Connecting the Dots
Connecting the Dots
A review of recent inflation data, and a follow-up on last week's long US-Tech call
In last week’s post I turned positive on US Technology, having been negative on the sector since the beginning of the year. This has caused a fair amount of pushback. In today’s post I lay out the reasoning behind this pivot in more detail, and how it relates to recent inflation data. In turn, this bears significance for US bond yields, the biggest driver for “long-duration” assets
I will explain why I singled out Large-Cap Software and Biotech to put cash to work in the sector, and also what I’m monitoring to judge if and when I’m wrong, and whether this remains a short-term trade or becomes a long-term holding
The post closes with some thoughts on the recent turbulence in Crypto
Let’s start with past week’s inflation data. First, the Consumer Price Inflation Index (CPI):
As outlined in the several reviews of prior releases, the headline annual inflation number of 8.3% is not instructive for our purposes. It compares to a date in the past, and we want to know what’s happening today
What we want to know: How entrenched is inflation? And does it still accelerate? For that, the most important datapoint is the month-on-month change in “core services inflation”, which covers ~75% of the CPI, and moves slowly and broadly (in comparison to goods inflation which is volatile)
And this datapoint was bad. It accelerated from March, and at 0.7% (~9% annualised) runs very high:
Ok, that’s not good. Despite the Fed’s aggressive stance, inflation seems to be getting worse?
That’s not the entire picture. Two days later, the Bureau of Labor Statistics released the Producer Price Inflation Index (PPI)
Simplified, the PPI measures how much companies charge for their output. It could also be described as an index for wholesale prices
And again, its headline 11% year-on-year print is not what we’re looking for. We want to strip out volatile items, and look at the month-on-month change instead, to correctly judge current inflation pressures
In this case, the data slowed considerably, to 0.3%, or ~4% p.a.
Ok, so what does that mean? One three-letter acronym (CPI) tells me inflation speeds up, another one (PPI) tells me it’s slowing down??1
I believe the PPI tells the more accurate picture. This is because the PPI has a lead function - what producers charge today is what consumers are charged tomorrow
The PPI likely already reflects the economy slowdown, while the CPI doesn’t. As discussed, this slowdown was first visible in inventories only, but since late April several high-frequency indicators also show a decline in activity (e.g. Opentable bookings, BEA Retailer Credit Card Spending)
A few additional dynamics support my view that the cycle-high for inflation is in:
Wage growth will likely slow down from here, despite full employment: Average hourly earnings for April, a good proxy for wage growth, came in below expectations, at ~4.5% annualised. The miss was entirely due to Retail were wages actually contracted. But Retail is a lead category, I think others will likely follow. The Atlanta Fed wage tracker for April came in sequentially flat. In general, just looking at current headlines, this does not seem a climate anymore to ask for raises
Asset market losses will reduce consumer spending: The Nasdaq is down 27% from its high, Crypto is down 56%. The wealth effect works on the way up just as much as on the way down. Below are two examples of weaker demand for products with a strong link to asset prices:
Housing is turning: I had written about this in several previous posts. Last week, US-nationwide housing inventory broke positive year-on-year growth. In some markets, such as Phoenix, inventory is up now 70% y-o-y. Housing is in the process of changing from a big economic tailwind to a big headwind
A side-note on housing: I am currently doing more work on leverage risks for the sector, which seem to be higher than I initially thought. While average credit scores track much better than during subprime, 52% of primary residence loans come with LTVs >90%. Further, individual investments into single family rentals are pervasive, which could turn into leverage issues if prices decline
Summary: Inflation pressures likely peaked in April, and will decline going forward
Keep in mind: This is not a statement on whether the long-term structural issues that drive inflation have gone away. In fact, these have likely worsened, as discussed before
More so, for this cycle, there are still intense inflation issues around food and gasoline (see more below). But the broad trend has likely reversed for now
What does that mean for US government bonds yields, the center of gravity for all Western financial assets?
