China is up 2 million barrels a day but oil is not going anywhere. It appears there is “ample supply in the market for us to not have a big impact from China coming back.”
Fed hikes now, pain comes later
Fed Chairman Jerome Powell announced a 75 basis point increase in the Fed funds target rate at his post-FOMC press conference today:
“Today, the FOMC raised our policy interest rate by 75 basis points, and we continue to anticipate that ongoing increases will be appropriate. We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2 percent. In addition, we are continuing the process of significantly reducing the size of our balance sheet. Restoring price stability will likely require maintaining a restrictive stance of policy for some time.”
The target range is now 3.75% to 4.0%.
Commenting on today’s announcement, Michael Contopoulos from Richard Bernstein says little has changed:
“Nothing really changed today, the Fed has been hawkish since Jackson Hole. It doesn’t matter how high rates go, what matters is that the Fed is going to be restrictive and they’re going to bring down long-term growth…..The end game is not cutting rates, at least any time soon, the end game is to slow growth and slow the economy.” (CNBC)
Chris Brightman from Research Affiliates, co-manager several PIMCO funds, offers a useful rule-of-thumb as to how far the Fed will need to hike. The unemployment rate has to rise by 1.0% for every 1.0% intended drop in core inflation.
Core inflation is close to 6.0% at present, if we take the average of core CPI (purple), growth in average hourly earnings (pink), and core PCE index (gray). To achieve the Fed’s 2.0% inflation target, using the above rule-of-thumb, would require a 4.0% increase in the unemployment rate.
That means an unemployment rate of 7.5% (red line below), making a recession almost certain.
The recent 10-year/3-month Treasury yield inversion also warns of a recession in 2023.
Conclusion
We expect the Fed to hike the funds rate to between 5.0% and 6.0% — the futures market reflects a peak of 5.1% in May ’23 — then a pause to assess the impact on the labor market. Employment tends to lag monetary policy by 6 to 12 months, so the results of recent rate hikes are only likely to show in 2023. The recent inversion of 10-year and 3-month Treasury yields also warns of a recession next year.
The unemployment rate will most likely need to rise to 7.5% to bring inflation back within the Fed’s target range. That would cause a deep recession, especially if the Fed holds rates high for an extended period as they have indicated.
Uncertainty still surrounds whether the Fed will be able to execute its stated plan. A sharp rise in unemployment or bond market collapse could cause an early Fed pivot as the Treasury yield curve and Fed fund futures still expect.
Important recession warning
We have had a number of major indicators warning of a bear market over the year, with the S&P 500 falling by more than 20%, completing a Dow Theory reversal, and 100-day Momentum holding below zero.
On the recession front, GDP recorded two quarters of negative growth — a useful rule of thumb recession measure. The middle of the Treasury yield curve also inverted — with the 10-year yield falling below the 2-year — warning of a recession ahead.
But unemployment (3.5%) is the lowest since the 1960s and the NBER has not moved to confirm a recession.
The front-end of the yield curve also remained positive, failing to confirm the signal from the 10-year/2-year negative spread.
Until now, that is.
On Tuesday, the 10-year/3-month Treasury spread turned negative, confirming the earlier 10Y/2Y recession warning.
Why is that important?
Because a negative 10-year/3-month spread has preceded every recession since 1960. One possible exception is 1966 (orange circle below). The 10Y/3M inverted, the Dow fell by 25%, and the NBER confirmed a recession but later changed their mind and airbrushed the recession out of the record. All-in-all, the 10Y/3M is our most reliable recession indicator, with a 100% track record in our view, over the past sixty years.
Conclusion
Our most reliable recession indicator, a negative 10-year/3-month Treasury yield differential, now confirms the recession warning from other indicators. But the signal is often early and it could take 6 to 12 months for the actual recession to arrive.
After their recent track record, expectations that the Fed will manufacture a soft landing are the triumph of hope over experience.
Employment is a lagging indicator and often only falls during the recession. Inflation likewise lags monetary policy by up to 6 months, before the full impact is clear. We expect the Fed to continue hiking, waiting for employment and inflation to fall, until the lagged impact of past rate hikes comes into view. Instead of cutting interest rates to soften the impact, the Fed has indicated they will hold rates high for longer. If so, we are likely to experience a severe recession.
