Macro Minute: A Tale of Two FOMCs

he FOMC’s November meeting might have been one of the most important meetings in a long time. 

At 2:00 PM EST, we saw a statement that was believed to be dovish by most and confirmed by market moves. It said that the FOMC expects that “ongoing increases in the target rate will be appropriate,” which even the most dovish observers would agree, but added that “in determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”

Thirty minutes later at the press conference, Chair Powell struck a hawkish tone, focusing on the least dovish parts of the statement and provided more hawkish commentary, leading the markets to react accordingly.

He mentioned that rates would be higher for longer: “The incoming data since our last meeting suggest the terminal rate of Fed Funds will be higher than previously expected, and we will stay the course until the job is done.” There is no pause in sight: “It’s very premature to think about a pause in our interest rate hiking cycle.” And lastly, he would rather do too much than too little: “Prudent risk management suggests the risks of doing too little are much higher than doing too much. If we were to over-tighten, we could use our tools later on to support the economy. Instead, if we did too little, we would risk inflation getting entrenched and that’s a much greater risk for our mandate.”

In sum, we saw an intentional dovish shift in the language of the statement, followed by a much more hawkish message at the press conference. We have two main takeaways.

First, we might be seeing the first signs of a fracture happening within the FOMC. That is exactly what happened in the 1970s and it was the main reason that led Volcker to shift to a monetarist approach of targeting monetary aggregates, even though he was not a monetarist. Volcker was an incredible central banker not just because of his technical expertise, but also because he was a savvy politician. He understood that he could not bring all members of the FOMC along to raise rates as much as was necessary to curb inflation. In changing the way the Fed did monetary policy, he saw a way to unburden the FOMC members from this responsibility. He understood that it would otherwise be politically impossible to keep raising rates.

Secondly, Powell changed the shape of the distribution of potential rates outcomes with his comment on “prudent risk management.” If the FOMC follows Powell’s lead, we could see rates going higher for longer, but only at much smaller increments. That will be the compromise. With eight meetings in 2023, we are talking about a potential hawkish rate increase of 200-250bps for the full year (compared with 425-450 in 2022). On the other hand, if they find themselves to have overtightened, they will have roughly 500bps or more to cut, depending on when that happens. The risk of maintaining a paying rates position at the short end of the curve, which was probably one of the best risk-adjusted trades of the year, materially increased.

In A Tale of Two Cities, Dickens opens the book with a sentence that has become famous: “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity (…)” This meeting might have marked the end of the golden age of monetary policy where consensus was the norm and developed markets’ central banks did not have to struggle with their dual mandate or politics.

Catalysts into Year-End

We’ve spent most of the summer discussing macroeconomic trends and data (from inflation to employment) that could change the course of policy and markets, so today we want to focus on a handful of catalysts between now and the end of the year that could have meaningful consequences for asset prices.

China 20th Party Congress

The 20th Party Congress begins on October 16, amid economic turmoil in the country largely driven by the property crisis and Zero-Covid policies.

What’s at stake?

It is widely believed that President Xi Jiping is aiming for a third consecutive (and likely life-long) term as President, bucking the trend of two-term limits established by law in the 1990s then reversed by constitutional amendment in 2018. On the real estate front, China has already begun to implement measures to provide relief to the troubled market and its developers by implementing a $29 billion loan program to help developers finish halted projects, relaxing home purchase restrictions, and lowering the mortgage rate for first-time homeowners in cities where selling prices continued to fall over the summer. With power consolidated post-Congress and a focus on Common Prosperity, we believe there is a chance of greater central government intervention in the market to assuage resident’s concerns about the sector and restart growth given the Chinese real estate market accounts for roughly 25% of the economy.

On September 30, Xi and other members of leadership attended National Day celebrations without wearing masks at one of their last public appearances before the Congress. This, along with Chinese MRNA vaccines being rolled out in Indonesia, could point to shift in Zero-Covid policies on the other side of the meeting. The last patient entered the 28-day EUA test for efficacy against current strains on August 29, and results are expected this month. With EUA approval of one or a handful of the 14 drugs that went to trial in November, we could see a full reopening of the country by April next year given the available vaccine manufacturing capacity.

What’s it means for markets?

China is one of the largest consumers of commodities in the world. A reprieve on the property front would put a floor under building materials like steel, copper, and aluminum. A reversal of Zero-Covid rules and the reopening of the country would boost goods consumption, improve mobility, thereby increasing energy consumption, and increase non-residential fixed asset investment in sectors like renewable infrastructure. Altogether, these changes would represent a material change to the demand-side of many commodities from oil to cobalt, and re-rate prices in the sector higher.  

Russia-Ukraine Escalation

This week, President Putin signed the decree approving the annexation of four Ukrainian regions (Donetsk, Luhansk, Zaporizhzhia, and Kherson), amounting to approximately 15% of the country’s area. Escalation in defense of “Russian territory” is a more significant risk than the market is pricing for the coming weeks and months as Ukraine continues its counter-offensive and other catalysts roll off the calendar. (Recall that Putin waited for the completion of the Beijing Winter Olympics to begin his “Special Military Operation.”)

What’s at stake?

Putin has ordered the Russian nationalization of Ukraine’s largest nuclear plant in Zaporizhzhia this week, and reports of Russian missiles hitting civilian and military targets in the region hit the newswire on Wednesday. Mounting counter-offensives from Ukraine across the territories could lead to further escalation by Russia. In the interest of defending land in the Russian Federation, the country’s articles of war or principles for engagement may allow for the use of more significant weapons against Ukrainian troops in the annexed areas.

NATO reported this week that Russia may be planning a major nuclear test near their border with Ukraine in the Black Sea, which the Kremlin has denied, but many news outlets reported the movement of nuclear weapon equipment by train toward Ukraine. We believe that the probability of a smaller tactical nuke being used in Ukraine, which has reportedly led to Kyiv distributing Potassium Iodide to its citizens, is being mispriced or at the very least, underappreciated in the market. Remember that the last nuclear test in the world occurred by the United States in 1992, and while the USSR conducted a test in 1990, the post-breakup Russian Federation has never performed one.

What it means for markets?

