The Bear Necessities - Covenant Capital

Folly of the Crowds

By Edward Lim

4 July 2023

One of my favourite childhood songs is “The Bear Necessities” from the Disney cartoon “The Jungle Book”. In this song, Baloo (the bear) shared with Mowgli (the boy) about living a life of simplicity and being adaptable to whatever life may bring to you. The part of the song that resonates most with me in these discombobulating times is “Look for the bare necessities, the simple bare necessities forget about your worries and your strife”. Sage words for the battered investors reminiscing about the good ole times of quantitative easing. But we are in the business of managing money and the fiduciary duties associated with this role are onerous. So, let’s map the contours of bear markets.

In our last macro update via podcast, Which is a greater risk from hereon? Inflation or recession? (Password: Podcast2022!) , we maintained our view that inflation will peak in the coming months in synchrony with a slowing growth trajectory. We cautioned that recession risk is a graver concern for us than high inflation. We acknowledge that the risk of recession has increased but it is not inevitable framing our conclusion with a four-prong approach that encompasses (1) Nowcasting analysis to ascertain the current state of the economy, (2) Forecasting analysis using data like PMI to help us gauge the direction of the economy in the next 3-6 month, (3) Taking cues from recession probability models, and (4) Bottom-up observations of what corporates are telling us about their operating environment.

The latest data on inflation reaffirms our view that inflation should moderate in the coming months. If we look at the four key sources of inflation chiefly from commodities supply shock arising from Ukraine-Russia war, supply chain pressures from covid lock-up, wage increase from labour shortage, and rising housing costs, there are clear signs that first three drivers have already peaked or will peak soon. It is the housing shortage that challenges our sanguine view of inflation given its direct contribution to inflation is as high as 17-20% in the US (see Everyone has a plan until they get punched in the mouth for more of this issue.

We are tracking several indicators of inflation and the most elementary is to track market prices of key commodities including those purported disrupted by the war in Ukraine. Brent and WTI crude oil prices have both retracted from their peak by -12/-13% and their peak was just 2 weeks after the war erupted in March. Natural Gas has fallen -34% since it peaked on 6 June, while coal prices has fallen -12% since peaking 2 Mar 22. Basic materials such as copper, steel, and aluminum (Russia is the 2nd largest exporter of alumina and 5^th largest exporter of aluminum products globally) have fallen -21%, -42% and -37% from their peak in early Mar 2022. In the soft commodities space, wheat, sugar, and the overall soft commodities index have retraced -34%, -19% and -16% from their peaks which occurred around March to May. Summing up the above points made, the breath of commodities price increase has also eased off significantly in the last few months with only 12% of 19 commodities that NDR tracks are trending above their 50-day moving averages, a far cry back from March when nearly 100% of all these commodities were trending above. Supply chain indicators such as the Fed Supply Chain Pressure Index, Shanghai Container Freight, and Bulk rates paint the same picture. PMI survey on input prices has also plateaued in the last several months. We are not blasé about inflation as most of these market prices and indicators have seen sharp increases on a year-on-year basis, however in the context of the stock markets, the delta of change is more important, and it is inflecting lower.

Many data are pointing to inflation has peaked though YoY increase is still large

Breadth of commodities prices increased has declined materially

Market participants’ view of inflation has also come off from their peaks. The 1-year inflation swap has retraced from a high of 6% in mid-Jun to 5% currently. The market has also repriced inflation expectations lower across the 5 and 10-year horizons. Critically, they are expecting inflation to be lower across time with inflation expectation 1-year out at 5% which is lower than the most recent headline CPI of 8.6%. Across the 5 and 10 years, the market is pricing lower inflation in each sequence at 3% and 2.8% respectively.

Market is saying inflation has peaked and expects inflation to moderate across time

As we have mused many times, inflation and growth move in tandem. While inflation should be moderate in the coming months, the deceleration in growth has been more pronounced since our last update. The nowcasting data we tracked points to the global economy is currently growing at 2.8% yoy below its long-term potential of 3.0% with both developed and emerging economies below their long-term potential. US 1Q22 GDP has already contracted by -1.5% and the latest nowcasting data from Goldman shows the US is precipitously close to a technical recession with just 0.90% growth in the current quarter. Our forecasting tool using PMI points to an even grimmer outlook for the upcoming months. The latest flash PMI in June from developed economies contracted 2 points to 52.1, the weakest this year, and it correlates to a growth of 1 to 1.2% in the coming months further slowing from the current quarter nowcast estimate of 2.8% and is half the pace of 1Q22 growth. Under the hood, the PMI reveals weakening internals. Output for manufacturing is just above the expansionary level at 50.1, contracting 2.9 points. We were already expecting goods demand to contract as the economy reopens with demand shifting towards the service sector. However, the decline in services output to 52.6 was unexpected. A critical leading component of PMI- New Orders for manufacturing and services new orders are now at contractionary levels.

