In his epic fight with Evander Holyfield, Mike Tyson was asked whether he was worried about Evander and if he has a plan. Mike nonchalantly answered, “Everyone has a plan until they get punched in the mouth”. Mike had a plan and so did Evander. Mike stuck with his plan while right at the onset Evander’s plan was not going too well. He had studied Mike’s deadly infamous left hook when he will dip to his left to land the punch, but instead, Mike elected to hit right crosses at him. Evander then had to adapt and eventually went to win the bout despite the betting odds of 25 to 1 was in favor of Tyson.
In our 2022 strategy The Long and Unwinding Road, we expect growth to moderate sharply in 1H22 as the unsustainable demand in goods in the past year will peter out in part due to the reopening of economies diverting spending from goods to services. Think of this example. I don’t need another Peloton bike (goods) anymore and would prefer to go to Disneyland(services). The fading of fiscal stimulus including no more helicopter money is another reason contributing to this slowdown. We also posit that inflation will moderate in 2Q22 in tandem with the slowdown in growth but also principally supply chains will normalize as covid restriction becomes less frequent and labour force returns to work. With these macro-dynamics in mind, we upgraded Fixed Income to Neutral for the first time in a while as we forecast inflation to peak in 2Q22 providing breathing room for the Fed to adopt a measured pace of monetary tightening. We kept our then contrarian call in October to underweight Equities but mused they could be a chance for an upgrade in 2Q22. However, history would have it that the unexpected escalation in Ukraine-Russia affairs would deliver such a profound and far-reaching impact to inflation through the channels of hard and soft commodities, and a tightening of financial condition complicating the reaction function of central bankers globally.
The multi-billion-dollar questions are (1) How long and how bad will inflation be, and (2) Has this raised the risk of policy mistakes on the geopolitics and/or monetary fronts such that a recession or worse stagflation becomes inevitable? As the foreword of this strategy has suggested, it is important to have a plan but equally important to be humble and mark to market the assumptions and devise a new plan if required.
US March Core PCE price index (which is the key inflation indicator the Fed monitors) continued to rise month on month by 35bps or 5.40% yoy. However, with many commodities spiking post Russian invasion of Ukraine in February, we now expect month-on-month and year-on-year inflation prints to trend even higher in the coming months. Even before this war, the jump in inflation has already been broad-based across many regions. The surge in oil and natural gas prices will impact Europe and Japan the most given they import much of their energy needs, while the surge in global food inflation of 9.2% ar poses a significant risk to many emerging economies as the food basket constitutes a larger portion of inflation computation than developed markets.
Broad-based jump in inflation across many regions
Rise in food inflation is the fastest since 2008
It is no surprise that every economic forecaster has increased their inflation projections materially. For example, Goldman Sachs raised their global inflation forecast to 7.6% and 4.2% in 2022/23 from their forecast of 5.4%/3.0% made just a month ago. The index of Common Inflation Expectations survey, which is an amalgamation of economic forecasts, market participants view of inflation, and consumers and businesses surveys is now at the highest since 2013.
Many are revising upwards inflation forecasts
Survey of inflation expectations have risen too
However, we maintained our view that the inflation trajectory will still peak this year but not in 2Q22 as we have earlier forecast, but by early 2H22 instead. As commented in January’s Navigator, there are several cyclical drivers of inflation we need to constantly mark-to-market. Taking the dynamics of US inflation as an example, the main contributor of the surge in inflation in the last 12 months has been car prices including new, used and rental cars. That category alone accounted for more than 70% of the jump in the US Core PCE Inflation. We have argued in our January webinar the automobiles are commodities and automakers do not have any pricing power. The surge is car prices are one-off driven by series of events. Firstly, a dramatic reduction in the pool of cars for both new and rental cars when the pandemic first took hold, followed by a surprise surge in demand several months later as more move out of the city to the suburbs to work from home, fueled by another round of demand from the government largess of transferring money directly to household. At the same time, production of new cars was hampered by wide-scale lockdown in key production hubs. In the early months of the pandemic, semiconductor fabrication facilities diverted capacity from the automotive segment to supply the demand coming from an insatiable consumer tech and when auto demand started to improve, the automotive supply chain was short of semiconductors. All these issues are unwinding now, and we are already seeing signs of auto production accelerating and car prices coming off. Historically, car prices lead its related component in the CPI by 3 to 6 months.
