'Buy the Umbrella' - Issue #40
Hi there!
Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things I’ve been reading and thinking about during the week.
If you missed the prior issue, you can find it here.
Quotes
“In this game the determined tortoise will always beat the excitable hare.”
— Peter Seilern
"It all depends on how we look at things, and not how they are in themselves."
― Carl Jung
Charts
U.S. private sector financial assets as a percentage of GDP
In BTU #36 we showed the degree of outperformance of bonds and stocks relative to commodities and real estate since the end of the last war on inflation in the 1970s and early 1980s.
Bank of America put together another fascinating chart, showing US private sector financial assets as a percentage of gross domestic product (GDP). The chart speaks for itself really.
What are the odds that this continues? We believe this is largely a function of interest rates and given the rise in global yields, this ratio is likely to have peaked.
How quickly can inflation be brought down?
With economists and central bankers continuing to believe that inflation can be brought down rapidly to 2%, it is worth looking at historical periods where inflation was above 5% in advanced economies.
Unfortunately, history suggests it takes on average 10 years for inflation to come down to the current target. The shortest period was 3 years.
Jeffery Gundlach from Doubleline raises a valid question: if inflation does indeed come down rapidly from its current 8.3% rate due to the federal reserve and other central bankers' actions, what are the odds it stops declining at their target level of 2% and then staying there?
To us, it seems wildly optimistic (although admittedly, not impossible) to assume that central bankers can achieve such precession.
Emerging markets underperformance since the global financial crisis
Emerging markets, which some believe are historically cheap, have continued to underperform the U.S. equity markets since 2010. The last peak, following the dotcom bubble in 1999/2000, saw emerging markets outperform on a relative basis for a decade.
U.K. government borrowing costs jump
Following the recent "mini-budget" by the new British government, the Sterling has taken a tumble, at one point reaching a record low against the dollar. Investors viewed the mini-budget tax cuts as unsustainable due to the size of the government's budget deficit and overall financial position. As a result, U.K. government bonds also declined with yields hitting the highest levels in at least a decade (bond prices and yields have an inverse relationship).
The chart below illustrates the size of the move in 10-year U.K. government bonds yield and the level at which they now trade:
At the end of 2020, the U.K. government was able to borrow for 10-years at a cost of less than 0.5% in interest. As of writing, yields for the same duration are now as high as 4.5%.
On Wednesday, the Bank of England (BoE) responded by announcing that it was "temporarily" stepping in and buying unlimited long-dated bonds to stabilize the market. If this is the start of the BoE putting a ceiling on government bond yields (known as yield curve control), the Sterling is likely to continue to weaken further relative to the U.S. dollar, as we have already witnessed with the Japanese Yen (the BoJ has already enacted yield curve control).
Following the BoE's emergency response, Bloomberg reported that the Biden Administration is 'alarmed' by the developments in the U.K. due to the potential of spillovers to the broader economy.
U.S. Commerce Secretary Gina Raimondo pointed out that cutting taxes and boosting spending won't help cool inflation nor "put you in good stead for longer-term economic growth". The International Monetary Fund, where the U.S. is the largest shareholder, pressured the U.K. government to "re-evaluate the tax measures".
Chinese renminbi breaks out above 7.00
With many investors talking about the British Pound's recent historic decline against the dollar, the Chinese Renminbi (off shore) has weakened beyond the key 7.00 level despite the Chinese government trying to support it from weakening further.
Other emerging market economies are also struggling with the strong dollar, such as the Indian Rupee which hit another record low.
The significant moves in currencies and bonds are likely to have significant knock on effects on financial stability over the next few weeks and months.
Articles
'The Great Transition' - from interest low rates to high anxiety
Sander Gerber and Jason Cuttler wrote a great piece highlighting the interest transition occurring, after nearly two generations of declines.
"Every OECD country (besides Japan and Switzerland) is running inflation above 4%. Wages are growing at 5.5% and inflation is broad-based with virtually all worker categories earning pay increases of 4% or more. [...] Despite Wall Street predictions of inflation moderating, uncomfortable levels are here to stay."
"Unlike some, we don't doubt the Fed's conviction..."
"Even with mounting evidence to the contrary, derivative markets price a mere 8% chance of 10-year yields being above 5% one year from now."
"Finally, virtually all asset classes — from property to private equity — benefited from falling bond yields and the low cost of capital. Most worrisome, the impact of higher yields is correlated across most holdings, overwhelming any delusion that diversification (or an algorithm) is sufficient defense against the great transition. [...] There are very few assets that truly hedge inflation risk."
Goldman's Apple Card business has a surprising subprime problem
The investment bank, which began its foray into consumer finance in 2016 to diversify from its traditional strengths of Wall Street trading and advisory activities, is currently struggling with its credit card business.
The bank's loss rate on credit card loans is the worst among big U.S. card issuers and “well above subprime lenders” at 2.93%, according to a note from JPMorgan.
A record number of British pensioners are working
According to the ONS, there are now almost 1.5 million Britons over the age of 65 in employment, driven by rises in part-time work.
The increase in people working past the UK’s state pension age could reflect rising cost of living pressures, forcing some out of retirement. The U.S. is seeing similar trends.
China reins in belt and road program, $1 trillion later
China's Belt and Road infrastructure program was designed to expand its influence across Asia, Africa and Latin America. One trillion dollars later, Beijing is working on an overhaul of the troubled initiative. A slowing global economy, rising interest rates and higher inflation have left countries struggling to repay their debts to China, as reported by the WSJ.
Transcripts
FedEx CEO Raj Subramaniam is prioritising cost cutting:
"Getting cost out rapidly is my priority...We saw a decline in our volumes during Q1, which accelerated in the final weeks. Our softening volumes in Asia & US were predominantly due to the economy while the shortfall in Europe was both economic & service related."
J.P. Morgan Chase CEO Jamie Dimon points out that the ESG agenda is hurting the American economy and that more oil and natural gas production is needed to reduce CO2 emissions:
“The world needs effectively 100 million barrels of oil and gas every day, and we need it for 10 years. To do that, we need proper investing in the oil and gas complex.
Investing in the oil and gas complex is good for reducing CO2, because as we have all seen, because of the high price of oil and gas, particularly for the rest of the world, you’ve seen everyone going back to coal. Not just poor nations like India, Indonesia and Vietnam, but wealthy nations like Germany, France and the Netherlands."
Things that make you go hmm...
The WSJ says that oil leases on Federal land have slowed to a trickle under the Biden administration. In his first 19 months in office he has leased out just 126,228 acres for drilling.
Since Nixon, no president has leased fewer than 4.4m acres at the same stage in their presidency. Harry Truman was the last to lease fewer acres at just 65,658 in 1945/6 when offshore drilling was just beginning.
Until next time...
Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone who would enjoy it.
Do you have any questions or thoughts? Please feel free to reach out.
Have a wonderful week.
Why ‘Buy the Umbrella’?
Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).
Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm when they are typically in short supply. We therefore need to ‘buy the umbrella’ before it rains.
Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.
Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.
It is not enough just to be conservative. One needs to be willing to put cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.
Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.