GS Nowcasting says global economy growing below trend

Forecasting tool says it is going to get worse

One of the recession probabilities models we are tracking is nearing it’s signaling thresholds. Based on JPM models, their economic indicator model is now predicting a 36% chance of a recession within a year and is close to its threshold signal of 40%. Their equity/credit recession model is elevated at 73% probability though we caution this signal have produced many false positive in the past. The yield curve they used has now narrowed to 155bps and is signaling a 14% risk in contrast to less than 10% chance many months ago.

One of our recession probability models is flashing red

Putting all the data above in layman’s language, the baton of growth of the global economy was supposed to transition from a goods demand to services. However, the increases in price of daily necessities have dampened consumption possibly truncating the growth in the service sector. Even as consumers tapped into their elevated savings and are seeing nominal increase in wages, it has not been able to offset the increase in prices and compounded by higher debt servicing costs across the globe as rates have risen. The risk of policy over-tightening is high and as US senator Elizabeth Warren recently questioned Jerome Powell how will raising interest rates help solve high fuel and food prices. Instead, higher interest rates will increase borrowing costs for families (and corporates) and potentially cause job losses.

I have always quipped the central bankers in developed economies are very poorly equipped to handle micro-economic issues of excesses or shortage. Their policy tools of controlling the cost of money and quantity of money are too blunt to address and curtail financial risks. As Singapore luminary statesman, Tharman Shanmugaratnam, cautioned in 2013 in the aftermath of the Global Financial Crisis, there is an over-reliance on an antiquated monetary framework and has espoused the view that central bankers and government should coordinate their fiscal and monetary policies, while the arsenal of the central bankers’ tools should also include utilizing counter-cyclical macro-prudential measures.

Think of the housing boom and bust cycle. Fed’s only tool to address this sector is using its Fed-Fund rate given mortgages rates are directly tagged to it. But that does not address issues of underbuilding or overbuilding of homes, loose credit evaluation, and excessive exposures in the banking system. Instead, by coordinating with the relevant government bodies to control supply of homes and tools like setting maximum Loan-to-Value and debt-service ceiling can curb over-leveraged buyers, over-exposed financial system and smooth out property cycle.

Asset Allocation Strategy

Recession risk has certainly increased and perhaps the recent bear markets is already foretelling one. Or is it?

Fact 1: Is the stock market a harbinger of an impending recession? Not really. There have been 16 bear markets for SPX since 1968, half of these bear markets did not coincide or lead an economic recession in the US. The SPX generally bottoms 6 months after the start of a recession. The problem with this fact is we will only know the economy is in a recession when the recession is officially declared two to three months after the fact. By then, the stock market would have already reacted during this 6-8 month period. Nonetheless, the average decline of these past 16 bear markets is -27% from peak-trough and lasted 26 months long. If the bear market does not accompany a recession, the average decline is smaller at -24% than the average of all bear markets and far smaller if there is a recession. Likewise, the duration of the peak-trough is shorter for non-recession bear markets than the average of all bear markets and recession bear markets.

Equities market not a good harbinger of recession

Application of Fact 1:

The equity market is not a very reliable indicator of recession.
The current bear market has already matched previous bear markets with no recession and if there is a recession, the current bear is already 74% through its course. Hence, not the right time to de-risk more while tactically deploy hedges on their equities exposure.

Fact 2: Most of equity market derating is driven by valuation and not by EPS decline. Valuation multiples tend to contract 15 points from its’ peak valuation to the trough. The multiple contracts less when there is no recession compared to a recession. The current bear market has already seen trailing PE contracted by 13 points exceeding the level of no-recession bear markets and close to all bear-markets average and just 3 percentage points away from recessionary bear market.

EPS increased on average of 4.32%pa during bear markets and half of the time, EPS increase against conventional thinking EPS growth should plummet. While EPS declined 75% of the time during recessionary bear markets, the average decline is small at -1.3%pa and the maximum is only -2.6% pa. That leads to the point that forward PE can be relied on as EPS declines should not be significant. SPX forward PE has derated from a high of 24x to 17x but at 17x is still above its long-term average and still above various bear market scenarios.

Application of Fact 2:

Valuation has retraced materially, and any further downside could be limited to another 10-15%, similar to the conclusion from Fact 1.

