Mutual Daily Mutterings
Quote of the day…
“The urge to save humanity is almost always a false front for the urge to rule”.…H. L. Mencken
Chart du jour…..yiellds vs oil…
Overview…”light data, modest headlines, light volumes”
- A low volume day offshore with some US markets (treasuries) closed for the Columbus Day holiday. Stocks fell in light holiday trading with a handful of negative headlines “overwhelming a slew of machine-driven buy programs that squeezed short positions and briefly pushed the S&P 500 into the green”. European bond yields rose +2 – 3 bps on inflationary pressures, with oil again advancing (more below). While treasuries were closed, futures were nudged higher. Goldman Sachs downgraded its outlook for the US economy, and, yesterday’s market pariah, Evergrande, missed more scheduled debt payments, all of which weighed on risk sentiment.
- Brent rose +1.4% to three-year highs, while WTI is sitting at 7-year highs amid continuing fears of shortages of both coal and natural gas. What’s the shortfall in supply then, or what volumes would ease the price pain? Market analysts have put the figure between ~500K – 1,000K barrels a day. While OPEC has a pledged to “ensure the stabilization of oil markets” at the core of its mission statement, earlier this month, the cartel elected to add no more than a previously-agreed 400K barrels a day, despite the consensus view from outside the group that more was needed.
- So, what now? If we assume no new supply is forthcoming any time soon, one way to balance energy markets is through ‘demand destruction’, which “means stalling, or at the very least slowing, the post-pandemic recovery until the peak winter demand season for heating fuels has passed.” Easier said than done, but let’s say it does happen, what then for markets? One could assume a flattening of the curve is a possibility…but not while inflation and stagflation are occupying the broad market narrative.
- Speaking of which, some interesting analysis of what is actually front of mind for investors at the moment. Bloomberg is reporting the volume of stories on its own service that mentioned ‘stagflation’ hit an all-time high last week and that such volumes have happened on four prior periods in the past ten-years. Bloomberg’s analysis into how markets performed during these periods found that “a focus on stagflation risks tends to coincide with weaker equities and a stronger dollar. However, the study also hints that risk assets can rebound handily once the volume of news stories citing the issue stops growing”. Not exactly traditional valuation analysis, but…
- Offshore Stocks – a decent (ish) sell-off in offshore markets with most indices moving in lock-step, down -0.6% – 0.7%. Within the S&P 500, three-quarters of stocks retreated and only one sector, REITS (+0.2%) fired a shot in anger. Elsewhere it was red, red, and more red. At the bottom of the pile was Telcos (-1.5%), followed by Utilities (-1.3%) and Financials (-1.0%). Despite the rally in oil prices, even Energy (-0.4%) struggled to land a blow for the bulls. As per previous comments, valuations remain elevated and I see more headwinds than not. An abundance of excess liquidity is keeping markets frothy.
- Local stocks – a modest pull-back yesterday with ~62% of the ASX 200 in the red. Only a handful of sectors really did anything on the positive side, led by Energy (+1.3%), Materials (+1.2%), and Staples (+0.2%). If not for gains in Materials, the day would have been considerably worse. As with offshore markets, valuations are still on the optimistic side compared to the array of risks on the table. Risk of further pull-back cannot be ignored. Futures are pointing to a modest down open, -0.4%.
- Offshore Credit – with bond markets shut in the US, not a lot done there. A little more active in EU IG markets with six deals printed, totalling €3.5bn. Main focus is tonight with the EU expected to print the biggest green bond it has ever issued, €12bn. You could buy a lot of Birkenstocks with that kind of coin.
- Local Credit – traders…”fairly steady volume session to start the week, with a decent move in outrights. Supply remains light, with new A$525m Macquarie Bank (A+/A2/A) 1yr FRN at +13bps following the recent A$ CBA 1yr transaction. Secondary cash closing mixed. Some selective buying in higher beta paper supporting spreads.”
- Bonds & Rates – local bonds again smacked around the chops with 10-year yields back to levels last witnessed around the ‘reflation trade’ period (Mar-May). While oil prices continue to rise, we’ll probably see continued upside risk to yields over the near term. US markets closed overnight, so minimal leads should see a relatively subdued day in local markets, although treasury futures have nudged higher.
- Local Macro – today (from NAB’s Markets Today)…”NAB Business Survey and Weekly Consumer Confidence. NAB Business Survey is out today (no hints here), while Weekly Consumer Confidence is also out. Consumer Confidence is likely to remain robust given the re-opening seen in NSW as well as VIC and the ACT getting closer to their own respective re-opening dates. Robust consumer (and business) confidence should ensure a sharp rebound in activity as lockdown restrictions ease”.
- Offshore Macro – I put up a chart of US CPI against US PPI yesterday that showed the former lagging the latter, suggesting the former had more room to run. The latest US CPI data is due out tomorrow night our time (+0.3% MoM & +5.3% YoY consensus), with PPI to follow on Thursday (+0.6% MoM & +8.7% YoY consensus). Given the rise in oil prices and the importance of transport costs on both consumer prices, but also manufacturing, and the risk higher energy prices will scuttle Fed transitory inflation expectations, I have re-run my CPI vs PPI chart with oil prices added (below). Talking heads…”beyond the issues of things like a global chip shortage or stubbornly low labour force participation, there’s nothing that can inform the public’s sentiment about real-time inflation quite like higher energy prices. Usually, you don’t get a rise like this with underlying inflation measures already at an elevated level — a further squeeze at the gas pump isn’t going to convince the public that this is all transitory”.