Our strategy is to invest in cash in the short-term and limit exposure to equities, other than precious metals, critical materials, and defensive stocks.
There’s always more than one cockroach
There is always more than one cockroach. ~ Doug Kass, 50 Laws Of Investing (#8)
Rising interest rates, soaring energy prices, and plunging exchange rates of major energy importers — Europe, Japan and China — are likely to expose widespread misuse of leverage in financial markets.
JPMorgan Chase CEO Jamie Dimon says investors should expect more blowups after a crash in U.K. government bonds last month nearly caused the collapse of hundreds of that country’s pension funds. The turmoil, triggered after the value of U.K. gilts nosedived in reaction to fiscal spending announcements, forced the country’s central bank into a series of interventions to prop up its markets. That averted disaster for pension funds using leverage to juice returns, which were said to be within hours of collapse. “I was surprised to see how much leverage there was in some of those pension plans,” Dimon told analysts Friday in a conference call to discuss third-quarter results. “My experience in life has been when you have things like what we’re going through today, there are going to be other surprises.” ~ CNBC
Contagion
Financial turmoil in one market soon spreads to others as market bullishness collapses.
Financial chaos in the UK is hitting the shores of Japan and roiling the $1 trillion global market for collateralized loan obligations. Norinchukin Bank, once known as the “CLO whale”, has stopped buying new deals in the US and Europe for the foreseeable future because of volatility sparked by UK pension funds…. (Bloomberg)
Misuse of debt
Speculators in a bull market, encouraged by the low cost of debt and the consequential rise in asset prices, borrow money in expectation of leveraging their gains. Companies, encouraged by the low cost of debt and rising stock prices, also borrow money to invest in projects with low returns or without proper consideration of downside risks should the economy go into recession. Companies may generate sufficient cash flow to service interest on their debt but insufficient to repay the capital. Their survival depends on rolling over their debt when it matures. Known as “zombies”, they are vulnerable to rising interest rates, shrinking liquidity and stricter credit standards during an economic down-turn.
The Great Repricing
“We’re seeing the beginning of the Great Repricing…and that repricing is going to have significant impacts on portfolios of many investors…But this is an inevitable consequence, in my view, of a return to more normal levels of interest rates…” ~ Mervyn King, former Governor of the Bank of England
Rising interest rates and tighter liquidity force speculators to sell off assets to repay debt. The sell-off causes a fall in asset prices, prompting further margin calls, fire sales and a downward spiral in asset prices. Also, zombie companies, devoid of support from creditors, go to the wall. Publicity surrounding bankruptcies and layoffs raises fears of further corporate failures and increases the difficulty for borderline companies to roll over debt, reinforcing the downward spiral.
The ratio of stock market capitalization to GDP — Warren Buffett’s favorite long-term indicator of market valuation — has fallen sharply to 211% (Q2) but is still well above the Dotcom bubble high of 189%. And a long way from the long-term average of 104% (dotted red line below).
Government intervention
Attempts to support inflated asset prices, as in China’s real estate markets, prevent markets from clearing and merely compound the problem. They simply prolong the bubble, allowing further debt accumulation and increase the eventual damage to financial markets.
No soft landing
In the past few recessions the Fed has stepped in, injecting liquidity to end the deflationary spiral but this time is different. The recent rapid surge in inflation has tied the Fed’s hands. They cannot inject liquidity to slow the rate of descent without risking a bond market revolt as seen in the UK.
Portfolios with a 60/40 split between stocks and bonds are showing their worst year-to-date performance in the past 100 years as both asset classes suffer from shrinking liquidity.
Conclusion
“The investor who says, ‘This time is different,’ when in fact it’s virtually a repeat of an earlier situation, has uttered among the four most costly words in the annals of investing.” ~ Sir John Templeton
We should not underestimate the ingenuity of governments and their central bankers in postponing the inevitable pain associated with sound economic management. Instead they kick the can down the road, compounding the initial problem until it assumes Godzilla-like proportions, making further avoidance/postponement almost inevitable. It takes the courage of a Paul Volcker to confront the problem head-on and restore the economy to a sound growth path.
