Inflation in things we want, deflation in things we donʼt want
Inflation in things we want, deflation in things we donʼt want
INTRODUCTION
The war in Ukraine, China’s sweeping lockdowns, soaring inflation, shortages of energy and key commodities, and the Fed’s tightening policy, are all taking their toll on equity and bond markets. The World Bank, IMF and major banks have slashed their growth projections, and concerns are mounting that the global economy could soon tip into recession. Whilst we believe that the market narrative (at the time of going to press), is due to be more upbeat in the coming weeks, equities will continue to face headwinds thereafter.
ASSET ALLOCATION HIGHLIGHTS:
• Inflation is now a dinner table conversation in many households.
• Whilst it’s true that most inflation is transitory, transitory can last for years when inflation is within a cyclical upswing.
• Commodities remain the stand out performer, and portfolios have greatly benefitted from positioning in the resource sector and ‘real assets’ more generally including precious metals.
• Bond markets have been in a tail spin – US corporate investment grade bonds have fallen 12.3% in over 200 years by some records.
• The S&P 500 fell more than 13% between January and April of this year. That's the worst four-month start to a year since 1939.
• Equities are overdue a ‘relief rally’ having been pushed lower by rising interest rates and a very hawkish US Federal Reserve.
• A coming global slowdown will perhaps take some of the wind out of the sails of the inflation debate, but only further lead to lowering companies’ earnings guidance and margins in the second half of 2022
KEY MARKET THEMES
Undoubtedly, COVID-19 accelerated what were mostly pre-existing trends. We also believe that the war in Ukraine similarly exacerbated what were pre-existing issues. In particular, chronic underinvestment in energy infrastructure, as well as highly optimised supply chains that afforded little to no flexibility. Europe was already experiencing spikes in energy prices before the invasion of Ukraine, as energy transition initiatives to greener alternatives sought to reduce reliance on fossil fuels.
With the invasion of Ukraine, the narrative moved from energy transition to energy security, in a just a few short weeks. This shift to energy security is reflective of a much grander change: that of the unwinding of a global monetary order that’s existed for the last half century or so, and a return of greater geo-political risk.
We are therefore considering and preparing portfolios for a world that is more de-centralised, (with divergent payment channels, and stores of value to match). Global alliances are shifting, and with these changes, supply chains as well. Commodity and food protectionism will become recurrent themes, and national priorities once more. We believe ultimately that global sanctions will have much more enduring consequences for global trade and economic growth. But for now, it is the inflation debate which dominates.
If we are looking for historical analogues to the present situation, we believe that the 1940’s are perhaps a better parallel, as opposed to the great inflation episodes of the 1970’s. Both periods are, however, instructive.
FIGURE 1: Rolling 5 year CPI and its relationship to US Money Supply growth
Chart Source: ARIA, LynAlden.com
NOTE: The chart shows a very tight correlation between money supply growth (resulting from all of the government and central bank largesse), and subsequent inflationary episodes.
The 1940’s did not see much by way of bank credit availability, but we did see wartime finance, and critically that brought the monetisation of very large fiscal deficits. That is to say, as governments issued bonds to finance large military expenditures, that same nation’s central bank was compelled to print money and buy these bonds: much like we have seen in the wake of the pandemic.
The 1970’s were characterised by a demographics boom: the boomers were entering their home buying years and banks were very supportive: meaning mortgage lending led to a significant increase in the money supply. The Vietnam War inter alia contributed to significant deficits too.
Both the 1940’s and 1970’s had price controls at various points. The latter also witnessed wage controls too. However, inflation was not a straight line, and there were disinflationary periods during both decades. In that respect, we believe five year rolling periods provides a better way to observe the trend.
An interesting difference between the two periods was government debt levels. The 1940’s had very high government debt to GDP levels: which limited the ability to raise interest rates to quell inflation for fear of widespread insolvencies that would result. Ultimately, we saw yield curve control. However, the 1970’s did not have the same levels of indebtedness allowing for a more aggressive tightening on the part of central banks. The 1970’s were course also famed for the oil price spike: at a time when the US energy production had peaked in 1970, mirroring how shale oil has fallen on harder times in the last 5 years and financial institutions appetite to lend has met an abrupt stop.
More generally, we believe we have entered a regime of shorter, sharper economic cycles, which will likely be mirrored in volatile inflation figures too. To our minds, it is not actually the high watermark in inflation figures we expect to see recorded in the coming weeks that matters, but rather as inflation normalizes again, will the consumer price indices show that systemic inflation has set in.