Auto prices is the major driver of US inflation
And they are coming off
Outside of car prices, we have observed that the supply chain disruptions caused by the Omicron variant is waning. We use a myriad of alt-data to conclude that. The recent Omicron surge across the globe has not led to mobility restrictions unlike the previous waves nor significant decline in Google activity. This improvement addresses the issue of factory lockdowns and labour availability.
Aside from the Delta wave, all subsequent waves of variants have a decreasing impact to mobility
Port congestion remains tight globally with the US easing but China worsening in the last couple of weeks. However, the cost of logistics across air, sea, and bulk have already moderated from its peak, albeit still at substantially higher levels than pre-pandemic levels. We are also tracking a newly developed index by the Fed that tracks supply chain pressure and that has started to moderate but caution we need to see March release to affirm the downtrend since Dec last year is intact.
Port congestion easing in the US but recently worsen in China
Logistic costs have fallen from their recent peaks
Fed Supply Chain Pressure Index eased
Source: Bloomberg. Green = Bulk rates Pink = Container, Blue = Index of companies in freight and courier. Black = Fed Supply Chain Pressure Index
From the early onset, we have disagreed with the consensus view of a severe shortage in semiconductors and argued only certain components in automotive production and graphic cards were. US imports of semiconductors are 135% above the pre-pandemic level while Taiwan and South Korea exports of semiconductors are at new highs. This data reinforced our view and should well suggest there are wide-spread double booking. The front-end and back-end assembly of the semiconductor production cycle are expected to sync now as key back-end assembly countries of Malaysia and Vietnam have eased or lifted restriction since 4Q 21.
Semiconductor shortage has eased since 3Q21
The drivers of inflation we have mentioned above are merely one-off pandemic-induced effects. The sticker form of inflation such as wages and shelter will remain elevated and we do not expect any easing of these two issues anytime soon. The gap between the availability of jobs and workers is the highest it has ever been in the US since World War II. Unlike many countries where labour force participation is already close to the pre-pandemic level, that has not happened to the US. Wages in the US are now rising above 5% yoy and are likely to rise even more in the coming quarters based on several leading indicators.
More jobs than workers available in the US
Surveys point to higher wages ahead
We have commented in last October, Another Lexicon, house prices, and rental rates will continue to rise because the US has under-built homes in the last many years. According to NDR, the US inventory-sales ratio now is only 2.3 months in contrast the long-term average of 6 months. The recent increase in mortgage rates will further reduce the supply as new home sales is down -4% year-to-date. Shelter inflation in PCE index is now running at 4% yoy, the hottest since 2007 before the US housing crisis.
More jobs than workers available in the US
Surveys point to higher wages ahead
On balance, we are expecting inflation to be higher and persist for a longer period but our view that the inflation trajectory will peak out in this year remains intact. This delta of change in inflation is probably more important than the absolute level for shifts in portfolio construction.
The latest hard and soft data we tracked is pointing to a very strong 1Q22 in the range of 3.5 to 4.0% ar. Forward indicators such as PMIs remain in the expansionary phase in February and flash PMIs released in March post the invasion is still indicating a global economy in firm footing with weakness in Europe and Japan offset by stronger releases in the US. China remains on the watchlist, but we believe it will achieve its 5% GDP target as forward macro data such as Total Social Funding are inflecting higher while the housing market has stabilized in the last 3 months. We understand the impact of a 10% increase in oil prices over a 12 month period to the global economy and inflation ranges from 0.5 to 1.0% reduction in GDP growth and lifting inflation by the same magnitude. At the start of the year, most oil forecasts were between $85-95 and with oil price now at average of $112 post-invasion, forecasters have expectedly downgraded their global GDP for 2022/2023 from 4.4% to 4.0% and 3.6% to 3.5% respectively from their end-Dec 2021 forecasts. Inflation forecasts have increased from 3.50% to 5.1% in 2022 and 2.90% to 3.30%. These numbers suggest a material slowdown from last year’s GDP growth of 5.9% and a jump inflation of 4.0% but these numbers are not recessionary nor stagflationary outcomes.
