Guest Haymaker - Louis-Vincent Gave

In The Ring - August 26th, 2022

Aug 26, 2022

The Always Suave Louis Gave

“These guys (at the Fed) really don’t know what they’re doing in any deep way. It’s a giant financial experiment that maybe right now is in the process of going wrong.” -Billionaire investor Seth Klarman

Meme generated via Imgur

Haymaker subscribers have a treat coming up very soon. Yesterday, my close friend and partner, Louis Gave, recorded a podcast with yours truly. It was the first where I acted as the interviewer instead of my usual role as interviewee. (His last name rhymes with “mauve” and, of course, “suave”, a quality he readily exudes) My intent is to do these on a monthly and possibly semi-monthly basis, chatting with the lengthy list of brilliant folks I am privileged to know and, often, call friends.

As you will realize as you begin listening to our discussion, Louis is a natural in this format. For someone on my side of the microphone — which was admittedly a strange experience for me — having a guest as lucid as Louis makes my job… well… not a job at all.

As a prelude to our podcast, I thought it was appropriate to run one of his recent articles as this month’s Gavekal Haymaker. It’s a relevant note considering the news out of Jackson Hole, Wyoming, today. This is the annual Fed gathering where key policy speeches are often revealed (and, for the last two years, with embarrassing ultimate ramifications for its chairman, Jay Powell).

Louis wrote this note roughly two weeks ago in the wake of this month’s benign CPI report. It was the first inflation number in almost a year and a half that implied the possibility of “peak inflation”. As you will read, however, Louis is skeptical this reprieve is anything more than — to use one of the Fed’s former favorite words — transitory.

Rather than steal his thunder, I’ll let him outline his reasons for this belief. However, in our podcast, but not in this piece, Louis discussed an intriguing thesis that energy stocks are the new antifragile assets. For most of the past 40 years, bonds fulfilled that role. They would frequently rise when stocks fell and fall when stocks rose. Now, the energy sector is providing that counterbalancing aspect. For example, in the first five and a half months of this year, when both stocks and bonds were being punished in unison, energy stocks soared. Then, pretty much around the time the overall stock market began to rally, the energy sector was slammed, as I’ve previously discussed.

This deep correction — which at one point had crashed the main energy ETF (XLE) by 27% in about five weeks — created what I felt (and wrote) was an outstanding buying opportunity. It produced the same situation with the midstream energy (pipeline) issues, causing me to add two of them to the Tracked Income Portfolio in our Making Hay Monday.

It’s interesting that since the alleged “peak inflation” news broke around August 11th, the S&P is down a couple percent, but the XLE is up about 7%. The midstream ETF, AMJ, has risen, too, though by a more modest 3%. Fortunately, the recently recommended oil service ETF has popped by 8%, even as the more speculative parts of the market, the leaders of this summer’s rally, have been getting beaten up once again.

To learn more about Evergreen Gavekal, where the Haymaker himself serves as Co-CIO, click below.

Private Wealth Management

Louis is also making the case in this article that certain emerging bond markets are vectoring to replace U.S. treasury debt in the antifragile, or negatively correlated, camp. He also articulates his positive case for this asset class in our podcast. However, there is a tremendous divergence in the fundamentals of developing world bond markets, with many in truly terrible shape right now. Accordingly, it’s critical to perform in-depth research on which countries are an attractive destination for investor capital and which are likely to be destroyers thereof.

Irrespective of Mr. Powell’s speech today, widely perceived to be hawkish, Louis and I remain convinced that the Fed is in a wickedly sticky wicket. One of his favorite sayings is that believing in central bank omnipotence is like second marriages: the triumph of hope over experience. The Fed’s goal of bringing inflation down to 2% without producing a recession, and a significant spike in unemployment, seems to me more like a fourth marriage — Hollywood-style.

-The Haymaker

The Pros And Cons Of A Pivot - Louis-Vincent Gave

(Originally Published August 11th, 2022)

US consumer inflation came in below expectations in July, the first downside surprise in 18 months. That’s the good news. The below-consensus number is helping to fuel the belief that inflationary concerns are going to melt away, and that the Federal Reserve is near to calling a pause on its tightening. Cue a relief rally in equities and a mild sell-off in the US dollar.