SLOWBALISATION
The corporate drive over recent decades have been to maximise earnings per share by virtue of financial engineering: including corporate buybacks, and geographical labour arbitrage by offshoring labour to the cheapest global locations. Optimisation in the form of just-in-time inventory management has sought to squeeze the pips. But inevitably the trade-off to offshoring and supply chain engineering is a lack of resilience. As we have witnessed, global food and medical supply chains have been shown to have wobbled in the face of systemic shocks. The most likely response will be a move towards ‘just in case’ supply chains, reshoring of manufacturing, and inevitably higher prices, as some of the ARIA Capital Management 3 efficiencies created are unwound. All of this is being brought to bear at a time when the unprecedented fiscal and monetary stimulus provided to counter the pandemic, is being withdrawn. This is a difficult balancing act to achieve.
Business cycle investing works by determining asset allocation according to where we sit in the cycle. Proponents of such an approach cite housing and durable goods (read manufacturing), as the two principal drivers of the business cycle. Housing as a percentage of GDP is at historic highs. Stimulus cheques have driven house prices globally higher. Lockdowns limited the options for consumption and so channeled cash towards property. In addition, those same lockdowns prompted consumers to look for alternatives to smaller urban dwellings. Manufacturing, or durable goods also saw a one-time boom, leading to a very hot manufacturing output and GDP numbers. Of course, as demand for new housing rises, so does the demand for mortgages; and mortgages rates have seen significant moves in recent times. We believe these impacts are temporary.
So what does this mean in terms of determining where we sit in the cycle? Higher food and fuel prices also mean that ‘real earnings’, or how far household incomes go each month, leads us to believe that consumers will begin to tighten their belts once more. As the driver of global growth, consumers, and specifically the US consumer, will become more spendthrift and this is likely to translate into a slowing economy once more.
Figure 2: Historically, peaks of inflation have coincided with recessions
Chart Source: ARIA, ALPINE MACRO
Recent performance of housing stocks (very uninspiring) and utility shares (very encouraging), also gives some credence to the idea of a slowdown. If we are to see consumers pull back, as the ‘real disposable’ incomes have declined, many companies, who had built inventories in response to supply short shortages, are likely to find themselves sitting on an excess.
FIGURE 3: CONSUMERS ARE BEING SQUEEZED WHEN ADJUSTING HOUSEHOLD INCOMES FOR INFLATION
Source: Heimstaden, ARIA and Macrobond
A DEARTH OF RARE EARTHS
We have been well positioned for this environment. Stubborn inflationary pressures have been anathema to the bond market (our portfolios have had little exposure to government bonds). Exposure to real assets, commodities and precious metals have very much been the place to be.
FIGURE 4: COMMODITIES SHINE IN BEST YEAR SINCE 1915
Source: Bof A Global Investment Strategy , Global Financial Data, Bloomberg, *2022 YTD annualized
That said, if forwards looking indicators are correct, then the hangover from unwinding of the sugar rush caused by unprecedented government COVID financial support for their citizens and businesses, could come swifter than is currently priced in. As such, we have begun to increase exposure to government bonds once more, having happily sidestepped some of the worst falls in history for the asset class.
Any retracing of steps in commodities are likely to be short lived. The climate debate is closed: globally we have committed to a colossal spend on rare earth minerals, cobalt, lithium. The committed numbers are almost unfathomable, and we are now beginning to see increasing coverage of the constrained commodity theme or ‘green metals shortage’. For example, the FT recently commented that electric vehicle production targets will be impossible to achieve without changes to the lithium supply pipeline.
One quote from the CEO of Lake Resources, an Australian listed lithium producer stood out: ‘There simply isn’t going to be enough lithium on the face of the planet, regardless of who expands and who delivers, it just won’t be there… The carmakers are beginning to sense that maybe the battery makers aren’t going to be able to deliver’.
The looming lithium shortage appears primarily attributable to three factors:
1. Aggressive targets set in the United States and Europe for the roll out of EVs to replace internal combustion engine (ICE) cars.
2. Lack of investment by Western governments and companies in developing supply chains of lithium and other metals essential to the production of EVs (such as cobalt and nickel); and
3. China’s strategic dominance of the clean energy metals supply chain, with China currently controlling 70-80% of the entire supply chain for EV lithium-ion batteries, and therefore energy storage..
Even Elon Musk, a man never far from the news, called for increased investment on Tesla’s earnings call last month: ‘I’d certainly encourage entrepreneurs out there who are looking for opportunities get into the lithium business’, Musk said.
