The Long and Unwinding Road

By Edward Lim

1 January 2023

In our last publication in October 2021, Another Lexicon, we downgraded Equities to Underweight for the first time since April 2020. Our downgrade was predicated on the views that rising inflation particularly around commodities and supply chain bottlenecks will lead to lower profit margin and subsequently downgrade in earnings forecasts. Furthermore, our expectation is that growth will moderate at a quicker pace from 4Q21 to 2Q22. We expect the goods sectors which have previously seen a torrid expansion over six straight quarters, to drive this moderation. While we expect the service sectors to pick up the slack from the goods sectors, incoming data has been choppy. A tricky monetary policy climate of balancing liquidity, growth, and inflation will add another dimension to the risk complex. The global equities market has fallen -2.5% since then which is quite remarkable considering the above issues and the onset of Omicron variant that occurred after our last publication. With regards to Omicron, our piece Another day, another scariant, we have cautiously opined that Omicron is unlikely to cause severe impact to the global economy as it is likely to be less virulent while technological advances should provide a tailored vaccine in a short period of time. While stringency level has increased in various large economies, we have not seen a corresponding widespread decline in mobility. Even where mobility has declined, they are no way near the levels of the Delta surge or the onset of the original virus confirming our view that there will be limited lockdowns as a higher rate of vaccinations should facilitate movements and there is a lack of political goodwill to enact them as well.

Workplace mobility increased after initial decline

Time spent at home has begun to decline

The latest forward-looking indicators such as PMI and Financial Conditions Index are just marginally lower than in Oct (pre-Omicron). December’s global PMI Composite remains in an expansionary zone at 54.3 with its sub-components, PMI-Manufacturing and Services at 54.2 and 54.6 respectively and are just off November level of 54.8 (-0.5 point decline), 54.2 (unchanged), 55.6 (1 point decline). Financial Conditions Indices across the major economies have eased slightly even as interest rates increased. It may still be early days to determine the extent of economic, social, and political havoc Omicron can wreck, but early signs seem to confirm great displeasure without great dislocations. Nonetheless, our view is unchanged expecting quarter-on-quarter of growth moderation for the global economy from the 4Q21 to 1Q22 though for the full year is still forecast to grow above its trend potential of 3.8-4.0%.

Global PMI remains expansionary post Omicron

Likewise Financial Conditions remain easy

However, the key risks facing investors in 2022 will be dictated by the path of inflation and the ensuing policy responses as well as the state of the China economy more than another covid variants. We have a contrarian view to the current narrative of run-away inflation leading. As for China, we are most bullish on China risk assets particularly equities than we have ever been since 2020.

In our last year’s webinar held in January 2021, After the storm what comes next, we cautioned that higher inflation is one of the key risks to watch. We cited easier year-on-year comparison for 2021 versus 2020 as we had experienced an unprecedented collapse in demand for both goods and services in the first year of the pandemic. The accelerated adoption of e-commerce penetration across many segments during the pandemic could also suggest this channel of price deflation should start to wane. We also cited longer-term structural developments such as the peak of globalization as the drive to localize production to ensure domestic supply chain security and abetted by the political appeal against free unfettered trade. China becomes a global exporter of inflation as its cost structure inflates along with the typical economic progression of any developed nation. We have also mentioned the world is not quite ready to wean itself off fossil fuels in their push away from it and embracing a carbon-free world. ESG will lead to higher costs in the medium term not lower. All these factors have played out last year, with the only factor we did not anticipate is the severity of bottlenecks in the supply chain.

For 2022, we are arguing some of these headwinds will reverse as the year progresses. Firstly, the year-on-year comparison will reverse from what we have experienced in 2021 simply because of the optical and very high base-year effects of 2021. We are already seeing those prints in US and China. The month-on-month prints of US Core CPI and PPI have moderated recently though on a YoY basis they are still high prints. In China, the month-on-month Core CPI and PPI have already moderated a few months ago while the critical Industrial Purchasing Price index, which is a barometer of global export prices, is now tracking month-on-month declines.

US Price Indices moderated MoM recently

Moderation in China Price Indices well underway

Second, we expect the well-televised supply chain issues to ease in the early second half of the year. The key culprit of supply chain dislodgement has been mass lockdowns, especially in key manufacturing hubs. With the increased rate of vaccinations and infections as well little tolerance domestically for such restrictions, such lockdowns should happen less frequently. By 2Q22, 60% of global GDP and 70% of the world population will be vaccinated. When we tracked high-frequency data such as finished goods inventory, price of leading commodities, they are normalizing. For example, steel price has fallen 23% from its peak, the Baltic Dry index -41%, thermal coal -25%, and natural gas -40% from its peak between September-November. Bottom-up research by Gartner also points to semiconductor inventory level to normalized by 2Q22.

