Lykeion https://www.alpha-week.com/ en Recession Risk Indicator: Yield Curve Or Inflation? https://www.alpha-week.com/recession-risk-indicator-yield-curve-or-inflation <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--title--features.html.twig x field--node--title.html.twig * field--node--features.html.twig * field--title.html.twig * field--string.html.twig * field.html.twig --> <!-- BEGIN OUTPUT from 'core/modules/node/templates/field--node--title.html.twig' --> <span>Recession Risk Indicator: Yield Curve Or Inflation?</span> <!-- END OUTPUT from 'core/modules/node/templates/field--node--title.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--field-image--features.html.twig * field--node--field-image.html.twig * field--node--features.html.twig * field--field-image.html.twig * field--image.html.twig x field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <div class="field field--name-field-image field--type-image field--label-hidden field__item"> <!-- THEME DEBUG --> <!-- THEME HOOK: 'image_formatter' --> <!-- BEGIN OUTPUT from 'core/modules/image/templates/image-formatter.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'image_style' --> <!-- BEGIN OUTPUT from 'core/modules/image/templates/image-style.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'image' --> <!-- BEGIN OUTPUT from 'core/modules/system/templates/image.html.twig' --> <img loading="lazy" src="/sites/default/files/styles/article_full/public/2022-03/Lykeion.png?itok=rwP6Ib5I" width="400" height="225" alt="Lykeion" typeof="foaf:Image" /> <!-- END OUTPUT from 'core/modules/system/templates/image.html.twig' --> <!-- END OUTPUT from 'core/modules/image/templates/image-style.html.twig' --> <!-- END OUTPUT from 'core/modules/image/templates/image-formatter.html.twig' --> </div> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--created--features.html.twig x field--node--created.html.twig * field--node--features.html.twig * field--created.html.twig * field--created.html.twig * field.html.twig --> <!-- BEGIN OUTPUT from 'core/modules/node/templates/field--node--created.html.twig' --> <span>Tue, 03/29/2022 - 14:32</span> <!-- END OUTPUT from 'core/modules/node/templates/field--node--created.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--body--features.html.twig * field--node--body.html.twig * field--node--features.html.twig * field--body.html.twig * field--text-with-summary.html.twig x field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <div class="field field--name-body field--type-text-with-summary field--label-hidden field__item"><h3><span><span><strong><span><span><span>The US Yield Curve</span></span></span></strong></span></span></h3> <p><span><span><span><span><span><span>Every recession over the last 40 years has been preceded by an inversion of the US yield curve (circled below). Therefore, when this portion of the yield curve approaches zero, alarm bells often start ringing, and media headlines about recession risk explode.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span><img alt="Lykeion" data-entity-type="file" data-entity-uuid="c1c5b83a-f1f4-449c-a5d8-e0b06c24c0dc" src="/sites/default/files/inline-images/Lykeion-2022-03-29-A.png" width="550" height="414" loading="lazy" /></span></span></span></span></span></span></p> <p> </p> <p><span><span><span><span><span><span>There are many yield curves to consider, but the most widely used ones tend to be the 5y10y and the 2y10y. The former has already inverted and the latter currently sits around 0.15% above zero (close to a potential inversion).</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>An inversion, however, is usually <strong><span>only the beginning</span></strong> of a lengthy countdown to a recession. Furthermore, whilst every recession has indeed been preceded by an inversion, not every inversion has preceded a recession (1997 – red arrow above).</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>The first instance of an inversion can take place from months to years in advance of a recession taking place. The sequencing is usually:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>The inversion begins, which is usually not particularly threatening to equity markets (1)</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>The inversion continues until it reaches its maximum (lowest) point, which is generally when stock markets also peak, give or take (2)</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>A re-steepening of the curve (2-Year Yields fall back below 10-Year yields), followed by a stock market sell-off (3)</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Somewhere between 6-9 months after, an economic recession begins (4)</span></span></span></span></span></span></span></li> </ul><p> </p> <p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="12f5a549-dca9-4285-98cb-894ffcb6dc40" src="/sites/default/files/inline-images/Lykeion-2022-03-29-B.png" width="550" height="407" loading="lazy" /></p> <p><span><span><span><span><span><span>An inversion is therefore a very poor <strong><span>timing tool</span></strong> for both recessionary events and peaks in the equity markets. And, as we all know, timing is incredibly important in the world of investing, as being “too early” is of no difference from being wrong.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>Remember: <strong><span>the prelude to a recession since the early 1980s has not been the yield curve inversion (there were a couple of small inversions not followed by a recession), but rather the re-steepening of the curve after a yield curve inversion.</span></strong></span></span></span></span></span></span></p> <p><span><span><span><span><span><span>This is largely down to the central bank’s reaction function:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>Over the last few decades, a typical boom-to-bust cycle has started with a pick-up in growth that allows central banks to raise rates.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>These higher rates track the higher growth until interest rates eventually reach a level where they start to hurt growth (the cost of capital exceeds the return on capital).</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>This is usually where the inversion begins taking place - higher short-term rates (driven by central banks) and lower long-term rates (reflecting the expectation of slower future growth) drive the inversion (short term yields higher than longer-term yields).</span></span></span></span></span></span></span></li> </ul><p><span><span><span><span><span><span>A consequence of these higher short-term rates slowing growth (and driving long term yields lower) is that, after a period of prolonged below-trend growth, central banks will begin to cut rates to get the economy back on track. This cut to rates drives short-dated yields lower at a faster pace than longer-dated yields, which steepens the curve (short-term yields moving back to lower than long-term yields), usually in advance of the economy entering recession (red arrows below highlight the re-steepening of the yield curve ahead of a recession).</span></span></span></span></span></span></p> <p><span><span><span><span><span><span><img alt="Lykeion" data-entity-type="file" data-entity-uuid="54095de5-611b-4abe-ba5c-b6044aa6f8f6" src="/sites/default/files/inline-images/Lykeion-2022-03-29-C.png" width="550" height="410" loading="lazy" /></span></span></span></span></span></span></p> <p> </p> <p><span><span><span><span><span><span>Ok, now you know what matters (re-steepening after the inversion) and why (central banks' reaction function slowing down growth).</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>So where are we currently in this process?</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>As of today, the yield curve has not even inverted, let alone re-steepened. Does that mean we are at least 6 months, if not further, from a potential recession? Maybe. On the face of it, other data points would suggest that no recession is imminent.</span></span></span></span></span></span></p> <h3 id="gmail-m_3551172550458321645financial-conditions-credit-spreads-and-the-consumer"><span><span><strong><span><span><span>Financial Conditions, Credit Spreads, and the Consumer</span></span></span></strong></span></span></h3> <p><span><span><span><span><span><span>Financial conditions are getting tighter, but they are still low (or loose) and a long way from the spikes of 2008 and 2020.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span><img alt="Lykeion" data-entity-type="file" data-entity-uuid="74947ef1-d429-41c0-af14-f77d5d0bb461" src="/sites/default/files/inline-images/Lykeion-2022-03-29-D.png" width="550" height="404" loading="lazy" /></span></span></span></span></span></span></p> <p> </p> <p><span><span><span><span><span><span>US corporate credit spreads (the difference between the yield on corporate bonds and government bonds) are widening (i.e. is getting larger), reflecting an increase in the perceived risk of default within the US corporate sector. But again, these wider credit spreads fall well short of 2020 and even the ‘2015 Profits Recession’ (the first time since 2009 that S&amp;P 500 profitability fell in back-to-back quarters).</span></span></span></span></span></span></p> <p><span><span><span><span><span><span><img alt="Lykeion" data-entity-type="file" data-entity-uuid="b9113df0-9053-4717-88ce-b9def7fd29f7" src="/sites/default/files/inline-images/Lykeion-2022-03-29-E.png" width="550" height="398" loading="lazy" /></span></span></span></span></span></span></p> <p> </p> <p><span><span><span><span><span><span>Spreads matter because credit is one of the main transmission mechanisms for the economy - credit growth helps to fuel economic growth (<a href="https://www.thelykeion.com/on-inflation-vs-deflation/"><span>up to a point</span></a>, according to Lacy Hunt).</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>A recession appears unlikely unless credit spreads significantly widen to the point where the cost of new credit becomes too expensive, causing credit-driven growth (which is most all growth) to slow. And whilst the credit market is not pricing in significant recession risks yet, we need to stress that, over the last decade, ending QE, beginning rate hikes, and rolling off the balance sheet would have taken four or five years – but this may now happen in a matter of months.</span></span></span></span></span></span></p> <p><span><span><span><strong><span><span><span>As such, credit spreads need to be monitored regularly.</span></span></span></strong></span></span></span></p> <p><span><span><span><span><span><span>Furthermore, most of the business surveys are also in expansion territory, with some showing renewed strength in recent weeks.