Rates, oil, inflation, year-to-date signals, Ukraine
The deluge of data markets produce and attempt to digest on a daily, weekly and monthly basis is more than most of us (and most of our computers) can make good sense of if we consider it all, all the time. So we try to slow the game down and focus on those things that matter in our process at this particular point in markets, understanding the list may vary over time. This is all about handling the data>information>knowledge>wisdom sequence, as the front end of that chain has erupted while the volume at the exit remains steady and much lower.
What matters to VIEW now in the midst of Q1:22 earnings:
Rates. Specifically, the US sovereign 10 year rate. As of 4/27 this was trading at 2.82%, up from 1.52% at the beginning of the year. For the week ending 4/8/22, when the 10 yr closed at 2.72%, this put the yield 49% above the 52 week high, a move over 3 standard deviations from normal going back to 1963. This fits into our 3 standard deviation rule, if something moves like this, we pay attention. This type of move is quite rare, happening just 0.4% of the time in our data series and all of these occurrences since 2013. Why? No idea, except that it may have something to do with the whale in the bond market, the Fed. More importantly for our market posture today, there is not much of a dependable series of mean reversion to hang our hat on. That said, given our view on the slowing of the economy we have been writing about, VIEW could see a fade of this sort of move as markets discount more visible post-peak activity slowing. Technically, the area at 3.15% to 3.24% is important and will be watched closely as any close above that level will start discussions of a renewed uptrend in rates after a multi-decade downturn. The straightforward nature of an any more positive, albeit contrarian stance, towards duration is complicated by two issues as we see it. First, the Fed is voicing its commitment to begin reducing its Treasury holdings in May, how this is handled will have ramifications for not only liquidity but potentially rate volatility. Second, VIEW cannot discount some probabilities of additional stimulus enacted in advance of the US mid-terms, where Democrats are under pressure to keep control of both Houses of Congress.
Oil. Given its large impact on inflation, the trajectory of oil prices remains key. In 2021, prices rose at the highest rate since the 1940’s, even higher than the advent of the Oil Embargo in late 1973. This was due primarily to the compare against the sudden and substantial decline in prices due to the initial pandemic lockdowns in spring 2020. Oil has remained bid, as supply and demand has been imbalanced due to production constraints precipitated by chronic under-investment (this tightness has generally been a risk on the horizon since 2016), regulatory constraints and a continued rebound in economic activity brought on by a re-opening supercharged with excessive direct stimulus. Secondly, since the Russian invasion of Ukraine, prices have seen another leg higher, although crude is trading off its best levels of the last six months. Whether oil has begun to sniff out a demand destruction scenario remains to be seen (keep watching China and high frequency US/European data here) but even a stable $120 brent price from here would result in a decline in the appreciation of the commodity as 2022 progresses. This contribution to the rate of inflation would be constructive but does not likely compensate precisely for some of the other input costs that price off of Brent. So, given our interpretation of more downside risks economically as we move through 2022 and resolution of some sort possible in Ukraine in the coming months, a scenario where Brent continues to contribute to rising inflation by approaching >$150/bbl seems low probability. Ultimately, while there are cost components that lag oil’s lead and could continue to accelerate after crude inflation has peaked, the importance of oil as an input should be well watched.
Inflation. Given the levels of inflation in both an historical context (highest in decades) and its spread across not just energy but importantly in food, VIEW sees political damage to incumbents in this environment as increasingly likely, including in the US this November. Inflation protests or riots have erupted in numerous countries across the Americas, Europe, Africa and Asia. Real wages remain negative and clearly the electorates feel this. If we were want to forecast inflation we would consider it very probable to have peaked yet measures need only remain elevated for the next several months and this could well be sufficient to generate large losses for the party in power come November. A further questions regarding inflation is the effect spiking prices will have on economic growth. Inflation rates at current levels have been effective at shocking the economy into a downturn in the past, to expect the current setup to be less fragile would be unwise.
Market signals through the start of earnings saw a bear steepening in the curve as the US 2 Year yield rose 186bps while the 10 Year lagged up 133bps. The 10-2 spread briefly inverted the first days of April. Much ink has been spilled on what inversion means and which rate spread we should use to calculate said differential. We find this generally unhelpful in that the point to us isn’t the specific level (in the case <0 on the spread) but as much the motion of the curve. We are also less concerned with whether the economy glides below zero and registers what is definitionally considered a recession. We are about the slope of the line as that is what we have found influences asset price relative moves and we can forecast slope more accurately than single point landing pads. In essence, starting at 10% GDP growth, if the economy slowed to 0.5% it would matter more than if we had expected the economy to accelerate from 10%, not whether it bottomed at -0.5% vs 0.5%. The US Dollar has been strong against the two big pairs, the Euro and Yen in the first three months, we believe reflecting some haven status given the hot war in Europe and the apparently steady positioning of the Fed in its battle against the now “non-transitory” inflation. 10 year sovereign spreads against the Bunds and Yen have widened fueling part of this move in the dollar index. Rate volatility was negatively felt in fixed income in the quarter, with the Aggregate Bond Index now -9.25% YTD in the US and EM Bonds -15.39%. High yield has outperformed as spreads remain tight. Risk equity assets have been week with S&P 500 now down -12.2% YTD, the NASDAQ -20.2% and small caps -16.1%. ACWI is -12.8% for the year, essentially on top of the S&P500 as the weighting of under-performing technology and comm services drags down US equities to nearly even with ACWI ex US. Gold outperformed equities and broader commodities, especially food and energy, materially outperformed all other asset classes.
Ukraine. The war in Ukraine drones on and predictably we are hearing about the toll conflicts take on ordinary people. It remains to be seen how the weaponization of finance will change global relationships and whether they will in fact, positively contribute to outcomes. We conclude that the use of monetary tools of supposed selective destruction carries a risk that those on the short end of that stick will concoct ways around these measures. Selected trading relationships with non-dollar terms or payment demands in ostracized currency may prove effective stabilizing measures. Either way, VIEW considers the monetary West to have played their high cards in this regard, if they don’t scorch the earth how effective will they be next time in say, Asia? Likewise, it is too early to see if many profound directional changes in geoeconomics and geopolitics that could conceivably result from the Ukraine war will in fact, transpire. Will Europeans and Americans realize their siloed views on mitigating environmental risks have resulted in a fragile landscape where true energy and military insecurities are revealed at the expense of their populaces and that of the invaded country? Will governments figure out that though they may protest to the contrary, the inflation construct citizens endure today is in large part due to the extraordinary stimulus measures enacted to overstimulate the economy through a sheer wall of money? Will the concept of globalizing supply chains, really the movement of higher cost manufacturing employment to lower cost locales (labor arbitrage) be seen for what it was, a grand multi decade import trade of disinflationary end goods pricing? One that cannot be unwound without great costs, despite narratives preaching this is in fact what we must do. And finally, will aggressors such as Russia or those currently just rivals like China, conclude the way forward to achieving their strategic goals is blocked by the West or is there no there there in terms of deterrence?
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