The Weekly Random Walk – July 31, 2023 From Stephen Colavito
An Aggregation of Various Economic, Market Research, and Data
Two Sides of The Coin
It’s good to be back.
If you say that two things are “two sides of the same coin,” you mean that they are different ways of looking at or dealing with the same situation. This “saying” keeps ringing in our heads regarding the Fed, economists, and markets.
More Sides to The Coin Than Just Two
We were in NYC last week and had multiple conversations with asset managers, traders, and market strategists. When we asked the question about their definition of liquidity, the answers were primarily different. A popular answer (or definition) in recent years has been the aggregate size of global central bank balance sheets, with the narrative that movements in equity prices are almost entirely “liquidity” driven. This view ignores the fact that markets had a nearly 25-year uninterrupted rally in the S&P from 1982-2007 without the Fed once conducting QE, that the channels through which this works are not defined, or that it ignores such traditional drivers as corporate profits, fiscal policy, or inflation. In any case, the divergence seen in all of 2023 between equity performance and this particular definition of liquidity should be a welcome development from a more fundamental standpoint.
But central bank liquidity isn’t the only one in the system. Higher equity markets and unlimited stimulus from DC also add to the system's liquidity. So, it comes as no surprise (in fact, we predicted it) that the Fed admits that liquidity is still a problem. Last week Chairman Powell in his press conference, finally admitted what we had known for months when he told journalists that “if financial conditions get looser, we {may} need to do more,” but said he “was confident interest rates were affecting economic activity and inflation.”
Even though liquidity is an issue, the committee hasn’t admitted to the depth of the problem. Since equity prices continue to go up and bond yields have come down since October of last year, this has made it easier for US companies to raise funds (for consumers with less than a 750 credit score, the story is different). The FT reported that higher capital markets had neutralized the impact of the Fed’s rate hiking cycle.
Sonal Desai, Chief Investment Officer for Franklin Templeton, said it best, “The reality is that financial conditions have loosened – we have [effectively] unwound roughly 450 basis points of rate hikes. Financial conditions are enough to take us back to March last year.”
So, the equity and bond markets' optimism may push the Fed to higher rates if inflation reaccelerates or stays well above target.
Negative Is A Positive That’s A Negative
So far, the seasonality in the VIX is holding true. Equity volatility has trended lower in July, with the VIX index remaining under 14 for most of the month. The lack of fear helps market momentum carry forward and indexes increase. Earnings have come slightly above consensus, but the CNN Fear & Greed Index remains in the “Extreme Greed” indicator.
However, there are two sides to the VIX coin, and If seasonal patterns hold, we should prepare ourselves for more volatility over the next three months. With real rates holding steady, stock valuations at expensive levels, and equity sentiment positive, it might take little to trigger higher realized and implied volatility.
To AI or Not To AI…That Is The Question
The number of companies mentioning AI in their earnings calls has doubled from 8.3% to 16.6% after ChatGPT was released in Q4 2022. While many segments of the economy are likely to be impacted by AI, the “Hyper-Scalars.” that provide the required computing power in the cloud for AI will inevitably see more demand for their products, and the market has reflected that with an average jump of 35% in their P/E ratios this year. However, it may take some time to impact earnings materially.
Don’t tell that to investors buying equities primarily on any announcement of AI.
Discounts, Dislocation, and Opportunity
Meeting with JP Morgan last week, we learned that primary and secondary alternative inflows have ballooned in recent years. Secondary markets have been rising, and the chart below shows where these secondary LP interests are selling relative to NAV. Current discounts are the largest since 2013, with venture trading at a whopping 32% discount and real estate changing hands at a 29% discount. Many private equity firms are raising “vulture” capital dedicated to the secondary market to take advantage of this dislocation.
Rates and Dollar Weakness
Even though the Fed raised rates by another 25 bps last week, the dollar continues to weaken. Over the last few weeks, the dollar has dropped by the most significant amount since March 2020, as the market has now priced in faster cuts in late 2023 or early 2024.
This is where the coin gets confusing. If the FX and Fed Futures market is correct, that would mean the economy is in a recession (not the soft landing theme we continue to hear) by the end of the year. But if liquidity continues to flow, how can the Fed lower rates? That could reaccelerate inflation which continues to be challenging to control.