Significant geopolitical risk often begets a flight to safety – namely the US dollar and Treasuries – away from equities. Specific to this case, any nuclear attack by Russia would cripple relations between Russia and the West (and possibly the entire globe), resulting in less energy and metals making it out of the country, limiting supply, which would further weigh on economic output across the world, particularly in Europe.

Brazil Presidential Elections

In the first round of elections, former President Lula da Silva received 48.4% of the votes, in line with polls, while current President Jair Bolsonaro secured 43.2% of the vote, roughly 5% above polling numbers. The run-off election is scheduled for October 30.

What’s at stake?

Pro-Bolsonaro and right-leaning candidates did well in congressional races, gaining 22 seats in the House and guaranteeing his PL party would be the largest in both the House and Senate. Overall, the bi-cameral congress became less fragmented, but more polarized, which could make for a more oppositional congress in the event of a Lula win. We believe this result increases the probability of fiscal responsibility, regardless the result of the presidential race.

What it means for markets?

Given the increased probability of fiscal responsibility from both sides, we believe that once election risk passes and the final result is accepted by both the parties and general public, risk assets in the country should do well in the coming months.

US Midterms

Amid poor presidential approval ratings, United States midterms elections are slated to take place November 8 as a quasi-referendum on Biden’s presidency.

What’s at stake?

In the House, all 435 seats are up for re-election as they are every two years. FiveThirtyEight currently estimates that Republicans have a 70% chance of winning a majority in the House of Representatives, shifting control from Democrats and Speaker of the House, Nancy Pelosi.

In the Senate, 34 seats are on the ballot this year, with 15 currently held by Republicans, 13 by Democrats, and six seats open after senators announced they would not be seeking re-election. The current split of 50-50 slightly tilts to the Democrats, with Vice President Kamala Harris serving as the tie-breaking vote, and FiveThirtyEight currently gives Democrats a 2-in-3 chance of holding the senate, with an average number of 51 seats.

A split Congress often leads to gridlock, meaning Democrats would look to maximize use of the post-election lame duck period to push an expansive agenda while they still controlled both chambers.

What it means for markets?

Wharton professor Jeremy Siegel noted to CNBC that markets tend to perform well when there is political “gridlock”. Since 1944, the S&P has averaged a 13% annual return in calendar years with a Democrat president and split Congress. More immediately this fall, the debt ceiling debate, the potential for more fiscal spending toward monkeypox and hurricane aid among other things, and the possibility of more SPR releases to dampen inflation effects for a voter-base most energized by the economy have the potential to impact Treasury markets and oil markets, with a derivative impact on equity prices. Finally, while the Fed maintains an apolitical stance, a deluge of inflationary fiscal measures could influence its interest rate path, which could weigh on all asset classes.

OPEC+ Meeting & Further SPR Releases

After announcing 2mbpd cuts to quotas on Wednesday, which will amount to roughly 900k bpd of less production by OPEC+ members after accounting for missed quotas, the cartel announced that the current production agreement would be extended to the end of 2023 and that they would be meeting every two months in lieu of the current pace of monthly meetings. In response, the White House said that Biden would continue SPR releases as appropriate, with reports of another 10 million barrels being released in November to combat rising gas prices, again.

What’s at stake?

The Strategic Petroleum Reserve (SPR) is at its lowest levels since 1984, with the population of the United States approximately 45% higher, and the Biden administration has leased the fewest number of federal acres for energy production through 19 months in office since Harry Truman in 1945-46, when offshore drilling was new and the federal government didn’t control deep-water leases that make up the largest part of the federal oil-and-gas program today. OPEC+, citing a potential global slowdown and less directly, a dissatisfaction with the price of oil, opted to decrease production as the US has either intentionally or unintentionally massaged prices lower through oil releases. Most of the actual production cuts will come from Saudi Arabia, and interestingly enough, Business Insider reported on Thursday that the kingdom had lowered oil prices for Europe but raised them for the United States. The administration appears to be gambling that SPR releases will help their prospects in the midterm elections, while at the same time playing chicken with OPEC+ on production, decreasing the country’s ability to manage in the event of any positive oil demand shock.

What it means for markets?

With interest rates marching higher increasing the cost of capital and the green lobby in DC targeting oil and gas companies, domestic producers have not been quick to bring more wells back online. Any rebound in Chinese demand, or a ban on domestic exports, could result in a significant increase in the price of energy at a time when domestic production is lacking and disincentivized from growing. Energy prices are a natural pass-through to virtually everything, raising the floor on commodity prices and potentially re-accelerating inflation which could possibly lead to more hawkish monetary policy in the US. Such a move would not only weigh on equity prices, but also be a tailwind to the US dollar in the event that other central banks have less latitude to tighten. Further tightening by other central banks, namely the ECB, could push those countries deeper into recession and further weigh on both global growth and markets.

Macro Minute: Dollar dollar bill, y’all

This past Friday, September 9th, Bill Dudley was on air early morning making the case that the Fed wants a strong dollar. We know very well why the Fed needs a strong dollar. We wrote on July 25th about the relationship between inflation expectations and the currency’s strength:

“The DXY Dollar index is more than 17 percent up YoY, while the US CPI is 9.1 percent. Being conservative, we can assume a short-run currency passthrough in the US at about 25 percent. This means that if the US Dollar was flat year-over-year, inflation should be a whopping +13%! This blind faith in central banks is what is keeping everything together.”  – Macro Minute: We Learn From History That We Do Not Learn From History. July 25th, 2022.

However, how long the Fed can enjoy this position is less clear. Free-floating exchange rates, as opposed to the traditional view that expects a move to equilibrium at fair value, are inherently unstable. The reason for that is the reflexive nature of exchange rates. A change in exchange rates affects inflation, interest rates, economic activity, and other fundamental factors that then have an impact on exchange rates. This effect creates self-reinforcing and self-defeating processes that are very pronounced in currency markets.

In the case of the US dollar today, the fundamentals and nonspeculative transactions point in the direction of depreciation. It is only when looking at speculative transactions that we can find an explanation for the strength of the dollar in the past 12 months. In reality, the classification of speculative and nonspeculative is much more subtle, but for the purposes of this analysis, a simplified version of the model should suffice.

