wknd notes: Building Back Better

“We’re hopeful it will land in a place where it won’t harm anyone,” said Lloyd Austin. “Hopefully in the ocean, or someplace like that,” added the US Defense Secretary, drifting off, thinking about Elon Musk’s Saturday Night Live debut like everyone else, and Dogecoin’s recent 1,000% stratospheric rise in anticipation of tonight’s show. And somewhere high above, China’s 18-ton rocket skipped across the outer reaches of our atmosphere, heating up, glowing, tumbling, an uncontrolled return.

Overall: “We can’t let up. This jobs report makes that clear. We’ve got too much work to do,” said Biden, reacting to Friday’s disappointing data that showed decelerating employment growth, production bottlenecks, accelerating wages. “We’re still digging out of an economic collapse that cost us 22mm jobs,” explained America’s president, holding the line, unwavering in his support of extraordinary stimulus and infrastructure spending. “We have to build back better,” said Joe, without elaborating. Naturally, business owners and their lobbyists complained bitterly, hitting every major media outlet in a coordinated offensive. Allegedly, supplemental unemployment benefits are making it unusually difficult to get the poorest Americans to exchange their labor for starvation wages without benefits. Denied easy access to this inexpensive input, output prices will need to rise, and profit margins compress. Unsurprisingly, labor lobbyists mounted a counteroffensive, describing how a lack of access to proper healthcare and childcare during a pandemic has further devastated the nation’s working poor. Only a dramatic rise in wages and benefits will be sufficient to allow these workers to escape the tightening grip of poverty, beginning a long process of lifting their productivity. Restoring their dignity. Naturally, investors in financial assets kept very quiet, heads down, praying this administration will allow them to retain at least some of the massive capital gains that compound as our central bankers amplify inequality while simultaneously debasing the dollar and funding a persistent 15% federal budget deficit. And students of economic history sat back and marveled as the pendulum begins its long arc back from an historic extreme. When it last reversed, with Reagan’s 1981 arrival, few could have foreseen the duration and height it would ultimately reach. And where today’s arc takes us is far from pre-ordained, nor will it be back to where we started in 1981. But when a nation borrows 30% of GDP over 2yrs and the president announces, “We have to build it back better,” it is not with an intent to create a shinier version of what has just been.

Week-in-Review (expressed in YoY terms): Mon: Several global holidays (UK, Japan, China) = light volumes, India calls on army to set up hospital beds, Congo contains an Ebola outbreak, Powel reaffirmed his focus on holistic employment measures, Yellen reiterates that inflation isn’t an issue, Brazil reaches 1m vaccinations/day, Korean equity short selling ban partially lifted, Australia considering removing Chinese access to the Darwin Port, HK 1Q GDP 7.8% (3.7%e), Indonesia CPI 1.42% (1.5%e), German retail sales 11% (-0.2%e), Turkey CPI 17.14% (17.3%e) / PPI 35.17% (33.1%e), US Vehicle sales 18.51m (17.6m exp), S&P +0.3%; Tue: Yellen spooks markets with higher rates talk, RBA unch as exp, Netanyahu fails to form government (again!), GS US staff set to return to office in June, Biden supports exporting US mfg vaccines, Biden admin increases refugees allowed by 4x from Trump era, Singapore announces strict 3w lockdown despite very low covid cases, India cases fall to 368k/day (lowest in a week), India’s foreign minister will self-isolate at G7 meeting in London, SK CPI 2.3% (2.1%e), HK ret sales 20.1% (34%e), US trade balance -74.4b, US dur goods orders 1.9% (1.6%e), S&P -0.7%; Wed: Yellen backtracks and says she wasn’t forecasting Fed rate hikes, more fed officials dismiss infl threat, US birthrate falls 4% YoY (largest in 50 years), US backs suspending vaccine patents, NBP unch as exp, Canada approves Pfizer vaccine for 12-15 year olds, Moderna said evidence that 3rd dose increases immunity against new variants, US federal judge strikes down eviction moratorium, NZ unemp 4.7% (4.9%e), Australia building approvals 17.4% (3%e), Singapore ret sales 6.2% (7.1%e), Swiss CPI -0.1% (0.4%e), Brazil IP 10.5% (8.5%e), S&P +0.1%; Thur: Biden may stick with Trump’s China investment ban, China to suspend all economic dialogue with Australia, BOE to begin tapering, CB of Turkey unch as exp, BCB hikes 75bps as exp, Fed’s Kaplan wants to see taper talks sooner rather than later, UK to offer AZ alternative to under-40s, German factory orders 27.8% (25.6%e), Hungary ret sales -2% (-5.3%e), Taiwan CPI 2.09% (1.86%e), EU ret sales 12% (9.4%e), US initial claims 498k (538k exp), S&P +0.8%; Fri: ECB’s Kazaks said ECB may consider tapering purchases at the June meeting, Merkel voices opposition to waiving intellectual property rights on vaccines, RBA policy statement marginally hawkish, China exports 32.3% (24.1%e) / imports 43.1% (44%e), Swiss unemp 3.1% (3.3%e), German IP 5.1% (5.7%e), Mexico CPI 6.08% (6.02%e), Brazil 2.4% (-1.6%e), Canada employment -207.1k (-150k exp) / unemp 8.1% (8%e), US NFP 266k (1000k exp) / unemp 6.1% (5.8%e) / AHE 0.3%(-0.4%e), S&P +0.7%; Sat/Sun: Chinese rocket tumbles to earth, a major US fuel pipeline closed due to ransomware attack, Musk debuts on SNL.

