Q1 2022: Instability 2022: Inflation, War and China
During the last call, I referred to a “quarterly string of extraordinary market environments.” Extraordinary doesn’t do justice to what was clearly a history-changing quarter – the largest European military conflict since WWII, U.S. annual CPI at a four-decade high, and a newfound hawkish bent at the Federal Reserve that is now anticipating the most aggressive tightening cycle since 1994. The confluence of such a challenging fundamental backdrop and highly speculative markets made for dizzying instability.
A couple headlines: “Bond Market Suffers Worst Quarter in Decades.” “Commodities Finish Best Quarter in 32 Years.” The quarter saw the greatest divergence between hard assets and financial assets in a very long time.
We all get caught up in the here and now. What’s the market going to do tomorrow. Bull or bear market? Correction, buying opportunity or bear market rally? Growth or recession? I’m as guilty as anyone, with my focus on fragility and bursting bubbles.
I have an overarching message for listeners take from this call: secular change is upon us. The world has reached a critical historic juncture – the transition away from an unparalleled financial and economic upcycle. Such a momentous development is usually recognized only in hindsight. We believe it’s critical to be ahead of the game on something so consequential to our lives and financial wellbeing.
An extraordinary multi-decade cycle is drawing to a close, a process triggering great uncertainty, disorientation, insecurity, market volatility and general instability. And this dynamic rather conspicuously accelerated during Q1. For much too long, global policymakers pushed stimulus measures to precarious extremes, monetary inflation that extended the cycle – but at great cost. Some of these costs are being revealed.
I’ve shared this analysis in the past. During the upcycle boom, the economic pie is perceived as robust and expansive. Cooperation, integration and strong alliances are viewed as beneficial - both individually and collectively. But as the cycle ages, strains mount and insecurity increasingly takes hold. Eventually, the backdrop is viewed more in terms of a stagnant or shrinking pie - with a newfound zero-sum game calculus. The downside of the cycle heralds a period of fragmentation, animus and conflict. From this perspective, the world appears well into the transition to a perilous downcycle dynamic.
Just think of what has unfolded over recent weeks with war, with trade relationships, financial networks and alliances. European cities turned to ruble, reminiscent of WWII. Russia extricated from global trade and financial systems. The G20 is now in jeopardy, with even the stability of the United Nations at risk. The relationship between the world’s two economic superpowers - hangs in the balance. There’s now talk of a present-day “iron curtain,” and even a new world order.
I don’t think we can overstate the significance and far-reaching ramifications of this secular shift – the shift away from the promise and assurances advanced over a multi-decade upcycle - versus today’s ominous downcycle uncertainties. The war has been framed as the battle between democracies and autocracies. We’re all shocked by images we thought had been relegated to history books and black & white photos.
The subject of a new world order was top of mind last week as Russian Foreign Minister Lavrov met in China with his counterpart Wang Li. I’ll quote from an AFP report: “Beijing and Moscow advanced a vision of a new world order… Lavrov painted a picture of a new world order, saying the world was [in quote] ‘living through a very serious stage in the history of international relations.’ ‘We, together with you, and with our sympathizers will move towards a multipolar, just, democratic world order…” Foreign Minster Wang was quoted: “There is no ceiling for China-Russia cooperation, no ceiling for us to strive for peace, no ceiling for us to safeguard security and no ceiling for us to oppose hegemony.”
And from CNN: "The top US military officer told lawmakers the world is becoming more unstable and the 'potential for significant international conflict is increasing… Chairman of the Joint Chiefs Mark Milley and Defense Secretary Lloyd Austin appeared before the House Armed Services Committee… Milley said that Russia's invasion of Ukraine is 'the greatest threat to peace and security of Europe and perhaps the world' in his 42 years serving in the US military…’ Quoting Milley: “The Russian invasion of Ukraine is threatening to undermine not only European peace and stability but global peace and stability that my parents and a generation of Americans fought so hard to defend.”
