Hope all goes well… “For as long as we’ve been trading, every time stocks fell hard, you knew they’d step in and cut rates,” said the CIO, describing the Fed Put. “But with the kind of inflation we’re seeing now, there’s no way the Fed can cut rates just because stocks fall,” he said. “Even if the S&P were to puke 25% in a week or two, the best you could hope for from the Fed is some kind of statement saying they’ll slow down, maybe pause.” US stocks had just finished lower for the 5th consecutive week. “What we’re seeing is the market pricing out the Fed Put. We’re on our own now, without a safety net. It’s a sobering reality, a bit like trading crypto.”
Overall: “Our plans and policies have produced the strongest job creation economy in modern times,” declared Biden. “The unemployment rate now stands at 3.6% - the fastest decline in unemployment to start a President’s term ever recorded,” he boasted. “There have been only 3 months in the last 50yrs where the unemployment rate in America is lower than it is now – a direct result of the American Rescue Plan, our COVID vaccination program, and my plan to grow our economy from the bottom up and middle out.” No one could’ve known exactly what would happen when Biden signed into law the $1.9trln American Rescue Plan in March 2021. Now we do. “Inflation is much too high,” said Powell, following his 50bp rate hike, and describing plans to reduce the Fed’s $9trln balance sheet. “We understand the hardship it is causing, and we’re moving expeditiously to bring it back down,” pledged the Fed Chairman. “We have both the tools we need and the resolve that it will take to restore price stability on behalf of American families and businesses.” The essential tool the Fed has is its ability to create slack in the labor market through forcing people out of work, undermining their position when negotiating higher wages. But higher wages and narrowing inequality are precisely what the administration wants from America’s hot economy. So begins a new conflict in a world of rapidly expanding hostilities. For decades, the disinflationary tendencies that accompanied rising levels of globalization, slowing working-age population growth rates, and accelerating microprocessor processing speeds, allowed central banks to act in general support of fiscal stimulus. In each cycle, their stimulus ratcheted up as our central bankers probed for the point at which their expansive policies would spur runaway inflation, wage-price spirals, hoarding, debasement. But they never found it -- until now that is. In that previous paradigm, stocks and bonds generally rose together. Even better, when the former temporarily declined the latter rallied. What replaces it will look far different. And we are only now getting a glimpse.
One River’s Head of Research, Marcel Kasumovich, published an interesting piece [here] on Proof-of-Stake digital assets and the importance of “staking” to investment portfolio returns (our strategies are built to accommodate staking while neither ETFs nor the largest incumbent passive grantor trust products are permitted to engage in this important activity).
