June 2022 Update
Long term expectations of inflation remain high (1-3 year):
- Businesses start bringing demand forward (build inventory and hoarding). Spend more actively now knowing that things will be more expensive later
- Investors will borrow at the feds negative interest rates and buy anything that is pinned down as securing against inflation (drive prices of commodities and hard assets higher) These two effects will accelerate inflation once it takes hold. There is a negative inflation spiral, a negative doom loop happening here. The feds are very aware of that and hence have defined the inflation as “transitory” early on. It wasn’t because they thought it was transitory. It was really to convince markets and to convince long term inflation expectations down. When that didn’t work, their next and only tool is to try to get the market to believe that they are going to do “whatever it takes” to lower inflation. The truth is, as we’ve talked about so many times before, the fed has little power to control inflation.
At some point, they can kill the market and really hurt the economy and can create an economic crisis that will ultimately be deflationary. But that’s akin dropped a bomb to on a forest to clear the underbrush. Once we start there, we begin to realize how unsolvable this problem is for the fed and we begin to realize the risks that we’ve been seeing.
Some of the effects are just getting started.
We are starting to see high yield spreads and junk bond spreads blowing up. HYG & JNK near march 2020 lows.
Japanese Government Bonds are blowing up for the first time. Everybody short the JPY have gone bankrupt over the years, but we’ve been and still are short the JPY since June 3rd. Un unpinning of the interest rates in Japan poses a serious risk of creating an existential crisis in Japan.
Crypto, far out on the risk curve is starting to implode. Many people believe that Tether is going to break the buck and that we’re going to see greater pain in that space.
We’re starting to see expansion in spreads between Italy and Germany to such an extent that the EU is being forced to secure that debt to tighten spreads. Russia is taking advantage of the perceived weaknesses cutting energy (nat gas) to Italy. They’re trying to make this economic crisis worse for the West. All of this as the dollar strength is at a record because this is viewed as a safe haven, it’s one of the few places to hide. This dollar strength will cause dollar denominated debt to be have harder for entities to pay back. We’ve seen this many times in the past. In 1997, we saw the Asian financial crisis and Russian Ruble crisis as a result of dollar strength and US raising of interest rates. We can expect more emerging market crises coming forward as well as expansion of risks spreads.
We’re seeing this in historic poor liquidity.
Top of the book liquidity is the worst in 15 years. This lack of liquidity means fatter tails for markets (sumo markets). We are down almost 30% from the top, and more than 35% in the NASDAQ. This is not a time to be drumming the table for a massive tail and yet one IS building. We will have 10% counter trend rallies as we’ve seen in March and again in May because short interest and bearishness in sentiment are historically bad (for a fundamental reason).
The Good News.
Amidst all of this, the good news is that we should see relative revenue strength. Increasing inflation expectations brings demand forward. Price to sales which have been at record levels should be slowly solved by this revenue growth. We might get a technical recession here because of the slight negative print last quarter but it is our belief that we are going to avoid any major recession. We are going to have an earnings recession. Margins have been at record levels for some time now will begin to secularly normalize because of the cost structure and inflationary push. At some point people are going to be unwilling to allow manufacturers and corporations to raise their prices. Corporations are going to have to begin digesting some of the inflationary pressures.
Also good news, consumer and investor sentiment is awful. Hedging and negative positioning are at record levels. This tends to mean that we’re likely to get some counter trend moves and down moves are less likely to be as continually powerful. On that note, although household equity allocations have dropped by 10%, they are still near all time allocation highs. Even though institutions are well positioned for this, there is still liquidation to come from households.
So where do you invest in times like this?
It’s time to invest in essentials and near Central Government: energy, nuclear, healthcare, defence, infrastructure, consumer staples, food, farmlands, domestic manufacturing. There are plenty of bull trends within this bear market.
It’s important to think about fundamentals for once. It’s been a long time since fundamentals have mattered. But we sit here in a moment where DCFs and active management will matter. They will strike a put in valuations going forward.
Passive is dead
The 60/40 risk parity game and passive DCA into broad and passive markets like most wealth advisors suggest will not work. There have been plenty of opportunities in what has been a very unbalanced market for some time.
Outlook for July:
The first skew pop from the otherwise incredibly depressed skew. That is an early warning sign of increasing fragility that may lie ahead. During times like this, there’s only one thing to be thoughtful of:
Position: Long gamma/long vol
This is especially true for August/September into the back half of the year. This compressing of vol is coming to an end by the next month or the month after. We can expect much more performance from long volatility at large. Tailwind is coming.