Russia is now moving aggressively to settle trade in rubles, while developing an alternative to the West’s SWIFT financial network. There are new cold war dynamics, with serious concerns that we are witnessing conflict and a hardening of alliances that could ignite into something akin to the world wars. And revelations of widespread atrocities have altered the trajectory of war. The West has become more unified and determined that Russian aggression cannot prevail. With each passing week, Ukraine appears less a proxy war and more a direct conflict between Russia and the U.S./NATO coalition. And a weekend Wall Street Journal headline read: “China Is Accelerating Its Nuclear Buildup Over Rising Fears of U.S. Conflict.”
My analytical focus is more on the unfolding global economic war – the dis-integration of trade and financial relationships. Even in the unlikely event of a near-term end to Russian aggression, we should not expect any relaxation of the onerous sanctions – perhaps as long as Putin remains in power. The Russian economy appears poised for economic depression, and we should expect Putin to employ about every mechanism at his disposal to retaliate. He’s an enraged corned animal. Putin is already threatening global energy and grain supplies, while alluding to Russia’s nuclear arsenal. The world has fundamentally changed, with elevated geopolitical risks for years to come.
Thus far, China has been careful not to assist Russia’s military or to overtly subvert Western sanctions. But the more protracted the war, the less sustainable this approach becomes. At some point, I expect China to demand a relaxation of sanctions. When rejected by the West, China will likely adopt a more combative approach and commence Russian support. This scenario – one that today seems probable to me – would risk major escalation in the global economic war – an unfolding showdown between the world’s two dominant powers.
This developing U.S./China confrontation comes at a most tenuous juncture for the Chinese economy. China bubble deflation gathered momentum during the quarter. The unfolding real estate developer crisis took a turn for the worse, in what was nothing short of a historic bond collapse. Major developers – Evergrande, Lonfor, Kaisa, Sunac, Yuzhou – to name a few – with hundreds of billions of debt, saw yields spike to 100%. Country Garden, China’s largest developer that until recently was viewed as financially sound – saw yields spike to almost 32% - after beginning the year below 7%. Indicative of a pivotal break in market confidence, China’s top 100 developers reported that sales transactions collapsed 53% in March from a year earlier.
Meanwhile, private surveys signal a broad-based tightening of financial conditions. Corporate bond yields have spiked higher, and credit is said to have tightened significantly. Economic activity has downshifted, pressured by the housing slump, weakening exports, and Beijing’s draconian “zero tolerance” Covid policies.
We monitor China’s Covid situation closely, recognizing the challenge a highly transmissible Omicron poses to Beijing’s “Covid zero” strategy. Our fears are coming to fruition, as Shanghai and other major cities face brutal lockdowns.
Nomura analysts this week estimated that 45 cities representing 373 million people and approaching 40% of GDP - have implemented full or partial lockdowns. Some cities have been under strict lockdown for a month, as the wave shows no sign of subsiding.
I contemplate China’s deflating bubble predicament and think Japan 1989. Many at the time recognized Japanese bubble excess, but who foresaw a secular inflection point and years – even decades – of economic stagnation? Yet China’s apartment bubble has been only more egregious, it’s structural maladjustment more epic, and its bloated $55 TN banking system more vulnerable.
So, what explains the ongoing complacency of the analytical community and global markets when assessing China’s prospects? Well, there remains unflappable faith in the power of Beijing to, once again, resuscitate the irrepressible Chinese boom.
“Beijing won’t allow bubble collapse” recalls the pre-1998 crisis mantra “The West will never allow Russia to collapse,” and 2007’s “Washington will never allow a housing bust.” Beijing has responded to accelerating crisis dynamics over recent weeks by loosening some restrictions and talking stimulus measures. Market response has been unimpressive, and Beijing’s capacity to reenergize speculative excess will only diminish in the unfolding post-bubble landscape.
Recall the Fed’s aggressive series of 2007 and early-‘08 rate cuts. Such measures work like magic when speculative impulses remain energized – when Bubbles are inflating. Yet their potency diminishes rapidly as confidence wanes – when Bubbles begin deflating – when greed is succumbing to fear. I expect fear to hold sway over greed in China for some time to come.
