By Edward Lim
When I was fifteen years old, my form teacher wrote in my report book, “Edward has a vociferous appetite to challenge and question norms. If that energy is channeled properly, he can be a great leader”. I had to look up in the dictionary what vociferous meant and when my dad asked me, I told him she said I was loud. I am sure her intended operative word in that sentence was “if” and not “great”. The common adage in investment is “Don’t fight the Fed”, but that doesn’t mean we should not question or even derided them for their mistakes, after all, the Fed governors are merely human like all of us and not some financial gods. As early as in Jan 2021, After the storm, what comes next?, we highlighted the risk that the market could be under-estimating inflation as a combination of cyclical issues such as overly large fiscal and monetary responses to the pandemic alongside long-term structural changes to operating costs as globalization reverses and decarbonization accelerates. We followed up on this view devoting much of Mar 2021 Navigator, Low and slow. By May 2021, When it peaks, we have downgraded Equities to Neutral on concerns about inflation as well as valuation grounds. In July 2021, Courage on the blocks, we wrote “ We expect a challenging second half of the year. The market will genuflect between economic growth that might be short-circuited by an emerging and even more virulent strain to that of pent-up demand stonewalled by supply chain bottles that could drive a transitory inflationary pressure to become more permanent. Overlayed with the herculean balancing act by central bankers to calibrate the correct monetary policy that promotes growth and full employment without stoking inflation and asset price bubbles.” We subsequently downgraded Equities alongside the underweight in Bonds and raised cash as a defensive strategy. These views articulated in early 2021 were contrarian at that time and had challenged the Fed’s proclamation of a “transitory inflation” and will only move “when they see the whites of the eyes” of inflation. We are again questioning the Fed’s narrative that inflation is stubbornly high and doubt their confidence that their financial maneuvers will not inflict too much economic pain.
We have highlighted four key inflation drivers that need to be continuously mark-to-marked as detailed in April 2022, Everyone has a plan until they get punched in the mouth. and Jul 2022, The Bear Necessities. They were supply-chain-induced pressures, energy and soft commodities complexes driven by the Ukraine-Russia war, wage inflation, and shelter inflation. We remain sanguine that the first two drivers have moderated significantly and will provide much relief to their respective categories in the inflation basket in the coming months. We track a myriad of high-frequency indicators such as a Fed-devised measurement of supply chain pressure, rates on container freight out of Shanghai, and bulk carrier as barometers of trade and commodities flows, as well as our trusted PMI survey on price. As evidenced in the chart below, all four indicators related to supply chain are substantially lower than their peaks in the year and is also down on a year-on-year basis and on a rolling 3-months.
High-frequency supply chain indicators show pressure is almost absent
We also tracked the prices of basic building blocks of economic activity such as ubiquitous copper and aluminum. These basic materials prices have similarly fallen on a year-on-year, on a rolling 3-months and from their peaks. When we look at the commodities most affected by the Ukraine-Russian conflict such as wheat, the increase is now only 8% yoy versus the high right after the invasion was a staggering +47% yoy. Wheat has fallen 35% from that peak and -22% on a rolling 3-month basis. The broader soft commodities index is down -9% for the year and is also down from the peak and on rolling 3-months.
Most hard and soft commodities prices are already negative for the year
The energy complex is more complicated. This is obviously due to the cartel that operates for its own objectives rather than on free-market principles. Even as OPEC+ tries to maintain high oil prices, Brent, WTI ,and US retail pump prices have also fallen from the peak and on a rolling 3month basis. Natural gas remains elevated, and its reasons are well documented given Europe over-reliant on Russian oil complicated by the messy attempt to coordinate their purchases and to impose price-cap among the EU buyers. The significance of OPEC+ recently cutting output by 2mn barrels on the day of Yom Kippur is not lost among keen students of history.