So, whilst any impending slowdown will impact many commodities, we feel that the supply shortages in a number of commodities (including agriculture, see recent comments on fertiliser), will limit the downside and it will be more important than ever to have more targeted exposures, which benefit from the structural bottlenecks. It is in our Real Asset Income Fund where we search for opportunities to generate returns deriving from exposures to the bottlenecks in the commodity supply chains.
THE RELATIVE IMPORTANCE OF INTEREST RATES, LIQUIDITY AND EARNINGS GROWTH FOR EQUITY MARKETS
There is a general consensus that low interest rates lead to higher valuations in stock markets and justify extended gains. Categorically, lower interest rates certainly spur risk taking and encourage investors to buy shares that fall within the growth category and are perhaps less cash generative at present. Lower interest rates mean lower opportunity cost in investing for ‘jam tomorrow’. However, the counter to such a line of thinking is that share prices are principally driven by earnings growth and that lower interest rates are indicative of economic conditions that are sluggish and therefore that it will be difficult for companies to grow earnings. Moreover, if the causation held, Japan, with negative interest rates, would be the most expensive stock market in the world.
The numbers bear all of this out. Earnings in quarterly forecasts, or trailing numbers today, are lower than they were at the peak in 2008. Outside of the US, we have very little earnings growth in the UK and Europe (nor Japan) and consequently their stocks markets have floundered as a result. The only market which of course did ‘re-rate’ higher was the US: we have seen substantial outperformance. However, as we have noted in previous reports, that was principally 6 stocks – the FAANGS – which account for all of that outperformance. In fact, if we were to refer to a ‘S&P 494’, rather than S&P 500, removing the influence of key tech stocks, the US market's performance is comparable to other international markets.
In another example of the shifting tectonic states of global finance, we believe the age of US exceptionalism, or outperformance is over (including that of the tech stocks). If low interest rates have been a challenge for the UK, Europe and Japan, we believe higher interest rates will be a real fillip to their fortunes. Higher interest rates in the round mean improving economic fortunes for those cyclical companies with operating leverage. The UK, Europe and Japanese stock markets are littered with such companies, and these will provide fertile conditions for earnings growth. In short then, leadership in stock markets is rotating to companies and markets who will benefit from a higher interest rate environment.
ASSET CLASS VIEWS
Equities
• A tough talking Federal Reserve, and persistent inflationary pressures has led to a bear market in the “tech darlings”.
• Until the Federal Reserve ‘pivots’ and confirms that monetary conditions are as tight as they would like them to be, equities markets face headwinds.
• We prefer valuations and prospects in international markets rather than the US (in general), as we believe the composition of those markets will fare better in higher rate environments.
• Even if a short-term bounce is overdue, ultimately, we expect to see stock markets at lower levels than even at the end of April’s marks. We think it possible, nevertheless, that markets may well have recovered by year end..
Bonds
• The sell-off in rates has been historic: US long term government bonds have fallen nearly 20% YTD, as quantitative easing programs globally have been reversed.
• Yield curve inversions (when short term interest rates are higher than long term interest rates), historically have heralded an incoming recession, but we feel that is more likely a third and fourth quarter 2022 story.
• In corroboration, corporate and high yield bonds, whilst losing ground, have fared better than government bonds, suggesting that any fully fledged recession is not to be expected in Q2.
Commodities
• Food shortages are a genuine issue, even in Western economies in 2022. This issue is of course exacerbated by the Ukraine conflict that has resulted in nearly 30% of globally traded grains not being available for export
• Energy security is now a front-page topic. Building up capacity takes years, and the catch-up requirements are significant: for example, whilst Europe scrambles to replace its present energy suppliers, it does so in the knowledge that its Russian natural gas imports represent the equivalent of 125% of the entire current US LNG export capacity.
• Gold has perhaps not performed as well as many would have thought given the backdrop: geopolitical turbulence, rising inflation, etc. However, a strengthening dollar and rising real interest rates are not supportive. On balance we believe it is consolidating before precious metals shine once more.
Currencies
• As global liquidity tightens, the world is ‘short’ or a net debtor in US Dollar terms, and that puts a significant bid beneath the greenback.
• We see many emerging market or commodity related currencies performing well (the Brazilian Real performed well against the US Dollar): meaning it is not simply a flight to safety move.
• The Chinese central bank appears ready to stimulate the economy, as the Renminbi has weakened significantly. This could mean support for stock markets even if the US is withdrawing its liquidity.