If inflation declines because the economy slows, Treasury yields will likely stall their ascent, for now
If they rose considerably from their current ~3% levels (10YR/30YR), they’d push the economy into an even deeper recession (e.g. housing would slow even harder, more credit events would happen). This would be deflationary and in turn weigh on yields
Also, please keep in mind last week’s post about the credibility of US institutions (“The Emerging States of America”). In an interview with Marketplace last week, Fed Chair Jerome Powell for the first time admitted that a soft landing is unlikely. This acknowledgment of the obvious supports credibility
What does this mean for markets?
Western stock markets have become incredibly efficient. As such, fundamental news are priced instantaneously, and today, only 20% of single stock performance is explained by company-specific drivers. Macroeconomic factors explain the remaining ~80%, which often provokes the adage “It’s all one big macro-trade”
US Treasury bond yields are the single biggest such “macroeconomic factor”
If yields halt their ascent, there should be significant effects on other assets, in particular “long-duration” assets
This brings me to last week’s call for a near-term bottom in US Technology stocks. As outlined last week, I’ve closed all market shorts, including shorts on the Nasdaq-100, which I’ve held since the beginning of the year. And I’ve put cash to work in US-Tech, in particular in Large Cap Software (ETF:IGV) and also in Biotech (ETF:XBI). Why?
First, on Software
IGV contains what I believe are some of the best businesses in the world, the US Large-Cap software companies (Microsoft, Adobe, Salesforce, etc). These businesses hold dominant or even monopoly-like market positions and are highly cash-generative. They have high pricing power as they’re often mission-critical, yet their cost only represents a small percentage of their customers’ expenses. Most run on high gross-margins, and commodities or labor-cost inflation are a minor concern given their input cost-composition
With US-Tech leading the recent sell-off, IGV has fallen almost 50% below its previous high…
… and Software valuations are now undemanding, even if compared to current, higher Treasury yields:
You might say, sure, these datapoints are nice, but what about the market? Surely Software will be dragged down, if the market keeps falling?
That’s absolutely correct, however, there have been several signs of capitulation last week. CNN’s Greed and Fear index (in my experience a good sentiment tracker) reached extreme lows that are historically associated with market troughs:
Retail favourites Bitcoin, ARK or Tesla all sold off violently. In total, US retail investors sold $3.9bn worth of stock last week, a number only surpassed before in March 2020 (COVID-19) and December 2018 (Powell Pivot). Historically, this has indicated a shake out of “weak hands”. There has also been a huge amount of pain in equity long-short hedge funds, many of them growth/tech centric, and many of them likely forced to cut exposure by significant YTD drawdowns
Finally, I found it notable that many VCs and business leaders made public appearances in which they advised to prepare for tougher times, alongside several financial media articles that suggested more pain ahead. Again, this is indicative of a market view that has become broadly consensual
For Biotech:
It’s very simple. After a ~70% decline from its peak, >20% of the Biotech Index XBI members trade market caps lower than the net-cash held on their balance sheet. For large-cap Pharma companies, Biotech takeovers are a way to replenish their R&D pipeline, and right now the entire XBI could be bought with 2.5 years worth of aggregate large-cap Pharma free cash-flow
To be very clear: I may be early with this call or I may be just plain wrong. But this is how narratives form, they are uncertain in their nascency. When it is evident to everyone, the opportunity is gone
To acknowledge this dynamic, I risk-manage these investments with a stop-loss set at the equivalent of 11600 for the Nasdaq-100. If the trade works, I will increase this stop-loss in correspondence, to reduce the maximum possible loss from inception. I’m also looking at yields and whether they have truly stalled their rise, and will exit these investments if the US 10-year yield exceeds 3.4%
Whether this will be a short-term investment only, or morph into a longer-term holding, depends on how the economic situation will evolve. To be frank, I do not have high hopes in that regard:
As discussed, over the past two years, there has been a staggering amount of misallocated capital, the unwind of which will weigh on economic growth
There are also substantial downside-risks emanating for US housing (see comments above and previous posts) as well as some commodity bottlenecks, in particular gasoline and Diesel
With regards to commodity bottlenecks, I’m currently monitoring this:
The chart above is a simplified depiction of the US refining margin offered to turn crude oil into gasoline or Diesel. As you can see it is going through the roof. Why?