Week-in-Review (expressed in YoY terms): Mon: UK markets closed / Golden Week in Japan = illiquid start to week, EU energy ministers meet to discuss Russian oil embargo, rumor that Chinese officials met with banks to discuss protecting assets in the event of similar sanctions put on Russia by the West, German foreign min says sanctions can only be lifted once Russia leaves Ukraine / Germany says could back immediate EU ban, Beijing closed gyms / cinemas, ECB's de Guindos says "no reason why" asset purchases should not end in July, Finland unemp 7% (6.7%p), German ret sales -5.4% (-0.5%e), Hungary PPI 25.9% (22.4%p), Italy unemp 8.3% (8.4%e), EU eco conf 105 (108e), US ISM mfg (55.4 (57.6e) / prices paid 84.6 (87.4e), S&P +0.6%; Tue: RBA hikes by 25bp (15bp exp) – first hike since 2010 / RBA gov Lowe says ready to tighten as necessary, Germany says will back Sweden / Finland NATO applications, ECB's Schnabel says "rate hike in July is possible", EU PPI 36.8% (36.3%e), EU unemp 6.8% as exp, US durable goods orders 1.1% MoM (0.8%e), US Job Openings 11.549m (11.2m exp), S&P +0.5%; Wed: Fed hikes 50bp (as exp) / QT to begin in June with $47.5b per month / unanimous decision (market expected Bullard to vote for 75bp / Powell says not considering 75bp sparking strong risk rally, EU proposed banning Russian crude over the next 6 months and refined fuels by the end of the year, India CB hiked 40bp in an unscheduled announcement, N. Korea fired another missile (14th so far this year), BCB hiked by 100bp as expected / did not commit to hike at next meeting (somewhat dovish), New Zealand unemp 3.2% as exp / AHE 1.9% QoQ (1.2%e), US vehicle sales 14.29m (14.15m exp), US ISM services 57.1 (58.5e), S&P +3.0%; Thur: BoE hiked 25bp (3 of 9 members voted for 50bp) but 2 other members dissented from the statement that more hiking was needed in the future / lowered 2023 growth forecast to -0.25%, Norges bank unch as exp, Poland CB hikes 75bp (100bp exp), Czech CB hikes 75bp (50bp exp), US 10s reach new cycle highs (closing above 3%), Opec agrees to modest monthly oil output increase, US energy dept will buy 60mm barrels to replenish SPR this fall, German factory orders -3.1% (-0.7%e), Swiss CPI 2.5% (2.6%e), Turkey CPI 69.97% (67.8%e) / Core CPI 52.37% (52.9%e) / PPI 121.82% (121.9%e), HK ret sales -13.8% (-12.6%e), US 1Q unit labor cost 11.6% (10%e), US init claims 200k (180k exp) S&P -3.6%; Fri: US NFP 428k (380k exp) / unemp 3.6% (3.5%e) / AHE 5.5% as exp / participation rate 62.2% (62.5%e), Chile CB hiked 125bp (100bp exp), ECB’s Villeroy says may raise rates above 0% this year, Musk raises $7b in equity financing from 19 wealthy “friends” for his TWTR bid to reduce his need to sell more Tesla shares, J&J covid vaccine restricted by FDA due to clotting risk, Fed’s Barkin did not rule out raising by 75bp at some point, ECB’s Holzmann says ECB will discuss rate increase in June and likely decide on one, Swiss unemp 2.2% as exp, Canada emp chg 15.3k (40k exp) / unemp 5.2% as exp, S&P -0.6%.
Manufacturing PMI (high-to-low): Switzerland 62.5 (previous month 64), Norway 60.64 (previous mth 59.72), Netherlands 59.9 (previous 58.4), Hungary 58.9/57.6, Austria 57.9/59.3, Canada 56.2/58.9, UK 55.8/55.2, France 55.7/54.7, United States 55.4/57.1, Sweden 55/56.8, Greece 54.8/54.6, India 54.7/54, Germany 54.6/56.9, Italy 54.5/55.8, Czech Republic 54.4/54.7, Japan 53.5/54.1, Spain 53.3/54.2, Poland 52.4/52.7, South Korea 52.1/51.2, Indonesia 51.9/51.3, Brazil 51.8/52.3, Taiwan 51.7/54.1, Vietnam 51.7/51.7, Hong Kong 51.7/42, Singapore 50.3/50.1, South Africa 50.3/51.4, Mexico 49.3/49.2, Turkey 49.2/49.4, Russia 48.2/44.1, China 46/48.1. Services PMI: Sweden 68.1/62.9, Ireland 61.7/63.4, Brazil 60.6/58.1, UK 58.9/62.6, France 58.9/57.4, India 57.9/53.6, Australia 57.8/56.2, Germany 57.6/56.1, Spain 57.1/53.4, Italy 55.7/52.1, US 55.6/58, Japan 50.5/49.4, Russia 44.5/38.1, China 36.2/42.