Non-speculative capital flows arise from the need (not the choice) to buy or sell dollars. On this account, all the fundamentals point towards the depreciation of the US dollar. The need to finance the US twin deficits is not new, but it has increased meaningfully recently. But one component in particular is seeing the largest changes- the need for USD in commercial transactions. Charles Gave, co-founder of Gavekal, wrote an excellent piece on “Network Effects and De-globalization.” In it, he proposes that reserve currencies benefit from the network effect, and that the turning point for the demand for US dollar transactions happened when the US insisted upon oversight of all US dollar transactions anywhere in the world. He argues that the catalyst for accelerating the contraction of this network was the US sanctioning Russian assets earlier this year. This decline has so far been masked by an increase in demand for USD coming from the energy crisis in Europe. We agree with that analysis and we can see the relationship between natural gas prices in Europe and the EURUSD (inverted axis) pre and post-mid-2021 below.

Speculative capital, on the other hand, is attracted by rising exchange rates and rising interest rates. Of the two, exchange rates are by far the most important. It does not take very large movements in exchange rates to render the total return negative. In other words, speculative capital is motivated by expectations of the exchange rate, a reflexive process. And when markets are dominated by speculative flows, they are purely reflexive. This is a very unstable situation. The self-reinforcing process tends to become vulnerable the longer it lasts, and it is bound to reverse itself, setting in motion a process in the opposite direction.

This is an obviously oversimplified model, but it brings useful conclusions. When the inflow of speculative positions cannot keep pace with the trade deficit, rising interest obligations, and lower demand for trade in US dollars, the trend will reverse. When that happens, the reversal may accelerate into freefall, as the volume of speculative positions is poised to move against the dollar not only on the current flow, but also on the accumulated stock of speculative capital. Lastly, when that happens, the exchange rate will have an impact on fundamentals (inflation and inflation expectations) which in turn will have an impact on exchange rate expectations in a self-reinforcing process. All of this will make the Fed’s job that much harder.

Given the unpredictable nature of speculative flows and self-reinforcing trends, we can’t say for certain when this will happen, but if pressed for an answer, I would say in the next 9 months. If the US dollar maintains or accelerates its trend during this period, the EUR would have to be trading below 0.86, the JPY above 170, and GBP below parity. And if it doesn’t, the reversal would be dramatic, if not catastrophic.

Macro Minute: GDP Deep Dive

Last week, just before the end of the month, we got the Second Quarter Advance GDP Estimate from the US Bureau of Economic Affairs (BEA). The quarter-over-quarter annualized number for real GDP printed a disappointing -0.9%, compared to a median expectation of +0.4%, but still better than the 1Q number of -1.6%. 

GDP releases are very important events for markets. Companies use them to help make investment decisions, hiring plans, and forecast sales growth. Investment managers use them to refine their trading strategies. The White House and Federal Reserve both use GDP as a barometer for the effect of their policy choices. 

These numbers are especially important for turning points in the economy. For some (but not the National Bureau of Economic Relations – the US agency responsible for classifying recessions), two consecutive quarters of negative real GDP growth is defined as a recession. If we took the early GDP releases at face value, this would imply that we are in a recession today, dating back to the first quarter. For all the above reasons, it is worth digging into how the BEA derives this number and how reliable the early releases are.

One of the tasks of the BEA is to calculate US GDP, measured as the total price tag in dollars of all goods and services made in the country for a given period. It is the sum value of all cars, new homes, lawnmowers, electric transformers, golf clubs, soybeans, barbeque grills, medical fees, computers, haircuts, hot dogs, and anything else sold in the US or exported during the period. When calculating current (or nominal-dollar) GDP, the agency adds the value of all goods and services in current dollars. But this herculean task does not end there, because what matters for most people is the real growth in the economy. And so, after tallying up everything in current dollars, the agency has to then make adjustments to try and come up with an estimate of the value of what was actually produced in the economy (e.g., ex-inflation). 

Imagine an economy that only produces two things, potato chips and mobile phones. Suppose that the economy is selling $1.1 million of goods this year, an improvement of 10% compared to the $1 million from last year. That $1.1 million number represents the nominal GDP for the economy this year. But that number does not tell us how much of that 10% increase is due to more goods being sold and how much derives from price increases. 

If last year there were 50,000 bags of chips sold for $10 and 500 mobile phones for $1,000, and this year there were 55,000 bags of chips and 550 mobile phones sold for the same price as last year, the economy had real growth of 10% and zero percent inflation. 

Alternatively, if this year the economy sold the same number of chips and mobile phones as last year but did so at a price of $11 and $1,100, respectively, the economy had zero real growth and 10% inflation. 

However, things are not so simple, for the methodology is designed not only to remove price inflation but also to adjust for the quality of the goods being sold. Let’s assume that this year the economy sold 55,000 bags of chips for $10, and 550 phones for $1,000 (the same as the first example). But in this example, the bags of chips sold this year only contain 40 chips versus the 50 chips in each sold last year, and the mobile phones sold this year have better computational power and an extra camera versus last year’s. In this case, the agency would have to account for those changes by calculating a positive price increase for the potato chips and a negative one for the mobile phones, even though the number consumers saw on the price tag did not change. Now imagine that the BEA must do this not just for all the goods sold in the US economy, but also for every service provided, and to deliver an advance estimate one month after the end of a quarter. 

Which brings us to the question, how reliable are early GDP estimates? The answer is… it depends. Each revision incorporates more and better data and is believed to be a better estimate of the true value of GDP. For example, comprehensive data accounts for only 25.5% of advance estimates and 36.8% of second estimates, but it accounts for 96.7% of what we can call “final” estimates[1].

To assess the reliability of the GDP estimates we can look at revision patterns to understand if there is a bias in these revisions and how large they can be. To assess bias, we calculate Mean Revision (MR) where components tend to be offsetting and a large positive or negative number would indicate bias. To understand how large revisions can be, we calculate the Mean Absolute Revision (MAR) and the standard deviations, which are both complementary measures of the distribution for the revisions around their mean. We calculate these revision metrics for the Advance release that comes out one month after the end of a quarter, comparing with both, the Second releases (two months after the end of a quarter) and what we here call the “final” estimates (also called, comprehensive revisions, which are released approximately five years after the advance release).