Importantly, there are signs of waning confidence in the great Beijing meritocracy. I believe the developer collapse marks the onset of a destabilizing apartment bust. While official prices are so far down only marginally, confidence has been badly – likely irreparably – damaged. And with housing a dominant component of overall Chinese wealth, faltering household confidence in the economy and economic management comes with major ramifications. I expect Chinese citizens to increasingly hold Beijing responsible for mismanaging apartment and economic bubbles.
The Chinese are already questioning Beijing’s “Covid zero” policies and overall economic planning. Add to this Xi Jinping and Beijing’s partnership with Russia - “without limits” - and one sees all the makings for a crisis of confidence in communist party leadership. For a society that developed such inflated expectations over an enduring boom cycle, this rude awakening comes with cycle-changing ramifications. I expect Chinese households to turn more risk averse and less willing to borrow and spend – even in the face of Beijing stimulus measures. This would hasten the transition to a post-bubble downcycle.
I have posited that vulnerable Chinese and global bubbles help to explain why 10-year Treasury yields have remained so low in the face of surging inflation. Think of this: The last time y-o-y CPI reached 8.5%, 10-year Treasury yields were 14%. Even after the worst quarter in decades, along with last week’s drubbing and today’s jump, bond yields are at 2.80%.
The Treasury yield curve has become a focal point. After beginning the year at 78 bps, the two versus 10-year Treasury yield spread recently traded at negative eight bps. Analysts traditionally view an inverted curve as foreshadowing recession.
This beckons for some analytical nuance. When we discuss traditional analysis and market relationships, it’s important to appreciate that so much changed as QE evolved into a primary policy tool. How can 10-year yields remain so low in the face of surging inflation and the onset of what is anticipated to be the most aggressive tightening cycle in 28 years? Because the marketplace anticipates tightening measures will prove short-lived. The Fed will surely be forced into additional bond purchases – yet another round of endless QE. The bond market’s disregard for inflation risk recalls the period heading into the 2008 crisis – a dynamic that worked to prolong excess and deepen the unavoidable crisis.
I see today’s flat yield curve as indicative of dysfunctional markets, distorted by years of Fed intervention and monetary inflation – with inversion not so much a predictor of recession as it is a reflection of bubble fragilities and the inevitability of additional crisis measures.
And these low long-term yields and expectations of Fed intervention have provided critical support for the stock market bubble. We are witnessing today dangerous consequences of years of Federal Reserve mismanagement coming home to roost. Stock and bond markets have been unable to adjust to the rapidly deteriorating fundamental backdrop, and I would contend that resulting wealth effects and loose financial conditions are working to sustain problematic inflationary dynamics. And the longer bonds and stocks disregard ramifications for an aggressive tightening cycle, the greater the pressure on the Fed to talk hawkish rate hikes and balance sheet liquidation.
Even the diehard FOMC doves have found religion, apparently coming to the realization that inflation hurts most those that can least afford it. It’s late in the game for such an epiphany. A cycle of Federal Reserve monetary mismanagement has dangerously weakened the foundations of economic, financial, social and geopolitical stability.
When contemplating secular change, we should think in terms of an extended period of instability. The war has caused a spike in already elevated food prices, with significant risk of future global grain and food shortfalls. This is a backdrop conducive to social and political instability, with recent unrest in Peru and Sri Lanka surely just the beginning.
The war also further stresses global supply chains. Russia, of course, is a major exporter of energy, materials and commodities. The Bloomberg Commodities Index has already gained 32% this year. The onset of war saw dislocations in many commodity markets, most notably nickel with its spectacular short squeeze, margin calls and dislocation.
We believe the war will likely mark a secular inflection point for commodities trading, both in spot and derivatives markets. Producers will approach derivative hedging strategies more cautiously, fearing big squeezes and onerous margin calls. Derivative dealers will back away from unstable and dysfunctional markets, while bankers will tighten standards for loans and backup credit facilities. It all points to less liquidity and more price volatility.
Russia will likely restrict the sale of key commodities to the West, leading to price spikes and shortages. There is risk that China eventually follows a similar course. I anticipate households, companies, and countries all moving to build inventories of key resources– only worsening shortages and supply chain issues. Panic buying of many things is a distinct possibility.
