Stagflation (THE UGLY)
As we anticipated, recession in the US is already a reality. Consumption data released a few days ago confirm this. US consumer spending fell month-on-month by 0.4% in real terms in May, while April’s figure was revised from +0.7% to +0.3%. A slightly negative June figure is likely. US consumer confidence is at a 16-month low. And that is not a negative. We continue to believe the current recession is only a technical recession, created by the collapse of the housing market, the securities market (stocks and bonds), cryptocurrencies, excess inventories accumulated during supply chain problems, and printing money. Between stocks and crypto in the US alone, the value of investments has fallen by USD 11 trillion, a huge amount (about 10% of Americans’ savings). It is a necessary recession to prevent inflation from becoming structural in the system. But it is transitory and probably limited to two/three quarters. Our view is absolutely very positive and absolutely not shared by the market.
Although every cycle is different, what happens to the stock market when rates are raised? It usually goes up. This is because the underlying economy is clearly strong, which is why rates are raised. A significant rise in rates, however, later leads to an economic slowdown, which, depending on the fundamentals, can lead to a hard or soft landing, i.e. a sharp recession or just a dampening of excesses. And that is why economists predict a recession in 2023, at the end of a series of upturns that would historically lead to a major slowdown. Why, instead, has the market been going down since the Fed’s first hike in March? The market is going down both because there was a massive tech bubble and then because of fears related to the repercussions of the return of the great monetary expansion that lasted a decade.
We believe that after the current technical recession linked to the rise in rates and the market crash, a recession in 2023 is unlikely to happen. Why? 1) The housing market, residential and commercial, is not in a bubble. The imbalance between supply and demand is substantial as a result of years of under-investment linked to the scarcity of bank financing in this sector. The end of the pandemic will lead to a recovery in demand for office space and confirm the home as the place to work. Inflation is also another support for this asset class. 2) Consumption accounts for about ¾ of GDP in the US. Today’s consumption dynamics are negative, as is natural after the market crash and recession fears. However, the labour market is extremely strong and this is the backbone of consumption. The relocation of many manufacturing industries will maintain full employment and, along with this, a positive wage dynamic in real terms. Bonds finally provide attractive yields for savers. The stock market has corrected from the tech bubble and the traditional side is extremely attractive and will gradually appreciate again in the not too distant future. This tells us that consumption will be robust in 2023, recovering from 2022. 3) Corporate profits will nominally benefit from inflation, absorbing any inevitable pressures during a rate adjustment phase. In addition, many industries, such as finance, armaments, fossil fuels, and everything related to infrastructure and energy transition, will grow in the next 12 to 24 months. 4) There has been a shift in the US from an attitude of complacency towards inflation to one of strong fear. So much so that by now there is no longer talk of recession but of stagflation, something not seen for 40 years, in completely different environments (Volcker at the FED and Ronald Reagan in the White House). Today, however, inflation is coming down and gradually in the coming weeks and months we will begin to see it in the numbers. The fall in commodities prices these days and the gradual unwinding of the supply chain will contribute to this. The overstocking created precisely to address these problems in the supply chain will lead to substantial discount campaigns. The rate hike cycle will be powerful but entirely manageable, and we believe that the Fed’s current expectations of 3.8% for 2023 will not be revised upwards but may even be tweaked slightly downwards in the not-too-distant future (3.4% at the end of 2022).
Jamie Dimon, CEO of the world’s largest bank and a keen observer who rarely says a word out of place, said a few weeks ago that he sees a storm coming. He doesn’t know if it will be big or small and the repercussions it will have, but he sees it coming. Where does this prophecy come from? Much of it has to do with the speed with which the Fed has decided to raise rates (from the current 1.75 per cent to 3.4 per cent at the end of 2022 and 3.8 per cent at the end of 2023) and the QT (quantitative tightening, i.e. the failure to reinvest the 9 trillion bonds held by the Fed as they mature) that has just begun in the US. This inevitably takes a lot of liquidity off the table in a short time. So some of the money earmarked for real estate or equity investments will inevitably end up buying bonds at (apparently) attractive yields, breaking the legs of speculation and in the short term depressing the real estate and equity markets. Moreover, the market anticipates the enormous volatility that these events can create. Indeed, the consequences of these manoeuvres are always difficult to define, particularly after the events of 2019, the last time the FED initiated a QT. At that time, bank reserves collapsed and REPO rates skyrocketed. So we think it is normal that there is some apprehension on the part of the banking system. However, today the banking system is better prepared (and Dimon himself states in the same interview that the banks are solid and ready) and the Fed has better control of the situation with adequate set ups to avoid a repeat of past tensions.