What we find is that inflation has a meaningful impact on reliability. More specifically, it creates a pronounced bias for advance releases in underestimating real GDP growth. This makes intuitive sense. The task of calculating real GDP becomes even more challenging during inflationary environments. Looking at the numbers, we find that in periods of low inflation [3,4], bias is virtually inexistent with MRs for Second and Final at +0.10% and -0.01%, respectively. While during periods when US CPI is above 7%, MRs are +0.40% and +0.80%, respectively. That means that, on average, in high-inflation environments, Advance GDP numbers are underestimated materially. It is also important to note that MARs and standard deviations are essentially unchanged from one environment to another. This means that the size of revisions is similar in both circumstances. 

To clarify the point, let’s look at last week’s 2Q 2022 GDP Advance release of -0.9%. We can say that the second estimate will be between -1.5% and +0.4%, while the final estimate will be between -2.6% and 2.4%, with 90 percent confidence. This distinction between inflationary and non-inflationary environments is important because if we used the low-inflation scenario numbers, we would say that the second estimate would be between -1.9% and +0.2%, while the final estimate would be between    -3.6% and +1.7%, with 90 percent confidence. [5]

One way to increase the reliability of activity numbers is to look at the average of GDP and GDI. In theory, GDP and GDI should be equal, but in practice, GDP and GDI differ because they are constructed using different sources of information – both are imperfect in different ways. If both GDP and GDI are interpreted as the sums of unobserved, true economic activity and measurement errors, it is possible to infer that the weighted average series of the two is a more reliable measure of activity than either GDP or GDI alone, assuming some of the measurement errors are averaged out.

In short, calculating GDP is a mammoth undertaking, early estimates of real GDP tend to underestimate growth in inflationary environments, and you are better off taking a holistic view of the economy when data is as volatile as it is today. 

P.S. We talked a lot about real GDP, but we should not neglect nominal GDP. Historically, S&P earnings growth tended to stay in line with nominal GDP. And that is how corporate sales, revenues, and profits are recorded. In the second quarter of 2022, nominal GDP in the US was approximately +7.9% QoQ annualized.  

P.P.S. For a depiction of how and when GDP revisions and their vintages are made and maintained by the BEA, please see below.

[1]  Comprehensive revisions are performed every five years and include major updates to classifications and definitions for the entire GDP time series – for more information, please see the endnote

[2] Holdren, Alyssa – Gross Domestic Product and Gross Domestic Income – Revisions and Source Data (June 2014)

[3] Fixler, Francisco, Kanal – The Revisions to Gross Domestic Product, Gross Domestic Income, and Their Major Components (June 2021)

[4] Using 1996-2018 period used in above paper, when US CPI inflation averaged 2.2%

[5] Revisions follow a normal distribution and therefore we can calculate the combined probability that the true value of real GDP growth in the 1Q and 2Q was below zero, i.e., two consecutive quarters of negative GDP growth. P (2Q < 0% | 1Q < 0%) = 36%.

Macro Minute: We Learn From History That We Do Not Learn From History

Despite all the efforts of the most brilliant economists and analysts in the world to build models mimicking the methods of physics that follow their own self-contained logic, rules, and patterns to predict outcomes, when faced with failure, they dismiss it by claiming that “random shocks” had somehow disturbed equations and did not need to be explained since they are “nonrecurring aberrations.” War, pandemics, and politics are not abnormal historical events, only in economics.

However, many questions in economics can be approached more simply through history. In the most recent record, from 2010 to 2020, US CPI YoY averaged only 1.7%, below the Fed’s target (how much did that play a role in the recent late response from the Central Bank is anyone’s guess). However, in the history of the US, there are only a handful of times that the inflation picture could be described as stable.

Looking back at American history, we find six inflationary spiral events. The first occurred in the late 1700s just after the Revolutionary War; the second in 1813 after the War of 1812; the third in the 1860s during the Civil War; the fourth in the late 1910s after World War I; the fifth around and after World War II in the mid-1940s; and, the most current one in the 1970s associated with the Vietnam War. These periods were always followed by long periods of deflation. Evidence would point to politics, not economics, to explain inflationary spirals, and war looks like the common denominator. War in itself has many different impacts on inflation (as we discussed in this Macro Minute: The Reflexivity of Inflation and Conflict). Still, it is really the increase in money spent by the government, above what it collects in taxes, that makes inflation and negative real rates an attractive solution to the debt problem.

Looking back to the latest inflationary cycles of the 1970s, we find a few similarities and one significant difference. [1]

Similar to the present day, in 1975, the government balance sheet resembled conditions only tolerated during periods of war. And in the preceding years, just like recently, conservative governments that were supposed to be fiscally conservative were actually accelerating the deficit. In today’s world, for example, if interest rates rise above inflation, the Treasury’s interest expense goes up as debt rolls over, and the Fed reduces remittances to the Treasury. The Congressional Budget Office calculates that a 1% increase in real rates increases the annual deficit by $250 billion, about 1% of GDP, planting the seeds for an explosive debt dynamic.

In the 1970s, oil price inflation was a big problem, increasing to around 6 percent per month. More recently, on average, oil has been growing at 4.2 percent per month since January 2021. That includes the price corrections we saw in the last couple of months. The contribution to the CPI is still high at 47% YoY at current gasoline prices.

In the 1970s, real interest rates reached -4 percent. Today, we are living through the most extended period of negative real rates, currently sitting at -6 percent. That is before factoring in what can happen with nominal rates in a recessionary scare. We calculate real rates by subtracting the US Treasury 10-year yield by the current CPI YoY number. We believe this is a better indicator of real rates on Main Street than the real rates derived from the TIPS markets on Wall Street. This is the rate that alters the lives and actions of people who are not traders or advisors and who do not follow the FOMC decisions or read the Wall Street Journal. Different from the previous cycle, when the Fed was focused on impacting asset prices, to have an impact on goods and services prices, the central bank needs to focus on the decisions in the real economy and not in financial markets. 

“At 15 percent inflation, an investor lending $1 million at 10 percent ‘loses’ $50,000 a year. You cannot count on the lender being a complete idiot, sooner or later, he will stop lending at low-interest rates and invest the money himself in commodities or real estate.” – Senator William Proxmire. October 1979

Another interesting observation from looking at real interest rates is that every recession is proceeded by positive real rates. More importantly, real rates tend to turn negative to help the economy once a downturn starts. This brings us to the recessionary debate. Like today, in 1979, most economists, including the Fed, were forecasting a recession. They had been wrong for many months, and in September, data showed the economy was not tipping over; it was accelerating again. This was true even with a deceleration in housing and autos and the fear of recession. “A Gallup survey found that 62 percent of the public expected a recession sometime in 1979.”