The bad news is that US CPI inflation is still 8.5% year-on-year.

• This is still much too high for comfort.

• An inflation rate of 8.5% continues to imply real capital destruction for all bond-holders in the US treasury market, regardless of their duration.

• The fall in the inflation rate from 9.1% in June was largely due to a fall in gasoline prices, driven by the decision to release oil from the US strategic petroleum reserve. These releases will come to an end in November, just in time for Europe to start importing massive amounts of oil in order to alleviate its coming winter energy crunch (see Trouble In Store).

• The dip in inflation was also partly attributable to a tame number for owner-occupiers’ imputed rents; a number that seems divorced from the recent experience of most US tenants.

July’s CPI print was depressed by releases from the US strategic petroleum reserve

If July’s CPI number had come in higher than expected, the rally of recent weeks would have rolled over aggressively, abruptly ending the bounce-back in meme stocks and aggressive, cash-flow-burning growth stocks (see The Fed’s Signaling And Markets). But does an 8.5% print mean that all is well for the AMCs, Teslas and Beyond Meats of the world?

Inflation remains at a level that prompted the Fed to become more hawkish

Consider that on March 10, the February CPI reading came out with consumer inflation hitting 7.9% YoY, the highest in 40 years. This, alongside the sharp rise in market inflation expectations following Russia’s invasion of Ukraine, prompted the Fed to switch up its hawkish rhetoric by a gear.

Immediately before the February CPI release, the 30-year US treasury yield was around 2.3%. Unsurprisingly, bonds did not like the fact that US inflation was heading above 8%, and today the 30-year yield stands above 3.0%. As yields rose, and as Fed rhetoric intensified, the US dollar (as measured by the DXY) gapped higher, from 97.8 before the release to 105.2 on Wednesday, August 10, wreaking havoc on asset classes including emerging markets, commodities and US industrials.

The S&P 500 index has ended the last five months pretty much where it began

But interestingly, as yields and the US dollar have risen, the S&P 500 has broadly held its ground. The day before the February CPI release, the S&P 500 closed at 4,278. On Wednesday this week, the S&P 500 closed at 4,210. This divergence in performance suggests a tentative conclusion: for bonds, the rate of inflation matters greatly; for the US dollar and equity markets, what matters most is probably Fed policy.

Logically, Fed policy and the US inflation rate should go hand in hand. As long as inflation remains high—and by any standard, 8.5% is high—the Fed should be seen to be hawkish and tightening. But clearly, the market does not see it this way since talk of a Fed “pivot” is now rampant (as Will Denyer and Tan Kai Xian discussed in Thursday’s Daily, see In Search Of A Fed Pivot). Looking at July’s CPI print, investors are therefore left with two questions.

Is the inflation threat over?

The answer to this question matters greatly to bond investors. Unfortunately, my answer is a broad “no,” for a long list of reasons

1) Wars are fundamentally inflationary. Today, the West is in an undeclared war with the world’s largest commodity producer. Worse, the war is not going particularly well, unless the aim is to turn Ukraine into a new Afghan quagmire for Russia and slowly to drain Russia’s resources into a new pit of destruction (see Elbridge A Colby On Ukraine And The Way Forward). However, even achieving this is proving costly (the weekly billion dollar packages for Ukraine recall Jacques Rueff ’s quip that “inflation consists of subsidizing expenditures that give no return with money that does not exist”).

Tensions over Taiwan will only accelerate the trend towards deglobalization

2) If globalization was massively deflationary, deglobalization is proving to be inflationary. Every week that goes by reminds investors that deglobalization is real and growing. The latest flare-up over Taiwan (see Pelosi Lights Up Taiwan) has provided a further incentive for US companies to “bring production home,” as well as an excuse for US lawmakers to subsidize the reshoring of production (perhaps more than the support of democracy, this was the real purpose of Nancy Pelosi’s visit).

