VIEW gets the fixation with the Fed and the direction of rates. If you believe liquidity matters in all the forms with which the central bank can deliver it, then the prospect of a diminished run rate of "support" is probably uncomfortable. The fact that most of the market was not trading positions in the inflation of the 1970's or the shock wave that was Paul Volcker in 1980 probably doesn't result in less volatility in current and near-term markets, but potentially much more. This is because their collective paradigms are not adjusted for a distinctly different landscape of variables. We would submit many models, mental or otherwise, are not agile enough to swiftly and accurately incorporate paradigm shifts, especially as the transition is under way. Simultaneously adjusting to velocity and direction is more complicated. Just remember, a majority of trading in equities daily is engineered through "machines", both quantitative and high-frequency model-driven flow. Not through what the dinosaurs would call fundamentally driven investing. How this has changed information content in prices is a topic for another day but our point is that dealing with an inflationary setup that has not been at this level in 40 years will not be without missteps by market participants whose average age may be the same. Models take time to adjust. The increasingly siloed mechanics of professional investing also diminishes the number of investors that either can or are able to look beyond a specific asset class and region to assess market risks and opportunities. There are quite honestly too many "growth", "momentum", "deep value", "small cap stock", "quant" or whatever-focused investors and not enough allowed and able to look across asset classes, styles and factors to determine the best destination for their capital. VIEW has nothing against the aforementioned style labels but why would anyone want to limit their degrees of freedom to a specific factor inside of a specific asset?
What does this have to do with oil and the title of this VIEW blog? Here's the thing. Knowing what matters at specific points in time is key to navigating change. Change at a single company, inside the equity market, commodities, rates or fixed income. These critical things have a nasty habit of morphing from one time period to another. So, sometimes the USD might be important to a commodity's price and other times, not so much. Sometimes revenue growth matters at a company, sometimes profit margins.We think one of those important things right now is oil. Not because it is the persona non grata among polite and enlightened investing circles but because of its outsized influence on inflation.
There are several transitions unfolding in markets today, one of which is the end of the era (most likely) of an epic liquidity deluge heaped onto the economy. This began in response to the GFC but that was over a decade ago. It began with the newer concept of quantitative easing via an expansion of the central bank's balance sheet and has culminated into an end-around of the entire banking system and direct issuance of stimulus funds to citizens. Judging by retail sales over the past year or so, these recipients did what Americans have historically done, they spent it. Yes, that is one of those pesky 3 standard deviation moves in retail sales ROC in the chart below. Three standard deviations always catches our attention.
What happens when consumer spending momentum inflects so dramatically in a system that has been built on a mean rate of change in the mid-single digits and with just-in-time inventory management embedded in standard operating procedures? The supply chain seizes up and further complicates a lockdown plagued global system. And prices rise as demand outruns supply. At the same time the labor market becomes distorted with civilian employment running below 2018 levels annualized and this shortage shows up in rising wage rates. Same as goods, demand for workers outrunning supply. Consider that BLS reports that job openings in December 2021 were +61.8% from 2020 and jobs filled are not even close +15.7%. The third nail in the inflation coffin is energy, specifically oil. And yes, the increase in oil in the chart is well over a 3 standard deviation event. We are paying attention.
Now we have inflation and since we have mercifully stopped arguing whether it is "transitory" or not, maybe we will now get down to the business of fighting it. And that means withdrawal of liquidity. For VIEW, the problem is complicated by what we see as another transition the market must incorporate, this is a slowing of the economy toward its longer-term rate of growth, far below the stimulus jacked levels of the last year. The rates market gets the risks of an inflation-fighting tightening combined with a less robust growth outlook-just look at the 10-2 spread in the chart below. The curve has flattened by 37bps YTD and this is one market signal that has not failed to signal a recession once it touches and pierces the zero bound.
VIEW has been clear in our interpretation of the overall cycle for earnings and growth that we have passed peak and are decelerating. Withdrawal of stimulus merely solidifies our view on this. The central bank we believe will take the current inflationary overlay as a risk along numerous fronts, not the least of which is political. Our reading of the rates markets is that the flattening we have seen reflects the impending move to confront rising prices but also the less positive view of the trajectory of the economy. Given oil's much higher volatility compared to other headline CPI inputs and its recent outsized move, how it behaves currently has a disproportionate impact on the policy setup. The longer it holds a geopolitical risk bid the longer it will influence how quickly or slowly inflation recedes as we progress through 2022 and by extension the aggressiveness of the central bank. Judging by comments from fourth quarter energy earnings, supply is coming back into the industry, especially through the short-cycle US onshore and we can already see the positive slope in US rig count. If we are right about overall economic trends diminishing, the snap back we saw in global oil demand in 2021 will not be repeated in 2022, especially if economic growth slows as we expect. VIEW would be careful to pay too much heed to those concocting longer-term, supercycle stories based on current drivers that can change in relatively short order. Especially for a commodity whose price volatility is to be respected. Watch oil now, incorporate it into the process.
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