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span><img alt="Lykeion" data-entity-type="file" data-entity-uuid="8f351cb3-fe83-4bca-9e13-e9cbe5ad170c" src="/sites/default/files/inline-images/Lykeion-2022-03-29-F.png" width="550" height="399" loading="lazy" /></span></span></span></span></span></span></p> <p> </p> <p><span><span><span><span><span><span>There is very little within the corporate sphere which suggests undue stress in the system or an imminent recession. Many data points within the consumer sector also appear to be robust. US unemployment rates are close to their pre-pandemic levels - although jobs are a lagging indicator and prone to significant revisions.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span><img alt="Lykeion" data-entity-type="file" data-entity-uuid="59acb03e-bb0d-47a9-a854-1b62cfab3ecb" src="/sites/default/files/inline-images/Lykeion-2022-03-29-G.png" width="550" height="396" loading="lazy" /></span></span></span></span></span></span></p> <p> </p> <p><span><span><span><span><span><span>The Conference Board Consumer Confidence Index (a monthly survey of consumer attitudes, spending plans, and expectations for inflation, stock prices, and interest rates) is also riding high. This indicator, however, has generally flowed with the performance of the equity market. This measure of consumer sentiment is really a coincident indicator of the stock market.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span><img alt="Lykeion" data-entity-type="file" data-entity-uuid="46e14619-60ed-4e62-9ff7-f0f7e96fc787" src="/sites/default/files/inline-images/Lykeion-2022-03-29-H.png" width="550" height="415" loading="lazy" /></span></span></span></span></span></span></p> <p> </p> <p><span><span><span><span><span><span>So, in summary, the yield curve and other economic indicators are sending a message that we’re months away from an equity market top, and further away from an economic recession.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span><img alt="Lykeion" data-entity-type="file" data-entity-uuid="f0a490ff-933a-43bf-8575-11ad4c9d3afc" src="/sites/default/files/inline-images/Lykeion-2022-03-29-I.png" width="550" height="253" loading="lazy" /></span></span></span></span></span></span></p> <p> </p> <p><span><span><span><span><span><span>But could it be that all of these indicators are late in flagging the real risk of a recession? And if so, why?</span></span></span></span></span></span></p> <h3 id="gmail-m_3551172550458321645inflation-could-be-the-leading-indicator-this-time"><span><span><strong><span><span><span>Inflation Could be the Leading Indicator This Time</span></span></span></strong></span></span></h3> <p><span><span><span><span><span><span>Whilst the above data is still not showing it, consumers are facing a significant headwind.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>Wages may be rising, but they are not rising as fast as inflation. <strong><span>Real disposable income growth has never been worse - this includes the 1970s era of higher inflation.</span></strong></span></span></span></span></span></span></p> <p><span><span><span><span><span><span><strong><span><img alt="Lykeion" data-entity-type="file" data-entity-uuid="dcc93156-5981-4e42-a276-b2e5fb490d74" src="/sites/default/files/inline-images/Lykeion-2022-03-29-J.png" width="550" height="398" loading="lazy" /></span></strong></span></span></span></span></span></span></p> <p> </p> <p><span><span><span><span><span><span>Price increases have been dramatic, with US CPI rising from zero to nearly 8% in a few months. Wages have not had time to adjust, and there is no guarantee that corporates will hurt their margins by raising wages any time soon.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>CPI is at its highest level in three decades, but, despite that, it still lags the rise in PPI (producer’s inflation, a proxy for the rise in cost of goods for businesses). These rises took place before the Russian invasion of Ukraine, meaning that the risks to PPI, and subsequently to CPI, despite already being at significantly high levels, remain to the upside (especially in Geopolitically sensitive areas like Oil and <a href="https://www.thelykeion.com/the-geopolitics-of-food/"><span>Food</span></a> prices).</span></span></span></span></span></span></p> <p><span><span><span><span><span><span><img alt="Lykeion" data-entity-type="file" data-entity-uuid="f7a1f167-a603-4b61-bfcc-2698e8e9a7de" src="/sites/default/files/inline-images/Lykeion-2022-03-29-K.png" width="550" height="381" loading="lazy" /></span></span></span></span></span></span></p> <p> </p> <p><span><span><span><span><span><span>Meanwhile, savings ratios are starting to fall below pre-pandemic levels, as consumers supplement their declining real wages with savings in order to be able to spend at the same rate as before.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span><img alt="Lykeion" data-entity-type="file" data-entity-uuid="1731b627-27ae-4a99-b192-0cb2a208d523" src="/sites/default/files/inline-images/Lykeion-2022-03-29-L.png" width="550" height="393" loading="lazy" /></span></span></span></span></span></span></p> <p> </p> <p><span><span><span><span><span><span>The consequence of this is that many consumers won’t be able to sustain the current level of demand – and in an economy like the US where 70% of the GDP comes from the consumer, <strong><span>this matters a lot.</span></strong></span></span></span></span></span></span></p> <p><span><span><span><strong><span><span><span>In fact, over the last 50 years, every time we had this level of inflation (or higher), the economy was about to enter or was already in a recession (except for the pandemic recession of 2020).</span></span></span></strong></span></span></span></p> <p> </p> <p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="c67c03c2-1849-4e21-b9f1-c47dc9434721" src="/sites/default/files/inline-images/Lykeion-2022-03-29-M.png" width="550" height="389" loading="lazy" /></p> <p><span><span><span><span><span><span>You don’t need peak inflation to enter a recession. Historically, inflation only peaks on the back of the slowdown it causes – i.e. it’s inflation’s impact on consumer demand that eventually starts a recession, and that same recession ends up slowing down inflation.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>One very important thing to flag is the difference between how the yield curve and inflation are currently moving, and what that implies for recession risk going forward.</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>Between 1980 and 2020, all inflation spikes (which were much lower than the current inflation spike) coincided with yield curves that were steepening (i.e. long-dated yields were moving higher at a faster pace than short term yields).</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>That happened because, whilst you had inflation, you had higher demand driving actual economic growth, which forced longer-term yields to move higher.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>During this period, it was the economy that led inflation higher, and that’s why higher inflation was followed by a steepening of the yield curve (red arrows in the chart below).</span></span></span></span></span></span></span></li> </ul><p><span><span><span><span><span><span>But the opposite of that is happening today - we have higher inflation and a flattening (almost inversion) of the yield curve (grey arrows below), more similar to what happened in the 1970s.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span><img alt="Lykeion" data-entity-type="file" data-entity-uuid="fe92080e-bf3d-46f9-a84f-1b5f4b27e216" src="/sites/default/files/inline-images/Lykeion-2022-03-29-N.png" width="550" height="435" loading="lazy" /></span></span></span></span></span></span></p> <p> </p> <p><span><span><span><span><span><span>Whilst the current period has many differences from the 1970s (there was a strong demographic backdrop and real wage growth), during the 1970s higher inflation was also destroying demand as it is doing today.</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>Side note: The 1970s was a period of structurally high inflation due to a combination of factors that included high rates of population growth, supply-side shocks in the energy markets, and inflexible labor markets which were able to command significant price increases (the US labor market was far more unionized in the 1970s than it is today).</span></span></span></span></span></span></span></li> </ul><p><span><span><span><span><span><span>The difference between the 1970s and now, versus the period in between (1980s to 2020) is that for the latter, economic growth caused inflation, whilst for the former inflation is curtailing economic growth.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>Why does this technical study matter?</span></span></span></span></span></span></p> <p><span><span><span><strong><span><span><span>Because if inflation today is demand destructive (like it was in the 1970s), then the yield curve sequencing we’re used to may actually be a lagging indicator – and we should instead use inflation as a recession risk indicator rather than anything else.</span></span></span></strong></span></span></span></p> <p><span><span><span><span><span><span><img alt="Lykeion" data-entity-type="file" data-entity-uuid="747baa86-4b2d-4918-bb5a-572fb1ca3526" src="/sites/default/files/inline-images/Lykeion-2022-03-29-O.png" width="550" height="374" loading="lazy" /></span></span></span></span></span></span></p> <p> </p> <h3 id="gmail-m_3551172550458321645lower-demand-is-the-only-antidote-to-higher-inflation"><span><span><strong><span><span><span>Lower Demand is the Only Antidote to Higher Inflation</span></span></span></strong></span></span></h3> <p><span><span><span><span><span><span>Central banks are now caught between a rock and a hard place:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>If they don’t tighten, prices will rise at a faster pace and destroy demand, which will likely capitulate the economy.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Even if they tighten, the impact on controlling inflation will likely be moderate as most of what we’ve seen has been driven by supply-chain issues (which central banks have little ability to solve).</span></span></span></span></span></span></span></li> </ul><p><span><span><span><span><span><span>Federal Reserve Chairman Powell has already hinted that interest rates may need to go up eight times this year. That would require a rate hike at every meeting in 2022 and at least one of them would need to be 50 basis points.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>This is a very different dynamic from all the hiking cycles of the last 30 years. Credit spreads, whilst still moderately low, are starting to widen and the high yield ETF is rolling over. On all the previous occasions, when this happened, the Fed was either in or went into easing mode.