State of Ambivalence

“Truth is ever to be found in simplicity, and not in the multiplicity and confusion of things.” - Isaac Newton

Looking at the conflicting US macro data from PPI (-0.5% Mom when consensus was 0.1%), to December retails sales tumbling (-1.1% MoM) and disappointing Industrial Production numbers (-0.7% MoM), in conjunction with Bloomberg’s US Financial Conditions Index showing that Financial Conditions are now easier than anytime during rate hikes, when it came to choosing our title analogy we decided to go for state of “Ambivalence”. A state of “Ambivalence” is a state of having simultaneous conflicting reactions, beliefs, or feelings towards someone or something that contains both positively and negatively “valenced” components. As such the latest various US macro data portend towards more recessionary pressure on the US outlook meanwhile rally in all thing high beta year to date, Bitcoin included, has been significant to say the least. Us being fond of behavioral psychology, “Ambivalence” refers to a psychological conflict between opposing evaluations, often experienced as being torn between alternatives. The psychological state of being torn between opposing evaluations, or ambivalence, is an inescapable part of human life. Ambivalence is not the same as feeling neutral or indifferent toward a situation, but is characterized by simultaneously having strong positive and negative associations for example between the negative macro data and the positive momentum in risk asset markets but we ramble again.

In this conversation, we would like to look at what the debilitating US macro entails when it comes to the potential continuation or not of the ongoing “high beta” rally and as well put in context some of the previous recommendations made in our recent musing.

On a side note we have decided that, going forward to switch to a subscription model for most of our posts. We will continue to publish some free contents as well but less frequently. We have been blogging on a free and regular basis since 2009 for those of us who have been following our long journey since our Blogpost days to now Substack. As many of you can surely understand, it takes a lot of time and dedication to write our musings. We sincerely hope you will understand our switch to this dual model approach. As always, we greatly appreciate your feedback and support to our endeavours and we would like to thank you for the growing number of followers we have managed to achieve.

Synopsis:

• The State of Ambivalence

• Clouds on the horizon

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·         The State of Ambivalence

Since our previous conversation the “Make Duration Great Again” (MDGA) trade which is in effect investing on the long end of Investment Grade Credit from a carry and roll down perspective has seen US High Grade (Investment Grade) 15+ years continue to “outperform” and is already up +7.48% (5.27% YTD in our previous conversation):

-      Graph source Macronomics - KOYFIN

Yet the latest dip in the performance we think is indicative of some “State of Ambivalence”. It has all to do with the “pivot narrative” and expectations of a slower hiking path pace from the US Fed. The big question is about the risk of the Fed “overshooting” on their “tightening stance.

As such the “state” of financial conditions being much easier regardless of the disappointing US macro data as of late is making many market pundits pondering about the trajectory of the Fed in that context:

-      Graph source Bloomberg – Twitter

The issue of course is the “sustainability” of inflation.

As such the softening of the stance of the Fed on October 21st with their 75 bps rumored “leak” to the WSJ led to a significant bounce in all thing commodities related, from Iron Ore to silver, to copper and of course oil as indicated by Lawrence McDonald on our Twitter feed:

“Off the Recent Lows

Iron Ore +48%

Silver +38%

Copper +35%

Uranium +32%

Aluminum +25%

Corn +20%

Gold +19%

Sugar +14%

Oil +16%

Coal +8%

Wheat +2%

*On Oct 21, 2022 - the Fed softened the path forward with a leak to the WSJ, this is how you nearly guarantee sustained inflation.” – Lawrence McDonald

-  Graph source Lawrence McDonald – Bloomberg - Twitter

The yield on the 10-year peaked at 4.33% on October 21st.  It's closing in on a 85 basis point decline since then, currently at around 3.48%.

Financial Conditions easing is of course leading the rally in the high beta space, yet when it comes to credit, we continue to expect an outperformance of US Investment Grade (LQD) relative to US High Yield (HYG) in 2023 as per below chart for the last 3 months:

- Graph source: Macronomics – TradingView

In our last musing YTD LQD was 9.36% versus 6.86% YTD for HYG. If indeed US macro is more “fragile” than anticipated, then Investment Grade is more appealing from a quality rating exposure perspective.

But returning to the “State of Ambivalence”, the issue is when the "Inflation Genie" is "Out of the Bottle" as warned by Fed's Bullard in 2012, it is hard to get it back under control:

“There’s some risk that you lock in this policy for too long a period,” he stated.  ”Once inflation gets out of control, it takes a long, long time to fix it” – Bullard

When it comes to “fixing inflation, as illustrated by Michal Stupavsky, CFA in our LinkedIn feed, it does takes time to “fix it”:

" US data clearly shows that the fight against significantly elevated inflation may take many years

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As the data from the US economy clearly shows, once an inflationary spiral starts, it can be very difficult to stop it. This is illustrated by the data on the US inflation between 1965 and 1983, which are shown in the above chart.

In 1965, inflation hovered around 1%, but then it began to rise sharply, reaching 6% around 1970. Then the stagflation years of the 1970s followed, when the growth of the US economy was rather weak and at the same time it was troubled by strongly elevated inflation, which was at the same time very significantly volatile.

From 1970 onwards, the inflation rate dropped to 3% in 1972, but in the following years, inflation began to rise sharply again, up to 12% in 1974. Then we again witnessed the disinflation process, i.e. the falling rate of inflation, and that to 5% in 1976. This was followed by another sharp increase in inflation to 15% in 1980, which represented the US inflation peak in modern history.

Inflation was only defeated in the early 1980s by the new governor of the Fed, Paul Volcker, who in 1980 raised the base interest rate - the fed funds rate - up to 20%. This was followed by two recessions of the US economy between 1980 and 1982, which finally helped, together with the very high interest rates, to stop the inflationary spiral, with inflation approaching 2% in 1983.