Rising immunity leads to fewer lockdowns, more production, and less inventory shortages

70% vaccinated by 2Q22

Inventory increasing to meet demand

Semi normalized 2Q22

Much has been written about the Great Resignation phenomenon in 2021, particularly in the developed markets. The articles contended that many are quitting in masses as they seek out the greater meaning of life thus putting pressure on wages as labour supply becomes acute. However, statistics tell us otherwise. We have found straightforward evidence that labour force participation rate moves in tandem to government disbursement of income-support benefits and the subsequent expiration of them. As shown in the chart below, US labour force participation rate fell when the government dole out stimulus checques in Dec 2020 and Mar 2021 but increased when these benefits expired in July and late September. If we drill down the participation rate by income level and overlay the number of months these federal benefits translate to savings for different income bracket, it is clear the lower income earners have had a bonanza of federal help to encourage them not to work. But once these benefits expired, their participation rate rose. This Great Resignation is not evident for the higher income bracket as their participation rate remained steady throughout 2021. In Europe, unemployment rate has already improved to near pre-pandemic level with little evidence of the Great Resignation seen in the US. It should not be called the Great Resignation but the Great US Slacknation.

US labour participation rate increasing

Europe unemployment rate near pre-pandemic

Thirdly, while we still expect wages to be a source of concern given it is a relatively stickier source of inflation, the supply of labour should improve as income support across the globe ends and covid induced hesitancy to return to work should be improved in the coming months. In all, our views that inflation will peak by early 2Q22 to levels that are within most central banks’ tolerable range as the combination of supply chain bottleneck eases alongside a sharp moderation in demand for goods, an increase in the supply of labour reduces wage pressures as well as fading fiscal impulses.

Global inflation to peak in 2Q22

As supply-chain induced inflation eases (eg US)

With fiscal thrust fading fast and policy rate increased is well underway for both developed markets and emerging markets like in UK, Canada, New Zealand, Korea, Russia, and Brazil, we expect growth to moderate therefore lifting the pressure valve of inflation. Moreover, with such a high level of debt globally, long-term growth is impinged. A study by NDR that has regressed GDP growth to government debt/GDP across a large period of time and over different large economies and has shown when government debt/GDP is that high, long-term real GDP growth slows to 1.9%. The same study on private debt shows comparable results when private debt level is so high as it is now, nominal growth falls to 3%.

Elevated level of debt hinders growth potential

For 2022, the two biggest risks for China come from the dramatic development in the property market in the last 6 months, and the slew of regulations against the tech and e-commerce industry that were passed in the last 15 months. We have mentioned in our last Navigator the importance of the property sector as it contributes 30-40% of its GDP, with the financial sector having a 35-40% exposure to this sector. 60% of China’s household wealth is in property and this ratio is far larger than any developed countries. China property is also the largest asset class in the world at $50trn. In a worst-case scenario, the current earnings forecast for MSCI China could be halved to a low-single digit. However, we are reiterating that China is unlikely to suffer a housing crisis like in the US in 2007/08 because inventory is low and there is still a real demand of 6-7mn homes per year. The current inventory level is relatively low at 11 months for Tier-1 cities and 70 months in Tier-3 cities when compared to 2011crisis where at its peak, Tier-1 cities had 21 months of inventory and Tier-3 cities, 10 months. When compared to its past housing crisis of 2008, 2011 and 2014, the new construction starts have fallen even faster within a shorter period largely due to lack of access to funding channels in this episode as the banks have been reducing their exposures to developers, while the credit markets have been shut for them for the last 7 months. The bright side of this sharp decline in new starts means the current inventory will be depleted faster and does not pose a supply deluge that could pressure selling price further. This is not China’s first housing crisis, and it will not be its last.

Inventory lower and new starts declined faster

But there is still a 6-7mn medium-term housing need

This property malaise is government orchestrated. Their long-term policy objective of ensuring “housing is not living, not speculating” is a noble one. Unaffordable housing is a detriment to long-term sustainable growth and anathema to social division. However, the Chinese government was trying to achieve this objective while at the same time exorcising the supply chain off its excess leverage. They have pulled these two triggers too fast, but since November they have started to ease selectively. We expect more to be done in the coming months including the possible extension to the adherence of the “Three Red Lines” that governs leverage, approvals to allow onshore bond issuance, and more moral suasion for the banks to lend credit-worthy developers particularly towards their national agenda to encourage further consolidation. The most critical development to watch is the easing of the project escrow account of the developers. The indiscriminate tightening of outflow from the escrow accounts has been the single most damaging regulation that has they have applied. This has led to cashflow problems even for well-managed developers.