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span><img alt="Lykeion" data-entity-type="file" data-entity-uuid="2c011b73-3eb8-4aaa-9a15-8f86576a547c" src="/sites/default/files/inline-images/Lykeion-2022-03-29-P.png" width="550" height="424" loading="lazy" /></span></span></span></span></span></span></p> <p> </p> <p><span><span><span><span><span><span>Today, the Fed is withdrawing support at the exact moment it previously used to add liquidity to the market. The current environment is nothing like we have seen over the last few decades.</span></span></span></span></span></span></p> <p><span><span><span><strong><span><span><span>It is our opinion that there is very little the Fed can do to rein in inflation, and that the only thing that can slow higher prices is the capitulation of consumer demand </span></span></span></strong><span><span><span>(<em><span>end to the Russian invasion and an easing of supply chain bottlenecks would help as well…).</span></em></span></span></span></span></span></span></p> <p><span><span><span><span><span><span>Whether because of high inflation or because higher rates might drive a financial markets meltdown (meaning that companies might start firing people and households would suffer negative <a href="https://www.nber.org/digest/aug19/new-estimates-stock-market-wealth-effect#:~:text=The%20%22wealth%20effect%22%20is%20the,and%20stimulate%20the%20broader%20economy."><span>wealth effects</span></a>), lower consumer demand is the only real force that can slow down inflation.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>Until that happens, we need to understand that we’ve entered a new paradigm. The old sequencing of the yield curve may now be obsolete, and a real slowdown could be on the near horizon despite the yield curve being months away from flagging any serious risk.</span></span></span></span></span></span></p> <p><em><strong>Roger Hirst</strong> is Editor, Macro, at <strong><a href="https://www.thelykeion.com/">The Lykeion</a></strong></em></p> </div> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--field-tags--features.html.twig * field--node--field-tags.html.twig * field--node--features.html.twig * field--field-tags.html.twig * field--entity-reference.html.twig x field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <div class="field field--name-field-tags field--type-entity-reference field--label-hidden field__items"> <div class="field__item"><a href="/directory/lykeion" hreflang="en">Lykeion</a></div> </div> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <drupal-render-placeholder callback="flag.link_builder:build" arguments="0=node&amp;1=9262&amp;2=bookmark" token="cc6eWpCSIHZrXSXyjbk7FGXTXrNPgeql2f4KJ1OBauw"></drupal-render-placeholder> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--field-author--features.html.twig * field--node--field-author.html.twig * field--node--features.html.twig x field--field-author.html.twig * field--entity-reference.html.twig * field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field--field-author.html.twig' --> <a href="/author/roger-hirst" hreflang="en">Roger Hirst</a> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field--field-author.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--field-content-role--features.html.twig * field--node--field-content-role.html.twig * field--node--features.html.twig * field--field-content-role.html.twig * field--list-string.html.twig x field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <div class="field field--name-field-content-role field--type-list-string field--label-above"> <div class="field__label">Content role</div> <div class="field__item">Public</div> </div> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> Tue, 29 Mar 2022 13:32:07 +0000 AlphaWeek Staff 9262 at https://www.alpha-week.com The Case For Peak Hawkishness https://www.alpha-week.com/case-peak-hawkishness <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--title--features.html.twig x field--node--title.html.twig * field--node--features.html.twig * field--title.html.twig * field--string.html.twig * field.html.twig --> <!-- BEGIN OUTPUT from 'core/modules/node/templates/field--node--title.html.twig' --> <span>The Case For Peak Hawkishness</span> <!-- END OUTPUT from 'core/modules/node/templates/field--node--title.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--created--features.html.twig x field--node--created.html.twig * field--node--features.html.twig * field--created.html.twig * field--created.html.twig * field.html.twig --> <!-- BEGIN OUTPUT from 'core/modules/node/templates/field--node--created.html.twig' --> <span>Thu, 02/17/2022 - 12:37</span> <!-- END OUTPUT from 'core/modules/node/templates/field--node--created.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--body--features.html.twig * field--node--body.html.twig * field--node--features.html.twig * field--body.html.twig * field--text-with-summary.html.twig x field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <div class="field field--name-body field--type-text-with-summary field--label-hidden field__item"><p><em><strong>Partner Content provided by <a href="https://www.thelykeion.com/">The Lykeion</a></strong></em><a href="https://www.thelykeion.com/"> </a></p> <h3>The ECB’s Pivot</h3> <p>For a full year, Christine Lagarde, President of the European Central Bank (ECB), actively refused to engage in conversations about the path of future monetary policy, despite the looming specter of higher inflation across the region.</p> <p>That all changed in the first month of 2022 with her comments about the <strong><span>‘normalization of our monetary policy’. </span></strong>It wasn’t a full-scale pivot to hawkishness of the Powell type in the second half of 2021, but it was enough for forward-looking European funding rates (<a href="https://www.investopedia.com/terms/e/eonia.asp"><span>EONIA</span></a>) to explode higher.</p> <p><span><span><span><span><span><span>This led European yields to surge higher across all maturities. German 10-year (Bund) yields <a href="https://twitter.com/thelykeion/status/1493250205101305858?s=20&amp;t=WLkgea33XAa6LFw0znELRg"><span>moved into positive territory</span></a> for the first time since 2019.</span></span></span></span></span></span></p> <p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="c8bb86dd-3cda-4f0a-bcbc-5fca18f31124" src="/sites/default/files/inline-images/Lykeion-2022-02-17-A.png" width="550" height="382" loading="lazy" /></p> <p><span><span><span><span><span><span>For Europe, higher interest rates are a double-edged sword:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>Banks want higher yields to help improve their net interest margins (NIMs – the difference between what a bank receives and pays in interest) and therefore profitability, which in turn helps to pay down some of their debts.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>But, for many banks, their debts are so large that the gains in profitability are more than offset by the rise in financing costs implied by higher interest rates.</span></span></span></span></span></span></span></li> </ul><p><span><span><span><span><span><span>This is one reason why many investors think the ECB can never <em><span>meaningfully </span></em>raise interest rates, which also helps explain the surprise reaction at Lagarde’s sudden change of heart.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>European inflation is also not the same as US inflation. The primary driver of inflation in Europe has been energy prices (and food), but core inflation has stayed relatively low:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>European energy prices have fallen more than 50% from their highs, but remain elevated. Underinvestment in traditional energy sources and the geopolitical tensions around the Nord Stream 2 pipeline will persist, but prices may have already peaked. </span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="ecef9c01-9586-42c2-bc3c-159dacd48481" src="/sites/default/files/inline-images/Lykeion-2022-02-17-B.png" width="550" height="363" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>Independently of this, there is very little that higher rates can do to address this specific problem, and more broadly speaking, it’s our stance that rates will have a minimal effect on exogenous geopolitical or supply chain related inflation (as we’ve highlighted in a previous <a href="https://www.thelykeion.com/repricing-of-rates-var-socks-and-the-dollar/"><span>Markets Update</span></a>).</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>European wage inflation, on the other hand, has remained relatively low, at about 2%, even while US wage inflation, measured as average hourly earnings, has headed toward 6%.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="7512abed-b4c1-4f90-b0eb-0311efd9d3f2" src="/sites/default/files/inline-images/Lykeion-2022-02-17-C.png" width="550" height="376" loading="lazy" /></p> <p><span><span><span><span><span><span>Therefore, the ECB (and the markets) may have performed a premature repricing of rates, reacting hawkishly to forms of inflation over which they have no control (supply-chain driven), at a time when global growth may be about to falter, something Tim <a href="https://twitter.com/thelykeion/status/1488524790847524864?s=20&amp;t=WLkgea33XAa6LFw0znELRg"><span>has been tweeting</span></a> about over the last few months.</span></span></span></span></span></span></p> <h3 id="the-case-for-peak-hawkishness"><span><span><span><strong><span><span><span>The Case for Peak Hawkishness</span></span></span></strong></span></span></span></h3> <p><span><span><span><span><span><span>The data points keep pouring fuel on the fire:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>The US CPI print exceeded expectations in January, coming in at 7.5% versus 7.3%.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>German producer prices hit their highest level… ever.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="88578984-76e2-42fd-a9aa-9c6d73e26a13" src="/sites/default/files/inline-images/Lykeion-2022-02-17-D.png" width="550" height="374" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>US 10-year yields broke through 2% and Japanese 10-year yields reached their highest levels since 2016.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="223e95e0-5a6d-4f98-ab41-e58a27c7278c" src="/sites/default/files/inline-images/Lykeion-2022-02-17-E.png" width="550" height="370" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>After the US CPI print on February 10th, the Dec 2022 Fed Funds futures were implying US rates would be around 1.75% by year-end, which would entail <strong><span>6 more hikes from current levels. </span></strong><em><span>(Note: Fed Funds futures work the same as other futures contracts (oil, gold, etc.), where the market forecasts where the rate will be on a certain future date).