Manufacturing PMI (high-to-low): Switzerland 69.5/66.3, Sweden 69.1/64.7, Netherlands 67.2/64.7, Germany 66.4/66.6, Austria 64.7/63.4, Taiwan 62.4/60.8, UK 60.9/58.9, United States 60.7/64.7, Italy 60.7/59.8, France 59.2/59.3, Norway 59.06/60.48, Czech Republic 58.9/58, Spain 57.7/56.9, Canada 57.2/58.5, India 55.5/55.4, Vietnam 54.7/53.6, Indonesia 54.6/53.2, South Korea 54.6/55.3, Greece 54.4/51.8, Poland 53.7/54.3, South Africa 53.7/50.3, Japan 53.6/52.7, Brazil 52.3/52.8, China 51.9/50.6, Singapore 50.9/50.8, Hungary 50.8/48.8, Russia 50.4/51.1, Turkey 50.4/52.6, Hong Kong 50.3/50.5, Mexico 48.4/45.6. Services PMI: Sweden 65.6/61.9, US 64.7/60.4, UK 61/56.3, Australia 61/58.7, Ireland 57.7/54.6, China 56.3/54.3, Russia 55.2/55.8, Spain 54.6/48.1, India 54/54.6, France 50.3/48.2, Germany 49.9/51.5, Japan 49.5/48.3, Italy 47.3/48.6, Brazil 42.9/44.1.

Weekly Close: S&P 500 +1.2% and VIX -1.92 at +16.69. Nikkei +1.9%, Shanghai -0.8%, Euro Stoxx +1.7%, Bovespa +2.6%, MSCI World +1.4%, and MSCI Emerging -0.5%. USD rose . USD fell -21.3% vs Ethereum, -3.7% vs Brazil, -3.0% vs South Africa, -2.2% vs Chile, -2.1% vs Russia, -1.8% vs Sweden, -1.7% vs Bitcoin, -1.6% vs Australia, -1.6% vs Mexico, -1.3% vs Canada, -1.2% vs Euro, -1.2% vs Sterling, -1.1% vs Indonesia, -0.8% vs India, -0.6% vs Turkey, -0.6% vs Yen, Gold +3.6%, Silver +6.1%, Oil +2.1%, Copper +6.6%, Iron Ore +8.2%, Corn +8.6%. 5y5y inflation swaps (EU -1bps at 1.54%, US +6bps at 2.49%, JP -4bps at 0.28%, and UK +2bps at 3.78%). 2yr Notes -2bps at 0.15% and 10yr Notes -5bps at 1.58%.