In an inflationary economy, people behave differently. Inflation doesn’t slow people down. With inflation at 16 percent, borrowing at lower rates seemed like a good deal. Bank credit was expanding at an annual rate of 20 percent. Most consumers did not care about what the higher interest rates were, as long as the monthly payments could fit their incomes. This is not a foreign concept for Latin Americans.

“Lenders were still surprised at how many families were willing to take on home mortgages at 13 percent or even higher. ‘ Perhaps it is not so hard to understand,’ Volcker said, ‘when you realize that the prices of houses have been going up at 15 percent or more.’” – 1979

Today, bank credit is growing at +12% for consumers and +8% for Commercial and Industrial clients. We’ve been following bank’s earnings calls very closely and we find that all the major banks see strong balance sheets, very low forward-looking default rates, and expect credit to grow in the mid-teens for the next few quarters. This past week, American Express reported that overall cardholder spending rose 30% from a year earlier.

Even when the Fed was finally able to create the presumed remedy, a prolonged recession that endured for 15 months with unemployment rising to 9.1 percent and industrial production shrinking to roughly 15 percent, as soon as the economy recovered, inflation came roaring back, rising even higher than before even with employment never getting close to its natural rate. With the supply of commodities constrained, even a short-term decrease in demand does not fix the inflation problem; it only postpones it to the following part of the cycle when policies revert to accommodative.

Lastly, the Fed genuinely did not know how much interest rates would have to rise to break inflation. If record levels of rates were not fixing the problem, how high would rates need to go to do it? Nor did it have the political capital to do what was necessary. Volcker acknowledges, ‘We could have just tightened, but I probably would have had trouble getting policy as much tighter as it needed to be. I could have lived with a more orthodox tightening, but I saw some value in just changing the parameters of the way we did things. (…) it would serve as a veil that cloaked the tough decisions.’”

“There is a wide concern about the Fed’s resolve in adhering to this policy in the face of an election year and the increasing likelihood of a recession. If strong words and actions are not followed by results, then holders of dollar-denominated financial assets in the US and abroad will conclude that the recent changes are no more significant than the statements and policy changes of prior years which did not reduce inflation. When rhetoric sufficed several years ago, tangible proof is now required of the Fed’s intentions.” – Federal Advisory Council 1979

The similarities are striking.

The main difference between the 1970s and today lies in the credibility that central banks around the world collected during a period of global deflationary forces that made them look like they could bend prices to their will and achieve their dual objective effortlessly, giving rise to the mantra “Don’t fight the Fed!” On July 14th, 2022, Governor Waller said, “The response of financial markets to the FOMC’s policy actions and communications indicate to me that the Committee retains the credibility and the public confidence that is needed to make monetary policy effective. (….) lenders and borrowers are still doing business at these rates, which indicates that they believe the FOMC’s policy intentions are credible, as broadly reflected in the interest rate paths in the Summary of Economic Projections (SEP).” Today, markets price the Fed’s projections to perfection.

What does history tell us about that? StoneX’s Vincent Deluard shows us that using post-war data from the World Bank of more than 350 events when inflation spiked above 7%, only 1.4% of the time, inflation slows to less than 3% in each of the next five years. Markets are pricing 1 in 70 odds as if it were 100 percent certain.

“Acting hastily is essential to [a trader’s] profitability. If today’s quickest-to-the-keyboard move makes little sense according to some notion of ‘fundamentals,’ who cares? Overshooting is a feature, not a bug.” – Alan S. Blinder, July 2022.

“Traders must and do therefore respond literally instantly to all news to which they think other traders might respond. Whether the news is considered economically significant or even true is immaterial.” – Albert Wojnilower, Chief Economist at First Boston 1964-1986

This confidence also has an impact on the USD. With the expectation that inflation will converge to 2% in the next 18 months, interest rate differentials make the currency attractive. That, in turn, keeps inflation in the US in check. The DXY Dollar index is more than 17 percent up YoY, while the US CPI is 9.1 percent. Being conservative, we can assume a short-run currency passthrough in the US at about 25 percent.[2] This means that if the US Dollar was flat year-over-year, inflation should be a whopping +13%! This blind faith in central banks is what is keeping everything together. But history also tells us that after a long deflationary cycle and the build-up in credibility, what comes next is the drawing down of goodwill until there is nothing left.

“We’ve lost that euphoria that we had fifteen years ago, that we knew all the answers to managing the economy.” – Volcker 1989

[1] A good friend of the firm and fellow investor, knowing of our quest to understand history, pointed out to us that the team at MacroStrategy research was studying a book written in 1989 by William Greider called “The Secrets of the Temple” about the Fed’s fight against inflation under Volcker to help them with a similar pursuit. This book has been invaluable in our understanding of the period, and all quotes in this letter are from the book. https://www.amazon.com/Secrets-Temple-Federal-Reserve-Country/dp/0671675567/ 

[2] Campa, Jose Manuel, and Linda S. Goldberg. “Exchange rate pass-through into import prices.” Review of Economics and Statistics 87.4 (2005): 679-690. (https://www.nber.org/system/files/working_papers/w8934/w8934.pdf)

Exchange Rate Pass-Through and Monetary Policy, Governor Frederic S. Mishkin, at the Norges Bank Conference on Monetary Policy, Oslo, Norway. March 07, 2008 (https://www.federalreserve.gov/newsevents/speech/mishkin20080307a.htm)

Takhtamanova, Yelena F. “Understanding changes in exchange rate pass-through.” Journal of Macroeconomics 32.4 (2010): 1118-1130. (https://www.frbsf.org/economic-research/wp-content/uploads/sites/4/wp08-13bk.pdf) 

Macro Minute: The Ides of June

When looking at the return of assets for the first half of the year, we find that US bonds posted their worst first half-year performance for over 100 years, while the S&P 500 declined 20.6% year-to-date, recording the worst first half of the year since 1970 and its 4th worst start on record. More broadly, the MSCI All Country World was down 20.9% for the period. Institutional investors are having one of their worst performance periods on record with the trusted 60/40 portfolio declining by 17% YTD, making it the second-worst start since the 1900s.