The million-dollar question facing investors is whether Fed chair Jerome Powell can do another Volcker. But Volcker had the advantage of a federal debt to GDP ratio below 50% in 1980. Treasury could withstand far higher interest rates than at the present ratio of well over 100%. So Powell is unlikely to succeed in meeting financial markets head-on.
We expect the Fed to pivot. Just not this year.
Acknowledgements
- Hat tip to Percy Allen for the Mervyn King/Great Repricing quote.
- Harald Malmgren for the Bloomberg/CLO whale link.
- Isabelnet for the 60/40 chart and the Fear & Greed Index.
- Patrick saner for the Zombie Companies infographic.
Bond market: No place to hide
Advance retail sales were flat in September, reflecting slowing growth, but remain well above their pre-pandemic trend. So far, Fed rate hikes have failed to make a dent in consumer spending.
Even adjusted for inflation, real retail sales are well above the pre-pandemic trend.
The culprit is M2 money supply. While M2 has stopped growing, there has been no real contraction to bring money supply in line with the long-term trend. A fall of that magnitude would have a devastating effect on inflated asset prices.
Inflation is proving persistent, with CPI hardly budging in September. Hourly earnings growth is slowing but remains a long way above the Fed’s 2.0% inflation target.
Treasury yields have broken their forty year down-trend, with the 10-year testing resistance at 4.0%. Stubborn inflation is expected to lift yields even higher.
Inflation is forcing the Fed to raise interest rates, ending the forty-year expansion in debt levels (relative to GDP). Cheap debt supports elevated asset prices, so a decline in debt levels would cause a similar decline in asset prices.
A decline of that magnitude is likely to involve more pain than the political establishment can bear, leaving yield curve control (YCC) as the only viable alternative. The Fed would act as buyer of last resort for federal debt, while suppressing long-term yields. The same playbook was used in the 1950s and ’60s to drive down the debt to GDP ratio, allowing rapid growth in GDP while inflation eroded the real value of public debt.
Conclusion
We are fast approaching a turning point, where the Fed cannot hike rates further without collapsing the bond market. In the short-term, while asset prices fall, cash is king. But in the long-term investors should beware of financial securities because inflation is expected to eat your lunch. Our strategy is to invest in real assets, including gold, critical materials and defensive stocks.
Appen Ltd (APX)
| Stock: | Appen Ltd | ||
| Exchange: | ASX | Symbol: | APX |
| Date: | 05-Oct-22 | Latest price: | A$3.29 |
| Market Cap: | $406 m | Fair Value: | A$2.99 |
| Forward DY: | 3.16% | Payback (Years): | N/A |
| Financial Y/E: | 31-Dec-22 | Rating: | HOLD |
| Sector: | Technology | Industry: | IT Services |
| Investment Theme: | Technology | Macro Trends: | A.I. |
Summary
Appen (APX) is trading at a discount to our estimate of fair value. Our recommendation is HOLD in the current bear market.
Valuation
We reduced our fair value estimate for Appen (APX) by 74%, to A$2.99 per share, based on the following projections:
- real organic long-term growth of zero (formerly 15%);
- EBITDA margin of 12% (formerly 15%);
- capital expenditure of 5.2% of revenue (formerly 5.4%);
- working capital of 0.4% of revenue (formerly 0.6%); and
- an effective tax rate of 25%.
We selected a payback period of 10 years to reflect the company’s small cap size and a competitive industry.
Business Profile
Appen provides quality data solutions and services for machine learning and artificial intelligence applications for technology companies, auto manufacturers and government agencies. The company’s business segments are Relevance; Speech & Image and Others. Relevance generates the most revenue, providing annotated data used in search technology for improving the relevance and accuracy of search engines, social media applications, and e-commerce. Geographically, the majority of revenue is derived from the USA.
Performance
“Appen’s half year results reflect lower earnings due to challenging external operating and macro conditions, resulting in weaker digital advertising demand and a slowdown in spending by some major customers…” (1H FY22)
FY22 EBITDA margin is expected to be materially lower than FY21.
Capital structure
APX has net cash (after deducting capitalized leases) of $33 million.
Disclosure
Staff of The Patient Investor may directly or indirectly own shares in the above company.
Will a recession kill inflation?
There is plenty of evidence to suggest that recessions cause a sharp fall in the consumer price index. Alfonso Peccatiello recently analyzed US recessions over the past century and concluded that they caused an average drop in CPI of 6.8%.
