Joined at the Hip

Three events unfolding simultaneously in far corners of the world are all entwined at the hip and could derail the nascent stock rally seen since November 2022 in a hurry.

1.?????The surprisingly excessive strength reported by the Bureau of Labour Statistics for January 2023 in the U.S. job market

2.?????Russia decided to curtail oil production by 500,000 barrels daily, giving strength to bulls and already high oil prices. This development comes after the U.S. drained its strategic petroleum reserve to minimal levels to lower prices and commodity inflation in 2022. There is less slack in the market now.

3.?????The Japanese PM expects to appoint a new Governor to replace Kuroda at the Bank Of Japan ("BOJ"). Kazuo Ueda, an MIT-trained economist, is a former member of the governing committee of the BOJ and is now rumoured to be the front-runner.

Turning to Japan first, the yield curve control policy of the BOJ is beginning to draw sceptical comments from all corners. Governor Kuroda himself widened the band on December 20, 2022. In the communique, BOJ said it would allow yields on the 10-year JGB to move up or down within 50 basis points around its 0% target, wider than the previous 25-point band. BOJ positioned it as a "tweak to the monetary policy". Nevertheless, like elsewhere, inflation is running high in Japan.

BOJ's intransigence in maintaining its current stance has caused significant Yen weakness and producer price index ("PPI") inflation that is running at twice the rate of CPI. The YoY PPI for December 2022, of 10.5%, is 2.6x the CPI. As an importer of commodities and an exporter of finished goods, input cost inflation is beyond Japanese control. The only way to tackle it is via productivity improvements and a stronger Yen. The Japanese equity market has held up due to a currency-driven windfall for some sectors, whereas consumers and manufacturers are now feeling pressured.

So far, inflation-backed pricing strength in N America and Europe cushioned the blow, but with both the ECB and the FED committed in their stance, i.e. working furiously to bring aggregate demand down, BOJ has another reason to unwind its policy. Exporters won't have pricing power forever. Moreover, with the BOJ reportedly owning more than 50% of JGBs, the entire debt market is distorted.

Russia Curtails Oil Production

The modification of the Japanese yield curve experiment is inescapably linked to global energy markets, which are once again playing truant. With Russia curtailing export production, OPEC unable to pump more, the global economy on a strong path given continued robust job creation in the U.S., #china coming back from COVID-19, inflation and higher energy prices are both in the offing. To the extent global diesel markets benefitted from surplus refining capacity in India using Russian oil to deliver diesel, while Chinese refiners idled their capacity due to travel restrictions within China,?going forward, less oil floating around puts a spanner in the entire inflation arbitrage trade. The inflation outlook is far from optimistic.

Consumers keep Spending

In N America, consumer credit card companies continue to point towards strength in consumer spending. Unexpectedly, wholesale pricing for used cars increased by 2.5% in January 2023. Demand for cars, replacement or otherwise, is derived from employment, and with job creation exceeding 500,000 for January 2023, cars got a lift. The coincident data corroborates our view that the U.S. economy is stronger than most expect and that the strength will continue.

A sturdy global economy and robust commodity prices imply rates are headed higher than anticipated and will stay higher longer. The implication being equity and bond markets will struggle to find a firm footing until a new consensus emerges that brings the 10-UST back above 4% and this time for good. Experts in monetary policy and BOJ have called for the 10-JGB to move to a range of 1.75%-2%. Bloomberg highlighted today that the USD/JPY hedging costs are running close to 5% annualized and that Japanese insurers and pension funds are bringing funds back home. That puts additional pressure on UST yields, with fewer recycled dollars from Russia, China, Japan and India making it to the Fed.

Conclusion

We believe a rate-sensitive portfolio is best positioned to benefit from the current turmoil. As far as stocks are concerned, equity investors were displeased to no end at a suboptimal; some might call it a shocking display of ineptness by an A.I.-based chatbot revealed by Google. The stock lost $100B in a single trading session. While that is in no way a commentary on the quality of the underlying technology and how quickly it might be fixed, it tells you equity investors' wayward character. #apple Inc. had a faux pas with its earlier versions of the mapping software. Meta was similarly grounded for a few quarters with its underwhelming metaverse outlook until it took off like a Space-X rocket. No one remembers or cares about the Metaverse now.

We maintain our bullish view on #google / #alphabet irrespective of ChatGPT's avowed success. At its current valuation, Alphabet will do a Meta soon. Moreover, we ultimately have more faith in Alphabet's A.I. delivering on its promise than in the Metaverse.

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