The month of June was marked by a sharp repricing of recession fears along with a VaR shock that led to risk reduction and high correlation across markets, providing very few opportunities for hedges and diversification. During the month, 10-year treasuries increased +16bps, with the difference between the 10 and 30-year bonds flattening by 3bps. The 2-year bond yield increased by almost +40bps for the month and jumped +54bps in two trading sessions, the largest move since 2008 when it moved +55bps. The S&P and Nasdaq were down -8.4% and -8.7%, while Energy and Materials sold off -18% and -15%, respectively. Commodities were down across the board, ranging from -10% to -40% in agriculture commodities, and -22% to -57% in industrial metals. In other words, you could not make money in June by being long.

Looking at the long-term we believe that commodity and commodity-related equities exposed to the green energy transition have an exceptional demand backdrop that arises from decarbonization initiatives that will only increase going forward while also possessing major supply challenges. As an example, the average EV consumes five to six times more copper than a combustion engine vehicle. Conservative estimates of EV production put copper demand, just from this source, increasing 20-25% over the next two decades. This does not even account for the increasing demand for copper arising from other electrification needs like batteries and cables.

This is happening against the backdrop of virtually no production increases and very low inventory levels. Mining companies learned from their mistakes in the previous CAPEX cycle of the early 2000s, and along with the more recent price declines and volatility, board members will not be in a rush to invest in capacity. Rather, they will prefer dividends and share buybacks. 

On a March 1st podcast interview with Eric Mandelblatt, he says “(…) three of the largest copper mines in the world were developed over 100 years ago. There’s been only one of the 10 largest copper mines in the world that’s been developed this century since (2001). So, you have this situation where supply in the near term is highly inelastic.”

Reflecting on the recent commodities drawdown, we put too much weight on the probability that markets would realize early that the Fed won’t be able to run the level of positive real yields required to bring down inflation to its target. Rather, when looking at prices, it appears markets are pricing the Fed outlook to perfection. We are now accounting for that and expecting that the crucible moment will occur after the Fed reaches their expectation of terminal rate, or just above, and inflation is still above target. At that moment, the Fed will either have to prove credible, or the market should then realize that the Fed will let inflation run above target for longer. It is worth pointing out that history is not on the Fed’s side. Vicent Deluard from StoneX shows that, historically, central banks only manage to bring inflation down to 3% in each of the next 5 years, following a spike above 7%, in less than 1.4% of the time. What we see today is a market that blindly believes in the Fed and prices that 1.4% probability scenario with full certainty, while completely dismissing the other scenarios. 

Also, we did not expect the market to aggressively price in a deflationary bust scenario so rapidly after a higher-than-expected inflation print and still extremely negative real rates. We expected that during this secular bull market in commodities, we would see some ups and downs in prices, but the speed and magnitude of these moves only compare to 2008, which was a massively deflationary bust period. We assign a very small probability of that scenario (for a detailed analysis on this, please see our recently published annual report), and we believe that if a recession is around the corner, it would be an inflationary bust instead. 

With the supply of commodities constrained, even a short-term decrease in demand would not fix the problem of inflation, it would only postpone it to the following part of the cycle when policies revert to accommodative to shore up demand. We know from history that during inflationary busts, commodities have two-thirds of their upward move after a recession begins. 

2022 Annual Report

We believe that 2021 marked the beginning of a secular bull market in commodities and commodity-related equities, with the usual peaks and troughs along the way. A decade of underinvestment by producers and refiners of natural resources coupled with burgeoning excess demand for those resources driven by a myriad of global initiatives including electrification, food security, and energy independence has shifted the long-term supply-demand outlook into deficit for many commodities.

Going back to the 1970s, a period where many investors are looking for clues given the recent run-up in inflation globally, commodity prices and related equities enjoyed a bull market that only ended in 1980 with the collapse of a commodity bubble. In the early 1980s, oil prices began to drop, and at the same time the Federal Reserve was credibly moving to “break the back of inflation”. Since then, we lived through a constant cycle of disinflationary forces that ended in the mid-2010s.

Almost all crises since the 1980s were balance sheet crises, and therefore deflationary. The Japan bust, the Asian crisis, the sub-prime crash, and the Euro crisis were all balance sheet and banking crises. Those crises were deeply deflationary in an already deflationary environment. As balance sheets were negatively impacted, borrowers constrained consumption and investment to pay down debt, while at the same time banks constrained lending, which in turn negatively impacted the price of assets used to collateralize said debt, restricting banks’ ability to lend in a never-ending vicious cycle… until governments stepped in.

Global demographics served as a tailwind for labor and led to an increase in savings that got recycled into US Treasuries – colloquially known as the global savings glut. With the fall of the Berlin Wall in 1990 and China being admitted to the WTO in 2001, globalization went into overdrive as companies could tap into a global labor force, resulting in even more disinflation.

Equities and commodities have swapped market leadership in cycles averaging 18 years in length for over a century. Over time these cycles have become shorter with technological advancements, but they are still fairly consistent, predictable, and long. Commodity price bubbles tend to bust after military or economic conflicts due to the well-known “peace dividend” which drives lower commodity and input costs, better profit margins, higher equity multiples, and more leverage brought on by lower rates and a low-inflation environment. Conversely, when equity bubbles deflate, inflation resurges. Large amounts of debt that were accumulated during the expansionary phase must be reduced using a combination of inflation and defaults. When that happens, easy monetary policy follows, and military or economic conflict once again occurs, perpetuating the long-term cycle.

In the subsequent sections of this report, we examine in detail three probabilistic scenarios for what the medium- to long-term outlook in markets may be, but a summary of the analysis is as follows.