The US, and in particular the East Coast, shut down refining capacity during COVID-19 and turned a net-importer of distillates (e.g. 20% of East Coast imports from Russia, 20% from Europe which processes Russian product). But Russian supplies are gone
As inventories decline and the summer driving season nears, this bottleneck can turn into shortages and rationing, with severe repercussions on consumer sentiment
There are engineering efforts to wring more product out of existing refining capacity. It’s unclear whether they will be sufficient. The industry isn’t hopeful, judging from comments on Valero’s recent earnings call
Please note that this is a net-negative for oil demand, as higher refining margins mean higher gasoline/diesel prices for the same oil price level, which brings demand destruction closer
In a distillates shortage, gasoline and Diesel would likely be prioritised over jet-fuel. This represents a significant risk for US-airlines (ETF:JETS)
While airliners may now rally if the broad market improves, as peak-reopening passed, I see the risk-reward for JETS soon firmly to the downside
In general, I think it likely that after a bounce, the next market leg-down will be lead by cyclicals (RTY, DAX in Europe) rather than Tech2
However, depending on the severity of the recession and given the potential for systematic events, Large Cap Software and Biotech won’t be immune. I will monitor this trade accordingly
Summary: It’s too early to tell, but the risks remain enormous. I think it’s likely we’ll see another big sell-off down the road
ADDENDUM: What’s going on in Crypto?
The collapse of UST/Luna has sent ripples across the space, and rightful comparisons have been drawn to the implosion of Bear Sterns in terms of its systemic relevancy
Stablecoin UST conveyed the resilience of a money market fund, and many investors approached it as such. Luna was a top-10 coin, with many VCs, investors and promoters enthusiastically embracing it
It’s descriptive for the state of crypto that UST wasn’t a Ponzi-scheme. There was nothing hidden about it, the formula was openly accessible. Still, billions of Dollars had been carelessly invested into something that promised a perpetual motion machine. See below headline from a few weeks ago - it’s not only 25-year old YOLOs who threw money at Terra:
A -100% wipeout of such scale creates an emperor-without-clothes moment. Aside from the obvious liquidity needs, investors across the board question assumptions and withdraw funds from anything that seems unsound. Thus, contagion forms
Given its unregulated nature, the likelihood of additional unsound structures is very high. E.g. Mike Novogratz has graced his biceps with big Luna tattoo, what’s the exposure to Luna at his firm Galaxy Digital? It issued a statement that evokes memories of Bear Sterns’ press releases preceding its collapse:
The other much-cited unsound candidate is $80bn stablecoin Tether, which refuses to lay-open its reserves. It couldn’t get any sketchier, but please bear this in mind: Based on my research, I believe most of its reserves do exist. If we assume that, say, 5% are fake/missing, 95% would have to be withdrawn before this comes to light. This makes me think that Tether won’t break until the regulator forces more transparency on its reserves
Until then, Crypto market makers such as Alameda Research will have a field day arbitraging the occasional Tether panic. One should note that Alameda also owns FTX, one of the biggest crypto-exchanges. A relationship unthinkable in traditional finance, akin to Citadel owning the NYSE
Summary: While it may not be Tether, I think it is highly likely that we’ll see more contagion and more pain ahead for Crypto in the coming months
This development may be a positive for Crypto’s innovative potential, as incentives move away from get-rich-quick and toward solving real-world problems
Aside from CPI and PPI, there is a third inflation metric, which is the Fed’s preferred measure. It is called the Personal Consumption Expenditure Index (PCE)
The PCE has a wider scope than the CPI. It also takes into account substitution effects. For example, if the price of vegetables increases more than the price of bread, and consumers therefore buy more bread and fewer vegetables, the PCE assigns a lower weight to bread
The PCE data for April is not out yet. It is released quite late, at the end of each following month. However, using input from CPI and PPI we can estimate where it likely turns out
With the weaker than expected PPI, Core PCE, the Fed’s main measure, will likely track 0.2% month-on-month. This also indicates a meaningful inflation slowdown
That being said, there is likely still substantial earnings risk in some parts of Tech from circular revenues (e.g. VC gives startup $200m funding → startup books GoogleAds → ad bookings are cancelled as startup cuts costs or folds etc.)