$14 BAD AND BETTER
This time is different®—there are strong arguments in favor of bonds not rallying into this bear market
Price pressures are unequivocally turning better, but inflation is proving structurally persistent
After four decades of lower inflation, markets will have to come to terms with higher for longer inflation—a potential, multi-year paradigm shift
This time might be different, so beware of bonds and think outside the box
Bad and Better
This concept—popularized by Hans Rosling’s masterpiece Factfulness—offers an appropriate way to depict last week’s July CPI print, at 8.5% YoY (bad) and 0.0% MoM (est. 0.2%).
“It seems that when we hear someone say things are getting better we think they are also saying “don’t worry, relax” or even “look away”. But when I say things are getting better, I am not saying those things at all.
I am certainly not advocating looking away from the terrible problems in the world. I am saying that things can be both bad and better. […] That is how we must think about the current state of the world.” —Factfulness, Hans Rosling
Price pressures are unequivocally turning better, as the headline gauge decidedly softened vis-à-vis previous torrid prints (1.3% in June and 1.0% MoM in May).
Here are the improvements:
Inflation less broad, with outright declines in several components / categories.
June’s 9.1% representing peak headline CPI inflation could be tantamount to leaving peak Fed hawkishness behind. Markets are experiencing some central bank policy relief and odds for Powell’s vaunted “soft landing” have increased.
A less urgent Fed lessens the odds of a policy error or in the words of JPM’s Marko Kolanovic, it “reduces the tail risk of a policy mistake”. Colloquially, a better chance of not crashing.
All of these improvements coincide with the Fed’s monetary policy stance being at “neutral”, according to Powell.
Is it possible we are taming inflation without being forced to delve too deep into restrictive territory?
Well… not so fast, paraphrasing Mr. Wolf. At 8.5%, things remain bad.
Categories spearheading the decline are historically less sticky than their hotter counterparts—e.g., shelter as the largest contributor to services inflation increased 5.7% YoY in July, the highest since 1991.
More importantly, core CPI (CPI ex. Energy / Food) was flat this month at 5.9% YoY. I explained in a previous note that “to some extent, monetary authorities are victims of circumstance” on my way to stating:
The Fed openly admitted last week that their capacity to deal with the effects of largely exogenous forces on supply—particularly war-induced energy / food shortages and pandemic-related supply chain shocks—is virtually zero. At the risk of stating the obvious, central banks cannot print oil or corn.
Read more: $9 MAKE 75BPS HIKES GREAT AGAIN
This cuts both ways—on our way up and down.
The bulk of the advances seen against inflation seem less rooted in the controlled demolition of demand the Fed’s is set out to pursue and more in exogenous factors that could turn on a dime:
Global surge in commodity prices—including agricultural and oil—is in full reversion with agriculture prices at pre-conflict levels, Brent crude oil at 6-month lows and WTI crude oil down ~30% from the peak. Biden blowing through half the Strategic Petroleum Reserve (SPR) surely helped.
Odds of a potential recession weigh on the price of energy, which in turn is the principal driver of last week’s cool CPI print and the subsequent easing of overtightening fears. If you see this as highly reflexive (circular reference, blue arrows!), it’s because it is. At least lower prices at the pump will partially boost US demand / discretionary consumption.
Europe’s economy is decelerating, contributing to the softening in global demand. A deterioration in Europe’s energy position1 would boost deflationary pressures. With oil at these levels we might see substitution for gas, supporting lower energy prices.
Effects are magnified by the dollar wrecking ball—a higher USD imports disinflation. China’s currency (RMB) and economy remains weak2, which in turn exports disinflation globally.
In terms of equities, let’s just say that these CPI reads shouldn’t be conducive to generous equity valuations—an “8.5% CPI implies 11x on trailing P/E” vs. “today’s PE of 19.4x, [which] implies 2.6% CPI”.
Finally, let’s not forget that CPI was not the only tier-1 economic indicator out in August. Monthly US labor figures came in scorching hot, with unemployment dropping to 3.5% (est. 3.6%) and average hourly earnings at 0.5% MoM and 5.2% YoY (est. 0.3% and 4.9%, respectively), adding to the sticky wage price spiral narrative. Note average hourly earnings, when adjusted for inflation, sit in negative territory for the 16th consecutive month, now at ~-3%.