YTD Equity Indexes (high-to-low): Venezuela +65.8% priced in US dollars (+317.5% priced in bolivar), UAE +21.9% priced in dollars (+21.9% in dirham), South Africa +19.8% in dollars (+15.1% in rand), Sweden +18.7% (+20.6%), Austria +18.5% (+19.8%), Taiwan +18.1% (+17.3%), Saudi Arabia +17.8% (+17.7%), Canada +17.4% (+11.7%), Norway +17.3% (+12.4%), Russell +15%, France +14.3% (+15%), Netherlands +14.3% (+15%), Russia +13.2% (+12%), UK +13% (+10.4%), Chile +13% (+10.6%), Euro Stoxx 50 +12.9% (+13.6%), S&P 500 +12.7%, Ireland +12.3% (+13%), Singapore +12.2% (+12.5%), Mexico +11.7% (+11.8%), Spain +11.5% (+12.2%), Belgium +11% (+11.7%), Germany +11% (+12.3%), Finland +10.5% (+11.7%), Greece +10.2% (+10.9%), MSCI World +9.7% (+9.7%), Australia +9.6% (+7.5%), Italy +9.5% (+10.7%), Czech Republic +9.3% (+8.1%), Korea +8.8% (+11.3%), Israel +8.3% (+9.8%), Poland +8.2% (+8.9%), NASDAQ +6.7%, Hungary +5.9% (+5%), India +5.7% (+6%), Thailand +5.4% (+9.4%), Denmark +5.2% (+6.3%), HK +4.9% (+5.1%), Switzerland +2.2% (+4.4%), Japan +1.6% (+7%), Brazil +1.5% (+2.5%), China -0.1% (-1.6%), Portugal -0.5% (+0.1%), Indonesia -1.4% (-0.8%), New Zealand -1.5% (-2.8%), Malaysia -4.6% (-2.4%), Argentina -10% (+0.4%), Philippines -11.9% (-12.3%), Turkey -12.1% (-2.4%), Colombia -19% (-10.8%).

Late and Awkward: “The March 2020 downturn resembled a natural disaster rather than a recession that cleansed imbalances,” said Marcel, our head of research, discussing economic cycles. “This was most evident in the goods sector. The global PMI survey fell from 50.3 in Jan 2020 to 39.6 in April, then fully recovered by July. It is equally evident in the finer details of today’s global good sector. US delivery times are currently equivalent to the period of the 1970s oil embargo. The supply-side of the economy is constrained and pushing on demand will merely crowd it out with higher prices. This is the root of an inflationary impulse.”

The High Debt Dance: “It is worth reflecting on the stylized facts of high debt countries,” continued Marcel. “Living standards go down in phases of high government debt. Per capita GDP declines 0.3% per annum on average. The path to then normalize government debt has two distinct regimes: (1) Orthodoxy – a long period of moderate primary surpluses with moderate inflation (Belgium 1993, Canada 1995), and (2) Inflationary – disregard of fiscal, proactive inflationary pursuit (Germany 1918). The important point is that moderate inflation outcomes always coincide with taut fiscal policy. And we are not there now. Not even close.”

Monetary/Fiscal Interaction: “The way forward will almost surely include macro prudential policies to regulate credit,” explained Marcel. “We are seeing this in New Zealand, where home prices are now mandated as part of price stability. The US historic example is a useful marker. Post WWII, the Federal Reserve was responsible for intervening to buy bonds if prices fell below par. This capped nominal interest rates, with the T-Bill at 0.375% and the long-term bond at 2.50%. Regulation Q capped rates on various types of bank deposits that, in turn, constrained banking competition and private credit activity. These are the types of policies that can emerge in conjunction with extraordinary Fed accommodation.”

Exchange Rates: “Given widespread concern about competitive devaluations, the overriding objective of postwar US exchange rate policy was the maintenance of a fixed par value of the dollar as established by the Bretton Woods agreement,” said Marcel, continuing to provide historical context for what is unfolding today to help us position portfolios for tomorrow. “Moreover, given that there were relatively few revaluations or devaluations of foreign currencies against gold, the overall system ensured fairly stable exchange rates during that high-debt postwar episode.”