Fact 3: During periods of high inflation, does the US10 yield peak ahead inflation peak and the end of Fed tightening cycle? Yes, it does. The US10 yield is far more important than the Fed fund rates when it comes to the real economy. Corporates and consumers borrow at a spread off US10 yield not Fed Fund rates. Asset prices are discounted against US10 yield. US10 yield incorporates not just Fed fund rates on the short end of the curve but also hosts other medium-term information such as counterparty credit risk, term premia, and inflation expectations. 70% of the time the US10 yield peaks ahead of inflation peak by 5 months. 70% of the time US10 yield leads the end of the Fed tightening cycle on average by 2 months and over a range of 1- 6 months.

Treasuries lead ahead of inflation peak and end of tightening cycle

Application of Fact 3:

The current estimate is for US inflation to peak by latest 3Q22 and the dots provided by the Fed and the market-implied expectation points to Fed tightening cycle to end in March 23. If history repeats itself, then the US10 yield should peak around May-June based on the lead inflation has. If we based on the lead Fed end of tightening cycle has, the US10 should peak around Sep 2022. Hence, we have a window of when US10 yield should peak around May to Sep 2022. The US 10 yield has recently peaked at 3.47% in June.
US long-dated Treasuries is attractive now. US10 is now trading at -1sd below its fair value relative to a composite of inflation, short-term bills and German Bunds. The yield on investment-grade bond compare to the S&P Dividend yield is now 3.5x and is the highest since 2008 and above its 30-year mean.

Long-dated US Treasuries and Investment-grade bond are attractive now

Fact 4: During periods of high inflation, does SPX trough ahead of inflation peak? No, unlike the bond market which tends to peak ahead of inflation, SPX does not. The weight of evidence informs us it is better to buy after inflation peaks. The incidence of positive months altered significantly after inflation peak with 58% and 67% of positive returns 3 and 6-months after inflation peaks whereas only 25% and 17% of the times SPX generated positive returns 3mths and 6 months before inflation peak.

Better to wait for inflation to peak to buy equities

Application of Fact 4: Better to have confirmation of inflation has peaked for equities.

Fixed Income: Upgrading to overweight but sensitive to price levels and only buying long-dated US Treasuries as well as high grade debt of companies that have defensive earnings quality and low gearing. There is a misplaced belief that yields can only peak after the Fed has ended its tightening. Our analysis shows that during periods of higher-than-normal inflation, 78% of the time of the US10 yield is lower than the Fed Fund rate at its end of tightening cycle. Furthermore, the peak of US10 yield during the tightening cycle is often lower than the Fed Fund rate by the end of the cycle 78% of the time. In fact, US10 yield on average is 183 bps lower than the Fed Fund rate at the end of the cycle and the peak of US10 yield during the tightening cycle is 136bps lower that the Fed Fund rate at the end of the cycle. The empirical evidence ties in with economic logic that yield curve flattens when the economy slows as Fed tightens.

Sliding Earnings Revision Momentum

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.

Commodities: Exiting as the economic risk has risen with several economies on the edge of a recession.

Alternatives: Our low/non-correlated strategies are now 20% of the portfolio. We have added a multi-strategy multi-asset class manager and are exploring a quant-driven short-term technical trading manager as well as bridging loan manager.

Cash: Cash still large 10-20% plenty of dry powder to capitalize on weakness.

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Edward Lim, _CFA

Chief Investment Officer
edwardlim@covenant-capital.com

Risk Disclosure

Investors should consider this report as only a single factor in making their investment decision. Covenant Capital (“CC”) may not have taken any steps to ensure that the securities or financial instruments referred to in this report are suitable for any particular investor. CC will not treat recipients as its customers by their receiving the report. The investments or services contained or referred to in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about such investments or investment services. Nothing in this report constitutes investment, legal, accounting, or tax advice or a representation that any investment or strategy is suitable or appropriate to your circumstances or otherwise constitutes a personal recommendation to you. The price, value of, and income from any of the securities or financial instruments mentioned in this report can fall as well as rise. The value of securities and financial instruments is affected by changes in a spot or forward interest and exchange rates, economic indicators, the financial standing of any issuer or reference issuer, etc., that may have a positive or adverse effect on the income from or the price of such securities or financial instruments. By purchasing securities or financial instruments, you may incur above the principal as a result of fluctuations in market prices or other financial indices, etc. Investors in securities such as ADRs, the values of which are influenced by currency volatility, effectively assume this risk.

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Folly of the Crowds

4 July 2023

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