(1) Sustained growth and higher prices via re-leveraging of consumers, a renewed corporate investment cycle, and the build-up of inventories in a more inelastic supply environment. This view is anchored in the belief that the world is transitioning from slack to generally tight commodities supply. (P = 55%)

(2) Rising conflict, disruptions, and nonlinear upside price movements leading to a prolonged period of stagflation. Major wars (or other exogenous shocks like pandemics) produce high inflation, and even minor wars can interrupt trade. Conflict and inflation are intrinsically linked, especially coming out of a period of extreme money supply growth. (P = 35%)

(3) Continued price disinflation or deflation, western-dominated status quo, resumption of the technology capital expenditure boom, and prolonged strength for US equity index returns. In this scenario, the belief is that the Fed will not be as aggressive in hiking rates this cycle given the unsustainable divergence between rising debt as a percentage of US GDP and the falling nominal GDP growth derived from that debt. (P = 10%)

The above scenario analysis and applied probabilities shape our forward-looking market views and positioning. Throughout this report, we provide the economic data and analysis in support of these ideas, and a summation of the key points can be found below:

  • We believe that for at least the next few years, we are entering a new environment for inflation with consistently higher price levels. Some indicators to watch for are surging real estate prices, high money supply growth, large fiscal deficits, strong commodity prices, increasing geopolitical instability, and stretched valuations for the US dollar.
  • In that period, we also expect strong nominal GDP growth, while the outlook for real GDP growth is more uncertain given the rising risk of conflict or a central bank miscalculation.
  • Rising inflation will lead to Fed rate hikes, but the governors may have little choice but to return to an accommodative stance due to the “hangover” of past financial excesses and, potentially, war. Government roll-over rate risk is very large, with approximately two-thirds of United States federal debt maturing in the next four years.
  • We expect strong global commodity demand and commodity prices to be a central theme as well. Poor profits have discouraged investment by commodity producers since the mid-2000s, and the growth of sustainability concerns has exasperated the underinvestment.
  • With supply already in short store, producers have moved from the last decade of short duration investment – restock, destock, capex binge, balance sheet distress, capital raise, boom, and bust – to longer duration, disciplined capex cycles.
  • As a result of these dynamics, we expect commodities to outpace the S&P 500 over the next few years. Commodities become a defensive asset in commodity-driven recessions.
  • We see single-digit compound returns for the S&P over the period. The first part of the period will see negative returns and the later part low positive returns, as the focus shifts from multiple compression and falling earnings to cheaper valuations. Free cash flow generation will be key in both phases.
  • Inflation could be made significantly worse if increasing geopolitical instability leads to wars.

Given this outlook, we have built positions across the commodity complex, the core ones being in industrial metals – namely copper, aluminium, and cobalt – emission allowances, and grains. Alongside those positions, we have further built upon the theme through equity allocations to global energy refiners investing in renewable fuels (e.g., sustainable aviation fuel, renewable diesel), miners and refiners of industrial metals who lead in low carbon intensity production, and industrial companies exposed to the renewable revolution with large market share and pricing power. We expect the supply-demand fundamentals facing commodity markets to persist for many years, pressuring prices and having a negative impact on prevailing market sentiment, with a particular emphasis on long-duration assets. We will be hedging a portion of our equities exposure by betting against indices we find to be richly valued given our probability-weighted scenarios. We expect interest rates, especially in the developed world, to make higher highs and higher lows over the next few years, a quasi-mirror image of the lower highs and lower lows of the deflationary past few decades. Lastly, we believe that the currencies of commodity-exporting nations will benefit greatly from this scenario.

To arrive at these views, we have done extensive research that involves proprietary information and third-party data. If you are interested in a full copy of the report, please contact ir@norburypartners.com.

Macro Minute: Flip or Flop

With so much talk about a recession lately, it is hard not to look for clues in housing numbers. This past week, we had numbers for US housing starts and building permits. While homes only directly account for roughly 5% of GDP, related goods and services can account for nearly 20%. Aside from 2001, the US has never gone through a recession when housing is doing well. Conversely, the US has never emerged from a recession without the help of housing (2009 being the exception with a rebound while housing was stagnant). Fort these reasons, it comes as no surprise that so much attention is given to the release of housing data.

Housing starts record how much new residential construction occurred in the preceding month, while building permits track the issuance of construction permits. The number for both releases is reported in number of units, with the latest number for housing starts and building permits disappointing the Bloomberg median survey at 1.549 million and 1.695 million, respectively. But how disappointing are these numbers, if at all?

First, let’s look at housing starts. The month-over-month number came in at -14.4%, and comparing the latest release with the same time last year, the number of starts contracted by -3.5%; however, these numbers are very volatile and prone to significant revisions. When looking at the rate of change of the 12-month moving average in May versus the previous month, we encounter only a -0.28% contraction, and when comparing the average with the same period last year, we find a growth of +9.5%. Building permits decreased by -7% MoM and increased +0.2% compared to last year. Using the same 12-month moving average to smooth volatility, the rates of change from the previous month and last year are +0.2% and +6.4%, respectively. We can see some deceleration, but we are still at very healthy levels compared to the past.

One thing to keep in mind is that looking at housing starts and building permit numbers only gives us an idea of the real component of the economy. But for prices and company earnings, it is Nominal GDP that matters. Therefore, we have constructed a nominal index for housing starts and building permits using the S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index. When looking at that number, we see some deceleration, but in aggregate both starts and permits are still running at very high growth rates.

We cannot draw firm conclusions from a single piece of evidence, but what a closer look at housing starts and building permits shows is that the probability of recession may not be as high as one perceives from reading headlines.

Macro Minute: The Russian Gambit

Last week, the European Union announced plans to ban Russian crude oil over the next six months and refined fuels by the end of the year as part of the sixth round of sanctions. Over the weekend, the proposed ban on its vessels transporting Russian oil to third-party countries was dropped, but the EU will retain a plan to prohibit insuring those shipments. Bloomberg reports that about 95% of the world’s tanker liability cover is arranged through a London-based organization that must heed European law. Without such insurance, Russia and its customers would have to find alternatives for risks, including oil spills and mishaps at sea, that can quickly run into multi-billion-dollar claims. (For more on the commodity trading business and how insurance impacts commodity flows, listen to “Javier Blas Explains How Commodity Trading Shops Really Work” on the Odd Lots Podcast).

The pain to European consumers is clear. The region last year got 27% of its oil imports and approximately 40% of gas from Russia (paying $104 billion for supplies of fossil fuels). Economists estimate a full embargo on Russian oil and gas reduces the area activity from 4% (Barclays) to 2% (Bundesbank), while some analysts have argued that the impact would be lower than that. Germany’s vice-chancellor Robert Habeck said his nation has already cut its reliance enough to make at least a full oil embargo manageable with the share of Russian crude in German imports falling to about 12% since the invasion.