Elon Musk says he is super negative on the economy and will reduce the workforce by 10k. What entrepreneur isn’t, after the recent market crash and rate hike? Indeed, the US is in recession. However, let’s remember that Tesla has been hiring like crazy and it is right to take advantage of fears about the economy to lay off less useful workers in less efficient locations. Let’s remember that 10k laid-off workers is equivalent to less than a third of Tesla’s net hiring in 2021.
Meanwhile Warren Buffet has since the beginning of the year bought some USD 60 bln in stocks, including Paramount, Citigroup and Chevron.
In an article in the NYT over the weekend Paul Krugman (Wonking out: taking the flation out of stagflation) anticipates that, following the latest economic data, the Fed may soon revise the rate hike rate downwards.
The Economist seeks to respond to the hysteria of those who see a ‘Volcker moment’ today, i.e. the need to raise rates enormously to prevent inflation from entering people’s minds. The British weekly rightly points out that by the time Volcker intervened harshly on rates, throwing the country into recession, inflation had been rampant in the US for ten years. Today we are a long way from considering inflation or super inflation a companion.
Finally, Lawrence Summer, in an interview over the weekend, revises downwards his expectations on inflation (he was one of the first in 2021 to anticipate an inflationary wave and to oppose the Biden tax plan) and on raising rates, in light of the slowdown of the US economy in the first two quarters of the year.
To be balanced, we also report two interesting, slightly less recent and very negative podcasts by Greg Jensen, Co-CIO of Bridgewater. He expects prolonged stagflation in the US and believes inflation will remain out of control here for a long time. However, the thesis is not properly substantiated in our view. He advises investing in cheap assets that produce cash flow (with which we can only agree) and can benefit from inflation while advising to stay away from technology (still agree). He also advises diversifying away from the US, which they believe is priced for perfection, and investing in the rest of the world (also agree). He’s also negative on Europe where he sees an even heavier recession than he sees in the US (which as mentioned we don’t see but, even if we did, it’s already priced in anyway). Here Bridgewater has shorted 27 stocks in the Eurostoxx50 for around USD 15 bln (including many cheap stocks that produce a lot of cash flow). On the other hand, they have been very positive on China for some time and continue to be so even after the big losses and recent geopolitical events. On the dollar, they are negative and anticipate a long bear market as soon as the Fed approaches the end of its bullish cycle. They remain extremely negative on corporate bonds. In general, our opinion is that they see a delicate phase in the markets, with volatility and radical changes and they are betting on a few crashes, ready as always to cover quickly if they are wrong. In short, they are trying, but let’s remember that they are not the only ones and there is a lot of shorting in the markets today that will have to be covered sooner or later. Here are the links: Bridgewater Co-CIO Jensen on Investing Outlook – YouTube Bridgewater Co-CIO Jensen on Markets, BOJ Policy, Dollar – YouTube.
In Europe, many of the themes presented for the US market apply. With a few distinctions: 1) The European economy does not benefit but is hurt by the current price of hydrocarbons. 2) The risk premium associated with the Ukrainian conflict is significantly higher in Europe than in the US (and, at the same time, the end of the conflict will benefit stocks in this region much more significantly). 3) Inflationary pressures are lower in Europe as fiscal stimulus has been spread out more thinly than in the US. Future fiscal stimulus will continue to support the economy and the labour market in the second half of 2022 and in 2023. 4) In Europe there is less dependence of consumption on financial markets, which we believe will avoid a technical recession in 2022.
As in the US, we do not expect a recession in Europe in 2023 even in the event of a Russian gas cut. Talking to large German industrial companies, we do not perceive any particular fears. Clearly, forecasts are made to be proven wrong, and clearly the development of the war in Ukraine is decisive for the region. However, it is important to understand that the market now expects a recession in both Europe and the US in 2023. The large infrastructure investments, the post-covid reopening, the savings accumulated during the pandemic and a strong labour market are incompatible with a recession in our view, unless other new events occur. However, even if there were, it would have to be mild and is now more than priced in by the market, with cyclicals in many cases travelling at the levels of the March 2020 hole. We reiterate that now is the time to buy the much-hyped (and often overpriced) cyclicals in 2021 in view of the infrastructure revolution ahead and they are now trading at extremely low levels. Anticipation and diversification is essential. Below are Berenberg’s GDP growth forecasts for 2023 in May and June, which make it clear how the US rate hike and market downturn have distorted analysts’ perceptions. However, we believe the new forecasts are just as unreliable as the previous ones.