Selective easing in China real estate since November 2021

The latest sales trend has been encouraging for both new sales as well as secondary sales. They have bottomed in early Nov while pricing declined has stabilized even for secondary transactions.

New sales bottomed and moving towards trend

Secondary sales ASPs are recovering too

The last 15 months have seen unprecedent regulatory edicts issued by the Chinese government on a wide array of industries. But in a study by UBS that compares to China regulatory regime to the US and Europe, they have posited that much of these new regulations are merely catching up to the global standards of which some of them have been around for decades. While the fines imposed on a standalone basis seem large, when compared to the fines by the US and Europe on the large global tech names, they do not appear excessive.

Key regulations enacted in China are merely catching up to global standards

Fines imposed on the Chinese companies are within global norms

The intended effects of these various regulations have been felt. The market dominance of the leading players has been reduced while their profitability is now within global peers.

Market dominance has been reduced

Not earnings excess profits now

Asset Allocation Strategy

Fixed Income: Upgrade to Neutral. For the first time in years, we are upgrading Fixed Income to Neutral. The upgrade pertains to government bonds and our preference for high-yield and emerging markets remains unchanged. We have already outlined the fundamental premise for inflation to moderate as early as 2Q22 but there are also many technical factors in favour of this non-consensus upgrade.

Frist, the US owes $28.4trn of debt or 193% of its GDP. It currently pays $512bn in interest payments which is 2.25% of its GDP and almost 8% of total government expenditure. For every 100bps increase in interest rate, interest savings will increase by another $350bn knocking off 1.5% of its GDP and increasing from 8% to 13% of the government budget. Just as a perspective, the entire Foreign Affairs, Law, Manpower, Finance, Prime Minister Office, Culture, Community, and Sport ministries of Singapore constitute 8% of the country’s yearly budget.

While it is already well known that the US is mired in debt, its hegemony as a haven is not going to be displaced any time soon. However, little is known about the ramification of what if the Fed starts operating at a loss. Over the many rounds of QE and interest rate cuts, the Fed’s balance sheet is earning lower and lower yields. Based on its 3Q21 report, it currently earns 1.75% on its bloated balance sheet. If interest rates rise beyond 1.75%, the Fed will start losing money. This author is not sure about the technicalities of a loss-making Fed but am sure it will invite a lot of congressional inquisitions. The third technical factor is the net supply in 2022 will fortunately, be lesser than the last two years.

Fed could run a loss if interest rates >1.75%

Net Treasury supply for 2022-24 will be smaller

The last time when inflation prints were that high as they are now, US10 yield was at 6%, not 1.78%. The question then is why rates are so low? Our fundamental and technical analysis on the short-term trajectory of inflation and supply dynamics, and the long-term trajectory of inflation juxtaposed against debt and future growth, helps us frame why US yields are so low. The most encompassing indicator of future expectation is “Common Inflation Expectations.” This gauge considers many inputs from consumers and businesses surveys, economists’ forecasts and market participants such as us. While it has risen from its low, it is at 2.0%-2.2% even as current PCE rises to 3.6%, way above Fed’s range. Put it differently, the market is calling the Fed’s bluff on its inflation forecasts as its future expectation of inflations is well anchored. We are expecting the Fed to hike twice this year, not three times it is forecasting. US10 yield is likely to range within 1.75% to 2.25% and is hard for it to go beyond that. If they were to ask this non-economics trained Singaporean sitting in the aisle of the global markets, I will tell them to taper more aggressively and bring forward their balance sheet reduction rather than to increase rates. Increasing rate is such a blunt tool. They should use their other lever by reducing the quantity of money rather than increasing the cost of money! Over the course of this quarter, we will be reversing our short in long-duration. We will be adding developed markets, longer-dated Treasuries as it is common for yield curve to flatten at this stage of the economic cycle.

Long-term inflation expectations are well-anchored

Yield curve flattens when Fed tightens

Equities: Remains Underweight but will be looking to upgrade them when long-term yield trades towards our target. In the near term, we expect growth and momentum stocks to be under further pressure from rotation to value and cyclical stocks, especially those cyclicals sectors that have robust growth. Crowded positions in the latter compounds the rotation risk as well. We reduced US equities to fund our bullish China view. Furthermore, China is th only large economy that has begun a series of macro and micro policy easing. Japan remains neutral as there is little near-term catalyst and Europe remains overweight for the time being as we do not expect the ECB to normalize their monetary stance till later part of the year.

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: Like our Dollar view, we looking to exit this trade.

Alternatives: Nothing much to add here.

Cash: Holding cash 5-8%.

Featured Picture/Quote:

I’m optimistic about life. If I can be optimistic when I’m nearly dead, surely the rest of you can handle a little inflation.

Charlie Munger

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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