Energy complex is still up for the year but is off from its peak and delta of change is negative
Putting all these data together, we are already seeing companies lowering their expectations of input and output prices. Global PMI-Input Price is already down -3.8% yoy based on Sep’s reading, while the Global Output price has moved down 0.1 point and it is at the lowest reading since March 2021! We have called out the Fed’s inaccurate reading of rising inflation in Jan 2021 and we are now calling out Fed’s poor assessment that inflation is sticky. If my late form teacher was still alive, she would have chided the Fed “Patience is a virtue; haste makes waste”.
PMI Input and Output Prices are fading fast; Fed should be patient
The other two drivers of inflation, wages and housing, are moderating but not as fast as the goods and services segments of the economy. A unique feature of this post-pandemic inflation dynamics has been the attrition in workers seeking re-employment in the lower-wage segment of the economy. This is driven by a combination of lesser mobility, lower vaccination rates, higher mortality rate, and the general reluctance to rejoin workforce as they have enjoyed a large fiscal windfall. The baby boomers were also electing not to return to work but instead to enjoy their remaining sunset years (I can attest to that during my recent trip to Italy. The number of elderly American tourists was overwhelming with one tour guide chiming that she is the busiest she has ever been with American groups in her 40 years in this business even though this was supposed to be the tail end of the season). But there are encouraging signs some of that is reversing. The chat below illustrates a few important points. The wage growth of “Production and Non-supervisory jobs” aka lower-wage segment” has increased at a much faster pace than overall wage growth. Their outsize increase has contributed to the surge in overall wage growth in the early days of reopening. However, the wage growth of “Supervisory roles”, aka higher-wage earners, was growing within its long-term trend of 2.5 to 3.0%. The latest data shows that “Production and Non-supervisory roles” wage is moderating from a high of 7% in 3Q21 to 5.7%; no doubt still higher than long-term trend. This has helped overall wage growth to moderate to 5.0% for its recent high of 5.6% in Mar 2022. Job openings have been slipping in tandem with weaker macro-outlook declining 1.1mn in August. This has allowed the gap between job openings and workers available to fall to 4.3mn down from a peak of 5.9mn. The easing of workers shortage should ease wage pressure in the coming months.
A bifurcated tale of wage growth between production versus supervisory workers in the US
The red-hot housing market in many developed economies has slowed as decades-high mortgage rates is curtailing demand, allowing supply-demand gap to normalize. Home sales in New Zealand, China, Canada, Sweden, and the US are now below pre-pandemic levels after the initial surge of post-pandemic migration from cities to suburbs.
Globally home sales are falling as higher mortgage rates bite into demand
Consequently, home price increases are already negative in China and are falling quickly in Canada, Australia, New Zealand, and Sweden. Some economic models are now expecting US home prices to be flat throughout 2023. Granted that inflation basket considers rent rather than home prices, there will be a lag effect of 9-12 months for falling home prices to feed into the rent component of the inflation basket. The latest rent inflation indicators are pointing to a 6.5% yoy increase, which is 3% ppt lower than the PCE Shelter Index of 9% and that gap is at the widest on record. In summary, three of the four main inflation drivers are moderating significantly and for rent, we expect that the recent decline in home prices will filter to lower rents in the next three quarters.
Home prices are falling and should feed into rent component of inflation basket by the next 3 quarters
Growth is a bigger risk than inflation. Since 1968, the Fed had to tighten monetary policy 7 times because of rising inflation. 5 out of the 7 episodes, recession ensued. In other words, Fed has a very poor record of engineering a soft landing rendering its latest economic projections as an anomaly. During this episode, the median GDP contraction has been 5.4% and if there is a recession, the GDP decline was larger at -5.4% peak-trough. This fact contrasts sharply to Powell’s Fed forecast of no recession in 2022 and 2023; just sub-par growth of 0.2% and 1.2% respectively. The median increase in the unemployment rate was 1.80% and if a recession ensued, unemployment rate increased by a larger extent of 2.4% defying the Fed’s forecast of just 0.8% increase in unemployment from the current level.
