Portfolio Construction Update

Summary

• Oil, stocks and gold all cannot rise without a corresponding rise in UST yields. The idea that inflation hedge and risk assets can be up but yields down is untenable.
• A rise in US yields and stronger USD short circuits emerging market economies especially those with USD currency boards who "import" UST yields or have significant USD denominated corporate debt.
• I have a long USD theme running through the portfolio and am net short/very risk-off but hold long positions in the versatile tanker sector.
• I am directly short through put options US tech, emerging market equities, precious metals, oil prices and producers, while being long tankers with call options.
• I am synthetically or thematically long US dollars and short US bonds.

Photo by kanawatvector/iStock via Getty Images

The last several years of monetary policy has been characterized by hawkish Federal Reserve rhetoric and subsequent tightening of financial conditions followed by the walking back and a return to loose conditions. For example, Bernanke 2013, Yellen 2016 and Powell 2019. The difference now is there is no policy space to walk back given the effective lower bound on the Federal Funds Rate and QE maxed out.

The 2021 rise in yields is not because of a hawkish Federal Reserve or projected rate hikes, which is a side show because the long end of the yield curve is of greater importance and less controlled by short run Fed policy. The rise in yields can be attributed to large US government Treasury issuance, improving US economic data, rising commodity prices, and tapering on the horizon. Rates are rising not because of a hawkish Fed, but despite a dovish Fed.

Source: Robin Brooks, IIF

Even though I believe US yields will climb, I fall very much into the dis-inflation camp more than any short-run inflationary outcome. The current environment reminds me very much of 2011 where hot, speculative money flew into the commodity sector and then commodity prices and inflation hedge assets later came down when the expected inflation from QE after the global financial crisis was not realized. I believe the main driver of a continued rise in UST nominal yields will be the real yield (driven by large issuance and strong US data), not the inflation expectation component.

The inflation crowd often points to rising input prices such as copper and lumber, but that is only on the cost-push side. The demand pull will likely continue to underwhelm and there are also global factors at play which I will cover below that have held inflation down for years and are unlikely to abate. I also will take the viewpoint that the speculative boom and future subsequent decline in currently ebullient commodity prices will pull down inflation figures as well.

Robin Brooks, IIF

The previous EM recovery after 2008 lasted three solid years due to China stimulus and a dovish Fed. It is fizzling much more quickly this time because of the "neutral" policy stance and push to control debt in China as well as rising US yields which the Fed is allowing calling it a reflection of improving US economic prospects and opting not to shift maturities of securities being purchased under the QE program or implementing a yield-curve control policy. This was all talked about frequently by market participants very recently and was expected by many. That ship has sailed.

Now the talk has moved to tapering, which is the opposite of any increased effort to hold yields down. Notice the lack of recovery in EM currencies as a sign of a weak global economy combined with a stronger euro that is deflationary for the export-oriented economies of Europe, a double negative. This strong euro, weak emerging market FX is exactly the wrong kind of US dollar weakness that the global economy needs.

Source: Robin Brooks, IIF.

As shown above, the recessions in emerging markets have been more severe and recoveries weaker than in the United States. This supports the US dollar against EM forex. China has been the bright spot in the EM complex but it is also a major risk and the headline data skews the strength of their recovery.

When analyzing the Chinese economy you have to look beneath the headline figures into the composition of the data. i.e. whether growth is demand driven or state-controlled supply driven - industrial SOEs vs. the new consumer economy. Fixed asset investment and industrial production versus retail sales. Growth for the sake of growth is not enough to prevent a hard landing of the Chinese economy in my opinion. The growth needs to be quality or the imbalances grow ever larger. The bank loans are mostly lent to the old industrial economy so there is an inherent NPL/corporate bond default problem in the consumer rebalancing thesis.

The boom in commodity prices, stronger PPI than CPI and fact that industrial production growth continues to outpace retail sales suggest China is still reliant on state-controlled supply side economics. The Chinese authorities can turn the factories on at will, but they cannot generate demand. According to Bloomberg:

“On a two-year average basis, which corrects for the huge drop seen last year as China introduced pandemic restrictions, retail sales growth was 3.2%, a sharp contrast with 8.1% growth in industrial output over the same period. Retail sales in February rose only 0.56% from the previous month, the data showed”

There is not a good option for China FX policy either. A stronger yuan cannot be tolerated because the reliance on net exports especially if other SE Asian currencies are depreciating. A weaker yuan creates USD corporate debt/bond issues. Employment and likewise consumption is strained either way. I expect China credit spreads to significantly widen here soon, that is, corporate yields up and sovereign down.

