Bedrock’s Newsletter for Friday 21st January, 2022
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”The power to do good is also the power to do harm”
–Milton Friedman
Friday 21st January, 2022
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Since the start of 2022, there has been a substantial correction in high growth equity sectors driven by the roaring rally in interest rates across developed market (DM) sovereign curves. The biggest moves in bonds and equities have been in the US, where persistently high inflation has caused the Fed to pivot 180-degrees from ultra-dovish in its outlook to surprisingly hawkish. US policymakers now expect to hike interest rates between three and four times this year; and, for their part, markets have fully priced in the latter according to the US Fed Funds futures (with lift-off due in March). In addition, the US central bank expects to proceed with quantitative tightening (QT) just as soon as it finishes tapering its massive quantitative easing (QE) programme in the summer. Reducing the Fed’s swollen balance sheet (at a relatively rapid pace) has the potential to push up long-end rates and drive a ripple of re-pricing across markets as portfolios are rebalanced accordingly. Together with higher US treasury issuance this year, QT is likely to cause substantial volatility in the US, and beyond. Even Xi Jinping is worried about what Jay Powell has in store. This week, President Xi cautioned against overly restrictive US policy being implemented just as the developing world picks itself back up off the ground; and, as China, which is in easing mode, attempts to reboot its slowing economy. We do not think that emerging markets will suffer much due to US tightening, but the knock-on effects are something to watch.
Today’s hawkish outlook for US rates is the result of an astonishing shift in expectations in the past few weeks; indeed, in October, markets were pricing in just one policy rate hike in 2022, and the Fed was hesitant to lift rates at all! But the rationale for the recent policy pivot is clear. International and domestic supply chains remain severely dislocated, despite modest improvements in port congestion, container and other transportation costs, and delivery times in late 2021. This means that inventories (particularly of electronic goods and raw materials) are low, and re-stocking will likely take quite some time. In the intervening period, shortages are likely to drive up costs for businesses still further and this is feeding through to higher consumer prices. What is more, coronavirus trends in Asia (where there is a battle underway between Zero Covid China and the highly infectious Omicron variant) are profoundly negative for supply chains and could drive further disruption if local lockdowns spread. This risk is likely to become most acute around the Winter Olympics, when China will import a lot of people from abroad (and some of these will undoubtedly have covid-19).
Another significant driver of inflation has been the dearth of CAPEX by mining and energy companies in recent years. The recovery from lockdowns in 2020 and early 2021 has caused a cyclical upswing in demand for raw materials and energy right across the world. Of course, at present, getting these goods to those who need them has been made much more challenging by the logistical disruption already discussed. However, another issue that will not be resolved anytime soon in our view is the complete lack of investment in new PP&E over the past 18-months, and the wave of industry consolidation and balance sheet retrenchment that took place before the pandemic. Many energy companies have also shelved plans for new fossil fuel assets in recent years given societal concerns about climate change (and this caused problems last year when renewable energy sources were unable to pick up the slack). To be sure, conservative CAPEX trends have put the mining and energy industries on a much sounder footing today than at any time in recent history; and we favour an allocation to precious and industrial metals miners to benefit from the commodity windfall that these companies are beginning to reap. However, such limited capacity in these industries is having negative consequences for the rest of the world economy, pushing up commodity prices and contributing to the inflationary surge. From where we stand today, CAPEX plans for mining and energy companies remain unambitious and there is a long lead time for new assets to come on stream. As such, high commodity prices are unlikely to moderate for some time (indeed, we think that they have further to run) and they are likely to be a major contributor to inflation going forward as well.
Of course, supply chain disruption and underinvestment by extractive industries are causing problems for countries all over the world, and inflation is by no means a US-specific phenomenon: producer price inflation (PPI) for Germany hit +24.2% YoY in December! However, two inflation-drivers are much more of a problem in the US. The first relates to the money supply. US data show that the narrow money stock expanded hugely in 2020 (much more so than in Europe) and that money supply growth since then has been remarkably strong relative to recent history. US authorities deployed one of the largest fiscal and monetary stimulus programmes in the world to offset the economic effects of the pandemic in 2020. And, at the same time, they used controversial policies such as cash payments to all US households (or ‘helicopter money’) in an effort to bypass the banks and boost spending directly (i.e., without any attempt to allocate that money efficiently). Spending and assets – including cryptos – were buoyed as a result, and the US economy bounced back from recession very strongly. But these policies seem to have resulted in the US economy overheating more than economies elsewhere.
However, perhaps more worrying than the growth in the money supply is the surprise reduction of the US labour force in the past 18-months – and the consequential tightness of the labour market today. Unemployment in the US is now c.4%, which is below pre-pandemic levels, but the participation rate is stuck at c.61-62% (c.1-2% less than it was before the pandemic struck). The reason for this is that many older Americans have chosen to take early retirement in the past two years. One can only speculate as to why, but since assets have risen in value and household debts have simultaneously fallen thanks to government support, those who do not want to return to risky social interactions are in a much better financial shape to call it quits. This trend towards early retirement has caused labour markets to tighten and wages to rise much earlier (and much further) than the Fed was expecting, and it appears to have caught them off-guard in their estimates of labour market slack. In some places, labour market tightness has also shifted the balance of negotiating leverage away from employers and towards workers (as can be seen with the +40% pay hike that was agreed by management to end the John Deere strike late last year). The Fed is playing catch-up thanks to this misunderstanding of the new labour market dynamics, and it is likely the biggest cause for their sudden about-turn on policy.
Simply put, all the major inflation drivers look set to remain in place for some time; and, taken together, it is no wonder that the Fed is revising their guidance. The Bank of England (BoE) and Bank of Canada (BoE) are beginning to hike rates too. But, so far, the Bank of Japan (BoJ) and the European Central Bank (ECB) have not followed suit. There is a lot of uncertainty about how long the ECB’s policy stance can last (and what the post-pandemic economy’s inflation dynamics are likely to be), but US monetary policy will almost certainly have to tighten more quickly than elsewhere even if all the big central banks eventually have to move. This is supportive for the dollar, which we favour as a diversifier for EUR and CHF clients, because it will lead to a widening of the interest rate differential with other major currencies. This should help to offset some of the impact from slower growth due to tighter financial conditions.
From an equity perspective, we think that rising rates and inflation globally is a favourable backdrop for value and cyclical sectors, such as financials and energy, which have already shown strong relative performance this year. Together with materials stocks, which should also benefit from the current commodity windfall, these sectors have a good chance of outperforming others this year. That said, many growth stocks (particularly smaller and less familiar names) have already fallen sharply from their recent highs (sometimes >50%). Some of these stocks look much more attractively valued now than they ever did in the past, and so a barbell approach (which incorporates an allocation to the recent losers from rotation on one side and a range of value/cyclical stocks on the other) has some merit.
Beyond equities, and perhaps unsurprisingly given our views on inflation, we have a strong preference for commodities (incl. agriculture, precious metals, and industrial metals). Copper and speciality metals in particular are set to benefit from both the transitory cyclical and supply chain story and the secular trend towards the electrification of transportation networks and the renewable energy transition (given the importance of these metals in the component parts of wind turbines and other energy assets). Most of the fixed income universe is unattractive in our view – given limited compensation for credit and rate risks. We do not anticipate significant credit spread widening this year or a wave of delayed post-covid bankruptcies, but a further narrowing seems very unlikely indeed (despite this often-accompanying rate hiking cycles). Periodic bouts of volatility are likely to accompany QT, and we do not think that returns from clipping coupons (for IG issues in particular) compensate you well for this risk today.
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