Fed’s track record of a soft landing isn’t great
As we have outlined in the previous Navigator, we used a four-prong approach to gauging the probability of recession. Latest nowcasting data points to below-trend growth globally with DM deviating from its potential the most. Global growth is currently growing at 3.1% but in Developed Markets growth is almost zero. Biggest weakness is emanating from Europe as expected with its nowcast at -0.3% and UK -2.6% while the US is growing at meagre +0.6% and that’s on the back of two consecutive quarters of negative GDP.
Nowcast data shows a weak global economy with Europe, UK already in recession and US barely positive
Forecasting data paints an even grimmer picture. The latest September Global PMI of 49.7 is the second consecutive month of negative readings. Weakness is widespread across both manufacturing and services sectors as both indices are below 50 for two straight months. Amongst all of PMI forward indicators, the New Orders and Future Output indicators are very important harbingers of growth momentum. New orders for manufacturing have been below 50 since Jul while new orders for services is just treading above 50 in the last few months. Echoing this weak sentiment is Future Output which has been on a downtrend since peaking in early 2022. These PMI readings are corresponding to a growth slump of only 1.8% ar; far lower than the current full year consensus forecast of 2.9% or the nowcast of 3.0%.
PMI indicators paint a grim outlook on growth in the coming months
Next, we look at the recession probability models. JPM recession models are all above their threshold signaling levels of an impending recession. NDR’s economic timing model shows we are likely heading into a mild recession.
Various recession models point to high probability of recession
Lastly, we listen from the bottom-ups to what corporates are saying about their operating environment. 3Q22 earnings season will be in full swing in the next couple of weeks, but based on the 2Q22 earnings transcript, we already have 240 companies in the S&P 500 mentioning recession during their calls, well above the average of 52 and is the highest going back since 2010. Key canaries in the coal mines sectors like Financials (85%), Real Estate (73%), Materials (64%) and Industrials (53%) have a very high percentage of companies talking about recession during their earnings call.
Highest on record number of companies since 2010 citing “recession” in their earnings call in 2Q22
At the start of the year, our macro narrative was for the unsustainable surge in the goods segment to abate and for the growth baton to be passed to the services segment as vaccination rates increases and the economies reopened. Given that the service segment is far larger for many economies, our base-case assumption was for the global economy to grow at a trend pace even as inflation bites and interest rates increase. Supporting this consumption resurgence are the high saving rates that consumers can tap on, and the relatively strong corporate balance sheet that supports a capex upcycle. Our view is for inflation to peak in 2Q22 and to moderate quickly thereafter. However, several unexpected developments have adversely affected this trajectory. The Ukraine-Russian spillover effects, reticence of labor to return to work was unexpected, while geo-political risks have intensified and are now played across many spheres beyond US versus China, to Western democracies versus authoritarian system, OPEC+ versus environmentalists. The consumer had to tap into their saving rates to sustain real spending and corporates are now delaying not only capex decisions but marketing and advertising expenses as well. The latest macro data points to an inevitable recession in the brew and the focus now is how severe this recession would be as the risk of policy mistakes have been amplified. The portfolio is positioned even more defensively than a year ago when we downgraded Equities to Underweight. For the first time, our cash holdings are more than our equities holdings, which is already way below the low-end of our 40% range. Our conviction in Treasuries have also increased not just for carry but also as a defensive hedge to a heightened risk of recession.
