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Good morning. Jay Powell told Congress yesterday that a recession is “certainly a possibility”, while Bill Dudley, never one to mince words, wrote that one is “inevitable” in the next year or so. Yields and oil fell hard, which feels very recession-y. Stocks, a day after rallying for no reason, held steady, also for no apparent reason. If you can make sense of it, write to us: firstname.lastname@example.org and email@example.com.
Also, listen to Rob talk about the Federal Reserve breaking things.
The Fed doesn’t want to tighten the economy into a recession, but unless inflation starts cooling down fast, it’s prepared to do so. The Fed, alas, cannot create new sources of supply or unclog supply chains. It only controls monetary policy, which slows inflation by reducing demand, and therefore growth.
Having looked dumb relying on supply before, it doesn’t want to wait for problems that it can’t control to get fixed. A wise policy. But might the Fed get lucky? The data on supply tells a mixed story.
The trend in energy costs, which seep into all sorts of prices, doesn’t look promising. Forecasts are for a summer cost surge in America, with wholesale energy prices trebling from last summer in some parts of New England. Russia is cutting off gas to Europe just as a big US gas export terminal caught fire, knocking more supply offline for a few months.
For supply chains, it’s less dire, if still not great. The New York Fed’s index of global supply chain pressure gives a good sense of the big picture. It pulls together data on freight costs, backlogs and shipping delays — stripping out demand to find how much inflation pressure is coming from supply constraints. Things are better than late last year, but we’re far from normal:
You see this basic trend — better but still bad — popping up all along the supply chain. Here, for instance, is how much it costs to send a shipping container from China to the US west coast:
Or read what executives at big corporations are saying. In general, larger companies will see better supply-chain conditions first, because they can pay top dollar to secure whatever shipping is available, including more expensive air freight. Some charter their own ships. So we read through several recent earnings calls to get a sense of sentiment. Here, to give one indicative example, is DuPont’s chief executive, Edward Breen, earlier this month:
Yes, so a little better, but it’s tough. Like the teams are working seven days a week and getting containers booked ahead of time. It’s crazy. Going into different ports on the east coast of the US, instead of the west coast — but we’re doing fine. We’re working our way through it. But it’s not normal times, I don’t want to [leave] you with that impression, but it’s just getting a little bit better and mainly because of the Chinese — China, it was so bad, and that’s easing up now.
Less globalised companies than DuPont are saying similar things. The co-chief executive of Lennar, a US homebuilder, called the peak on supply-chain pressures during Tuesday’s earnings call:
There were still intermittent disruptions and an increase in construction costs. But for the first time since the disruptions began, we saw a flattening in cycle time [ie, total time to build a house]. Over the past four months, cycle time has expanded by only five days, which we believe signals [a] peak.
That is good news, but it will take months or years to show up in inflation data. The Fed is not keen to wait. Early signs that inflation expectations are unmooring have thoroughly spooked the central bank. Nice, growth-friendly disinflation from the supply side, it seems, isn’t coming to save us.
Instead, what we might soon get are supply-side gluts that will lower inflation — but also hurt growth. Recall the bullwhip effect, where companies buy too much during times of scarcity, ending up with excess inventory that later becomes a problem. Last time we wrote about this in May, we noted that inventory-to-sales ratios didn’t look bloated by historical standards. But they have grown exceptionally fast. The latest data, published last week, showed all industries but cars and furniture expanding inventories merrily:
Too much in stock eventually means selling at a discount, as in Target’s huge clearance sale this month. Or it means putting in fewer orders, as in Samsung freezing procurement thanks to bulging inventories. Both are drags on growth.
What is happening in inventories is linked to what has happened in supply chains, explains Eytan Buchman of Freightos, a freight booking platform. He told Unhedged:
One of the most important lessons businesses have learnt over the past couple years is when you can import something, import it. You don’t know whether they’ll be blockages in the port in Shenzhen, or lines of ships waiting to dock in Long Beach. You don’t know what the cost will be.