A recession no doubt reduces inflation but it does not necessarily kill underlying inflationary pressures. It took massive pain inflicted by the Volcker Fed in the early ’80s to reverse the long-term up-trend in inflation. Average hourly earnings (gray) is a better gauge of underlying inflation as can be seen on the graph below.
Recessions cause a fall in earnings growth but do not interrupt the underlying trend unless the economy is administered a severe shock. In the early 1980s, it took four recessions in just over a decade, a Fed funds rate (gray below) peaking at 22% in December 1980, and unemployment (blue) spiking to 10.8%.
In the current scenario, we have had one recession, but cushioned by massive fiscal stimulus and Fed QE. Another recession would be unlikely to break the up-trend in underlying inflation unless there is a sharp rise in unemployment.
A study by Larry Summers and Olivier Blanchard maintains that unemployment will have to rise above 5% in order to tame inflation. The chart below suggests that unemployment may need to rise closer to 10% — as in 1982 and 2009 — in order to kill underlying inflationary pressures.
Conclusion
We are not suggesting that the Fed hike rates sufficiently for unemployment to reach 10%. That would cause widespread destruction of productive capacity in the economy and take years, even decades, to recover. Instead, we believe that the Fed should tolerate higher levels of inflation while Treasury focuses expenditure on building infrastructure and key supply chains, to create a more robust economy. Largely in line with Zoltan Pozsar’s four R’s:
(1) re-arm (to defend the world order);
(2) re-shore (to get around blockades);
(3) re-stock and invest (commodities); and
(4) re-wire the grid (to speed up energy transition).
An early Fed pause, before inflation is contained, would drive up long-term yields and weaken the Dollar. The former would cause a crash in stocks and bonds and the latter would increase demand for Gold and other inflation hedges.
A weaker Dollar would make US manufacturing more competitive in global markets and reduce the harm being caused to emerging markets. Unfortunately, one of the consequences would be higher prices for imported goods, including crude oil, and increased inflationary pressures.
The US Fed and Treasury are faced with an array of poor choices and in the end will have to settle for a strategy that minimizes long-term damage. In an economic war as at present, higher inflation will have to be tolerated until the war is won. An added benefit is that rapid growth in nominal GDP, through high inflation, would reduce the government’s precarious debt burden.
Acknowledgements
Alfonso Peccatiello for his analysis of CPI and recessions.
CPI shock upsets markets
The consumer price index (CPI) dipped to 8.25% (seasonally adjusted) for the 12 months to August but disappointed stock and bond markets who were anticipating a sharp fall.
The S&P 500 fell 4.3% to test support at 3900. Follow-through below 3650 would confirm earlier bear market signals.
Services CPI — which has minimal exposure to producer prices and supply chains — climbed to 6.08%. Rising services costs indicate that inflation is growing embedded in the economy.
Fueled by strong growth in average hourly earnings.
But it is not only services that present a problem.
Food prices are growing above 10% p.a. — signaling hardship for low income-earners.
The heavily-weighted shelter component — almost one-third of total CPI — climbed to 6.25%. We expect further increases as CPI shelter lags actual home prices — represented by the Case-Shiller 20-City Composite Home Price Index (pink) on the chart below — by 6 to 12 months.
CPI energy is still high, at 23.91% for the 12 months to August, but the index has fallen steeply over the past two months (July-August).
The decline is likely to continue until the mid-term elections in November, as the US government releases crude from its strategic reserves (SPR) in order to suppress fuel prices.
The reduction in strategic reserves is unsustainable in the longer-term and reversal could deliver a nasty surprise for consumers in the new year.
Conclusion
Strong CPI growth for the 12-months to August warns that inflation will be difficult to contain. Services CPI at 6.08% also confirms that inflation is growing embedded in the economy.
Energy costs are falling but this may be unsustainable. Releases from the strategic petroleum reserve (SPR) are likely to end after the mid-term elections in November.
The Fed is way behind the curve, with the real Fed funds rate (FFR-CPI) at -5.92%, below the previous record low of -4.97% from 1975.
We expect interest rates to rise “higher for longer.” A 75 basis-point hike is almost certain at next weeks’ FOMC meeting (September 20-21).