</span></em></span></span></span></span></span></span></span></li> </ul><p><span><span><span><span><span><span>Sell-side analysts have been falling over each other to revise their rate forecasts higher. Everyone thinks that rates and yields can only go in one direction, right?</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>Not necessarily.</span></span></span></span></span></span></p> <p><span><span><span><strong><span><span><span>We could be entering a period of peak hawkishness, especially if inflation and economic growth start rolling over.</span></span></span></strong></span></span></span></p> <p><span><span><span><strong><span><span><span>Potential signs of peak inflation:</span></span></span></strong></span></span></span></p> <ul><li><span><span><span><span><span><span><span>Firstly, many of the year-on-year price comparisons from across the commodity complex will be falling in future months as higher comparative bases kick in.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Secondly, the pandemic surge in goods consumption has likely peaked and will probably subside as restrictions are lifted and consumers substitute goods spending (staying in) with services spending (going out).</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Andreas Steno Larsen in his ‘<a href="https://andreassteno.substack.com/"><span>Stenos Signals</span></a>’ newsletter highlights an additional accelerator of this dynamic. The US CPI basket has changed, with the weighting of stay-at-home items increasing at the expense of going-out items. Therefore, when the substitution effect of consuming services instead of goods kicks in, it will amplify the decline in inflation (falling prices on a larger component of the CPI basket).</span></span></span></span></span></span></span></li> </ul><p><span><span><span><span><span><span>To be clear, we’re talking about the rate of change of inflation, not the level. The new, higher level in costs of goods, are likely with us for good, but the rate of change is likely to slow over time. </span></span></span></span></span></span></p> <p><span><span><span><strong><span><span><span>Potential signs of peak economic growth:</span></span></span></strong></span></span></span></p> <ul><li><span><span><span><span><span><span><span>If a flatter yield curve (<em><span>flattening = </span></em>the difference between the long end and the short end of the yield curve is getting smaller) is a sign of a weakening economy, then the rates market is screaming “there’s a slowdown dead ahead”.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>The difference between 10-year and 2-year yields is 40 basis points. If it continues to trade lower, one needs to be reminded that a decline to zero or under (an inversion) has preceded all the recessions since 2000.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="268ed041-1573-4afa-b7ce-3549913126f3" src="/sites/default/files/inline-images/Lykeion-2022-02-17-F.png" width="550" height="376" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>If we really want to make the case for a yield curve inversion, we can find it in the 1-year forward version of the 5-year 30-year yield curve <em><span>(this is looking 1-year out at the market's view of the 30-year less the 5-year yield).</span></em></span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="aa4a3a2e-5cda-4c79-adca-812220a541a4" src="/sites/default/files/inline-images/Lykeion-2022-02-17-G.png" width="550" height="379" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>In full disclosure, there are so many different versions of the curve that we can almost always find a section that fits any narrative. But this forward curve has tended <em><span>to lead</span></em> the widely accepted 2-year versus 10-year yield curve, which has a great track record of inverting ahead of the last few recessions.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="346f546f-0379-4a2b-a5dd-cb789d6c622d" src="/sites/default/files/inline-images/Lykeion-2022-02-17-H.png" width="550" height="397" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>Besides yield curves, high energy prices are also a drag on growth and have coincided with three of the last four recessions (the outlier being the exogenous shock of COVID).</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="9e2fc0ae-a6f9-4f66-8105-67723ced1a61" src="/sites/default/files/inline-images/Lykeion-2022-02-17-I.png" width="550" height="385" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>Inflation (if it remains elevated) is a significant drag if there isn’t sufficient growth to offset it.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Related, whilst wages may be rising, real wages growth (adjusted for inflation) are still negative. This will be a drag on consumption.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Consumer sentiment today has fallen below where it was during the pandemic. The cost of large ticket items and the erosion of purchasing power is punishing the consumer.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="33ef3be5-6b1e-4eba-93d9-3c592be51ac5" src="/sites/default/files/inline-images/Lykeion-2022-02-17-J.png" width="550" height="379" loading="lazy" /></p> <ul><li><span><span><span><span><span><em><span><span>Tim’s Note: need another sign of peak economic growth? Ask Diego to send you some photos of his birthday bash last week at a Tuscan villa. We’re a bootstrapped startup and he somehow found a way to party like he was a member of the Medici clan for a weekend.</span></span></em></span></span></span></span></span></li> </ul><p><span><span><span><span><span><span>Ultimately, the key factor that leads us to believe that we may have reached peak policy is that almost everyone is now pricing higher inflation, higher growth and higher interest rates. This is <strong><span>THE </span></strong>narrative. It is what everyone expects. And what everyone expects, everyone rarely gets.</span></span></span></span></span></span></p> <p><span><span><span><em><span><span><span>Sometimes you gotta zig when everyone else zags.</span></span></span></em></span></span></span></p> <p><span><span><span><span><span><span>Consider this:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>If inflation is peaking and growth is rolling over, the Fed will be tightening into a slowing economy. Too much tightening will negatively impact risk assets <em><span>(which are our favorite kind of assets)</span></em>.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Slowing economies nearly always lead to lower levels of inflation.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>That double whammy will drive down growth and inflation, even though today’s inflation is more a problem of supply than demand, which interest rates have little ability to fix.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>The end of QE, counter-intuitively, has always led to periods of lower bond yields as the market moves ahead of Central Banks. QE is about to end in the US and, potentially, in Europe, so should we really be pricing in higher bond yields?</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="6540763e-fcc5-47bc-bf83-a110c4a3f604" src="/sites/default/files/inline-images/Lykeion-2022-02-17-K.png" width="550" height="377" loading="lazy" /></p> <p><span><span><span><strong><span><span><span>This is what peak policy hysteria looks like: pricing further economic growth, higher yields, and more inflation as we’re about to end QE and hike interest rates. We might see the market readjust itself to reflect this more </span></span></span></strong><em><strong><span><span><span>dovish</span></span></span></strong></em><strong><span><span><span> outlook soon.</span></span></span></strong></span></span></span></p> <p><em><strong>Roger Hirst</strong> is Editor, Macro, at <strong><a href="https://www.thelykeion.com/">The Lykeion</a></strong></em></p></div> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--field-tags--features.html.twig * field--node--field-tags.html.twig * field--node--features.html.twig * field--field-tags.html.twig * field--entity-reference.html.twig x field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <div class="field field--name-field-tags field--type-entity-reference field--label-hidden field__items"> <div class="field__item"><a href="/directory/lykeion" hreflang="en">Lykeion</a></div> </div> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <drupal-render-placeholder callback="flag.link_builder:build" arguments="0=node&amp;1=9175&amp;2=bookmark" token="493zV6_hV3mS8FDdbwok5i2qlK2fs76a9CCZ5RdqfBI"></drupal-render-placeholder> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--field-author--features.html.twig * field--node--field-author.html.twig * field--node--features.html.twig x field--field-author.html.twig * field--entity-reference.html.twig * field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field--field-author.html.twig' --> <a href="/author/roger-hirst" hreflang="en">Roger Hirst</a> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field--field-author.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--field-content-role--features.html.twig * field--node--field-content-role.html.twig * field--node--features.html.twig * field--field-content-role.html.twig * field--list-string.html.twig x field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <div class="field field--name-field-content-role field--type-list-string field--label-above"> <div class="field__label">Content role</div> <div class="field__item">Public</div> </div> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> Thu, 17 Feb 2022 12:37:11 +0000 AlphaWeek Staff 9175 at https://www.alpha-week.com Higher Rates, Peak Margins, And How We're Allocating https://www.alpha-week.com/higher-rates-peak-margins-and-how-were-allocating <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--title--features.html.twig x field--node--title.html.twig * field--node--features.html.twig * field--title.html.twig * field--string.html.twig * field.html.twig --> <!-- BEGIN OUTPUT from 'core/modules/node/templates/field--node--title.html.twig' --> <span>Higher Rates, Peak Margins, And How We&#039;re Allocating</span> <!-- END OUTPUT from 'core/modules/node/templates/field--node--title.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--created--features.html.twig x field--node--created.html.twig * field--node--features.html.twig * field--created.html.twig * field--created.html.twig * field.html.twig --> <!-- BEGIN OUTPUT from 'core/modules/node/templates/field--node--created.html.twig' --> <span>Tue, 01/25/2022 - 14:34</span> <!-- END OUTPUT from 'core/modules/node/templates/field--node--created.