Where Are We Headed?
This weekly is on the early side and I am wary of what Friday brings, especially as the debt ceiling saga gives rise to further bond market volatility.
In this week’s update – It’s all about the bond market. Is this a good time to be revisiting bonds? There is a growing argument to say yes, however, when we look deeper into the four components to inflation (Demand Driven + Supply Chains + Energy Consumption + Geopolitical Risk Premia), things may not be as straightforward as they may seem.
Continue reading for the full weekly update:
A question often asked is whether this is a good time to be revisiting Bonds? There is a growing body that says yes and the arguments supporting this are, on the surface, very compelling:
The Inflation conundrum has four components to it: Demand Driven + Supply Chains + Energy Consumption + Geopolitical Risk Premia. When you look at each in turn, things are not so straightforward:
even before Covid (2020) and Ukraine (2022) struck, demand was on the rise. There are many who overlook this fact. In fact, combined with the growing labour shortage (which was apparent even back then), We believed then – and still do – this presents the base case for at least a 1960s style inflation environment (4% to 6%) in the Advanced Economies (AEs) and not much less in Emerging Economies (EEs). The impact of the demographic time bomb was heavily underestimated as more and more people left the workplace to chance earlier retirement on the back of stellar, stock market returns. We never had it so good à low rates, low inflation, good growth, endless money printing, cheap money…It was a whole new culture, what could possibly go wrong and what could possibly change it?
Inflation matters – after all it burns a hole in one’s pocket. But interest rates matter more - because the latter defines cashflow stability. Any individual / corporate naturally wants to know what their cashflow is with as much certainty as possible. With inflation, consumers – and indeed companies – can try and shop around to mitigate against the impact of rising costs. We are not saying it’s a zero sum game. Of course, they feel the pinch - just look at rising food costs and the struggle that has led to, but there are ways to cut corners. Ultimately, you have control over how you spend it – unlike say, loan repayments. Helping to compensate against this are rising wages – even though they are not keeping pace with inflation. Food, as a share of household disposable income, is between 20% (AEs) and 50% (EEs). So even if your food bill goes up say +20%, it will sting you, but it won’t kill you. With interest rates, it’s a different story. Mortgages & rents take a huge bite. So when interest rates get out of hand, personal and corporate livelihoods are at stake thus putting assets (e.g. property) at risk. Remember the old saying “your home is at risk if you don’t keep up with the payments”?
We have often likened the start of the last 12 months to a 3,000 metre steeplechase race. It’s a 7.5 lap race, highly strategic and full of obstacles. You won’t win it by trying to lead from the outset. Instead, stay with the pacemaker (inflation). When the moment comes, that’s when the pacemaker runs out of steam and that’s when you make your move. That’s how this cycle will play out. We are almost one year in. Going into 2023, inflation will start to run out of steam and begin to fall back so, be patient and be positioned for it. This is of direct relevance when it comes to bonds as I will explain towards the end.
These are definitely improving. They are about two-thirds back to pre-covid levels and increasing numbers of companies are reporting reducing, wholesale prices. Bottlenecks are easing. A big driver of the recent fall in US CPI Inflation was down to used cars. Chip production is picking up again and getting through supply lines. Soon, new car prices may start to come down for the same reason. The relaxation of covid rules in China will have a significant impact for both the domestic and international economies. Eventually, this variable in the above equation will fade but there’s still another six months of clear up required.
There’s no denying it, Russia has been facing heavy defeats and embarrassment. The latest is its withdrawal from Kherson announced by the Russian defence minister and top military commander. Putin is in a bind amongst his key allies: China warned him against the use of nuclear weapons while India made it clear AEs are feeling “pain very acutely” re food and energy. US military estimates over 100,000 Russians have died or been wounded since February and a similar number for Ukrainians. All this helps to drive down risk premia by reducing the uncertainty around energy and food – the drivers of headline inflation. What Putin does next is a complete mystery.
There has been a great deal of euphoria around energy prices recently which have come off their highs. As mentioned above, this has helped headline inflation to slowdown. Despite Russia’s efforts to cut off its gas supplies, Europe has done a remarkable job in replenishing its gas storage. To date in 2022, Europe is further ahead than it has ever been vs previous years (2017 to 2021) – extraordinary when you consider they have lost their number one gas provider. It did have some luck along the way in the form of less Chinese competition for LNG due to its strict covid policies that limited loading at its ports. Europe has enough gas to get through the winter in the absence of a severe winter.
So good has been its success with gas storage, the front-end of the Dutch Title Transfer Facility (TTF) contract fell back to €100 per MWh from a peak of €300 MWh. This is where sensitivity to weather kicks in quickly. If a nasty cold streak arrives, this all changes. Europe’s big challenge is 2023 à it will have no Russian supply at all unless there is a major advancement on geopolitics. Furthermore, if China exits zero-covid, then its own demand will shoot up – and Russia is increasingly transitioning to Asia. In fact, one reason headline inflation has been constrained lately in Asia is because of the discounted oil Russia sells it.
The really big challenge arrives 5th December when the EU bans imports of Russian oil (and oil-related products). That equates to a loss of some 3mn to 4mn bpd of oil! Additionally, the US and Europe are still trying to convince those ex-G7 to cooperate with them on a price cap whereby Russian oil can still flow but at much cheaper prices. It’s debateable how successful this will be when it comes to implementation (e.g. what happens with intermediaries / third parties that transport Russian crude at or below the price cap). However, the ban itself on Russian oil look set to go ahead. The infrastructure is simply not there to cope. This all comes at a time when OPEC+ cut production 2mn bpd in early October (the actual cut is less) while the US keeps releasing oil from its SPR (Strategic Petroleum Reserve) in what seems to be a political move to ease gasoline prices ahead of the recent midterm elections. The US will need to top this up at some point soon – and we are talking hundreds of millions of barrels. There are two scenarios that could play out:
energy prices fall and this drives an increase in global GDP via consumption. Headline inflation will fall but core inflation remains elevated. Effectively, we head into a 1960s style inflation alluded to above.
energy prices rise substantially ($90 pb to $100 pb) and headline inflation starts to soar again causing a nasty recession à stagflationary.
The two scenarios we are facing are either 1960s style inflation (growth plus moderate inflation) or 1970s style inflation (subdued growth pus outsized inflation). A recent HL article compared bond yields as of 30th September: US 10y reached 3.85 (from 1.5% end 2021), UK 10y reached 4.15% (from 1.0%) and German 10y reached 2.1% (from -0.1%). These are big moves – since 30th September, these 10y bonds have strengthened (yields have fallen). Corporate bonds are yielding even more impressively. The S&P Global Developed Corporate Bond index yield reached 5.2% (from 1.8% end 2021) while the S&P $ HY Corporate Bond index reached 10.6% (from 6.1%). These yields are of course averages so beware of the dispersion within these indices. Dividend yields for the major indices ranged from about 2.46% (MSCI AC World) to 4.13% (MSCI UK).
So coming back to that 3,000 metre steeplechase race, do you buy bonds or stay out. It’s all about positioning! Buying them covers you for the first eventuality (“Putin gives in”) because you receive a decent compensation for inflation while the upside potential improves; in the event of the second (“Putin stands firm”), you stay closer to the pace-maker (inflation) and reduce your loss in real terms and wait patiently! In either case, we cannot predict what will happen. It is important to stay the course and position yourself effectively.