In the world of investing, twelve months can seem like an eternity. That’s because it only takes a year to go from one extreme to another, from a bullish to a bearish, or from a bearish to a bullish extreme. Take the end of the first quarter of 2021 compared to today, for example. A year ago the Federal Reserve was adding nearly $120 billion a month to its balance sheet, and today the Fed has started raising interest rates and is about to shrink its balance sheet. As the Fed has failed to acknowledge the persistent nature of today’s inflationary environment by insisting that it is merely “temporary” (a view we strongly disagree with and have warned against since April 2020 – see here), It could now be forced to raise interest rates by half a percent (50 basis points) at its May meeting. If implemented, it would be the first 50 basis point hike in 22 years since the peak of the tech bubble in May 2000. What could go wrong?
housing headwind
The Fed is finally being forced to deal with the runaway inflation problem that is affecting every area of our economy, affecting consumers and businesses alike. The surge in inflation not only drives up the cost of everything, but also the cost of financing with higher interest rates. The rising input and financing costs we are facing have sown the seeds of an imminent slowdown. For example, new home sales are down by double digits from last year’s levels as a 30-year fixed-rate mortgage rose to nearly 5% from under 3%. Unless mortgage rates come down significantly soon, the slowdown in housing construction is likely to continue.
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Headwinds in production
Not only the case starts to cool down, but also our production base. The Institute for Supply Management’s (ISM) Manufacturing Purchasing Manager’s Index (PMI) is now weakening from its 2021 highs, and based on price-leading relationships, we’re likely to see manufacturing soften for the remainder of this year before it will reach a possible low point in 2023.
The current slowdown in manufacturing prompts FreightWaves CEO Craig Fuller to call for an impending recession, as highlighted below:
Why I think a freight recession is imminent
I’d rather say the US trucking market has been robust and expansion will continue into 2022. But I can not. Ever since I wrote the bloodbath article, FreightWave’s SONAR tender data has continued to reinforce the prospect of a declining freight market.
Supply rejections are the best indicator of real-time supply/demand in the truckload sector. The data comes from actual electronic loading requests – “bids” in the truck loading contract market.
A high rejection rate means truckers have more options to choose from. A low rejection rate means carriers have fewer freight options to choose from. Since this measures actual loading activity and doesn’t load board posts or searches, it tells us what the market is actually doing.
And since it measures the willingness of contracted carriers to accept or refuse a load for which they have a contracted rate, it suggests that capacity is slipping when the rejection rate drops.
At the beginning of March, the rejection rate was 18.7% – today it is 13.90%. Although it’s only been a week since I wrote the “bloodbath” article, the rejection rate has dropped another 1.3%. The last week of March is usually one of the best weeks of the year for shippers, but this year has been one of the worst. Just wait for April…
Consumer Headwinds – Restoration Hardware a Canary in the Coal Mine?
On Wednesday, March 30, Restoration Hardware (RH) CEO Gary Friedman made a number of notable comments during the company’s earnings conference call that drew the attention of investors and economists to the company’s challenges and prospects. While the comments section included below may be lengthy, it is packed with insights into the plight of businesses in the current environment.
How old was everyone on this call in 1980 when the federal funds rate was 20%? I’m not trying to scare anyone. But almost everyone on that call, see, 1980, I was a kid, I didn’t know what I was doing. I had no wisdom then. I just don’t think there’s a lot of people in the business today other than Warren Buffett and Charlie Munger and I don’t know George Soros and there’s a handful…
I mean, I don’t think anybody really understands what’s coming from an inflation perspective because either companies are going to make a lot less money or they’re going to raise their prices. And I don’t think anyone really understands how high prices are going to go everywhere. In restaurants, in cars and everything. It is – and I think it will overtake the consumer. And I think we’re going to be in a difficult area. So it all happens at once. And I think you have to prepare for war. I mean when you’re going into a very difficult, unpredictable time, you just have to be super flexible, you have to be able to improvise, adapt, overcome and kind of be prepared for anything.