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--body--features.html.twig * field--node--body.html.twig * field--node--features.html.twig * field--body.html.twig * field--text-with-summary.html.twig x field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <div class="field field--name-body field--type-text-with-summary field--label-hidden field__item"><p><em><strong>Partner Content provided by <a href="https://www.thelykeion.com/">The Lykeion</a></strong></em></p> <h3><span><span><strong><span><span><span>Anyone Out There Panicking?</span></span></span></strong></span></span></h3> <p><span><span><span><span><span><span>During the first three weeks of the year, markets have seen their first meaningful correction since March 2020, after almost two years of a relentless surge higher.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>The carnage has been most prevalent in the meme stocks of the past 18 months, SPAC names, and broader Tech, with extreme moves in Netflix and Peloton dropping more than 20%, Bitcoin losing half of its value in a couple of months (<em><span>classic</span></em>) and the ARK Invest flagship fund now worth less than half its February 2021 value (<em><span>”Innovation isn’t linear” – Something Cathie Wood may say</span></em>).</span></span></span></span></span></span></p> <p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="8d4e651b-a1b9-4ea6-87b2-35093367859b" src="/sites/default/files/inline-images/Lykeion-2022-01-25-A.png" width="550" height="342" loading="lazy" /></p> <p><span><span><span><span><span><span>There’s a ton of anxiety in the market, and for good reason. The Fed’s hawkish stance (tapering QE and raising rates, effectively removing liquidity from the market), forced upon them in order to fight the highest inflation print in four decades, comes at a time when the economy is slowing (US Consumer Confidence is the lowest since 2008) and year-on-year comps are getting tougher.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>To our readers who haven’t spent the last decade living and breathing financial media, you may be wondering, “Why are liquidity and low interest rates so important?” Because, as noted by our friend Bobby Vedral, it allowed the S&amp;P 500 to close last year up 27% despite:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>COVID, PLFs and PCRs</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>European Nat Gas priced 250% higher than at the beginning of the year</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>China’s tech crackdown halving the value of Chinese Tech</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>SPAC ETFs down 40% and retail darlings down 20%</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>US Inflation reaching almost 7% whilst bond yields were less than a third of that</span></span></span></span></span></span></span></li> </ul><p><span><span><span><span><span><span>This is why the market reaction to this hawkish stance has, so far, been so dramatic (finance nerds are every bit as dramatic as the Kardashians – true story):</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>10-year bond yields have moved to the highest level since the beginning of COVID.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="9ddb6055-76d8-499e-a028-8f75bf44e4f8" src="/sites/default/files/inline-images/Lykeion-2022-01-25-B.png" width="550" height="367" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>The market is now expecting an extra 25 basis points rate hike versus Jan 1st, for a total of four hikes in 2022. For reference, in early Q4 2021, we were out there debating if there was going to be any hike at all.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="a3ba9d3e-a620-4143-a995-5cd737fe9b40" src="/sites/default/files/inline-images/Lykeion-2022-01-25-C.png" width="550" height="400" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>Whilst the stock market tends to be the slowest to react to changes in economic fundamentals, the downward move has begun and headlines about the Nasdaq 100 (which includes the mega cap tech stocks) dropping 10% and entering <em><span>correction</span></em> territory have exploded.</span></span></span></span></span></span></span></li> </ul><p><span><span><span><span><span><span>But how relevant is all of this, really? Let’s take a step back:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>Despite the move higher, yields continue to be depressed, and well within the 40-years range of lower highs and lower lows. Real yields, which take into account the level of inflation, continue to be negative, just slightly less so. This is not a sign of a <em><span>corrected </span></em>market.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="092cab39-c319-4f0d-884e-85693415cdce" src="/sites/default/files/inline-images/Lykeion-2022-01-25-D.png" width="550" height="372" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>Even if all four hikes where to materialize, this would mean that the top of the target range of Fed funds rates would still only be 1.25% - which, in historical terms, is very far away from being excessive, especially when we realize that the last time we saw this rate of inflation, the Fed’s base rate was significantly higher.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="398b71a1-3730-4a14-ab4b-b14609af4f73" src="/sites/default/files/inline-images/Lykeion-2022-01-25-E.png" width="550" height="388" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>As highlighted by Bloomberg’s John Authers, since the bottom in 2009, the NADSAQ 100 has registered 10 corrections of at least 10% and 2 bear markets of at least 20%, meaning that corrections seem to happen almost every year. But if you zoom out, these events are barely noticeable in the grand scheme of things, and one shouldn’t be overly dramatic about them (Damn Kardashians).</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="816ce5aa-25d3-4d79-8e7a-b8959ba7eae6" src="/sites/default/files/inline-images/Lykeion-2022-01-25-F.png" width="550" height="358" loading="lazy" /></p> <p><span><span><span><span><span><span>What all of this means, really, is that we’ve corrected very little still. Valuations are still through the roof, and there’s hell of a lot more downside in the market if the Fed chooses not to shy away from pushing a hawkish agenda (<em><span>Volcker would be so proud</span></em>). And whilst that’s a BIG IF (more on that later), we wonder: if we’d like to cry wolf, how big could the downside be? And what should we do, besides panic?</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>To answer that, we’ve outsourced investment strategy to Jeremy Grantham, founder of GMO (+$100 billion in AUM) and traditional value-oriented investor, who is of <a href="https://www.gmo.com/europe/research-library/let-the-wild-rumpus-begin/"><span>the opinion</span></a> that:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>In the US we are in “the fourth superbubble of the last hundred years” (the others were the US in 1929 and 2000, and Japan in 1989).</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>“Previous equity superbubbles had a series of distinct features that individually are rare and collectively are unique to these events. In each case, <strong><span>these shared characteristics [of superbubbles] have already occurred in this cycle</span></strong>”, meaning that the bear market should be imminent.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>We currently face the risk of “the largest potential markdown of perceived wealth in US history” - ($35 trillion, more than its annual GDP).</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>If history is of any guidance and if this is the start of the crash, given that all bubbles in equity markets over the last 100 years have reverted back to trend, the S&amp;P 500 could trend lower all the way down to 2,500 - <strong><span>40% decrease from current levels (and 48% since last peak), which would be enough to get in the top 3 of Bear Markets, and give Michael Lewis a couple of more stories to tell.</span></strong></span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="6d3ca40c-1f06-46b0-8e83-6113ecb6c741" src="/sites/default/files/inline-images/Lykeion-2022-01-25-G.png" width="550" height="371" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>Investors should avoid US equities and focus on non-US Value and alternative strategies (<em><span>no Tim, leveraged VIX trades do not fall into this bucket</span></em>). <em><span>[Tim’s Note: Jokes on you, I have no more money to throw away on the VIX. RIP BTC. Only oil can save me now.]</span></em></span></span></span></span></span></span></span></li> </ul><h3 id="three-things-to-keep-an-eye-out-for"><span><span><span><strong><span><span><span>Three Things to Keep an Eye Out For</span></span></span></strong></span></span></span></h3> <p><span><span><span><span><span><span>OK, alright, stay calm. First of all, Jeremy Grantham was born in 1938 – which means that (1) he has a hell of a lot of experience, most of which he turned into financial success, but (2) he could easily be catalogued by venture capitalists and ARK believers as one of those white-haired investment managers who <em><span>simply don’t get that this time might be different.</span></em></span></span></span></span></span></span></p> <p><span><span><span><span><span><span>In fact, they could argue that all those numbers highlighted above are indeed cool stats, but they’re not telling us anything really new. We’ve been hearing about the bursting of the <em><span>everything </span></em>bubble for years now… and had we listened, we’d missed one of the most spectacular and synchronized stock market rallies in the history of markets.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>So, as a way to avoid sensationalistic headlines, with the <a href="https://www.lynalden.com/january-2022-newsletter/"><span>inspiration</span></a> coming from the always mesmerizing Lyn Alden, here are the main questions we're asking ourselves before going out there with a party-pooper vibe.</span></span></span></span></span></span></p> <p><span><span><span><em><strong><span><span><span>Is the Fed going to increase interest rates to a level that will force a sustained market correction?</span></span></span></strong></em></span></span></span></p> <ul><li><span><span><span><span><span><span><span>Interest rates and market multiples have historically moved in opposite directions. Most of the growth in the US stock market of the past decade has mainly been explained by higher multiples (with the exception of a handful pandemic beneficiary high performers), so needless to say that higher rates are <em><span>no bueno.