3) The energy crisis that is engulfing Europe is far from over. This promises to cause significant further global supply chain dislocations over the coming months, and especially this winter.

4) With its labor force now shrinking, China’s business model is no longer to keep adding excess capacity on top of excess capacity in a runaway bid to create jobs at any cost (see Avoiding The Punch).

5) Covid means that optimizing labor forces is no longer an option. Instead, every business now needs to have redundant workers—which suddenly skews bargaining power away from capital and towards labor.

Unfortunately for bond holders—and for central bankers—it is premature to conclude that the inflation threat will disappear any time soon. This leads to the second question, whose answer is by no means a foregone conclusion.

Is the Fed set to stop tightening aggressively?

The market’s immediate takeaway from July’s US CPI release was that instead of hiking 75bp in October, the Fed would likely raise by 50bp. After that, it would likely hike by another 50bp in November, maybe followed by 25bp in December. Then it would likely pause to assess the impact of its tightening.

Investors are now expecting the Fed to be less hawkish

Such a rate hike trajectory would leave US short rates still far below the rate of inflation. It would also highlight the Fed’s inherently “pro-inflation” bias. While the Fed was slow to raise interest rates in the face of rapidly rising inflation, this pace of rate increases, and the pause, would show that the Fed is also sensitive to the rollover in growth. This scenario makes a lot of sense. In fact, pricing in another 125bp in rate increases (50bp in October, 50bp in November and 25bp in December) could even prove too hawkish.

• US and global growth rates are slowing. Sure, July’s payrolls were strong. But most other data points seem to be coming in on the soft side. And most leading indicators—PMI surveys, OECD leading indicators—are pointing south.

Growth is slowing and leading indicators are soft

• Most central banks are clinging to the belief that inflation is largely driven by supply chain disruptions. And with more supply chain dislocations likely in the near future, whether because of tensions over Taiwan or because of Europe’s energy crisis, central banks are likely to continue to hold on to this particular fig leaf with both hands.

• Governments everywhere, but especially in the US, need to be funded. And in times of war, central banks fund governments.

On this last point, it is interesting to note that the Bank of Japan is following a very different policy path to other major central banks (at a significant cost to Japan’s exchange rate). The BoJ has embraced yield curve control, with the stated aim of helping the Japanese government continue to fund its debt at attractive rates (attractive for the government; not so much for investors). And even though a veritable legion of hedge funds have piled in to short the Japanese government bond market in an attempt to break the BoJ’s resolve, the central bank has stood fast.

The Bank of Japan is sticking to its policy of yield curve control

This is interesting because in the last 20 years, time and again the BoJ has adopted policies—zero interest rates, quantitative easing—that the rest of the world initially decried as unsustainable. And, as we now know, it wasn’t long before other major central banks found themselves boldly heading down those very policy trails initially blazed by the BoJ.

Could it be the same this time? Looking at the growth in budget deficits and government debt across the US and Europe, can a future of yield curve control policies really be dismissed out of hand? And if it cannot, the countries that do not follow very easy fiscal policies funded by central bank printing are likely to see their currencies revalued. And most of these countries are to be found in emerging markets.

On this note, it is interesting to see that since the release of the US CPI report that saw consumer inflation hit 7.9% in February, the larger emerging market currencies have broadly held their own, even as the yen has fallen -18.5%, the euro -14.6% and sterling -12%.

Major emerging market currencies have been relatively resilient

This is unusual. In a strong US dollar world, one would expect currencies such as the Brazilian real, the Mexican peso, the Indonesian rupiah, the renminbi and the South African rand to do poorly. Instead they have all outperformed the likes of the yen and the euro, with the Brazilian real up 22.7%, the Mexican peso up 12.9%, the Indonesian rupiah up 2.3%, the renminbi up 0.8% and the South African rand down only by a modest -1.5%. Is this a sign that, in the current inflationary cycle, some of the world’s bigger emerging markets might provide a haven from the storm? (see The Silver Lining In Emerging Markets)