- Steak Knives – some commentary on inflation and the impact on stocks that are worth repeating…from Bloomberg’s Cameron Crise (some editing from me), which links in somewhat with the market cap vs GDP charts I published last week. Firstly, while we don’t ‘do’ equities at Mutual Limited, one needs to have a view on the market because of the broader connectivity with other markets and asset classes –
- While the dust from the latest payroll report may have settled a bit over the weekend, there is plenty on the docket over the next few days to keep investors fully engaged. Beyond the onset of an earnings season that coincides with the loss of economic momentum in the U.S., there’s also some key data releases (including CPI), a slew of Treasury auctions, and a number of Fed speakers. The question of just how transitory inflation will prove to be won’t be answered this week, but perhaps the very question itself will come under questioning. Another issue is just how high and persistent inflation needs to be before it really matters for financial markets. We may not be there yet, but the historical record suggests that we aren’t that far away.
- Every so often a central bank will coin a phrase that enters the financial market lexicon, to be repeated ad nauseam by policy makers and punters alike. Phrases like “patient,” “considerable period,” “measured,” and “strong vigilance” may still provoke a shudder in some quarters, and I suppose we can now add the word “transitory” to the list. It’s been pretty clear for years that monetary authorities haven’t had a good handle on the drivers of inflation, and there’s no particular reason to think that their errors will be any smaller to the upside than they were to the downside.
- As the new week kicks off, a lot of the inflation focus is on crude oil, which has surged to multi-year highs on both sides of the Atlantic. Energy tends to be one of those sectors that influences the public more than the PhDs; the FRB/US model cannot literally shake its head as it fills up a gas tank or pays a heating bill. But the inflation story obviously extends well beyond petroleum products, and is radiating across just about every facet of economic life.
- Remember lumber? Its massive squeeze and subsequent reversal was seen as a sort of poster child example of the transitory nature of price rises. To be sure, just about every parabolic rise in prices contains a degree of excess — including natural gas prices recently — that eventually gets reversed. But that reversal can in some ways make you ignore or forget the underlying trend. It was easy enough to say “let’s open more sawmills” … but finding the people to staff them might prove to be trickier. And so lumber prices have once again risen more than 40% over the last month, after never having done so between 1995 and 2019.
- Here’s the thing, though; It’s not just the level of price rises that is troubling, it’s the general amplitude. There’s a reason that inflation volatility has historically been inversely correlated with equity multiples — high volatility makes planning for the future a lot more difficult, and thus requires a higher risk premium.
- Of course, these days we have the central bank money machine helping to support financial assets. That being said, it’s not altogether clear how encouraging a bunch of money funds to stuff assets into a reverse repo facility (which has been the primary result of Fed QE since the spring) is super-bullish for risky assets, though in fairness monetary aggregates have continued to rise.
- As discussed a couple of months ago, there is a narrative that the slowdown in money growth relative to nominal GDP — otherwise known as Marshallian K — may herald some troubles for the stock market. Ironically, a supply bottleneck-driven slowdown in growth could make this measure look a little less threatening for fans of the Naive Overlay Chart of Doom.
- But what if we take out the middleman and simply look at equity market cap relative to M2 money supply? This perhaps provides an alternative valuation measure that captures the “money printer go brrr” zeitgeist that seems to have driven investment psychology over much of the past eighteen months. The good news is that we are nowhere near a record high in this ratio. The bad news is that we are basically at the highest level of the past 50 years other than that record peak posted during the frenzy of the internet bubble.
- OK, so let’s square the circle here. Does inflation tell us anything about the market’s willingness to buy equities, as seen through the prism of the W5000/M2 ratio? The answer appears to be “yes,” and it seems to confirm a framework with intuitive appeal, one which was expressed by Alan Greenspan in the mid-1990s and more recently by the (in)famous Jeremy Rudd paper: inflation either doesn’t matter, or it does.
- Analysis shows that if we plot the one-year average of YoY headline CPI on the x axis and the Wilshire 5000/M2 ratio on the y axis, going back to 1971. It makes for pretty fascinating viewing. With the one-year average CPI below 4.0%, equity valuations are all over the shop, with a wide dispersion of ratios. This is pretty suggestive that factors other than CPI are the primary driver of equity pricing: In other words, inflation doesn’t matter.
- Above 4.0%, however, and it is a very different story. Valuations fall and are confined within a much narrower range, suggesting that there is a significant constraint on the willingness to pay up for stocks relative to the amount of money that is out there. In other words, inflation matters. The good news is that we are not yet at that point.
- That being said, we’re not terribly far away from 4.0%. The data suggests that there may well be a statute of limitations on just how long the Fed and other central banks can persist in claiming that inflation will be transitory without observing some negative consequences. In fairness, there are a few cracks appearing in the global monetary facade, with the Bank of England at least admitting that “transitory” ain’t so transitory, after all.
- In real time, of course, markets may decide to fixate on the inflation story or they may choose to ignore it. That’s the beauty of choosing to believe that all of these price pressures are just a temporary phenomenon. But equities are unlikely to remain immune to ongoing inflation indefinitely. At some point, the bears will come out of hibernation if prices keep rising like this. Another few months of 5% inflation could make things very interesting indeed.
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Scott Rundell, Chief Investment Officer
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