situation of the inverted yield curve, we can break this down into two basic parts. First, is the Fed pushing up short term rates through its policy decisions and second, is the bond market pushing down long-term rates from sheer demand for treasury securities.
The front part of the curve is the easiest to explain with the Fed having embarked on its rate hiking cycle back in December 2015 and driving the Fed Funds rate from essentially zero all the way up to the 2.25-2.50 range In December 2018 and thus taking market based short-term rates with it. So, while the Fed was performing its economically justified policy adjustments on the front end of the curve, the rest of the curve was being held down by a confluence of forces:
As a result of the financial crisis, significant regulatory actions were taken on financial institutions in order to mitigate systemic risk. Regulatory actions like the Dodd-Frank Act and Basel 3 Accord have forced institutions to hold a larger proportion of their assets in high quality liquid assets (HQLA) so that in the event of another crisis, they could be more easily liquidated to raise capital and not become a tax payer burden again. As seen in the chart below, these higher quality holdings have nearly doubled since the crisis.
Because treasuries are already considered a vital component by institutional asset managers due to the treasury market’s unparalleled liquidity, the additional regulatory demand has generated a significant source of downward pressure on rates.
Next, we have an interesting situation of persistently low inflation helping to keep rates low which is unique to this economic expansion. In the past, economic expansions that approached the length of our present one have always been associated with rising inflation and sometimes very strong inflation. However, thanks to recent technological advances ranging from fracking, smartphones and open source software, to name just a few, there has been an unprecedented increase in productivity without an equivalent increase in prices. With fracking allowing the US to go from being not just the world’s largest oil consumer to also being the world’s largest producer, the reduced energy costs have helped anchor inflation while providing significant benefits throughout the economy. These technological advances along with a consumer shift in preference towards experiences versus goods has also helped to keep prices in check. It is this persistent lack of inflation that has been an ongoing point of discussion at the Fed and also a stated reason for ending this hiking cycle at the January 2019 FOMC meeting.
Lastly, we have the concept of relative value which has been another source of downward pressure on rates. Relative value describes a bond investors preference to always seek the highest yielding (return) bond with the best credit (likelihood of receiving that return) in a related group of bonds. So, in the case of treasuries, the comparable (relative) bonds would be those of similar developed sovereigns, which is primarily the European Union. With some EU sovereign yield curves having gone mostly negative and even being less credit worthy than the US, it’s easy to see why the US is such a great relative value and why foreign holdings of treasuries have risen significantly since the end of the crisis.
Thus, by taking the confluence of forces acting to keep long-term rates down along with Fed policy changes pushing short term rates up, we can see why the yield curve was literally pushed into inversion by various market participants and not by omniscient investors who had “divined” that a recession is imminent. Even research which concludes that yield curve inversions precede a recession by some amount of time are spuriously correlated at best because of the significant events that happen in that time span that do actually cause a recession. All of this is not to say that yield curves do not provide any information because they definitely do. Rate curves are the fundamental basis for valuation models across multiple asset classes and are an invaluable economic metric. However, thanks to global quantitative easing and low inflation, rates have been anchored in such a way that some of the curves’ descriptive ability has been muted.
Moving on to our next mystery, let’s look at the spike in overnight (REPO) funding rates that occurred last week. As a quick primer in its most basic form, the repo market is where investment banks and other leveraged participants secure funding for their trading and investing activity. The repo market allows institutions with excess cash, like money market funds, insurance companies, corporations, banks and sovereign wealth funds to lend that cash to institutions that need it on a daily basis. These cash loans are collateralized by high quality securities like treasuries and are grouped into a category called general collateral (GC). For this exercise we will only refer to the spike in GC rates even though there were spikes across the spectrum of money market rates. Here is a brief history of GC rates from before last week and through it:
With some definitions and history out of the way, we have an understanding as to what happened. Now, the question is why did it happen? Similar to the confluence of forces that helped drive the yield curve inversion, there were several issues that came together to drive the spike in GC which could have been avoided had the NY Fed been more in tune with the markets. It turns out that the immediate cash shortages were driven by corporations withdrawing cash from the market to pay for tax liabilities and newly auctioned treasury securities that had to be paid for by various investors. There was also speculation that Saudi Arabian related funds withdrew cash in light of the bombings over the weekend. Then, on a larger-time frame, cash has been regularly drained from the market as a result of Basel 3 regulations which went into full force in January and that essentially forced global systemically important banks (G-SIBs) to hold enough cash to be able to cover a 30-day period without any need for funding in the event of another crisis. As things unfolded on Monday, the NY Fed was able to get its processes running to add the needed liquidity to the market and the situation was eventually fixed. But before the NY Fed was able to remedy things, financial media had already begun speculating that this situation was a redux of the spike in funding rates that happened during the crisis and that a new crisis was upon us. However, the major difference is that the funding problems back then were driven by the sudden introduction of counterparty risk into a market where it was previously inconceivable that a major US investment bank would become insolvent and that some collateral might actually be worthless. All one had to do last week was look across different asset classes to realize that this funding issue was limited in scope because other markets were functioning with a risk-on tone to them as opposed to the total calamity that existed during the crisis. It’s funny how media always seems to fill in the knowledge gaps with fear.
Throughout all the wild swings last week that started with what looked to be a significant market drop due to the Saudi Arabian oil field bombings, there was still some good news delivered. We got a strong industrial production (IP) report for August which also supports the idea that the weak ISM manufacturing reading earlier this month was a one-off driven by Boeing related issues. The IP report saw strength in business equipment, construction supplies and mining output. Then we had a Philadelphia Fed manufacturing report that showed healthy readings in new orders, production, shipments and employment data. There was a jump in the prices paid / received data in both current and future expectations readings that could be reflecting tariff-related effects, so that will have to be monitored. Given the strong IP report and solid Philadelphia Fed data for September, a rebound in the national ISM and Markit manufacturing surveys could be in store for September. On top of the solid manufacturing data was a second month in a row of a pickup in existing home sales (EHS). EHS, which account for 90% of total home sales saw increased buyers taking advantage of lower rates. The continuing lack of inventory is still holding sales back though as the market awaits homebuilders to complete new projects. With mortgage lending standards significantly stricter than what they were back before the crisis, the economic health and sustainability of purchasers today is something to note as an additional tailwind for this expansion. Last, but certainly not least, we got another week of historically low unemployment claims. And unlike the inverted yield curve, weekly unemployment claims are a reliable recession indicator. This week’s claims came in at an historically low 208,000. We need to see that number get above 300,000 and stay there before we start taking the R-word seriously. Overall, the data from last week indicates that the soft spot the economy had throughout the summer is firming up as we head into fall.
Having worked through the inverted yield curve and repo market madness we’re now ready to face a new week with earnings season right around the corner. We have plenty of A-list economic data to look forward to and what is certainly no mystery, more China trade war news to swing the market back and forth.
Marco Mazzocco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG. Marco has no positions in Boeing.