At least until financial conditions tighten meaningfully, I am not as pessimistic as some on near-term U.S. economic prospects. I will turn quite negative with the onset of market crisis. For now, it’s difficult for me to focus on recession risk with a 3.6% unemployment rate and 11 million open jobs – with robust wage growth, with WalMart hiring truck drivers with $100,000 starting salaries.
At this point, I think more in terms of an unhealthy and unstable inflationary boom. There will be a big national push for self-sufficiency – in energy, agriculture, renewable energy, basic commodities, semiconductors, and so on. Our nation will be spending huge sums on defense. And despite higher mortgage rates, for now I expect robust home construction – at least until backlogs clear and more normal inventory dynamics materialize.
But this is anything but a constructive view. It’s worth noting last week’s release of February Consumer Credit data. More than doubling estimates, households expanded non-mortgage borrowings by a record $41.8 billion. For perspective, during the decade 2010 through 2019, Consumer Credit growth averaged less than $14 billon monthly. This is an example of how inflation spurs self-reinforcing credit growth – as we take out larger loans to purchase higher priced vehicles, appliances, home remodels and such, while putting the higher cost of filling gas tanks and shopping carts on credit cards. It’s worth adding that Q4 mortgage credit growth was the strongest since 2007 – once again highlighting the dynamic of inflating prices spurring only greater credit expansion. Moreover, rising debt service and huge federal deficits will continue to fan inflationary fires.
We are witnessing the onset of a new cycle with inflationary dynamics reminiscent of the seventies and eighties. And the Fed today faces one momentous challenge, as it attempts to get inflation under control. This will prove nothing short of a secular shift in monetary management. The previous cycle’s subdued consumer price inflation - empowered a Federal Reserve policy regime focused on championing the asset markets - as the key mechanism for economic advancement and prosperity. “Baby step” rate increases were signaled well in advance and implemented gradually, all to ensure booming securities markets avoided instability. And it went without saying that any so-called “tightening” would be quickly reversed in the event of market anxiety. Importantly, a powerful policymaking regime dynamic took control: no longer was it even necessary for financial conditions to tighten during so-called “tightening” cycles.
And securities markets grew to revolve around loose conditions and the “Fed put” – as confidence in the Fed’s willingness to do whatever it takes to bolster the markets incentivized speculation, leverage and risk-taking more generally. Cash was made trash, with savers then plowing Trillions into the securities markets, most notably in perceived liquid and “money-like” ETF shares.
From Fed Z.1 data, we know that Household Net Worth ended last year at a record 626% of GDP, compared to previous cycle peaks 491% (in Q1 2007) and 445% (in Q1 2000). The source of unprecedented perceived household wealth was chiefly from record holdings of Financial Assets - at 492% of GDP, dwarfing previous cycle peaks 374% and 354%.
For the new cycle of monetary management, the “Fed put” will surely not be completely discarded. But the FOMC will now be forced to think hard before unleashing additional inflationary fuel. Measures to support the markets – including bailouts – will not come as quickly – and I expect future QE to at least initially be doled out in moderation. This implies a major shift in the Fed’s willingness, capacity and tactics for backstopping the markets.
A revamped policy doctrine with less predictable and generous central bank market support will require an adjustment in securities and derivatives pricing. Financial assets become riskier, implying greater risk premiums and lower valuations. Derivative markets must also adjust to new realities. If the Fed no longer actively controls the weather, the previous cycle’s boom in cheap flood insurance is no longer viable. Said differently, the assumption of liquid and continuous markets - that defined contemporary “dynamically hedged” derivatives markets over the boom cycle – becomes difficult to rationalize.
Selling derivative insurance has become a riskier proposition. This suggests a secular shift to more expensive derivatives protection – with higher-cost market insurance - on the margin - providing less support for risk-taking and speculative excess. I believe the popular strategy of just buying cheap hedges and sticking with risky portfolios through difficult market environments was anomalous to the previous cycle.
The first quarter provided overwhelming support for our thesis of a new cycle of hard asset outperformance versus financial assets. The Bloomberg Commodities Index surged 26%. Sanction fears saw crude spike to $126, before ending Q1 at $100, up 33%. Gasoline and natural gas jumped 41% and 51%. Wheat was up 34%, corn 26%, and soybeans 20%. Safe havens gold and silver rose 6.9% and 6.4%.