Weekly Close: S&P 500 -0.2% and VIX -3.21 at +30.19. Nikkei +0.6%, Shanghai -1.5%, Euro Stoxx -4.5%, Bovespa -2.5%, MSCI World -0.4%, and MSCI Emerging -1.6%. USD rose +8.5% vs Bitcoin, +6.7% vs Ethereum, +2.2% vs Brazil, +1.8% vs Sterling, +1.3% vs South Africa, +1.3% vs Sweden, +0.9% vs Chile, +0.9% vs China, +0.7% vs Yen, +0.7% vs Turkey, +0.7% vs India, and +0.2% vs Canada. USD fell -6.0% vs Russia, -1.5% vs Mexico, -0.2% vs Australia, -0.1% vs Euro, and flat vs Indonesia. Gold -1.5%, Silver -3.1%, Oil +4.9%, Copper -3.2%, Iron Ore +2.9%, Corn -3.5%. 5y5y inflation swaps (EU -13bps at 2.31%, US -1bp at 2.73%, JP +15bps at 0.88%, and UK -25bps at 3.86%). 2yr Notes +2bps at 2.74% and 10yr Notes +19bps at 3.13%.
YTD Equity Indexes (high-to-low): Saudi Arabia +21.9% priced in US dollars (+21.7% priced in riyals), UAE +18.7% priced in US dollars (+18.7% in dirham), Turkey +17.2% in dollars (+32.4% in liras), Chile +12.1% (+12.3%), Colombia +11.2% (+10.3%), Brazil +10.4% (+0.3%), Indonesia +7.9% (+9.8%), Singapore +2.6% (+5.4%), Venezuela -1.9% (-3.6%), Norway -3.8% (+3.2%), Canada -4.5% (-2.8%), Thailand -4.5% (-1.7%), Malaysia -4.7% (-0.2%), Portugal -5% (+2.3%), Mexico -5.3% (-7%), Australia -5.5% (-3.2%), Philippines -7.5% (-5.1%), India -8.5% (-5.4%), Argentina -8.5% (+3.6%), UK -8.7% (+0%), Israel -8.7% (-1.7%), South Africa -8.8% (-8.6%), Greece -9.9% (-3%), Spain -10.8% (-4.5%), Belgium -13.4% (-6.7%), S&P 500 -13.5%, MSCI World -13.9%, Czech Republic -15.1% (-8.4%), HK -15.1% (-14.5%), Denmark -15.2% (-9.2%), Switzerland -15.6% (-8.9%), Taiwan -16% (-9.9%), New Zealand -16.3% (-10.9%), Korea -16.6% (-11.2%), Japan -17.2% (-6.2%), Russell -18.1%, France -18.8% (-12.5%), Germany -19.6% (-13.9%), Italy -19.8% (-14.2%), Netherlands -20.6% (-14.5%), China -21.4% (-17.5%), Euro Stoxx 50 -21.6% (-15.6%), Finland -21.7% (-16.2%), NASDAQ -22.4%, Ireland -22.5% (-16.5%), Austria -24.5% (-19.2%), Hungary -25.2% (-17%), Sweden -25.8% (-18.9%), Poland -27.5% (-20.3%), Russia -30.6% (-36.8%).
Crack: “Something’s going to spring a leak,” said the industry’s greatest market plumber, banging about beneath the sink, belt slung low, crack. “That’s how tightening cycles end. But what will it be? It is conventional to think of Emerging Markets – the common trigger in the past. Greenspan’s ‘soft landing’ in the mid-1990s was courtesy of Mexico’s 1994 devaluation and Asia’s deflationary devaluations. Emerging countries built a war chest of dollars to make sure that can’t happen again. The search for the weakest links in the plumbing of global credit markets is more likely to take you to developed countries, a blind spot to investors conditioned to seeing central bankers as market saviors. Not this time.”
Crack II: “Snaking through pipes of the financial system reveals that Europe’s system is clogged,” continued my favorite plumber. “We are a long way from the ECB’s ‘whatever-it-takes’ moment. Enough time has passed without strain to give the false impression that structural improvements were made. A lot of new ground was covered, to be sure. The European Stability Mechanism was created as a European-IMF. And the ECB invented Outright Monetary Transactions to allow bond market intervention for countries who entered the ESM. But this didn’t prevent the balkanization of the banking system, hidden in plain sight through ECB’s Target mechanism.”