We continue to believe those who think it will be rainbows and unicorns with the Fed navigating a soft landing into 2024 will be proven incorrect (not that we are hoping for that scenario).
Cloudy With A Chance of Thunderstorms
One of the best things about writing these updates is creating corny sayings, titles, etc. Trying to make an update flow isn’t the easiest thing to do. But we are not going to lie, like a “Dad joke,” I may not make you laugh, but we do, and I guess that’s all that matters.
A few weeks ago, we highlighted how the Biden administration had taken the Strategic Petroleum Reserve (SPR) down to levels not seen in 40 years and is now down to less than 19 days' supply. The Pentagon has warned the White House about these dangerous levels but has been ignored.
So now that the administration has little room to add supply, US retail gas prices are starting to climb again and have reached their highest level since November 2022. AAA says the average price has risen by 13.4 cents over the last few weeks.
Policy by the Biden administration has also impacted oil and gas infrastructure. Exxon Mobil had to shut down a gasoline unit at one of its largest refineries that desperately needed repairs. This refinery will be down for at least four weeks or longer. After the announcement, gasoline futures shot up more than 5% on the news. With various pipeline and infrastructure projects stopped by the administration, the US has no wiggle room.
So instead of soft-landing, many expect gas prices to reaccelerate as we anticipate; this would create some economic storm clouds as higher gas prices will likely push inflation higher. Looking at the chart below, wholesale futures prices are exploding– signaling that due to the implicit lag between wholesale distribution and retail pump prices, consumers may start putting those Biden stickers back on gas pumps and saying, “I did that.”
Disclaimer: We are not pro any party. We are just calling balls and strikes relative to policy. This has been something we have been critical of based on policy decisions.
Heads, Tails, Arms, and Legs
Our conversations this week within our Rolodex were interesting, particularly with trading desks. Several told us that asset managers had come to them to price out liquidity if/when they needed it. So even though the markets are going higher, those who lived through 2008-2009 (no one said we are going through that again) remember how liquidity shifted away from markets. Those with long portfolios wanted to understand internally what pricing would look like on a ¼ or ½ sale of the portfolio. This is an exercise in “find your trusted liquidity source” if/when you need it – but listening to those desks, it’s undoubtedly a yellow flag on how smart money feels about the market.
We listened to the entire press conference after last week's FOMC meeting. Nothing new on the Powell jargon front…” Dual mandate, inflation to 2% over time, full effects not yet felt,” blah, blah. Unless otherwise notified by data or earnings, it would appear the market continues to have the “green light” to grind higher. But per this report, there is never something for nothing and a flip side to a coin.
What may also help markets is that people are still feeling under-invested. This is typical as FOMO (fear of missing out) leads investors (mainly retail) to come in at high valuations. We admit that we didn’t see this rally coming (actually, after our trip to NYC, we feel better that we were not alone), but we would rather be safe than sorry. We will be careful investors and believe that valuations and fundamentals matter.
In a nutshell, we continue to issue caution with equity markets. We are no longer fading rallies, but any new allocations are based on harvesting. We have been allocating money to high-grade bonds, municipals, and treasuries. Anything north of 5% seems to be an opportunity as we believe it will provide investors a plus 2% real return. We continue to monitor the economy and markets to hopefully only had one side of a coin to worry about. Until then, we keep flipping.
Lastly, if you haven’t seen the movie Oppenheimer or read the book American Prometheus (by Kai Bird and Martin Sherwin) on which the film is based, do yourself a favor and go. After watching, if it doesn’t make you think about what is happening in our world (war & politics), you didn’t pay attention.
Trade and invest carefully.
Have a great week.
Stephen Colavito
Chief Investment Officer
San Blas Securities
stephen.colavito@sanblas-advisory.com
General Disclosures
This research is for San Blas Clients only. The opinions represented in this research are that of the CIO, not advisors or officers of San Blas Securities. This research is based on current public information that we consider reliable, but we need to represent it as accurate and complete, and it should not be relied on as such. The information, opinions, estimates, and forecasts contained herein are as of the date hereof and are subject to change without prior notification. We seek to update our research as appropriate. Some research can and will be published irregularly as appropriate in the analyst’s judgment.
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