Inflation has peaked and is moderating
But global growth is slowing even faster
Fixed Income (Overweight in US Treasuries): The key tenet of our analysis is that we expect inflation not only to have already peaked but to fall materially in the coming quarters alongside a pernicious and possibly precipitous decline into a recession. In our last Navigator, we provided a detailed analysis on how we have derived the range where US10 yield should be trading using historical precedents when the Fed was tightening in face of rising inflation. Hence, we are contrarian here and prefer to own long-dated US Treasuries and to own a well-diversified high-grade corporate debt portfolio but are eschewing emerging market, high-yield, and private credit debt structures that lend to vulnerable sectors of the economy. We know from similar tightening episodes since 1960s, 70% of the time US10 yield peaks lower than where the Fed Fund rate is at the end of the tightening cycle, and it peaks 3 months ahead of end of the tightening cycle. Even as the Fed has recently moved its terminal rate to 4.5-4.75%, the latest Fed fund futures show the Fed will front-load the increases and will be done by Feb-April 2023. With history as a guide, we can gauge the US10 yield should peak in this quarter and should trade in the range of 2.4% to 3.5%, ie lower than end Fed Fund rate. From a fundamental valuation perspective, US10 Yield is trading at an attractive level now relative to a regressed model consisting of PCE, 6-months Bills, Real German Bond Yield, and Real GDP Output gap. The current positive spread of +58bps is in sharp contrast of -90bps during periods of recession. From a TINA (There Is No Alternative) perspective, US Treasury yield offers an attractive carry relative to Japanese, German and Canadian government bonds . Owning US Treasuries is also a portfolio hedge if indeed the economy slumbers more than we are currently anticipating as yield will fall further than our fair value computation.
UST10 Yield is 25-50bps too high and offers attractive spreads relative to other govies
We like US investment grade debt as well given the OAS spread of 182bps is trading at the high end of its historical range and is within the recession ranges of 160-250bps. Yield of an BBB US credit is now 5.7% and offers 3.88% pick up from S&P500 dividend yield. This spread is also the highest it has been since 2008. We have recently collaborated with Principal Asset Management; a global investment company based in the US that specialises in fixed income investing. Our mandate is to create a customized well diversified global investment grade bond portfolio that offers more than 5.7% yield and has a short duration of less than 5 years. (Please speak to your relationship manager for more details about this collaboration)
IG debt OAS is at recession level
US IG Yield 5.7% and 388bps more than equities
Equities: We have been underweight Equities since October last year, the longest streak of being underweight on our record. As recession risk has heightened and is arguably inevitable, our past analysis tells us that the equity market could fall further by another 15-20% from the current level as valuation needs to fall closer to 13-15x depending on which valuation metric versus current valuations of 17-18x forward and trailing PE. Moreover, earning revision momentum (ERM) has only fallen 2-3% from its peak while our past analysis shows ERM needs to decline by 9% from its peak to mark the trough of earnings expectation during recession.
Equities valuations are expensive if we are heading into a recession
While we have kept our equities exposures through the last 12 months within 30-45%. In hindsight, we should have made an extraordinary exception to run an even lower allocation. Currently, nearly half of our 35% equity exposures are in long-short hedge fund managers that has demonstrated their abilities to outperform challenging markets including this year. Thematically, we continue to like companies engage in the multi-decades de-carbonization efforts and companies that have consistently compound their dividend. We are conducting due diligence on a long-short technology manager.
FX: Long US dollar overlay. We think the dollar smile exerts its influence for the next couple of months driven by the flight to quality in an environment of beggar-thy-neighbour economics and geopolitics schism.
Alternatives: Our low/non-correlated strategies are now 25% of the portfolio spanning across credit, volatility arbitrage, CTAs and long-short equities managers.
Cash: Cash holdings is large >25% and been put into fixed deposit to avoid cash drag.
Commodities: Nil, the investment clock says we are already in the recession/stagflation quadrant
Oh dear, we are in good hands.
Tenure
FED Governors
Arthur F Burns
Feb 1970 to Jan 1978 (8 yrs)
Economics major from Columbia University
George William Miller
Mar 1978 to Aug 1979 (1.5 yrs)
Law from UC Berkeley and came from private sector
Paul Volcker
Aug 1979 to Feb 2011 (31+yrs)
Princeton and an economist in the Fed
Alan Greenspan
Aug 1987 to Jan 2006 (19 yrs)
Economics MA from Columbia University
Ben Bernanke
Feb 2006 to Jan 2014 (8 yrs)
Economics Phd from MIT
Janet Yellen
Oct 2014 to Feb 2018 (3+ yrs)
Economics from Brown University
Jerome Powell
Feb 2018 to present (Present)
Politics from Princeton and Law Degree from Georgetown
Edward Lim, CFA
Chief Investment Officer
edwardlim@covenant-capital.com
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