Balance of Payments: “There were few external imbalances in those historic periods, which is very different from today,” he said. “Thus, external imbalances are rarely part of today’s conversation on inflation dynamics as there are no historic norms to rely upon. Consider the US balance of payments (BOP) in the 1960s: gross trade and financial flows were 11% of GDP. Gold was the nominal anchor. The USD was too rich, a BOP deficit emerged, a drawdown of gold followed (it was transferred to foreigners), which pressured for policy orthodoxy. The net financial balance to be closed was just 0.5% of GDP in 1960 – tiny. Today, trade and financial flows are 40% of GDP (nearly 4x the 1960s level). The nominal anchor today is no longer gold, but rather US policy credibility.”

Moving Off the Gold Standard: “Policy makers were aware that the end of the US dollar tether to gold would threaten reserve status. The ‘substitution account’ is something that was considered by the IMF and the NY Fed and would have allowed a controlled reserve diversification into a basket of currencies, thereby preventing USD fire sales. It was not needed for two reasons. First, the US brokered the beginning of petrodollars in 1974. Second, policy moved rapidly to orthodoxy with rapid rate hikes in the early 1980s.”

Orthodoxy and EM: “US policy orthodoxy reinforced the central role of the US dollar through the emerging market debt strains that followed. The Latin American debt crisis in the early 1980s saw an increase in USD debt to $327bln in 1982 from $29bln in 1978. The Asia crisis that began in the Summer of 1997 yielded a similar outcome for different reasons. The successive crises terrified emerging market governments and they responded by accumulating an unprecedented quantity of US dollar reserve assets. It was a golden period for the US and the dollar. Large and growing external imbalances didn’t matter.”

Unprecedented US External Imbalance: “This sets the table for a very different external position today. The US net international liability is 65% of GDP and rising. It was less than 10% of GDP in 2007. It was a surplus in the early 1970s when the world fretted about the US dollar standing as a reserve currency. There are two broad ways to cleanse today’s imbalance – fiscal/monetary orthodoxy with a very deep domestic recession or inflation to revalue assets and devalue liabilities. This is precisely why there is scant domestic focus on today’s imbalances – a weaker dollar is the cure, and scares nobody. It is the foreigners who are growing nervous.”

Blind Spots: “I focus on balance sheet imbalances precisely because the setup we observe today has no good precedent and is therefore absent from the data sets that most investors rely upon when considering the future,” said Marcel, tying it all together. “There are interconnected domestic policy and political choices that will be made as the global system is increasingly drawn toward a rebalance. But it is not just foreign official reserve managers who are nervous players in this game – private foreign portfolio managers have large US equity holdings and have ‘hot money’ characteristics. And this set up produces an inherent non-linear, reflexive dynamic with a range of possible market outcomes that reside well beyond consensus expectations.”

Anecdote: “The coaches called us into the office one by one,” said my oldest, finishing plebe year, his team having failed to make quarterfinals. “They told each of us exactly what we need to work on if we hope to ever see the field,” he continued. “They said I have almost everything except for consistency, but without that, I’m useless to them. If a human doesn’t drink water every day they die, and if I don’t spend 45mins every single day throwing and catching against a brick wall it’s the same,” he said. “I was mostly expecting that, but it was a relief to hear it directly. They also told me to not practice shooting at all this summer - I already have more than enough speed and power – but to focus exclusively on overcoming my weakness. I’m so lucky that I can work through it; consistency is in my control. Height and speed are not.” Coaching at the highest level is science and art. A process of tearing down, building up. Creative destruction applied to the human psyche. “When we arrived last summer, coach asked us to find him a rock, so we did. Seemed odd, but whatever, and we’d all forgotten about it.” First year at the military academies is something plebes generally try to forget. “So yesterday, after all our individual meetings, coach called our whole class together into his office.” 14 young men, their brotherhood only just begun, the great adventure. “He pulled that rock out from under his desk.” A nondescript stone, the size of two fists. “He told us he wanted to watch us work together for a year before having this conversation, to see whether we had substance or were just hype.” They had arrived as the top-ranked incoming class in Division-1 Lacrosse, but talent alone doesn’t win championships, tenacity and teamwork does. “Then he pushed the rock across his desk. He told us to go find a place on campus that we all walk by every single day and bury it there together. When we win our first championship quarterfinal, we can dig it up in celebration, leaving no stone in our lives unturned. But if we don’t, it’ll remain buried there forever.”

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management           

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.