CONCLUSION
Traditional equity/bond portfolios have had their worst start in over 40 years. Our asset allocation with emphasis both on active management and real assets have performed well in a new macro environment. This new environment is characterised by ‘inflation in things we need, and deflation in things we don’t need’ – respectively food, energy, iWatches, cloud storage and Zoom. For all four of our baskets to be up between 3 and 12% YTD at time of going to press, when equities markets have fallen double digits in the first four months of the year, is very pleasing.
The Federal Reserve has been very clear: what it giveth in one hand (COVID stimulus and quantitative easing, now with a political mandate to do so), it will take away with the other. Central banks globally are tightening policy i.e., removing the punchbowl to quell inflation and tighten financial conditions. If there was any doubt as to their intended impact, we would point readers to the recent April 6th Bloomberg interview with Bill Dudley, a former President of the NY Fed and Vice-Chair of the FOMC. Such plain speaking is not an everyday occurrence, and one that we feel is orchestrated.
We ultimately believe that those shares and markets which benefited most from the pandemic stimulus will ultimately suffer most from its subsequent unwind. The US Federal Reserve is seeking to engineer a soft landing for the economy, which we all hope they achieve. Our sense though is that it might seem a little more like a white knuckle ride at times. If there was any doubt as to the extent of some of the froth which needs to taken out of markets, we proffer the chart below. We would also underline we recognise that Apple remains one of the most exceptional companies on the planet.
FIGURE 5: APPLE AND ITS $2.8TRN VALUATION
Source: HedgeFundTelemetry, ARIA
In the next twelve months, global central banks are expected to drain $2 trillion of global liquidity, with the Fed accounting for about half that. The shift to quantitative tightening (QT) will pose a headwind for risk assets in our view. Recent stock market converts, (retail traders), drunk on the ‘buy the dip mentality’ are likely to experience a hangover or two.
In short, as we said last quarter, last year’s winners are likely to be this year’s losers. That is to say a regime change is afoot and new leadership for a new bull market will emerge. Geo-economics may become a new buzzword, and perhaps Merrill Lynch’s Private Client Group are onto something in their lexicon modification with their ‘FAANG 2.0’, the same famed acronym but this time with a very different meaning.
FIGURE 6: THE NEW FAANGS
| F (fuels) |
Geopolitical tensions, strong demand. constrained supplies„ underinvestment—several factors will keep energy prices elevated over the medium term. Despite the outperformance of the Energy sector year-to-date (YTD), the sector still accounts for just 3.7% of the S&P 500 market cap, well below a 13.4% weighting in 1990. |
| A (aerospace) |
Defense stocks have outperformed the broader market YTD by 16% amid
expectations that heightened geopolitical tensions could lead to greater
military spending. Germany has pledged to double its annual defense budget; the UK and others made less specific pledges. At minimum, North Atlantic Treaty Organization (NATO) requires each member to contribute more than 2% of GDP by a 2024 deadline. Defense spending is also climbing in Asia. Spending on cybersecurity will remain in a secular upswing. |
| A (agriculture) |
The planet will need to produce more food in the next four decades than in the past 8,000 years. The Food and Agriculture Organization›s (FAO) Food Price Index hit an all-time high in January 2022. Equipment shortages, higher costs, climate challenges amid burgeoning demand from the EM middle class all suggest more upside earnings potential for the global agricultural complex. Ditto from the expected decline in agricultural exports from Russia and Ukraine. Russia supplies about 20% of world wheat exports; Ukraine supplies about 10%, according to the FAO. |
| N (nuclear and renewables) |
Nuclear energy has the highest capacity factor of any energy source,
producing reliable, carbon-free energy more than 92% of the time—twice as
reliable as coal (40%) or natural-gas (56%) plants, and almost three times
more than wind (35%) and solar (25%) plants. Renewable energy use increased as the pandemic induced major declines in all other fuels in 2020. Long-term contracts, ongoing installation of plants and priority access to the grid undermine renewables growth |
| G (gold and metals/minerals ) |
Viewed as a “safe haven”, gold prices are up over 6% in 2022 and posted the
best February since 2016, underscoring worries over inflation and war. The Electric Vehicle (EV) transition will be mineral-intensive. A typical EV requires six times the mineral inputs of a conventional car, according to the International Energy Agency. The high mineral intensity required for batteries could imply 40 times the current lithium demands by 2040. |
Sources: Merrill Lynch, Chief Investment Office. Data as of 3/21/2022 except where otherwise noted.
DISCLAIMER
This communication is from the ARIA SICAV, which is, as well as the above referenced sub-fund in Malta and regulated by the Malta
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