</span></em></span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="f53da03d-a64d-4161-91d7-ca8abddfb95e" src="/sites/default/files/inline-images/Lykeion-2022-01-25-H.png" width="550" height="385" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>What we need to remember is that a hawkish move requires a HUGE strength of character from Central Bankers in order to actually increase interest rates. They know that higher rates are going to tank the market, and that they will be subject to direct or indirect pressure from the top 10% of Americans who own 89% of the stock market and are therefore directly and disproportionately affected by the level and directional moves in rates.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>In fairness, this is not all Jerome Powell’s fault, but rather the group of Central Bankers that preceded him, and decided not to increase rates when it would have had a less severe market impact. This is precisely why Central Bankers have kept rates so low for so long (no one was really held accountable, and it was easier to kick the can down the road), and also why we’re still not convinced they’ll <strong><span>hike rates to levels that will cause a party-pooper scenario, despite the higher level of inflation (which will continue to be high, but probably not </span></strong><em><strong><span>this</span></strong></em><strong><span> high).</span></strong></span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Powell found himself in this position at the end of 2018, and he eventually backed down. We wonder: is inflation a force powerful enough to make him behave differently this time around? <em><span>(*Hans Zimmer music ensues).</span></em></span></span></span></span></span></span></span></li> </ul><p><span><span><span><em><strong><span><span><span>Have the dynamics around passive investing changed?</span></span></span></strong></em></span></span></span></p> <ul><li><span><span><span><span><span><span><span>Nope. Passive products have been the most important and consistent demand for US equities over the past decade, and whilst we may be approaching levels where passive alone can’t push the market higher, it sets a price-insensitive level of demand which will support markets, for better or worse, like an early 19th century catholic marriage.</span></span></span></span></span></span></span></li> </ul><p><span><span><span><em><strong><span><span><span>Where are corporate profits, and corporate profit margins, going?</span></span></span></strong></em></span></span></span></p> <ul><li><span><span><span><span><span><span><span>If we make the case that the market still cares somewhat about fundamentals, margins are likely <em><span>the</span></em> key variable to look at.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Taxation, amidst the growth of populist agendas, is one of the most significant areas of change. Effective corporate tax rates in the US have consistently come down over the last fifty years, from over 50% to 21%, and there’s plenty of popular arguments that politicians can make to see this going higher, especially after the explosion of corporate profits post COVID (after a decade of going nowhere), little of which has been shared with labour and instead leading to margin expansion (S&amp;P 500 profit margin is now close to 13%, the highest ever).</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="ff65d2bb-d209-42b1-84a5-b66b6a2c4644" src="/sites/default/files/inline-images/Lykeion-2022-01-25-I.png" width="550" height="374" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>Additionally, (1) many industries aren’t able to pass higher raw materials and labor costs onto the consumer (hits corporate margins); (2) if they’re able to pass it on, it leads to lower demand for most companies (hits revenue), unless they're selling virtue-signaling products (<em><span>egos &gt; inflation</span></em>).</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>In summary, higher taxes and a continuation of supply chain issues might lead to lower profits, which would mechanically lead to lower stock prices, unless the market continues paying higher multiples. After the past decade, that’s far from impossible.</span></span></span></span></span></span></span></li> </ul><h3 id="what-we%E2%80%99ll-focus-on-in-2022"><span><span><span><strong><span><span><span>What We’ll Focus On in 2022</span></span></span></strong></span></span></span></h3> <p><span><span><span><span><span><span>We’ll avoid digressing too much on the rationale for each of these bullet points below (more on that in future pieces), but for 2022 we broadly think that:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>The risk of being exposed to the liquidity trade (long bonds, tech, private equity, ESG, most of crypto) given peak profit margins and hawkish environment is now significantly higher, and we might want to hedge our exposure or take some profits where we can.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Real Assets continue to be our preferred theme: from commodities to real estate (selectively, and <em><span>hopefully near a surfable beach</span></em>) and some buckets of equities (significant preference for value over growth simply because it allows us to sleep at night, and we really like to sleep). This is a multi-year theme that will continue to play out.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>You know our <a href="https://www.thelykeion.com/bitcoin-in-2021/"><span>view on Bitcoin</span></a>, and broadly think that we should (1) only allocate money that, if we lose it, it won’t change our life (2) only think about taking profits when Tom Brady retires, or Tim stops trying to be a surfer.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>After the beating last year, Emerging Markets might bring some positive upside, especially if the US Dollar softens – but we need to know what we’re investing in, and that also includes an awareness of the local rule of law and of the “<em><span>in between the line</span></em>s” shenanigans of politics.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>We're avoiding leverage <em><span>(please Tim, please) </span></em>and bonds, we're being strategic about cash amidst an inflationary environment, and definitely avoiding being a <em><span>protocol picker</span></em> in the world of crypto – we either make it our full-time job or we won't try to play God in a world of atheists <em><span>(we might have been reading too much Nietzsche)</span></em>.</span></span></span></span></span></span></span></li> </ul><p><em><strong>Diego Tremiterra</strong> is Co-Founder and Editor In Chief at <strong><a href="https://www.thelykeion.com/">The Lykeion</a></strong></em></p></div> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--field-tags--features.html.twig * field--node--field-tags.html.twig * field--node--features.html.twig * field--field-tags.html.twig * field--entity-reference.html.twig x field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <div class="field field--name-field-tags field--type-entity-reference field--label-hidden field__items"> <div class="field__item"><a href="/directory/lykeion" hreflang="en">Lykeion</a></div> </div> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <drupal-render-placeholder callback="flag.link_builder:build" arguments="0=node&amp;1=9116&amp;2=bookmark" token="pQondL30mxB_2S9xzGNpwmE_g_T4WsFDd7NZIkfzFSY"></drupal-render-placeholder> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--field-author--features.html.twig * field--node--field-author.html.twig * field--node--features.html.twig x field--field-author.html.twig * field--entity-reference.html.twig * field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field--field-author.html.twig' --> <a href="/author/diego-tremiterra" hreflang="en">Diego Tremiterra</a> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field--field-author.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--field-content-role--features.html.twig * field--node--field-content-role.html.twig * field--node--features.html.twig * field--field-content-role.html.twig * field--list-string.html.twig x field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <div class="field field--name-field-content-role field--type-list-string field--label-above"> <div class="field__label">Content role</div> <div class="field__item">Public</div> </div> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> Tue, 25 Jan 2022 14:34:27 +0000 AlphaWeek Staff 9116 at https://www.alpha-week.com The US Dollar In 2022: Cautiously Bullish https://www.alpha-week.com/us-dollar-2022-cautiously-bullish <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--title--features.html.twig x field--node--title.html.twig * field--node--features.html.twig * field--title.html.twig * field--string.html.twig * field.html.twig --> <!-- BEGIN OUTPUT from 'core/modules/node/templates/field--node--title.html.twig' --> <span>The US Dollar In 2022: Cautiously Bullish</span> <!-- END OUTPUT from 'core/modules/node/templates/field--node--title.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--created--features.html.twig x field--node--created.html.twig * field--node--features.html.twig * field--created.html.twig * field--created.html.twig * field.html.twig --> <!-- BEGIN OUTPUT from 'core/modules/node/templates/field--node--created.html.twig' --> <span>Mon, 01/10/2022 - 12:14</span> <!-- END OUTPUT from 'core/modules/node/templates/field--node--created.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--body--features.html.twig * field--node--body.html.twig * field--node--features.html.twig * field--body.html.twig * field--text-with-summary.html.twig x field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <div class="field field--name-body field--type-text-with-summary field--label-hidden field__item"><p><em><strong>Partner Content provided by <a href="https://www.thelykeion.com/">The Lykeion</a></strong></em></p> <p><span><span><span><span><span><span>At the end of 2020, there was an overwhelming consensus for the US dollar to decline in 2021. The Dollar Index (DXY) however, gained over 7% since its low in early January.</span></span></span></span></span></span></p> <p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="e574276f-feaa-4ebd-9e10-b457fa26e1ef" src="/sites/default/files/inline-images/Lykeion-2022-01-10-A.png" width="550" height="362" loading="lazy" /></p> <p><span><span><span><span><span><span>The bearish consensus view at the end of last year was built upon two major expectations for 2021:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>The US twin deficits (government budget deficit and trade deficit) would undermine the US dollar, and</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>The reflation trade (fueled by government stimulus) would support coordinated global economic growth.