PMIs still point to a strong global economy
Leading indices for China housing improving
Another important indicator we monitor is Financial Conditions Index. This index encapsulates various market indicators to assess if events have led to a tightening of credit availability and higher cost of liquidity/credit. Since credit is the lubricant of the global economy, this index is often a good harbinger to future growth. Except for China, the Financial Conditions Indices of all regions are nowhere near 2020 covid levels, 2015 commodity shock and EM growth slowdown, 2011-2012 Europe existential crisis, and certainly not the 2008 Global Financial crisis levels.
Financial Conditions Indices have tightened but nowhere near previous crisis levels
Source: Goldman Sachs
Tracking 3 different recession prediction models: None suggesting one is near in next 12 months.
Since the media started touting the world stagflation, we must define the differences between recession and stagflation. Recession is commonly defined as two consecutive quarters of decline in real GDP and inflation falls as instructed by conventional economic theory. Stagflation is defined as slower economic growth accompanied by high inflation and slower economic growth. “Slower economic growth” is loosely defined as below-trend growth which for the global economy it is anything below 3.0%. The US economy has only experienced a few periods of stagflation in 1980, 1974-75 and to a lesser extent 1958-59. If we dissect our ever-reliable investment clock into five phases instead of four: Recovery, Reflation, Overheating, splitting Recession, and Stagflation, there have only been 9% of the time Stagflation has happened since the 1950s in contrast to Recovery (27%), Reflation (39%), Overheating (6%), Recession (17%) according to NDR. Among the five cycles, Stagflation is the only phase that average return is negative -7% for the S&P500. Even in a recession, the average return has been positive 9.4%. Stagflation is a rare occurrence but is the most deleterious phase as returns for bonds and equities are negative from a nominal and real returns perspective. It is important to remind readers that the latest consensus GDP and inflation forecasts are not suggesting this will be the case in the next two years. Neither are we subscribing to that view as well.
Stagflation has rarely occurred but is the worst outcome for both equity and bond returns
This author is well aware that his formal education in economics only started in the late 1980s. We have been lulled into assuming equity and bond are negatively correlated meaning when bond prices go down (ie yields go up), equities generally go up. However, Goldman Sachs have examined the last 100 years and concluded that this negative relationship is the exception rather than the norm. Only during the Great Depression, the roaring 50/60s, and the late 1990s equity/bond correlations were consistently negative and that is often because inflation is well anchored during these periods and the lexicon of Fed’s put became a common adage.
We have noticed that since QE started in 2009, such positive correlations between bond prices going down (yields go up) and equities go down are happening more frequently. There have been 36 months out of 170 monthly returns that the equity/bond correlation is positive and has resulted in negative returns or 21% of the time. But of the 36 months, 7 of them have happened from 2020. The duration of such incidents has been on average 1.28 months which is not a prolonged dislocation but the incidents when it lasted more than the average of 1.28 months have happened more frequently in the last three years. The average declines in those incidents where -5.9% and -1.8% for MSCI World Equities and Global Bond respectively (All source from Bloomberg). The simplest reason for this slow recoupling is that bond yields at such artificially low level as a result of QE have rendered bonds less of a portfolio diversification tool while the elevated valuation of equities has been made possible by cheap and abundant liquidity.
Negative correlations between equities/bonds were exception than norm.