China is also bordering on deflation. The China producer price index at the highest level since July 2018 yet the CPI barely moves out of two months of deflation. This signals weak end-demand as Chinese businesses seem to be unable to pass on costs and lack pricing power leading to contracting margins.

Chinese bank assets are three times the size of the underlying economy approximately. This is a clear sign of over-leverage. Chinese NPLs are hovering around 2% though much of the non-performing debt is being deferred and there is widespread scrutiny the figure is understated. There is also an NPL amplifier effect in the sense a 5% NPL ratio for Chinese banks would mean 15% of the economy is non-performing debt because the oversized banking system.

To put this in perspective, in the United States in 2008 the banking system was still smaller relative to the economy and NPLs were at 7% approximately. This means though even at the worst moment in 2008 in the United States only around 5% of the economy was bad debt, a far cry from the potentially 15% in China.

The uncertainty regarding the potential for a Huarong debt restructuring also is an overhang for risk and is in my view a sign of larger credit stress in the Chinese financial system. The moral hazard problem for SOE bailouts trouble the Chinese authorities because bailouts encourage more risk-taking that the Chinese government wants to prevent, but they also don't want a financial crisis.

I really do believe China is teetering on an '08 type moment and I think they will get through it but not without a downturn in global risk assets, large scale printing of RMB and a banking system recapitalization where bad loans are absorbed by the PBOC.

Source: Zero hedge

Source: CEIC

Lastly, regarding China there seems to be a large unification of world leaders against Xi and the CCP relating to human rights issues and the Xinjiang province and Hong Kong. The Biden administration was also expected to be easier on China than Trump yet the tariffs remain and there is significant bipartisan support for a tough on China political stance. Anthony Blinken and Jake Sullivan are not doves on these issues.

The core problem is the US is recovering strongly while the global economy falters and this disengagement is the inherent problem because it significantly pressures EM FX and foreign USD debt. When local currencies depreciate against the USD, the real debt burden becomes larger.

Inflation is not really significant in the United States even though it is higher than in Japan and Europe. The latest core reading was 1.6% and headline was at 2.6%. I have two takes on this. One, this is factoring in large base effects on the year over year number from very weak Spring 2020 readings. Second, headline typically converges to core, not vice-versa.

Headline CPI, United States

Core CPI, United States

I fundamentally disagree with Federal Reserve policy right now as well. I think it is revolving around preventing or delaying the global downturn I am describing rather than pursuing a goal of price stability, maximum sustainable employment and what is best for the United States. The Fed is placing their “role” as the central bank of the world above their US congressional mandate. They need to keep their own house in order and not worry so much about EM in my opinion. At this pace a long-run Volcker-type recession, where high inflation rates cause an abrupt policy tightening in a few years will be unavoidable. I don't think that time is yet, but it is a plausible long run scenario.

The exorbitant privilege of the US is in its generally low inflation rate and I think this should be welcomed or a greater emphasis should be placed on general price stability rather than thinking a central bank can control inflation down to the basis point. Low inflation allows wide US trade and government deficits without weakening the currency. Brazil and many other emerging market economies are envious. I don’t know why the Federal Reserve wants inflation much higher. That would see the US trading more like an EM economy in the sense that it would put the Fed in the classic EM central bank bind. Tighten to defend the currency, lower import prices and fight inflation at the expense of growth and employment risking a recession. Or let the currency fall and inflation rise.

I wouldn’t rule this emerging market-like United States scenario out in several years but as for now I am steadfast long the USD, as I believe US nominal yields will outpace any rise in inflation expectations leading to a real yield advantage. The euro is also a much better funding currency for carry.

China has severe financial stability and government data credibility risks making a hard-landing not unlikely. Disinflation is deeply ingrained in Europe and Japan. And emerging markets are in the bind described above facing a choice between a growth or currency crisis. Oil supply is rising (OPEC+, Iran/Libya and US shale) and there is no imminent shortage.

Inflation in Europe and Japan are lagging the United States. Japan is not expected to reach its 2% goal until after 2024 with the Bank of Japan expecting 0.1% in 2021 and 0.8% in 2022. The Japan situation really discourages the idea of a short-run inflationary outcome.