That big commodities outperformance unfolded during a period of relative dollar strength is intriguing. The dollar index is up 5% so far this year. Moreover, even the industrial commodities have been robust in the face of faltering China. Some commodities are exposed to weakening Chinese demand dynamics. But this risk is at least somewhat offset by Russian sanctions, supply constraints and the impetus to build rainy day stockpiles.
Going forward, we expect commodities markets to be underpinned by general currency market instability along with dollar vulnerability. Dollar weakness would catch most by surprise.
There has been of late insightful discussion of the potential negative impact sanctions and the bi-polar “iron curtain” new world order might have on the dollar as the world’s reserve currency. Some of this analysis resonates.
But there’s another aspect of dollar vulnerability that goes unrecognized. I believe the previous cycle of well-contained consumer price inflation - that emboldened the Fed’s securities and derivatives market focus - was instrumental in underpinning the dollar. This experimental monetary regime bolstered our currency even in the face of massive monetary inflation, persistently huge trade deficits and deep structural impairment. Why would the world not recycle excess dollar balances back into U.S. securities markets, confident that the Fed was doing whatever it takes to ensure those securities rose in value? Traditional currency fundamentals – prudent monetary and fiscal policies, stable money, a favorable current account position, and sound financial and economic structures – no longer mattered - so long as Federal Reserve policy focus was directed at sustaining booming asset markets.
The world is now experiencing momentous change, with overwhelming evidence supporting our view of a transition to a new cycle. Federal Reserve focus has begun the shift to consumer price inflation, leaving the status of the Fed’s market backstop a major open question. Going forward, we expect the dollar to be increasingly vulnerable to waning confidence in the Fed’s capacity to underpin the markets. This raises the possibility of the next serious bout of de-risking/deleveraging being accompanied by destabilizing currency market volatility. This is a looming risk for a financial world dominated by leveraged speculation.
For the most part, currency markets have remained relatively stable, as volatility dominates commodities, bond and equities trading. If we’re correct in our secular thesis, the world could be at the cusp of acute currency and market instability, along with alarming geopolitical turmoil.
With Russia’s invasion, geopolitical analysts are now more focused on the possibility of China moving forward with its long-held ambitions for Taiwan. Hopefully Chinese officials are dissuaded by the utter calamity and human carnage witnessed in Ukraine. I have for a while feared a scenario where a collapsing Chinese bubble swayed Beijing into a belligerent stance with Taiwan, while somehow blaming the U.S. for its predicament. The unfolding economic “iron curtain” and the potential for punitive measures against China - only further my concerns.
And a final thought on the new market cycle. The unfolding crisis of confidence in monetary management and financial assets more generally has momentous ramifications. As hard assets outperform financial assets, liquidity will now gravitate to real things, working to underpin inflationary pressures even as growth weakens. This would keep pressure on the Fed, with higher cash rates reducing the appeal of risk assets. Moreover, these new inflation dynamics dramatically alter the risk versus reward profile for QE and monetary stimulus more generally. Fed bond purchases will create additional liquidity now likely to gravitate to – and reinforce – commodities and general price inflation.
This implies a major cycle inflection point for the bond market, now faced both with a secular upturn in inflation and diminished QE prospects. And a secular jump in Treasury yields would demand a long overdue downward valuation adjustment for stocks, corporate credit and other financial assets.
If we are correct in our view of a secular shift in inflation dynamics, we would expect a new paradigm of tighter monetary policy and tighter financial conditions more generally. This will be highly disruptive to economic and financial structures that over the previous long cycle overindulged in ultra-loose finance. In particular, there is post-bubble vulnerability for scores – literally thousands - of negative cash-flow companies and enterprises. In this regard, we anticipate a difficult and protracted structural adjustment ahead. And when I look at our nation today, I dread how this adjustment will intensify social and political strife.
We titled today’s call “Instability 2022: Inflation, War and China.” Unfortunately, there is every reason to prepare for only greater instability ahead – certainly through the end of the year and beyond. Today’s macro backdrop is extraordinarily fluid.