Real interest rates
- State of play
- Monetary policy
State of play
The past week has seen some interesting macro market movements. Nominal risk free yields have continued to fall, credit spreads have ground tighter, and commodities, from copper to corn, have started to come off their highs.
Note the following quirk about monetary policy. If low nominal rates lead to increases in economic activity (investment, consumption rise as borrowing costs fall) and that economic activity encounters supply-side constraints, it resolves itself in the form of higher prices.
The higher inflation, if nominal yields are “pinned”, lead to yet lower real rates, which lead to increases in economic activity (investment, consumption) which again encounters supply-side constraints, leading to higher prices, and so on.
And that’s exactly what we are seeing here. The recent US +5% CPI prints are leading to ever lower real interest rates (-3.5% at present using actual inflation, and around -1% using expected inflation) which are causing economic activity to accelerate. Ergo looser policy at a time when nominal GDP is growing by 12%.
It is somewhat stunning to even type that sentence out, but, it is where we find ourselves. Hence Paul Tudor Jones commenting that should the Fed (at the forthcoming FOMC) not signal a “pull forward” in taper talk that he intends to buy crypto, gold, commodities and presumably (although he didn’t say it) guns. Similarly, Larry Summers commenting that the current policy stance was the most reckless he’d seen in 40 years.
Larry is probably the most famous economist/academic/former-treasury-head of his era, after Paul Krugman, and Tudor Jones is up there with Jeremy Grantham, Druckenmiller, and the other big hedge fund/multi-asset managers of the past few decades.
All of the above eventually boils down to the graph below. Larry, et al, are looking at the pink dot below (most recent joint print of Core CPI and 10yr yield) and concluding that the Fed really needs to taper, lest we overheat, requiring rates to be tightened to the point at which they’d almost certainly induce a recession.
And given the backdrop for global indebtedness, and the presently lofty valuations of just about every asset class, you can very quickly paint a materially negative outlook. Hence Paul Tudor Jones with crypto and other non standard asset allocation items.
Simply put, it is a little hard to think that the Fed has lost its mind.
If, as a thought experiment, I tried to place probabilities on what was more likely, that a) the Fed had forgotten how monetary policy works, how bond markets work, how the mechanics of inflation work, and b) that not only had the Fed forgotten these things, but that the bond market had also forgotten these things, well, I guess we’d have to place a fairly low probability on this combination of surprising forgetfulness. And yes, we can lump the bond market in there with the Fed because, for the most part, the Fed doesn’t control the 10 year yield, and as such, whatever number it prints is mostly the result of an unfettered market in all of its prevailing wisdom.
We are already in a defensive stance, relying on our SAA weights to give us a good exposure to risky assets regardless of the outcomes, but using our DAA stance to blunt some of the downside risks should overheating give way to negative spill overs, and don’t quite feel the need to follow Paul, Druckenmiller and Grantham down the rabbit hole.
A 700bp underweight to shares at the portfolio level is a meaningful underweight, but, very, very distinct from the towel-throwing outlined above.
Lumber is now 40% off its peak. Recall that lumber was the “first” commodity to skyrocket, and is now likewise leading the way back down (or at least, leading the moderation from peak). Corn, rubber, nat gas, iron ore and to a lesser extent, copper are all modestly down from peaks, suggesting that the most acute phase of the commodity squeeze appears to be behind us.
Sky rocketing house prices are working their magic on demand, ie pulling it right back in. This is the so-called “buyers strike” which is useful and evocative wording to describe the aversion to presently overheated pricing.
It does suggest that US homebuilding activity should start to moderate from here, which would be a negative to the US-exposed ASX-listed building materials companies.
One of our favourite, confounding topics is ESG implementation in funds. The 3 leading agencies offering ESG ratings differ so markedly on their scoring for the same stock that consistent/harmonious implementation is almost impossible.
The standard graph held out to support ESG incorporation into fund allocations is shown below, where ESG rated stocks perform seemingly better than the market.
But lifting the hood leads to a fairly confused picture, where the average to poor ratings seem to be the best performers. In turn, the explanation is often one of sector bets (e.g. oil, gas, energy markets recover) over specific time periods measured.
What it means, to us, is that ESG is not necessarily a “clean, standalone” factor, but rather one that is at best blended with the more normal heavyweight factors (value, momentum, growth, quality, etc) as part of the everyday portfolio construction approach. You don’t have to pay for it separately.
The past week was a relative busy one for some our direct equity holdings. Altium (ALU) had a takeover offer tabled, and quickly rejected, for a 40% premium to prior trading. IRESS (IRE) had a similar theme, with Barrenjoey active in the market at a a substantial premium to 5 day VWAP.
Tech, health and REITs all share a common thematic, namely real rates. They fell when rates rose, but now the record lows in real rates due to higher inflation prints we discussed above have provided a boost to these hithertofore out of favour sectors and stocks.
We used the opportunity to exit our ALU position, and pro-rated the holding over some of the smaller, newer positions within the portfolio.
ResMed (RMD), in addition to getting a boost from lower rates enjoyed a competitor’s product recall, which added to the positive narrative around the forthcoming AirSense 11 launch. A new product at a time of a competitors recall is a handy combination.
TPG (TPG) also saw some improved momentum, as selling pressures (the stock exited a couple of global equity benchmarks) abated. We’ve viewed TPG as a high quality, good value defensive play, and used Spark New Zealand (SPK) as a funding vehicle.
Lastly, Origin (ORG), and to a lesser extent all oil and gas names, are running hard on oil prices trading a circa $70/bbl.
Whilst we are bearish on commodities, we are much more constructive on energy, and perhaps more explicitly, on the underlying commodity producers, whose share prices have not re-rated inline with the commodity price.
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