Author: Colin Twiggs

Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters. Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis. Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events. He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
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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.

Extreme Fear

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.

Zombie Companies

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).

Stock Market Capitalization to GDP

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.

30-Year Gilts Yield

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.

60/40 Portfolio Performance

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.

Federal Debt to GDP

We expect the Fed to pivot. Just not this year.

Acknowledgements

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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.

Advance Retail Sales

Even adjusted for inflation, real retail sales are well above the pre-pandemic trend.

Advance Real Retail Sales

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.

M2 excluding Time Deposits

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.

CPI & Hourly Earnings Growth

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.

10-Year Treasury Yield

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.

Non-Financial Debt/GDP

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.

Federal Debt/GDP

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.

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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.

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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%.

MacroAlf: CPI & Recessions

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.

CPI, Average Hourly Earnings & Recessions

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%.

Fed Funds Rate & Unemployment

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.

Unemployment(U3) & Average Hourly Earnings Growth

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.

Federal Debt/GDP

Acknowledgements

Alfonso Peccatiello for his analysis of CPI and recessions.

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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.

CPI

The S&P 500 fell 4.3% to test support at 3900. Follow-through below 3650 would confirm earlier bear market signals.

S&P 500

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.

CPI Services

Fueled by strong growth in average hourly earnings.

CPI & Wage Rates

But it is not only services that present a problem.

Food prices are growing above 10% p.a. — signaling hardship for low income-earners.

CPI Food

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 Shelter

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).

CPI Energy

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.

SPR Levels

The reduction in strategic reserves is unsustainable in the longer-term and reversal could deliver a nasty surprise for consumers in the new year.

SPR Lowest since 1984

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.

Real Fed Funds Rate (FFR-CPI)

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.

10-Year Treasury Yields

Stocks and bonds are both falling, with the S&P 500 down 18.0% year-to-date compared to -25.4% for TLT.

S&P 500 and iShares 20+ Year Treasury ETF (TLT)

The best short-term haven is cash.

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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:

  1. Use energy shortages to drive up inflation;
  2. 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:

Robert Habeck

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.

Europe: Steel Production

Aluminium smelters face similar challenges from rising energy costs.

Europe: Aluminium

How is the West responding?

Europe is reverting to coal to generate base-load power.

German Coal

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.

Europe LNG

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.

Russian Oil

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.

Dollar Index

While Gold has fallen.

Spot Gold

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?

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Optimism bias

As humans, we are programmed to assume our solutions will work. It is an important evolutionary trait. The military solution to this optimism bias is to assert deductive reasoning and the arrangement of a reserve capacity, to compensate when systems fail, resources run out, or solutions are exhausted…..

~ Rob Johnson

Comment: The equivalent for investors, to maintaining a reserve capacity, is position-sizing: never bet so much on any one trade that an adverse outcome, or string of adverse outcomes, would affect your ability to keep investing/trading.

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Base case: global recession

The Treasury yield curve is flattening, with the 10-year/3-month yield differential plunging sharply, to a current 0.24%. Another 75 basis point rate hike at the next FOMC meeting is expected to drive the 3-month T-Bill discount rate above the 10-year yield, the negative spread warning of a deep recession in the next 6 to 18 months (subsequent reversal to a positive spread would signal that recession is imminent).

10-Year & minus 3-Month Treasury Yield

The S&P 500 is retracing to test short-term support at 4200. Breach would warn of another decline, while follow-through below 3650 would signal the second downward leg of a bear market.

S&P 500

 

21-Day Volatility troughs above 1% (red arrows) continue to warn of elevated risk.

S&P 500

Dow Jones Industrial Metals Index is in a primary down-trend, warning of a global recession.

DJ Industrial Metals Index

Supported by a similar primary down-trend on Copper, the most prescient of base metals.

Copper

Brent crude below $100 also warns of an economic contraction. Goldman Sachs project that crude oil will reach $135 per barrel this Winter, while Ed Morse at Citi says that WTI Light Crude will likely remain below $90 per barrel. Obviously, the former foresees an economic recovery, while the latter sees an extended contraction. Of the two, Morse has the best track in the industry.

Brent Crude

Natural gas prices are climbing.

Natural Gas

Especially in Europe, where Russia is attempting to choke the European economy.

Russia: EU Gas

Causing Germany’s producer price index to spike to 37.2% (year-on-year growth).

EU: PPI

Conclusion

Our base case is a global recession. A soft landing is unlikely unless the Fed does a sharp pivot, Russia stops trying to throttle European gas, and China goes all-in on its beleaguered property sector. That won’t address any of the underlying problems but would kick the can down the road for another year or two.

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In the Ways That Count, Liz Cheney Won | Frank Bruni

Liz Cheney

Extract from Frank Bruni’s piece in the New York Times:

I know what the numbers say. I can read the returns. By those hard, cold, simplistic measures, Liz Cheney was defeated overwhelmingly in her House Republican primary in Wyoming on Tuesday night, and her time in Congress is winding down.

But it’s impossible for me to say that she lost.

She got many, many fewer votes than her opponent, an unscrupulous shape shifter unfit to shine her shoes, because she chose the tough world of truth over Donald Trump’s underworld of lies. That’s a moral victory.

She was spurned by conservatives in Wyoming because she had the clear-eyed vision to see Trump for what he is and — unlike Mitch McConnell and Kevin McCarthy, whose titles perversely include the word “leader” — she wouldn’t don a blindfold. That makes her a champion in the ways that count most.

Come January, she will no longer be Representative Cheney because she represents steadfast principle in an era with a devastating deficit of it. History will smile on her for that. It will remember the likes of McConnell and McCarthy for different, darker reasons. You tell me who’s the winner in this crowd…..

Conclusion

We try to stay out of party politics but Liz Cheney’s stand is about principle — the preservation of American democracy — which should be above politics. Sadly, that is no longer the case.

Related articles

Retired Admiral James Stavridis | Setting fire to the Wells – November 19, 2020
George Orwell | The appeal of Fascism – November 11, 2020
The Threat to Global Democracy – August 18, 2022
Thomas Homer-Dixon: The American polity is cracked, and might collapse. Canada must prepare, The Globe & Mail – January 2, 2022

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