Monetary policy works on a lag, so it’s not surprising that most of the effects on the real economy / main street should be felt starting in H2 and in 2023.
This time is different®
It’s mathematically impossible to bring down inflation to 2% in short order without multiple negative MoM CPI prints and that would likely entail job losses. Decisions, decisions.
Following a four-decade bond bull market fostered by deflationary forces (i.e., the triple D) and the largest QE program the world had ever seen over the pandemic, inflation feels entrenched and sometime in Q4 / early 2022 markets may have to come to terms with the notion of structurally higher inflation for longer.
A scenario where inflation hovers above / around 4% would warrant a protractedly restrictive Fed—in terms of both rates and balance sheet reduction, freeing up countercyclical breathing room. That or a Fed that moves the inflation target / goalposts from the arbitrary 2% in a dispassionate exercise of cold, economic realism.
The most accomplished investors are starting to recognize that the paradigm might have shifted. A multi-year regime change.
When Stan Druckenmiller’s regales us with one of his rare appearances they often become a gift that keeps on giving. After including one of his quotes in my last piece, I’ll weave in another one from that same interview on June 10, which seems particularly prescient today:
“I had to learn—particularly in bear markets—that I had to morph into bonds, commodities, foreign currencies, things like that. One of the most challenging things for me right now is—maybe it says something about my dysfunctional personality—but I’ve always made even higher returns in bear markets than bull markets. But the way I did it was just pretty much ignore equities, take them off the table, buy bonds, buy treasuries and go home.
Well… I’ve never been presented with a cocktail where you have 8% inflation you think the economy might weaken and bonds yield 3%. It's an analog with no precedent in history.
For the golfers out there, going into the situation I’m describing I feel like im about to play a round of golf without a driver and without a 60-degree wedge because bonds—which have been my go-to asset in terms of a recessionary, bear market atmosphere—may work, but there’s good reason to believe things will be different this time, because we’ve never had central banks with this situation.
[…] So you can’t get into black-and-white, it’s an art form investing from cycle to cycle… you have to constantly innovate and not be a slave to past models.”
There you have it, from the 🐐 himself. There are strong arguments in favor of bonds not rallying into this bear market.
Things might be different this time after all.
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How (not) to play it
Under a “restrictive Fed for longer” scenario, Powell & Co would soon move—possibly after delivering 50-75bps in the next meeting—to a data-dependent single / no hike stance, but would not outright cut rates. That was wildly inconsistent with the cuts being priced by Eurodollar futures for Q1 2023 (EDZ2EDH3, -25bps at one point) and for 2023 (EDZ2EDZ3, -82bps).
The cuts priced in for Q1 2023 have since been fully reverted, but markets continue to price in -42bps in cuts for 2023. Thus, one way to play it is via Eurodollar futures either by betting on those -42bps reverting or by betting on outright hikes in Q1 2023. A simpler way is to simply short bonds or bond proxies because ~3% bonds don't belong in a prolonged 4% inflation environment.
I have not yet put on any of these investments (Eurodollar or short bond / proxies). The market has repriced fairly swiftly over the past week and I missed the train. I’m looking for a potential entry point while I mull over sizing and correlations in light of my current portfolio.
But the message I want to leave you with is this. Just as important as how you play it is how not to play it. Druckenmiller is quite literally telling us to beware of bonds and think outside the box.
Time to get creative.
Thanks for reading,
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Germany’s cost of energy has continued to skyrocket, but gas storage facilities have grown to 75%, several weeks ahead of schedule.
China’s economy has not picked up pace yet and the monetary impulse has undershot expectations. Mine included, as I own a hodgepodge of ChinaTech—$KWEB and $BABA, mainly—bought at fairly distressed levels. Inflation at 2.7% and bond yields going down reinforces the thesis explained in my earlier three-part deep dive, starting with #5 WHATEVER IT TAKES (WITH CHINESE CHARACTERISTICS).
Either way, the latest figures have forced the PBoC to cut a slew of rates this week—1Y medium-term lending rate (MLR), 7-day reverse repo rate and probably 1Y loan prime rate (LPR) as it tends to follow the MLR—for the first time in seven months.