For Russia, an oil embargo would limit the inflow of foreign currency and make difficult spending cuts necessary. Russia’s Finance Ministry expects its GDP to shrink as much as 12% this year, on par with the turmoil seen in the early 1990s, when the Soviet Union ultimately dissolved. On Monday, Russia said it expects its oil production to rise in May, and that it is seeing new buyers for its crude, including in Asia. But how much of this is true and how much of it is just posturing?

Changing oil shipping routes from Europe to Asia is not as trivial as Russia would lead us to believe. Different vessels are required to efficiently transport oil on different sea routes. When done properly, transport of crude oil by tankers is second only to pipelines in terms of efficiency, with the average cost of transport at $0.02 to $0.03 per gallon. When transporting oil, there are three main types of vessels: Very Large Crude Carriers / Ultra Large Crude Carriers, Suezmax, and Aframax vessels. There are about 800 VLCCs/ULCCs in the world used for long-haul routes and they carry around 2 million barrels each. There are about 700 Suezmax vessels capable of passing through the Suez Canal in a laden condition, and they can carry around 1 million barrels on long-haul routes. Lastly, there are about 600 Aframax carriers in the world, known as “go-fast boats,” moving about 600,000 barrels on short-haul routes.

Zoltan Pozsar of Credit Suisse estimates that roughly 1.3 million barrels of oil get shipped from Primorsk and Ust Luga to Europe on Aframax carriers and these journeys take a week or two to complete. Russia does not have pipelines to Asia so the only way to sell its product to new buyers is by using sea routes. However, it is uneconomical to transport crude on long-haul voyages on Aframax carriers and they would need more VLCCs/ULCCs to make that happen. Because Russian ports are not deep enough to dock VLCCs/ULCCs, they would first need to use Aframax vessels to get to a port to then transfer the crude to larger vessels. This transfer itself can takes weeks. After the transfer, the larger vessel would then take about 70 days to get to Asia, unload, and take a similar amount of time to return. This compares with just a couple of weeks when shipping to Europe. This would cause a sharp slowdown in Russia’s economic activity. The world would also need an extra 80 VLCCs/ULCCs to accommodate that change which represents 10% of the current global capacity of those vessels. Additionally, this only accounts for the re-routing of one product, oil, but Russia exports every major commodity.

The increasing competition for selling oil in Asia would have an impact on one of the Middle East’s biggest consumers. It is then no surprise that Saudi Arabia cut oil prices for Asia buyers over the weekend. This will not make Russia’s situation any easier. China benefits when Russia becomes weaker and more isolated and hence more dependent on Chinese goodwill. Let’s not forget that during Russia’s invasion of Crimea in 2014, China got Russia to agree to build (and possibly pay for) a dedicated pipeline at lower prices than it sells to Germany, even when the cost of gas from the new field is higher.

The cost of banning Russian oil might be large for Europe, but it can be even larger for Russia. This should increase the impact of sanctions and diminish the possibility of a unilateral cut in supply in the near future. 

Macro Minute: Inequality and Economic Growth

On a macroeconomic level, inequality can affect economic growth, productivity, and political stability, which in turn has direct implications for corporate profitability.

As with most social science endeavors, there is a healthy debate about the precise impact of inequality on growth. For starters, does it hinder or accelerate economic growth? Economic theory shows that with higher income and wealth come higher savings rates and, therefore, a higher level of investment and gross domestic product. In this case, if marginal productivity is higher for capital than for labor, one can see that more inequality would create higher economic growth. Also, in economies with underdeveloped credit markets, significant investments can only be made if wealth is accumulated. In the presence of imperfect capital markets and indivisibility of investments, an economy with higher levels of inequality may be able to introduce new industries, technologies, and markets and ultimately grow faster than the same economy with lower levels of inequality. Finally, there is an argument that reducing inequality reduces incentives to accumulate wealth through labor, entrepreneurship, and innovation, having, therefore, a negative impact on long-term growth.

However, a healthy debate should not be confused with a balanced debate. The bulk of the literature supports the theory that inequality hurts economic growth. Studies that found a positive relationship between inequality and growth were focused on the short term, and studies that found a negative relationship were focused on the long term. In other words, inequality can produce a small contribution to growth in the short term but will substantially adversely affect growth in the long term. Empirical results have increasingly supported the arguments for impaired economic growth and a negative impact on productivity in the face of rising inequality.

Poor people without access to credit markets often defer health care treatments, cannot procure housing or transportation and lack the means to further their education. This results in missed opportunities and diminished productivity and growth potential. The same applies to poor parents with multiple children compared to wealthy parents with few children. The inability of low-income families to invest in their children’s education, and the inability of poor workers to invest in developing job skills because of either financial constraints or time constraints while working multiple jobs, can result in a reduction in overall skills and knowledge of the potential employee pool. That can have a drag on growth, productivity, and business performance. Finally, there is the problem of the indivisibility of consumption. In the absence of developed credit markets, expensive items can only be acquired by accumulating wealth. If the economy became more equitable, part of the population initially excluded from the acquisition of these goods would enter the market, encouraging the creation of new domestic industries.

Societies with higher levels of inequality also tend to have higher levels of crime, keeping a larger share of the labor force from productive activities and decreasing potential growth. Also, with the increase in social instability, trust and social cohesion can erode, leading to conflict, political crises, and the resulting retraction of investments. One of the potential consequences is the rise of nationalism and the splintering of support for globalization. This scenario has played out in economies around the world over generations. Ray Dalio, the founder of Bridgewater Associates, the world’s largest hedge fund, has warned of the corrosive effects of inequality on faith in capitalism and, therefore, the stability of the institutions and markets in which business operates.*

*This excerpt appeared in the article “Business Risks Stemming from Socio-Economic Inequality” by Todd Cort, Stephen Park, and Decio Nascimento at the Columbia Law School Blue Sky Blog published on April 15, 2022. The article is based on the paper “Disclosure of Corporate Risk from Socio-Economic Inequality” by the same authors published on March 18, 2022. You can find the article here, and the paper here.