What does this emerging and possible break from conventional wisdom means for a multi-asset portfolio allocation? The conventional suggestion of a 60/40 equities/bond will become riskier as we witness more frequent positive equity/bond correlations with negative return outcomes. Having the liquidity to quickly reposition your public market investments is critical, anchoring the portfolio with predictable income from both physical and financial assets to help generate “passive” cashflows is necessary, and the search for low and uncorrelated strategies has become a bigger imperative for us. On this front, we are quite excited with the opportunities we have recently and will discuss more about them in the next Navigator.
Fixed Income: Neutral and happy to own US Treasury if 10 yield is more than 2.5% even if the real return of the US Treasury is negative, the same can be said for owning Singapore REITs (barely 1% spread), German property, let alone fixed deposits with inflation at such high prints everywhere. US Treasury is still the largest asset class in the world and its relative yield even after currency hedging offers the second-best returns after China government bonds on comparative credit quality. There will always be natural buyers coming from pensions, insurance companies, and foreign governments for now! However, a pernicious outcome of the US and its allies unilateral exclusion of Russia from the SWIFT system will have serious long-term implications on the dollar’s safe-haven status. Sticking mostly to government bonds, unconstrained fixed income managers, low-correlation alternative credit managers.
Equities: Still underweight but will be looking to upgrade them when we have clearer confirmation that inflation is peaking and/or long-term yield trades above our target of 2.5%. US equities are now the preferred exposure at the expense of Europe, Japan, and the rest of Asia. The US is the only major country in the world that is self-sufficient in oil and agri-commodities. It now has a well-articulated monetary normalization policy that is in sync with the market, whereas we see the risk of a disconnect between the market and ECB on inflation and the appropriate policy rate in Europe. China economic recovery has been slower than expected but the equity valuations have already discounted much of that as it trades below its 10yrs PE and PB averages and is witnessing the largest shares buyback in the A-shares market in the past few years.
Valuations discounted bad macro and shares buyback in A-share largest in many years
FX: Long US dollar overlay. We think the dollar smile exerts its influence for the next couple of months but as inflation peaks and US yield retreats, we will exit this long dollar trade. Similarly, to the US Treasury, the rest of the world must be casting a cautionary stance of holding too much Dollar after the melee of sanctions the US has waged against China and now Russia.
Commodities: Like our Dollar view, we look to exit this trade as we are expecting growth to transition from overheating to the slowdown phase. The math behind the oil shortage is not insurmountable. Russia exports 4.5-6.5 mbd in the seaborne trade. The return of Iranian oil will add 0.80 mbd, US shale is forecast to increase by 0.80 to 1.0 mbd in the next 12 months. The IEA has already announced a 60mb release from its strategic reserves while the US has announced over the weekend a release of 1.0 mbd over an unspecified length of time. There is speculation they will cajoling the IEA to release more in the coming weeks. Saudi and UAE each have 1.0-1.2 mbd of spare capacity if they were to accede to international pressure. Lastly, there is natural effect of demand destruction when oil is so extensive. Time to downgrade the V12 to EV! JPM latest update is now forecasting oil surplus by 4Q22 and into 2023 in contrast to their forecast in Dec for oil to remain in shortage in 2022 and 2023.
This weaponization of the oil and Dollar will certainly fuel an accelerated interest in energy independence. The renewables will get another leg up in investment post-Covid world surge but more importantly, the prospect of large-scale adoption of hydrogen and nuclear fusion technology will be very interesting trends to watch. We will be keeping tabs on them especially nuclear energy. We are keeping our long-structural call on Copper though in retrospect we should have replaced it with a general commodity ETF for a quicker bang for buck.
Oil foecast has tilt from shortage to balanced by 4Q22
Copper inventory lowest in years
Alternatives: Plenty of new opportunities have emerged. Will comment more when appropriate.
Cash: Holding cash 5-10%.
君子动口不动手
Edward Lim, CFA
Chief Investment Officer
edwardlim@covenant-capital.com
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