Some Investment Themes With Staying Power
A slight miss to the downside in the April CPI inflation report had investors bidding up everything last week. The S&P 500 gained +1.5%, which pushed its year-to-date advance north of 11%. The Nasdaq rallied just over +2%, and the Dow tacked on a gain of +1.24% while climbing above the 40,000 level for the first time (873 sessions after crossing 30,000 back in November 2020). Bonds rallied as interest rates fell, and the price of long-term Treasuries gained nearly +2%. Commodities ripped higher, with gold gaining +2.24%, the price holding above $2,400/oz, and copper futures making a new all-time high. But the biggest winner on the week in the precious metals space was silver which surged more than +11% and is now up more than +30% ytd.
After a jam-packed week of data, this week is quieter with no major market-moving data releases – sparse data release weeks have historically been a positive for stocks. Fed Governor Waller has two speaking engagements this week, which will garner investors’ attention given he is viewed as the most critical Fed member outside of Powell. Outside of that, the biggest concern on my mind now is off-the-charts bullish investor sentiment. The Investors Intelligence Bull/Bear ratio is nearing extreme levels, with 56.5% of respondents in the bull camp and just 17.7% bears as of May 14th. Undoubtedly, the bull camp has been the right place to be, but when you start to see three bulls for every bear, you know that investors are positioned and expecting good things, which implies that such optimism is already in the price.
Let's return to last week's inflation print for a moment. The reaction in asset prices throughout the remainder of the week following last Tuesday’s PPI release and then CPI on Wednesday showed how sensitive markets have become to inflation. A measly one-tenth miss to the downside on CPI sparked a substantial rise in stocks, bonds, and commodities. Very little attention was paid to the fact that the April retail sales report, the May Empire State manufacturing index, NAHB homebuilder sentiment, and housing starts all disappointed to the downside.
The collection of data so far reported in May for the month of April is showing a growth backdrop that is undeniably slowing from where it was at the turn of the year. A similar message can be gleaned from the inflation data outside the BLS CPI report. The Atlanta Fed created an inflation model that deconstructs CPI into ‘flexible’ and ‘sticky’ categories. The flexible CPI moves with the business cycle and contains prices for goods and services over which the Fed has some influence. The sticky index consists of inherently price-demand-inelastic staples and, therefore, rarely experience price declines. For example, segments like rents, insurance, education, and health care are almost always pushing through some level of price increases on an ongoing basis. That's why it's called a "sticky" index. Without question, the economy is experiencing persistent inflation in this core metric, which rose +0.4% MoM in April for the third month in a row and is running at +4.4% on a YoY basis.
However, breaking out the flexible CPI components (i.e., sensitive to the economic cycle), they collectively declined -0.2% MoM in April and have declined in three of the past four months. The year-over-year change is at -0.9%, which is a massive decline from +1.1% a year ago, and for reference, this metric was flat in February 2020 (just before COVID-19 hit). Sure, things are not the same today as pre-COVID, but the fed funds rate back then was 1.75% compared to 5.375% today. The CPI that excludes the stuff that Fed policy has no control over or has little to no impact on (insurance premiums, healthcare services, education, and a lagging rental calculation) shows inflation running at levels well below the Fed's target. The purely cyclical index of goods and services (the ‘flexible’ stuff) is actually experiencing price declines.
All of this leads me back to a thought exercise I've been going through repeatedly in this post-COVID world – how trustworthy is the data coming off a once-in-a-century event, and can we reliably make comparisons to historical data given the possible measurement error? Simplify it for me, Corey – explain it as you would to your five-year-old daughter. Is the Fed making a policy mistake by keeping rates 'higher for longer'? When you decompose the inflation metrics, we can see that inflation is below their mandate for the prices tied to the economy. The prices that Fed policy has little to no impact on remain stubbornly high and are, therefore, keeping headline inflation readings elevated, which is causing the Fed to keep interest rates higher than they should be. Not to mention the interest burden this is putting on the U.S. Treasury, where annual interest expense has exceeded the level of defense spending while tracking towards $1.1 trillion over the next twelve months.
Adding to the complexity of this thought experiment are the broadening claims that high interest rates may stimulate the economy as they subsidize savers with a high-yielding, low-risk place to park money. Blackrock’s Rick Rieder recently made this point in an interview with Wall Street Week:
“I’m not certain that raising interest rates actually brings down inflation…In fact, I would lay out an argument that actually if you cut interest rates, you bring down inflation." Middle- to higher-income Americans "are getting a big benefit from these interest rates."
I will stick with Rick Rieder for a moment but tie this in with another recent interview with Real Vision and Raoul Pal that was incredibly thought-provoking and highly relevant to what we’re talking about. This excerpt of the interview is discussing the thought of structurally higher interest rates:
Rick Rieder: I think they're coming, so I think they're structurally higher because of all this massive spend we talked about in A.I., infrastructure, climate and the U.S. government has too much debt, way too much debt. And so I think the amount of funding they have to do, so I think we try to say structurally higher.