Europe is very similar and I think EUR/USD will depreciate. At the most recent ECB meeting Lagarde said the ECB didn't discuss any phasing out of the PEPP program and it would be nice to move in tandem with the Fed, but not likely.

Excess liquidity as a percent of GDP is around 16% in the US compared to 36% in Europe. ECB balance sheet assets to GDP is higher. There are negative rates in Europe. The Federal Reserve will taper earlier than the ECB as vice-versa would place unwanted upward pressure on the euro. The US has stronger data and higher vaccination rates. The US also has higher real sovereign interest rates and nominal yield premiums over Europe.

I think it was a smart move for the ECB separating the Pandemic Emergency Purchasing Program (PEPP) from the APP. This should avoid any tantrum in euro yields in my opinion if/when they scale back PEPP purchases as they can make the case QE is not ending, only the "pandemic" part.

Thank you for reading.

Analyst’s Disclosure: I am/we are long BZQ, ERY, JDST, REW, EDZ, GLL, ZSL, FXP, SQQQ, YANG, DUG, DHT, FRO, STNG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Short: VALE, RGLD All positions are in option contracts. Many of the "long" positions are inverse ETFs.

Comments

[Michael Roat]

Quick note on the employment report:

This jobs report miss really throws some shade on any short-run inflationary outcome given the labor market is still far from pre-pandemic levels (where we still didn't have 2% persistent core inflation) and healing slower than expected. What it doesn't change is US budget and issuance projections. So I'd say the reaction down in yields is a bit overdone. The driver for yields is mainly the deficit. IMO this report is a tailwind for real-yields because I think inflation expectations will come down here faster than nominals.

In short, there is still too much slack in the labor market and capacity utilization. Growth should stay firm but this really takes a US economic overheating scenario off the table in my view.

Bloomberg Intelligence Chief U.S. Rates Strategist Ira Jersey:

“Treasury Inflation Protected Securities market may consider a repricing of inflation risks with payrolls’ large miss compared with consensus. Longer-term wages are usually driven by employment gains, and with slower employment growth than anticipated, inflation breakevens may decline. The knee-jerk reaction for TIPS yields may reverse some over the course of the day as traders focus more on the inflationary situation than just the bad data.”

[JHHAlpha]

Michael, Thanks for a well reasoned note, although I believe it missed one over-riding factor controlling unstated fed policy. In your providing a framework for analyzing and forecasting fed interest rate decision making, you wrote:
" I think it is revolving around preventing or delaying the global downturn I am describing rather than pursuing a goal of price stability, maximum sustainable employment and what is best for the United States. The Fed is placing their “role” as the central bank of the world above their US congressional mandate. "

This framework ignored the rising federal debt that began in response to the 2008 collapse. The debt rose under Obama, and Trump, and is now accelerating under Biden. Managing this huge and expanding debt requires the fed to constrain interest rates and monetize the debt. Thus the USA has entered into a Japanification of its monetary system for as far as the eye can see. Any collapse in China's economy will only strengthen current fed (unstated) policy.

[Michael Roat]

@JHHAlpha Hey JHHAlpha. Thank you for always reading and commenting on my articles.

I think the Fed is in a bind in the sense the deficit and issuance has become so large demand for UST's cannot keep up. They could up purchases, shift maturities or implement yields curve control, but I see problems with all three.

1) More QE could send yields higher on inflation expectations and cause an unwanted tightening of EM policy with USD currency boards.

2) Operation twist would just bear-flatten the curve and could de-anchor the front-end.

3) YCC is untenable on the middle to back-end which is the problem (5+ year UST's).

Also you wrote:
"Any collapse in China's economy will only strengthen current fed (unstated) policy".

I agree but the marginal effect of additional QE from the Fed while facing a massive deflationary shock of a China financial crisis or hard economic landing is insufficient. The Fed already fired their bazooka last year and rates are expected to stay at zero for the next couple years. I think the Fed knows it's coming which is why they are so adamant about staying accommodative, but by doing this they are increasing the magnitude of the eventual downturn - pushing risk asset valuations to sky high levels.

China's inevitable landing is the largest road block to any synchronized global recovery and global pickup in inflation. My opinion is it should be allowed to happen. Get it out of the way and move forward. Their banking system needs to be recapped and RMB need to be printed. Until then it will be the same start/stop global economy. When it does the Fed should stay accommodative, don't over-react and keep markets functioning. But if one thinks risk assets won't come down in the scenario they would be kidding themselves especially given the elevated valuations.