Crack III: “A euro is a euro is a euro – this is a must for a monetary union,” explained the plumber, pulling out a schematic, an utter mess to us mortals. “Users of the euro must be indifferent to its locality. Europe operationalized this through a Target2 system that nets claims across regional central banks in the system. It’s simple enough. We know that the balance of payments between nations must sum to zero. A persistent deficit would see a drain of foreign exchange reserves and vice versa. This is true in a monetary union, too, only with very different accounting. Italy’s persistent BOP deficit to Germany is recorded as a liability to the Banca d’Italia and an asset to the Deutsche Bundesbank.”
Crack IV: “It is the invisible hand of Europe’s monetary system,” said the plumber, a life-long student of the connections that allow money to move. “Target assets and liabilities net to zero – they are equal and offsetting. But today’s gross balances speak loudly to Europe’s clogs. Italy’s Target2 liability is a record 597bln euros; Spain has also jumped to record 536bln euros. Germany’s surplus is up to 1,170bln euro. The twist in Europe’s monetary union is that the Target2 balances never settle. Italy never has to issue bonds to cover its obligation to Germany.”
Crack V: “Target2 serves as a glue and an accelerant to the Union,” said the plumber, a light spray springing from somewhere deep from within. “A breakup would be exceptionally costly – the glue. Spain’s Target2 liability is 42% of GDP, and those funds would be owed to creditors in a hard currency. A large enough liability becomes a political tool – the accelerant. The message of the invisible balances is a strong one. A German euro is viewed more dearly – funds accumulated in Germany’s banking system aren’t moving back to Italy or Spain.”
Crack VI: “ECB intervention was made easier by low and falling inflation. Inflation hawks were barking dogs. But not now. Germany’s ten-year breakeven inflation, at 2.68%, is hovering near all-time highs. The ECB will be practically unwilling to respond to a market problem until it gets deep and threatens Europe systemically. Target2 balances are not a cause of anything – they are the spotlight on growing imbalances. As Italy ten-year spreads approach 200 basis points, European banking and fiscal imbalances are an emerging risk. Tools built under the Italian Prime Minister’s leadership – ESM and OMT – may be the only option. And it’ll take crisis-like conditions to convince politicians. Europe’s union remains fragile.”
Anecdote: “The pandemic catapulted us into a new policy paradigm,” I said. The allocator had asked for a tight explanation of what to expect from markets, policy, politics. “Monetary policy dominance ended in the pandemic, replaced by fiscal policy dominance,” I said. “So far, monetary/fiscal have been cojoined; the Fed buying bonds to finance government deficits. This shifted us to a higher and more volatile inflationary environment. Engaging fiscal policy requires politicians to reassert themselves after decades in hibernation. Politicians determine where and how to deficit spend; central bankers don’t. Elected leaders (autocrats too) are a heterogeneous group, prone to power grabs, conflict, scapegoating, big ideas, obsessed with legacy building. It’s hard for politicians to agree how to share international power. And domestically, parties fight bitterly to pick economic pet projects, buy votes, influence. As politicians increasingly assert themselves, we naturally see rising geopolitical conflict and tensions within nations. This is now unfolding as humanity is grappling with climate change, a crisis that requires an unprecedented level of global coordination. In aggregate, our recent actions have so far resulted in substantial disinvestment in global energy and commodity production. So supply is not responding to higher prices in the same ways as it has for decades. This creates shortages. Politicians are rationally acting in their nation’s best interests, and in a world increasingly fractured, those interests are competing. Throughout history, such periods tend to run quite a distance before we collectively come to see that the cost of conflict is too great to bear, and we come together once again, cooperating in healthy competition. Between now and then, expect market relationships, correlations, and investment strategies that worked well in recent decades to struggle. And those that suffered, to prosper. Mean reversion will be replaced by trends, big ones. Violent reversals. Dispersion wins. Volatility. Active management destroys passive. Digital adoption wins big. You must take real risk to make money. Embrace it, adapt. And expect a breathtaking, tumultuous decade.”
Good luck out there,
Chief Investment Officer
One River Asset Management
Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.