That being said, I think the Fed is going to cut rates and I think they want to, and I think they have to because of the pressure they're putting on low income that we talked about. So I think they will, and I think their mandate is price stability. Everybody thinks the Fed's mandate or the ECBs mandate is two, it's not it's price stability as long as you're close to the pin and the economy's operating. So I think they'll bring rates down. So I think rates will come down.
Raoul Pal: If they don't, how do they finance the rollover of the debt? Because that's the other issue here is the elephant in the room is Janet's got a very big job to do is to try and refinance all this debt.
Rieder: They can't. And I think the biggest risk in the next couple of years is the debt's too darn big. And I think we've seen the most immense movement of leverage from the private sector to the public sector. And it used to be I was on the treasury borrowing committee and for a number of years, U.S. Treasury loves using treasury bills because you manage the tax receipt of the country effectively to toggle up and down bills. We used to issue bills at zero to 1%, we're issuing them at five and change $400 billion a week. It's too big. And so what I worry about, part of why I think the Fed has to get the rate down is, A) we don't have as many buyers internationally as we used to have. Chinese used to be a buyer, Japan was a bigger buyer, et cetera. Banks used to buy, Fed used to buy, we don't have the buyers. And B), the debt service in this country is going to eclipse our military spend and we'll have enough fiscal. The mandatory spend doesn't seem to move because we can't make good decisions on mandatory spend.
So listen, if you said to me what's the biggest risk in the next couple of years? That's it. The debt's too big.
Pal: How I see it is every central bank and government is now basically using liquidity. So they're basing currency to pay for the debts. We see it at every level. We've seen the gain between the treasury general account, the reverse repo and qt and they're pretending they're doing qt, but in fact they're injecting liquidity into the system. It feels like that's the game. I mean the Japanese have done it for a long time. The Europeans have done it. Pretty much everybody's doing it.
Rieder: So I mean think about it at some point, I don't think it's going to blow up in 2024. And if the Fed is reducing rates and people feel good about the rates will say stable, this is a tremendous amount of income you garner. Particularly if inflation is down, your real rate of interest is investors really good.
But I think over the next two or three years there's going to be a point in time where the federal will have to hike rates or rates for whatever reason are going higher. If people always say, I don't want to own it, Fed's going to have to put it on their balance sheet, a Fed put, you have this very similar paradigm to, as you described in Japan, we're watching real time play out around the currency.
U.S. is a reserve currency in the world and the benefits you get from that are immense. I think it's a really dangerous thing and I think policy, I've said it before and I've said to a lot of policymakers, I think we need to address it and I'm just not sure nobody's going to run for election and win on let's cut the debt in this country. So I think we're going down a dangerous path
Pal: Not with an aging population. I use the charts of the labor force participation rate and against it. Look at government debts of GDP inverted. They're actually the same chart. So as the population ages out, the government debt goes up. I don't see a way around this. So I just think of the 1950s and it's like yield curve control is, well Japan, Japan has led the way on all of this.
Rieder: So there's only one way out and I really believe this and nominal GDP has to eclipse your cost of the debt. So the only way you get there is you have to bring down the cost of the debt, which I think the Fed's got to do and I think we'll engineer that.
But B, you have to find a way with our demographics. U.S. demographic is aging, thankfully not as bad as Japan was or Europe is. But it is to your point, the fertility rate is not fast enough. The other benefit when it gets into a super controversial area, but immigration has actually helped expand nominal GDP tremendously. What we do with immigration, I'm not a big fan of illegal immigration, but we have to have immigration because like you say otherwise you can't grow nominal GDP fast enough to offset the cost of the debt.
And then because the U.S. has this extraordinary ability to innovate and technology, if you can do things that are initiatives like R &D credits, accelerated depreciation in areas like chip development, like clean energy, that if you create enough fiscal programs that have velocity to 'em versus just helicopter money, keep nominal GDP up, allow appropriate immigration and then keep the cross of the debt down. But it's hard. You got to have both; both have to happen.
How BlackRock Makes Billions Using The World’s Money
This was a fascinating discussion that I encourage all investors to watch. The bottom line is that we're in uncharted territory regarding the interplay of monetary policy, fiscal policy, geopolitics, demographics, and the existing world order. Just because it’s complicated and unfamiliar doesn't mean it's unsolvable or destined to implode, which is possible, but history has proven that a bet against humanity is a bad bet. Is it scary? Yes, but uncertainty and unknowns often are. From an investment standpoint, it's difficult to put a stake in the ground and take a stance one way or the other. A better approach today is to be like water and have the willingness and flexibility to go wherever necessary to preserve and compound your capital.
