Clients and Friends,
It’s been 4 months since my last update when I decided to break a pause on writing updates, mainly since I felt I wasn’t saying anything new. It’s no fun feeling like a broken record which anyone who has young kids understands (example: I have to tell my son 10 times in the morning to get his shoes on). Obviously, a lot has happened in the past few months as Russia invaded Ukraine. I want to keep this update focused on the following key points:
- what the freezing of ~$250B of Russian central bank assets means
- how globalization has lead to supply chain problems and inflation
- inflation in various forms (housing, wage growth, food, etc.)
- interest rates and the Fed
- market implications from all of the above
Russia’s Frozen Assets 🥶
Russia, like a lot of other countries, doesn’t keep all their money inside the country and their central bank had assets scattered in countries like Japan, France, Germany, etc. After sanctions were imposed, the Russian Central Bank (RCB) lost access to about half of their assets and were unable to prop up the Ruble which prompted it to fall to its worst level in two decades. The RCB has access to other assets, although a lot of it is in gold which isn’t easy to convert into fiat currency. There’s even talk that the confiscated/frozen funds should be given to Ukraine outright and/or to help them fight Russia.
I am not stating this is right or wrong but it does send a signal to other countries that your money isn’t safe if it’s not held within your borders. Now, Russia is viewed to have stepped way out of line and invaded a neighboring country out of fear over NATO, expanding their commodity reserves and potentially various other reasons. But the freezing of their central bank assets could lead to countries such as China to accumulate gold reserves vs. US assets such as treasury bonds. It’s possible that they (central banks and citizens of the world) start accumulating Bitcoin and other digital currencies as well as individuals in these sanctioned countries. Russia has restricted Rubles from leaving the country and digital currency is a way to obfuscate these rules. I don’t believe oligarchs can do this in a meaningful way as everything that happens is propagated to the blockchain and moving large sums of money raises red flags. If you’re an ordinary citizen though, the case for Bitcoin and other digital assets seems to be supported by these recent events.
Bottom line, these are events appear to be a tailwind for gold and digital assets.
Globalization
The trend of globalization and offshoring happened over the previous decades as countless industries and companies moved a high percentage of their production to countries where they benefited from cheap labor. It allowed those companies to increase profits while lowering the cost of goods for US consumers. The pandemic and war highlight the downside of this trend. Prior to COVID, we didn’t give much attention to the risks of China producing the majority of the world’s masks, or Taiwan producing most of the world’s semiconductors. But when a pandemic comes and disrupts our just-in-time supply chains, all of the efficiencies gained from a globalized economy turn into weaknesses, dependencies, and risks.
Just a few years later, we’re seeing similar knock-on effects as a result of the Russian invasion of Ukraine. Ukraine and Russia combine for about 30 percent of global wheat exports. The Ukrainian government banned the export of wheat and other food staples this week, to “meet the needs of the population in critical food products”. But it’s not just wheat. Fertilizer, phosphate, and potash are also key exports out of Russia, which they appear to have stopped exporting all of these things since invading Ukraine. Fertilizer has gone from $200/ton to $1,500/ton.
Thus many companies are seeking to bring production back on shore. This will be the theme of the coming years as companies choose reliability over the cheapest costs. One thing is clear though as BlackRock Inc. President Rob Kapito pointed out recently, “for the first time, this generation is going to go into a store and not be able to get what they want.”
Inflation
I’m not really sure where to start since there are so many ways to discuss inflation that we’re experiencing. Brevan Howard, the very large alternative asset manager is warning of a 1970’s style inflation shock as are other firms.
In their note, they highlight tight labor markets amongst other things. We are seeing wages increase finally for those in low wage jobs, although the gain in wages is likely fully or mostly offset by the rise in goods and services. We had a steep drop in job openings when the pandemic started and now everywhere I look companies have open positions and are trying to hire. If you’re unhappy with your job, I believe it’s one of the best times to find new work than I can recall since entering the job market in 2003. Just ask any recruiter.