</span></span></span></span></span></span></span></li> </ul><p><span><span><span><strong><span><span><span>Twin Deficit: </span></span></span></strong><span><span><span>The bear case of the ‘twin deficit’, where additional debt issuance (from the government) and money printing (from Central Banks) would lead to a continued loss of confidence in the US dollar versus other major currency blocks, has been made for many years, but even more so in 2021 given the size of the pandemic-related fiscal and monetary support.</span></span></span></span></span></span></p> <p><span><span><span><strong><span><span><span>Reflation: </span></span></span></strong><span><span><span>At the end of 2020, the <a href="https://www.thelykeion.com/reflationary-expectations/"><span>reflation</span></a> trade was a major argument in favor of dollar weakness as, over the previous 20 years, similar economic environments saw (1) emerging market equities outperform, (2) the US dollar underperform, and (3) commodities rise (most notably during the period of China growth from 2002 to 2010).</span></span></span></span></span></span></p> <p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="1f65c6f4-1df0-4177-b23c-95d6198de43a" src="/sites/default/files/inline-images/Lykeion-2022-01-10-B.png" width="550" height="392" loading="lazy" /></p> <p><span><span><span><span><span><span>In November 2020, two events supported the reflation narrative:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>Biden’s US Election victory, which was expected to spark a wave of loose fiscal policy (government spending) and an equally accommodative Fed.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>The announcement and rollout of vaccines, which was expected to re-open the global economy, with the rebound expected to be more prominent in Emerging Markets.</span></span></span></span></span></span></span></li> </ul><p><span><span><span><span><span><span>At the end of 2020, the reflation trade appeared to be in full swing. Commodity prices were soaring, the DXY was on its way to a loss of over 10%, and bullish sentiment on EM stocks was a consensus trade for 2021 (according to the Bank of America Fund Manager Survey).</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>Why did the consensus for dollar weakness in 2021 turn out to be wrong? It was largely due to:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>Global economic growth was not as synchronized as anticipated to create true reflation (countries staggered their reopening as opposed to altogether)</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Inflation</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Consensus in positioning</span></span></span></span></span></span></span></li> </ul><h3 id="2021-staggered-economic-growth"><span><span><span><strong><span><span><span>2021: Staggered Economic Growth</span></span></span></strong></span></span></span></h3> <p><span><span><span><span><span><span>Recurring strains of COVID, supply chain bottlenecks, and divergent policy meant that global growth was insufficiently synchronized in 2021 to create true reflation. Emerging Markets stocks underperformed, whilst the DXY rebounded off the lows. Commodities did rise, but this was the red herring of inflation from bottlenecks, not economic growth.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>This uneven pace of global growth was generated by a divergent policy response in both style and sequencing. Let’s look at two of the most important engines of global growth: the US and China.</span></span></span></span></span></span></p> <p><span><span><span><strong><span><span><span>The US Fiscal Response</span></span></span></strong><span><span><span>:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>The US implemented demand-side policies that boosted the consumption of durable goods, helping the economy rebound at a faster pace than many global peers. This can be seen below, with US imports having recovered better than exports.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="2ffa7696-7bb7-46d1-b678-24c83dad0aeb" src="/sites/default/files/inline-images/Lykeion-2022-01-10-C.png" width="550" height="366" loading="lazy" /></p> <p><span><span><span><strong><span><span><span>China Rebalances:</span></span></span></strong></span></span></span></p> <ul><li><span><span><span><span><span><span><span>China was one of the first nations to recover from the pandemic, using supply-side policies in 2020 that focused on maintaining factory production, rather than demand-side policies to support household consumption.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>During 2021, China implemented strategies such as '<a href="https://www.reuters.com/world/china/what-is-chinas-common-prosperity-drive-why-does-it-matter-2021-09-02/"><span>Common Prosperity</span></a>', to help rebalance the economy away from leverage and inequality. This redirection would impact other export nations (such as Emerging Markets) whose growth models had historically benefitted from Chinese demand.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>The consequential impact of this can be seen in emerging market currencies, which have severely lagged the DXY (a basket of global currencies vs the US dollar and heavily weighted by the Euro). By the end of 2021, the JP Morgan EM Currency Index had made a new ten-year low.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="50882897-a314-45bb-ac63-92cbbe83c037" src="/sites/default/files/inline-images/Lykeion-2022-01-10-D.png" width="550" height="373" loading="lazy" /></p> <h3 id="2021-inflation-not-reflation"><span><span><span><strong><span><span><span>2021: Inflation (not Reflation)</span></span></span></strong></span></span></span></h3> <p><span><span><span><span><span><span>The combination of loose fiscal policy and higher inflation was expected to undermine global real yields, especially in the US (which would have led to a lower US dollar). But:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>Although US inflation has soared, it has been exceeded in many other regions. Spanish Producer Price Inflation (PPI) is at its highest level, 31.9%. <em><span>No Bueno.</span></em></span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="7f5eb50c-4509-4112-8284-d22313667d75" src="/sites/default/files/inline-images/Lykeion-2022-01-10-E.png" width="550" height="361" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>US real yields have collapsed, but that decline has been matched in other regions. Real yields on the German Government 10-year bond are at the same level as the US 10-year treasury. The decline in real yields has therefore not undermined the US Dollar on a relative basis.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="eb3fbb29-291f-41d2-b976-b9cd29db7a2a" src="/sites/default/files/inline-images/Lykeion-2022-01-10-F.png" width="550" height="394" loading="lazy" /></p> <p><span><span><span><span><span><span>Adding to this, the boost from fiscal policy, the switch out of services and into finished goods, and the inability of supply chains to cope led global commodity prices higher. Higher raw material prices meant different things for the US and elsewhere:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>For the US, this was both inflation and reflation (i.e. higher prices and economic growth).</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>For the rest of the world, this was inflation, not reflation - it lacked the accentuated economic growth profile of the US given that, without China's demand, there was very little real growth in other regions.</span></span></span></span></span></span></span></li> </ul><p><span><span><span><span><span><span>Within the US, companies were able to pass on higher prices and generate higher margins (consumers had extra cash that could absorb those higher prices, whilst companies focused on cost reductions), leading US corporate profits to surge during the pandemic after five years of going nowhere.</span></span></span></span></span></span></p> <p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="678775f5-9786-4205-85b3-f87e84358b96" src="/sites/default/files/inline-images/Lykeion-2022-01-10-G.png" width="550" height="363" loading="lazy" /></p> <p><span><span><span><span><span><span>Ironically, this allowed US stocks to remain attractive despite (or because of) the fiscal policy that many had expected to undermine the US dollar, <span>which led to a persistent bid for US equities and, consequently, US dollars.</span></span></span></span></span></span></span></p> <p><span><span><span><span><span><span>All in all, inflation in the US led to higher economic growth, and it had less of an impact on real yields, both of which helped the USD perform well in 2021.</span></span></span></span></span></span></p> <h3 id="2021-the-consensus-in-positioning"><span><span><span><strong><span><span><span>2021: The Consensus in Positioning</span></span></span></strong></span></span></span></h3> <p><span><span><span><span><span><span>At the beginning of 2021, the non-commercial (or speculative) longs in the Euro versus the US dollar were close to an all-time high (i.e. investors were very bearish on the US dollar). After the combination of Biden’s victory and the positive vaccine news, investors were anticipating the global reflation trade in 2021, buoyed by a strong performance from many commodities.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>The consensus of strategists was matched by a consensus in positioning (strategists and the market don’t always agree – on this occasion they did).</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>Historically, however, once the positioning (bear US dollar) begins to turn from an extreme, it tends to keep going for a while, with the Euro usually falling by 10% or more (which is what we saw at the beginning of 2021).</span></span></span></span></span></span></p> <p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="a3f23491-d941-4617-979c-c722279a17ee" src="/sites/default/files/inline-images/Lykeion-2022-01-10-H.png" width="550" height="389" loading="lazy" /></p> <p><span><span><span><span><span><span>Investors are far more constructive toward the dollar in 2022 but positioning is far more neutral than at the beginning of 2021.</span></span></span></span></span></span></p> <p><span><span><span><span><span><span>Can the dollar have a second consecutive year of gains? The key determinants for 2022 are similar to 2021:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>Divergent Fiscal and Monetary Policy</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Supply Chains Constraints</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Positioning and Technicals</span></span></span></span></span></span></span></li> </ul><h3 id="2022-divergent-policy"><span><span><span><strong><span><span><span>2022: Divergent Policy</span></span></span></strong></span></span></span></h3> <p><span><span><span><span><span><span>Going into 2021, Fiscal and Monetary Policies among different countries was fairly harmonized, but the turn into 2022 presents a different landscape.