Without question, the Fed and other prominent policymakers are aware of this and certainly consider it when making policy. Whether you and I agree with the policies they enact is one thing, but how they may impact markets and our investments is entirely different. As an investor, sometimes it will be prudent to be proactive and anticipatory of policy changes. Other times, it will be better to be reactive to policy moves. Sometimes you'll be correct, and sometimes you'll be wrong – that's just the way it is. What's most important is that when you’re wrong, you figure it out quickly and adjust. Apollo's Torsten Slok hit the nail on the head a couple of weeks ago in an interview with Barron’s “…the polishing of the crystal ball has become much more complicated,” where he was trying to describe the difficulty in interpreting economic data in this post-Covid period that has been plagued by collection flaws and distortions.
As for some closing thoughts on markets as I wind down this week’s missive. I think several themes are currently unfolding that are legitimately exploitable for investors today. Furthermore, the ways to express a view on these themes are broad, but understand that while these themes have a long runway, there will be times when they are out of favor and not working. The trick will be constantly keeping up with them to determine if it's just a short-term blip you must endure and look through or if something has changed, altering the theme.
Fiscal dominance overtaking monetary dominance: The U.S. government is running 6-7% budget deficits at a time when nominal GDP growth is +5%, the unemployment rate is below 4%, and asset prices (stocks and housing) are at all-time highs. There is no putting this toothpaste back in the tube, and no politician will be elected on a platform of fiscal austerity or the pledge that they will take some benefits away. After all, the total outlays by Uncle Sam are equivalent to the 3rd largest economy in the world.
However, it's worth noting that this fiscal dominance theme is not relegated to just the U.S. According to the European Commission’s autumn economic forecasts, deficit levels in 12 countries (including France, Italy, Spain, Poland, Belgium, and Romania) will exceed the 3% of GDP target in 2023 and likely fall under the new corrective mechanism in 2024.
As an investor, this is a structural argument against sovereign debt as the most plausible solution is to inflate away this over-indebtedness problem over time. There will be times when sovereign debt will be a relative outperformer, benefitting from a 'flight to safety' bid, and works quite well, like during cyclical downturns or extreme risk-off events. But for the most part, investors will be better off focusing on real assets, stocks, and commodities.
Passive investing and the financialization of the U.S. economy: the mass adoption of index investing over the past two decades has brought us to the point we are today where flows have become the structural driver of price movements, not fundamentals. Don't get me wrong, fundamentals are important and still relevant, but the majority of investment participation today is done via indexes, which, in the words of Mike Green, are operated by the world's most straightforward algorithm, "Did you give me cash – then buy. Did you ask for cash -then sell." Not, what is the valuation? Is the balance sheet strong? What is the growth profile over the next 12 – 48 months? The majority of investors no longer derive value from doing this work.
As a result, the most important economic variable for the stock market is the labor market. As long as people stay gainfully employed and the economy adds jobs at a similar pace to population growth then the automatic salary deferral flows into retirement plans will continue. Combine this with share buybacks, and you will have a solid perpetual bid supporting stock prices.
This is also a significant driver of economic growth not only via the 'wealth effect' but also because the U.S. economy has become so financialized that business and fiscal decisions are made based on the level of asset prices. CEO hiring and firing decisions correlate very highly with the underlying level of the company's stock price. The same goes for tax revenues for Uncle Sam, where wages and stock-based compensation are the largest revenue drivers. So, yes, there is a lot of incentive for job holders, companies, and the U.S. government to keep asset prices high and rising.
It doesn’t mean asset prices will always increase, but it's important to understand that the tailwinds pushing them in that direction are overwhelmingly greater than the headwinds that occasionally pop up to disrupt the status quo.
A.I./Reshoring/Infrastructure: while each has its idiosyncrasies, they align with some common principles. Each requires a significant level of capex/investment to fulfill its objectives. Each will make a substantial contribution to future productive capacity. All represent a considerable demand impulse to energy and commodity markets. One of the biggest takeaways from the COVID pandemic is the fragility and lack of reliability of global supply chains. CEOs got a pass on this during the pandemic but will not if/when it happens again. The same goes for governments worldwide, where all are building out local sources of redundancies, and some are even doing away with offshore options altogether as they focus on resurrecting domestic capabilities.
Green Revolution/Climate Change: There is nothing new here, as this transition has been underway for almost a decade now. However, we are witnessing firsthand the stress put on the grid when too much reliance is placed on intermittent power sources like wind and solar. Renewables are an excellent carbon-free energy source that should be utilized, but the narrative that they are as reliable, cost-effective, and efficient as fossil fuels is misleading. But that's different than the point you or I should focus on; your focus should be on the ensuing demand created by all the initiatives listed above, which require more energy demand than currently exists for them to be rolled out successfully. This means we'll need more copper, steel, rare earth metals, uranium, oil, natural gas, nickel, and lithium… not all at once and not all the time, but the world will need more commodities.
Keep this in mind when investing in commodities: they are inherently mean reverting – stated simply, the cure for high prices is high prices, and the cure for low prices is low prices. When prices are high, participants are incentivized to increase production until more is available than is in demand, and then prices fall. Sure, they can trend in a direction for extended periods. Still, no matter how bullish or bearish they may be given underlying fundamentals, eventually, the productive capacity catches up or down to the price.
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