Two years ago the price of a container went from 2,400 to 4,800? Yes, yes, it’s doubled. I’m not going to tell you what just happened. But let’s just say that looked like a nice step up. So – and it’s not just us, but everyone. So people will either do stupid things like reduce the quality to make their goods look like they are better value or they won’t, they have to raise the prices and where they don’t If if prices go up, they will hurt – their margin profile will change. But it’s not just us, it’s everyone I know, in every industry. And I just don’t think it is, again, I don’t want to scare everyone. But I’m talking about how there’s that scene in The Big Short where everyone’s in this ballroom and the guy thinks it’s the Bear Stearns guy or someone’s up there, one of those things, and he says like they do repurchase $1 billion of their stock, that’s not, and then a guy walks on his blackberry, can I ask the question, sir? In the 20 minutes that you were speaking, your stock is down about 55%. And everyone ran out of the room.
I just think – we tend to just try to be transparent and honest. And look, maybe because of that, our stock will take a big hit and people will think that Gary Friedman wasn’t thrilled. I’ve never been – I said – I’ve never been here in my 22 years, I’ve never been so excited. I’ve never been more insecure, have I? So — and I think you need to take a really balanced view now.
The slowdown Gary Friedman sees in his business reflects the changing spending habits of US consumers, who are facing a challenging environment of skyrocketing prices. The higher inflation rates run, the more the consumer is pressured and forced to reduce discretionary spending. The slowdown RH is facing was forewarned in a report on consumer intentions by Nielsen IQ for spending in 2022. home entertainment and travel.
Liquidity headwind
It really does feel like markets are being attacked on all fronts, which is likely a payback for the extreme stimulus used in response to the COVID outbreak in 2020. In addition to consumer, manufacturing and housing headwinds, markets are still facing financial liquidity headwinds. Financial institutions here in the US continue to pump capital into the Fed’s reverse repo facility, effectively draining liquidity from the US financial system. Over the past year, the facility has soared to over $1.5 trillion in liquidity losses, largely offset by the Fed’s expansion of its balance sheet with its quantitative easing (QE) program. Now that the Fed ended QE last month and pledged to reverse it by shrinking its balance sheet from the next few months, instead of making up for the loss of liquidity in the reverse repo market, the Fed will help. One of our concerns is that the reverse repo facility is on the rise again and is expected to surpass $2 trillion in the coming weeks, which is clearly not a favorable development for financial markets.
Not only do we have a drop in US financial market liquidity, we are witnessing the same development on a global scale. Annual global money supply growth (as measured by global M2 monetary aggregates valued in USD) peaked last autumn and has been decelerating rapidly with no sign of a turnaround. Until we see a significant slowdown in inflation trends, both US and global liquidity rates are likely to continue to deteriorate going forward.
Portfolio Strategy & Outlook
Our commentary in the Q1 newsletter expressed our concerns about a weak equity market and our plan to use any market weakness to increase exposure to attractive areas. That’s exactly what we’ve been doing over the past few months. On the fixed income side, we made some purchases in convertible bonds, which offer attractive yields of over 4% to maturity, with the potential option for higher yields should underlying equity prices rallied strongly.
Looking ahead to the current quarter and beyond, we believe the headwinds mentioned above will create market turmoil and as such we have recently added client account protection. Our aim was to reduce our equity exposure below neutral to reflect our conservative macro outlook. We plan to further increase our exposure to the energy sector given the large inventory gap and we will look to reduce our exposure to bond funds given the lack of yield available in the corporate bond space.
We have correctly anticipated a rising interest rate environment by underweight client exposure to bonds while keeping our maturity well below that of our fixed income benchmark. Looking at the data, the rise in interest rates has been so steep that the recent drop in long-dated US Treasury prices is now the largest in almost half a century, even exceeding the losses seen in the early 1980s, as shown below.
We will continue to monitor the risk of a recession as this would change our portfolio strategy dramatically with likely reductions in our exposure to equities as well as commodities as they fall the most during recessions due to the collapse in demand. The past two years have been volatile and challenging to say the least and we expect this momentum to continue. At times like this, flexibility in thinking and portfolio positioning can be a huge advantage.
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