What are the lessons for investors from this volatile US inflation period? The key takeaway, in my view, is that once an inflationary spiral gets going, it's really extremely difficult to stop it.

Although we have seen some sequential decline in US inflation in recent months, and this also applies to most of the world's key economies, it is quite evident that the 2% inflation target will still have a long way to go. And even if the Fed managed to really get closer to this goal in the coming months (or even years), I believe that we would still be far from having won the inflation battle.

As the US stagflation years of the 1970s show, after a period of disinflation, i.e. falling inflation rates, another period of accelerating inflation can paradoxically come, for example if central banks abandon the hawkish policy of high restrictive interest rates too soon or if massive fiscal deficits fail get under control which is in fact the case right now.”- Michal Stupavsky, CFA

When it comes to the inflation receding narrative recently pointed out by many pundits on the back of the latest US CPI print, we think it is way too early to take a victory lap as indicated as well by our friend Zoltan Szelyes, CFA, CAIA:

-      Graph source Macro Real Estate – Zoltan Szelyes, CFA, CAIA

There goes your “State of Ambivalence and hence our recommendation for our “put-call parity” strategy previously recommended via ETF ZROZ (PIMCO 25+ Year Zero Coupon US Treasury Index ETF) which is extremely sensitive to rates move in conjunction with buying Junior Gold miners through ETF GDXJ. Both trades are highly sensitive and convex (3 months chart below):

-      Graph source Macronomics - TradingView

This "put-call parity" strategy continues to play out in 2023 with falling yields with a change in the Fed’s narrative, and rising gold prices:

-      Graph source Macronomics – Refinitiv Eikon

We remain convinced this “put-call parity” strategy will continue to perform in 2023. Why is so?

The current combination of higher US inflation and loss of momentum in US growth surprises should weigh on the dollar:

-      Graph source Bloomberg – Twitter

China matters because it is the biggest part of the US current account deficit. According to the US Commerce Department, in November, the trade deficit was back down 21% YOY. But part of it was due to a strong US dollar. Now that the US Dollar is weakening, gold in sympathy is rising with receding “real yields” in recent months (our famous Mack The Knife: US dollar + US Real yields and his 2022 murderous rampage on 60/40 portfolios).

The fading of the Fed pivot narrative is the big question. As such the US CPI is the most important macro data in the coming months, particularly with the risk of continued rising oil and gasoline prices on China re-opening:

-      Graph source Bloomberg – Twitter

Analysts expect China's oil demand to resume from March with a return of industrial activity and economic rebound. Saudi Aramco CEO is as well very optimistic on China’s reopening prospects in conjunction with a recovery in air travel.

In terms of “asset allocation”, both “oil” and “gold” seems appealing as such. This is at least the take from maverick asset manager Ruffer who according to FT adviser has moved GBP 55 million into gold and GBP 35 million into oil as inflation hedge as per Investment Director Duncan Macinnes stated:

“We are waiting for the opportune moment to pivot towards a portfolio positioned for higher nominal growth alongside inflation and financial repression – but it’s not yet. So there is a degree of what appears to be cognitive dissonance in our portfolio construction, because the portfolio we believe you want for the coming six to nine months is almost entirely different from the strategic portfolio you might want to navigate the coming decade.

"The risk is we are trying too hard; the danger is, by not trying to navigate through choppy markets, investors could get hurt.”  - FT adviser – Duncan Mcinnes

There goes the current “State of Ambivalence” we think.

In our conversation “The Scarcity Principle” we argued that a full re-opening of China could bring in more inflationary pressure in the commodities space in that context. No wonder copper is up 12% YTD  (9.1% YTD in our last conversation):

-      Graph source Macronomics – KOYFIN

No wonder Copper Mining shares have been rallying on the back of a surge in copper prices (1 year chart below):

-      Graph source Macronomics – Refinitiv Eikon

In the context of tight inventories overall and lack of supply, no wonder YTD some shares are rising significantly such as Chilean outfit Antofagasta which we like in the current context.

As well Diversified Miners are continuing their run on Chinese expectations (6 months chart, disclosure we are long VALE SA):

-      Graph source Macronomics – Refinitiv Eikon

Regardless of the fear of “demand destruction” on the back of recession fear, current markets are tight supply wise and as such we continue to believe in allocating into commodities exposed players in the “scarcity environment” discussed in our previous conversations.

• Clouds on the horizon

While the latest print of US CPI coming in line with expectations has seen a bullish narrative building up, when it comes to the build-up in US recession expectations, the sale of previously owned US homes fell in December to the slowest pace in a decade, capping one of the housing market’s worst years on record amid a rapid jump in mortgage rates according to Bloomberg:

-      Graph source Bloomberg – Twitter

Housing is now the least affordable since the Great Financial Crisis (GFC). Existing-home sales totaled 5.03 million in 2022, down 17.8% from 2021, as last year’s rapidly escalating interest rate environment weighed on the residential real estate market. As well the Empire State Manufacturing came in way below expectations at -32.9 vs -8.6 estimate.

Citi’s US economic surprise index is gradually breaking down according to Bloomberg:

-      Graph source Bloomberg - Twitter

If history is any guide, bear market tends to materialize around a recession,

-      Graph source Bloomberg

What the yield curve is telling us indeed is that clouds are lining up on the horizon:

-      Graph source Bloomberg

From a “State of Ambivalence” perspective, one can ask if 2023 be a positive year for stocks simply because back-to-back years of losses are unlikely?

-      Graph source Bloomberg

We admit having simultaneous conflicting reactions, beliefs, or feelings towards financial markets in the current state of affairs, are we in a “State of Ambivalence”? We wonder.

“Learning without thought is labor lost; thought without learning is perilous.” - Confucius

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