Long-term Treasury yields are rising, with the 10-year at 3.42%. Breakout above resistance at 3.50% is likely, signaling the end of a four decade-long secular bull trend in bonds.
Stocks and bonds are both falling, with the S&P 500 down 18.0% year-to-date compared to -25.4% for TLT.
The best short-term haven is cash.
Luke Gromen | The Dollar end game
Putin’s war
“The economy of imaginary wealth is being inevitably replaced by the economy of real and hard assets”.
Vladimir Putin gave some insight, last week, into his strategy to force Europe to withdraw its support for Ukraine. It involves two steps:
- Use energy shortages to drive up inflation;
- Use inflation to undermine confidence in the Euro and Dollar.
Will Putin succeed?
There are plenty of signs that Europe is experiencing economic distress.
When asked whether he expected a wave of bankruptcies at the end of winter, Robert Habeck, the German Federal Minister for Economic Affairs and Climate Action, replied:
Belgian PM Alexander De Croo also did not pull his punches:
“A few weeks like this and the European economy will just go into a full stop. The risk of that is de-industrialization and severe risk of fundamental social unrest.” (Twitter)
Steel plants are shutting down blast furnaces as rising energy prices make the cost of steel prohibitive. This is likely to have a domino effect on heavy industry and auto-manufacturers.
Aluminium smelters face similar challenges from rising energy costs.
How is the West responding?
Europe is reverting to coal to generate base-load power.
And increasing shipments of LNG. Germany is building regasification plants and has leased floating LNG terminals but there are still bottlenecks as the network is not designed around receiving gas from Russia in the East, not ports in the West.
Also, extending the life of nuclear power plants which were scheduled to be mothballed.
The new British prime minister, Liz Truss, is going further by lifting the ban on fracking. But new gas fields and related infrastructure will take years to build.
The President of the EC, Ursula von der Leyen’s announcement of increased investment in renewables will also be of little help. It takes about 7 years to build an offshore wind farm and the infrastructure to connect it to the grid.
Energy subsidies announced are likely to maintain current demand for energy instead of reducing it. A form of government stimulus, subsidies are also expected to increase inflation.
Price cap
The G7 has also responded by announcing a price cap on Russian oil. The hope is that the Russians will be forced to keep pumping but at a reduced price, avoiding the shortages likely under a full embargo.
Vladimir Putin, however, will try to create an energy crisis in an attempt to break Western resolve.
Putin responded to the price cap at the Asian Economic Forum, on Wednesday, in Vladivostok:
“Russia is coping with the economic, financial and technological aggression of the West. I’m talking about aggression. There’s no other word for it…….
We will not supply anything at all if it is contrary to our interests, in this case economic. No gas, no oil, no coal, no fuel oil, nothing.”
Ed Morse at Citi has expressed concerns about the price cap, calling it “a poor judgement call as to timing.” His concerns focus on the political implications of Winter hardship in Europe, especially with upcoming elections in Italy, the potential effect of lower flows out of Russia, and the impact increased demand for US oil would have on domestic prices.
The Dollar
Attempts to undermine the Dollar have so far failed, with the Dollar Index climbing steadily as the Fed hikes interest rates.
While Gold has fallen.
Conclusion
The West is engaged in an economic war with Russia, while China and India sit on the sidelines. War typically results in massive fiscal deficits and soaring government debt, followed by high inflation and suppression of bond yields.
We expect high inflation caused by (1) energy shortages; and (2) government actions to alleviate hardships which threaten political upheaval.
The Fed and ECB are hiking interest rates to protect their currencies but that is likely to aggravate economic hardship and increase the need for government spending to alleviate political blow-back.
We maintain our bullish long-term view on Gold. Apart from its status as a safe haven — especially when the Dollar and Euro are under attack — we expect negative real interest rates to boost demand for Gold as a hedge against inflation. In the short-term, breach of support at $1700 per ounce would be bearish, while recovery above the descending trendline (above) would signal that a base is forming. Follow-through above $1800 would signal another test of resistance at $2000.
Acknowledgements
Brookings Institution: Discussion on the Price Cap
FT Energy Source: How Putin held Europe hostage over energy
Alfonso Peccatiello: Putin vs Europe – The Long War
Andreas Steno Larsen: What on earth is going on in European electricity markets?