</span></span></span></span></span></span></p> <p><span><span><span><strong><span><span><span>High vs Low Yielders:</span></span></span></strong></span></span></span></p> <ul><li><span><span><span><span><span><span><span>Fed Chairman Powell, at the December FOMC, outlined a path of policy tightening via a faster pace of tapering bonds purchases and higher interest rates (the release of the minutes this week sparked a significant market sell-off). The US joins a group of countries who are, for now at least, in the tightening camp, where bonds also have attractive levels (in relative terms, let’s be clear) of yields for investors.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Other regions, such as the Eurozone, Switzerland, and Japan are expected to keep their policy on hold. In many cases, their policy rates and bond yields are already in negative territory, creating significant opportunities for additional divergence.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>There are signs, however, that tighter policy in the US may cap longer-dated bond yields by reducing the expectations for further inflation (tighter policy means increased yields on the short end and lower long term inflation expectations, capping the long end of the curve creating a “yield curve flattening" environment… <em><span>try to use this sentence as an ice breaker next time you’re in a bar and see what happens</span></em>). If that materializes, tighter policy may not be as supportive of the US dollar after all.</span></span></span></span></span></span></span></li> </ul><p><span><span><span><span><span><span>On balance, divergent policy should favor dollar strength, but it could also push longer-dated yields down to unattractive relative levels, capping the upside.</span></span></span></span></span></span></p> <p><span><span><span><strong><span><span><span>China:</span></span></span></strong></span></span></span></p> <ul><li><span><span><span><span><span><span><span>China is expected to maintain its policy of ‘Common Prosperity’ in 2022. China’s regulatory oversight in 2021 has impacted the performance of the tech sector, which in turn has an impact on broad-based emerging market indexes.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="2b7d11ae-4b95-41de-8864-031819660a55" src="/sites/default/files/inline-images/Lykeion-2022-01-10-I.png" width="550" height="388" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>China’s property sector, which is a large component of the Chinese economy (directly accounting for around 15% of GDP) is also under pressure with the issues around Evergrande having spread to other property developers <em><span>(though it should be firmly understood by now that Evergrande was NOT a Lehman moment… looking at you FinTwit extremists). </span></em>Policymakers will not want to lose control of the rebalancing process, especially if the US is embarking on a tightening cycle <em><span>(though <a href="https://twitter.com/thelykeion/status/1471524234480414728"><span>our survey</span></a> says they’re not… and our survey participants have never been wrong. Ever.).</span></em></span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>An easing of macroprudential policy in China could initiate a relief rally that helps broad-based EM equities perform better. This would be supportive of EM currencies versus the US Dollar. That’s not our base case though.</span></span></span></span></span></span></span></li> </ul><p><span><span><span><span><span><span>Current policy in China is negative for other EM currencies as the rebalancing tightens liquidity, and thus Chinese demand. It would require a change in policy stance to fundamentally change this.</span></span></span></span></span></span></p> <h3 id="2022-supply-chains-constraints"><span><span><span><strong><span><span><span>2022: Supply Chains Constraints</span></span></span></strong></span></span></span></h3> <ul><li><span><span><span><span><span><span><span>Supply chains remain impaired, leading Energy prices to soar across Europe.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="1f5bcd29-9039-4b6e-a53b-c189275a89ba" src="/sites/default/files/inline-images/Lykeion-2022-01-10-J.png" width="550" height="363" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>Higher commodity prices that reflect higher demand can be a positive for margins, but higher prices without a rise in demand will tend to erode margins. The US is not suffering from the same energy issues as Europe, nor is it seeing the same margin compression.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Supply chains should normalize <em><span>(though no one seems to have a reliable answer to ‘when?’), </span></em>and energy prices should recede, but Europe is currently a <a href="https://www.thelykeion.com/geopolitical-update/"><span>prisoner of geography</span></a> given its reliance on energy imports.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>Until these issues are resolved, European companies will either have to swallow these input costs (at the expense of margins) or pass the costs on (at the expense of demand).</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>That being said, energy demand in Europe during the winter is about as inelastic as insulin is for diabetics. So, we’d expect to see demand stay strong (i.e. so people don’t freeze), while European governments continue to subsidize energy costs. At least until the Spring.</span></span></span></span></span></span></span></li> </ul><p><span><span><span><span><span><span>Energy issues will, therefore, remain a drag on the outlook for the Euro, but they could be resolved in a short period of time. US corporates appear to have better pricing power for now.</span></span></span></span></span></span></p> <h3 id="2022-positioning-and-technicals"><span><span><span><strong><span><span><span>2022: Positioning and Technicals</span></span></span></strong></span></span></span></h3> <ul><li><span><span><span><span><span><span><span>Despite the strength in the US dollar over the last year, the DXY has merely returned to the middle of the six-year range.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="930f2f10-3f64-4d23-bcc5-634a582ecff0" src="/sites/default/files/inline-images/Lykeion-2022-01-10-K.png" width="550" height="347" loading="lazy" /></p> <ul><li><span><span><span><span><span><span><span>The dollar, in its broadest sense, is overbought today. Consensus has shifted from extreme bearishness to mild bullishness. This is reflected in positioning, which is less extreme, having recently reached a neutral speculative position.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>The DXY has also seen some major inflection points (higher and lower) through previous year-ends. Although this is a tiny sample size, it’s still worthy of a note.</span></span></span></span></span></span></span></li> </ul><p><img alt="Lykeion" data-entity-type="file" data-entity-uuid="2fcb4e77-c972-4291-974f-c547051cbd4c" src="/sites/default/files/inline-images/Lykeion-2022-01-10-L.png" width="550" height="347" loading="lazy" /></p> <p><span><span><span><span><span><span>The current rate of change in the dollar has also been relatively gradual when compared to 2014. A rapid move can accelerate the relationships between the dollar, emerging markets, and currencies.</span></span></span></span></span></span></p> <h3 id="wrapping-it-all-up"><span><span><span><strong><span><span><span>Wrapping it all up</span></span></span></strong></span></span></span></h3> <p><span><span><span><span><span><span>This all means that, for 2022, we would expect:</span></span></span></span></span></span></p> <ul><li><span><span><span><span><span><span><span>The dollar to rise against low-yielding currencies (Euro, Yen, and Swiss Franc).</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>In the absence of a policy U-turn in China, the dollar should do well against broad-based EM currencies.</span></span></span></span></span></span></span></li> <li><span><span><span><span><span><span><span>The dollar may struggle against commodity currencies (like the AUD), especially if those commodities are energy-related.</span></span></span></span></span></span></span></li> </ul><p><span><span><span><span><span><span>The expectation for a stronger USD in 2022 is in stark contrast to the bearish consensus for 2021. But the view today is not as extreme as it was at the end of 2020 given that positioning is now much more neutral. <em>Cautiously bullish</em>, that sums it up well.</span></span></span></span></span></span></p> <p><em><span><span><span><span><span><span><strong>Roger Hirst</strong> is Editor, Macro, at <strong><a href="https://www.thelykeion.com/">The Lykeion</a></strong></span></span></span></span></span></span></em></p></div> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--field-tags--features.html.twig * field--node--field-tags.html.twig * field--node--features.html.twig * field--field-tags.html.twig * field--entity-reference.html.twig x field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <div class="field field--name-field-tags field--type-entity-reference field--label-hidden field__items"> <div class="field__item"><a href="/directory/lykeion" hreflang="en">Lykeion</a></div> </div> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <drupal-render-placeholder callback="flag.link_builder:build" arguments="0=node&amp;1=9048&amp;2=bookmark" token="bF0JmCljLXn8qbvCgG_1kK7BsRgG_5LbgbFnI2sOuA8"></drupal-render-placeholder> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--field-author--features.html.twig * field--node--field-author.html.twig * field--node--features.html.twig x field--field-author.html.twig * field--entity-reference.html.twig * field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field--field-author.html.twig' --> <a href="/author/roger-hirst" hreflang="en">Roger Hirst</a> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field--field-author.html.twig' --> <!-- THEME DEBUG --> <!-- THEME HOOK: 'field' --> <!-- FILE NAME SUGGESTIONS: * field--node--field-content-role--features.html.twig * field--node--field-content-role.html.twig * field--node--features.html.twig * field--field-content-role.html.twig * field--list-string.html.twig x field.html.twig --> <!-- BEGIN OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> <div class="field field--name-field-content-role field--type-list-string field--label-above"> <div class="field__label">Content role</div> <div class="field__item">Public</div> </div> <!-- END OUTPUT from 'themes/gavias_vinor/templates/fields/field.html.twig' --> Mon, 10 Jan 2022 12:14:05 +0000 AlphaWeek Staff 9048 at https://www.alpha-week.com