Home price changes from a year ago (Jan ’21-Jan ’22) are up substantially across the US, but more-so in Phoenix, Tampa, Miami and Dallas. These areas saw an influx of people as the pandemic forced work from home and location became less relevant. Why be cooped up in NYC when you can be in Florida or Texas and reduce income taxes? If this were a Jim Cramer show I’d be hitting buttons and acting like a trained monkey. The supply of houses is dwindling coupled with low rates created a powder keg for prices. Anyone attempting to buy a house or who’s purchased one in the last year understands this.
Divergence of home prices relative to average hourly earnings has happened before and was a precursor to our last financial crisis. It’s entirely possible housing doesn’t create another crisis although when the markets are betting on 7-8 interest rate increases by the Fed into a slowing economy, it’s not far fetched to think some recent home buyers could find themselves upside and their equity eroded.
Oil prices have risen significantly as anyone who drives can tell you. For premium gas by my house, the prices range from $4.65-4.90 as of the last few weeks. Here in the US, crude stocks are below their 5 year average.
While our refinery utilization is at around 93%. Meaning, there’s only so much more we can produce in the near term.
Energy companies have underinvested in new wells for so many reasons that I won’t enumerate here. The point is turning on additional supply isn’t easy and takes time. If demand stays high and if Russian oil and gas get sanctioned (which is likely as soon as Europe can find new supplies), we could see energy prices rally even higher.
As we all know, correlation isn’t causation. It is hard to argue higher energy prices had nothing to do with the many recessions with which they are correlated, though. This chart makes the point clear. One reason to think this is more than coincidence is that severity correlates, too. The biggest oil spikes coincide with the worst recessions (1973, 1980, 2007) and are associated with the highest-jumping oil prices. But we’ve also seen recessions without oil spikes and oil spikes without recessions. So the connection isn’t perfect. As for now, there are good reasons to think recession was approaching anyway. If it happens, the war-induced oil surge may not be entirely to blame. But it will certainly have contributed.
Interest Rates and the FED
“I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come.” (and subprime is contained.)
—Ben Bernanke, March 2006
In hindsight, that was obviously a very foolish comment. On 4/1, the 10-2 rate went negative by .05% but is now hovering around flat to slightly positive. We know a negative yield curve as a harbinger of recessions. When taken alone, it’s an ominous signal. The previous oil spike chart coincides with this one however and should increase the probability that we may fall into a recession in the near future.
When an inversion does occur, it’s important to note that the time delay between an inversion and a recession tends to be anywhere between 12 and 24 months. Six months has been the shortest and 24 months has been the longest. We can only know after two negative quarters of GDP growth. Q1 2022 will likely report positive growth. Therefore, at best the official start date will be the end of Q3. It’s a look back thing so we have to do everything we can to look forward. The 2-year vs. 10-year spread is about the best we’ve got. Why does this matter? The reason is the market declines on average ~ 36% and waiting too long will be too late.
As of the time I’m writing this, the market is pricing in another 2.25% of interest rate increases, the most in one year since 1994.
Markets
I’m going to keep this short and sweet. Prudence wins right now in my opinion and not to be over-leveraged. This is where risk management matters. Interest rates are rising which is making fixed income investments less attractive if you’ve been holding them as prices fall when rates rise. However, there might be a time when bonds will compensate holders for the risk and all depends how high rates go. Now doesn’t feel like the right time to make that call though.
US equity markets are still very expensive on historical levels. I have concerns (as do others) that rising rates could impact both stock and bond portfolios. Stocks current high valuations rely on high profits margins, earnings growth and low interest rates; all of which are shifting in the “wrong” direction.
KKR has a proprietary earnings growth indicator which has been fairly predictive of actual earnings and shows earnings growth from June ’22-Dec ’23 declining and eventually becoming negative.
According to Factset, we are seeing negative EPS guidance increase while positive guidance has been falling. This confirms KKR’s view that earnings will likely decline.
In Conclusion
Jared: I’ll take Fed Mistakes for $1,000.
Jeopardy Host: This is what happens you print enough money that M2 spikes by over 20% while keeping interest rates at 0% for several years?
Jared buzzes in: What is inflation and asset price appreciation which forces the Fed to raise interest rates dramatically causing a recession and reversal of the asset appreciation it helped facilitate?
All I can say is be careful.
Best Regards,
Jared Toren
CEO & Founder
Most Used Sources: Edges & Odds, WSJ Daily Shot, 361 Capital, Steve Blumenthal’s On My Radar