Financial Repression (THE GOOD)
We are living through a historic economic phase. Areas that, for various reasons, have suffered economic stagnation and deflation, such as Europe and Japan, are now about to embark on a journey that should return them to growth. It is an experiment, but there is so much at stake that all actors will make sure it succeeds.
From the post-war period until the late 1970s, much of the Western world reduced its war debt through so-called financial repression, i.e. through a level of interest rates slightly below inflation, achieved by banks buying up the debt themselves. Reducing debt in this way is politically more acceptable than raising taxes or reducing public services. The real rate of US short-term government bonds was negative from 1945 to 1980. Anyone who invested in British bonds between 1945 and 1960 would have lost over 1/3 of their purchasing power.
Actually, financial repression has been present in many areas since the great financial crisis of 2008, but as inflation was close to zero, the effects on debt reduction were insignificant. Now inflation has returned and, thanks to structural trends such as deglobalisation and the energy transition, it will not return completely. Through a constant inflation level, financial repression will bring its results. And it is the answer, the only possible answer for Japan and Europe. In a climate of financial repression, the creditor loses in real terms but the system in which it operates grows and develops, balancing these losses through gains on equity and real estate. In this context it will be appropriate to stay away from government bonds and invest in equities and real estate, and not only in inner-city residential but also in commercial and suburban areas, areas that lack of growth has often reduced to semi-abandoned dormitories. Restoring economic growth implies stimulating the demographic trend by accelerating the immigration process necessary to expand consumption and production.
In an editorial over the weekend Seth Carpenter, global chief economist at Morgan Stanley, says that given the rate forecasts released by the Fed Market Committee there is a willingness to accept higher-than-expected inflation for an extended period of time. The ECB seems even more in that camp. Japan is beyond that, continuing to monetise government debt and keeping rates at zero. When inflation finally kicks in vigorously in Japan as well, we would not be surprised if the debt held by the BOJ (about 35%) is wiped out, setting the stage for the last mighty leg of yen devaluation and the recovery of the Japanese economy.
Here is a link to an interesting podcast by Professor Russell Napier, where he talks about financial repression: Professor Russell Napier: The equity index fund is a dangerous product – YouTube
War (THE BAD)
Russia has captured the last city of Luhansk, one of the two regions that make up the Donbass, the area of the country that Putin promised to ‘liberate’. This represents a major victory for Putin, who needs to demonstrate his successes in order to balance heavy losses and growing internal discontent. At the same time, the new HIMARS mobile launching stations provided by the US to Ukraine are beginning to take effect, destroying Russian weapons depots and command centres with great precision. More will come in the coming weeks. Apparently, the war cannot end until the whole Donbass is in Russian hands. However, several commentators seem to indicate that Russia, after the last dramatic blow to conquer Luhansk, which brought huge losses to the army, is now finding it difficult to proceed further and, at the same time, keep control of the already conquered territories. Russian missiles fired haphazardly at the rest of Ukraine may indicate this. Anything can still happen. Russia may now have an interest in sitting down to negotiate, keeping part of the Donbass and releasing other territories. Ukraine will surely want to continue the war to retake occupied territories and demand damages. The Western world intends to penalise Russia and the Putin regime but, at the same time and without clearly admitting it, to avoid the risks of Russia using tactical nuclear weapons. So it will provide the necessary weapons to balance the forces on the field, nothing more. Today the consensus is for a very long war. And we believe this is indeed a possibility, already well digested by the market. However, we do not exclude that in the course of the next few weeks things may change. Ukraine’s fear of the launch of tactical nukes on Kiev may soften their stance. Indeed, Russia could use the recent Ukrainian missile attacks on depots on Russian territory to threaten missile repercussions on the capital and possibly the very use of tactical nukes. Against this the West has no weapons, not wanting under any circumstances to risk a nuclear war. As always, in the absence of a clear winner, both sides have a lot to lose in order to reach the negotiating table. We believe we are not far from that point.
Any news of opening negotiations would have a significant positive impact on world markets, especially European markets. It would also lead to lower gas and oil prices, easing inflationary fears.