Such uncertainty incentivised companies to build supply buffers, even in the face of lower projected demand. But now, between swelling stocks and easing demand from monetary tightening and the pivot to services, it’s adding up to a “classic bullwhip period”. Buchman added:
So they’ve been building up an inventory. And suddenly there’s this decline in demand from customers. A very large chunk of our [clients] are attributing it to inflation. So now they have more inventory than they’ve ever had, they’ve paid more to import it than they ever have, but the demand they were expecting to make up for that is suddenly starting to evaporate.
If inflation is your top priority, perhaps these gluts are welcome. But it is another reason to suspect a recession is around the corner. (Ethan Wu)
Readers pointed out a couple of mistakes, or at least failures of transparency, in this week’s letters that we should clarify.
In Tuesday’s discussion of the bond market, Rob compared the yield on the two-year Treasury bond with the yield on the HYG ETF, and quoted the yield on the latter as 5.2 per cent. Readers objected that the yield on HYG is actually over 8 per cent. Well, sort of. The higher number is the yield on the fund’s underlying bond portfolio. It is not the yield on the ETF, which is in fact 5.2 per cent (taking the last monthly distribution and multiplying it by 12). Why the difference? The HYG managers will have bought many of the bonds in the portfolio when rates were lower, and as rates have risen, the prices of those bonds have fallen, increasing the yield on the portfolio (but not the ETF).
Eventually, as the HYG portfolio turns over, its distributions should rise to meet the portfolio yield. But for now, if you want the most liquid available exposure to the high-yield market you will have to live with 5.2 per cent, as against 3 per cent on the shorter duration, credit-risk-free two-year Treasury. We know which we would take, but we are paranoid.
In Wednesday’s letter on the European debt mess, loads of readers thought Rob was a dunce to characterise the mathematics of the situation this way:
Italy’s debt is 150 per cent of gross domestic product. Its 10-year bonds, for example, yield 3.7 per cent. Of course it will have sold debt at lower yields than that, but as old debt rolls over, the cost will rise. GDP, on the other hand, is not going to grow at anywhere near 5.5 per cent (3.7 per cent x 150 per cent). So the Italian debt burden is set to grow steadily bigger relative to GDP.
There are two things left out here that are, as readers insisted, important. The first is inflation and the second is the budget deficit. Inflation increases nominal growth, which is what matters to the debt/GDP ratio. And inflation is high now. The second is that if Italy can run a primary (that is, pre-interest) surplus, then it has more breathing room to service debt — since it doesn’t need to tap capital markets to pay for basic spending.
There is a maths mistake implied in the above: debt can grow at 3 per cent, not of GDP but of itself, and the debt/GDP ratio remains unchanged. That is, at a 150 per cent debt/GDP ratio, with nominal economic growth of (say) 3 per cent, debt can grow by 4.5 per cent of GDP and the ratio remains stable.
My point, however, remains. High inflation will make debt more bearable — but this will of course be a tax on Italians’ real incomes; not an attractive solution. Italy ran a primary deficit of 3.7 per cent next year. And its debt payments are headed up, as a percentage of GDP, unless spreads narrow or it is able to fund itself with cheap short-term debt (which would create another risk). Bring on fiscal union.
A study shows rightwing Germans tend to be hotter, or maybe hot Germans tend to be rightwing (hat tip to Tyler Cowen for flagging this).
Good morning. Ugly day for stocks yesterday. The blame was pinned on a bad reading on the Conference Board’s consumer confidence index. Feels more like a market looking for an excuse to sell, though. And for good or bad, the market half-life of economic data is measured in hours at this point. Email us with measured, sensible, long-term views: firstname.lastname@example.org and email@example.com.
Working on yesterday’s letter about long-maturity corporate credit, I chatted with Jim Sarni, a principal at Payden & Rygel, a good friend of Unhedged. He pounded the table a bit, saying that I had things backwards: the real opportunity was in the short to middle bit of the curve.
“It’s appealing from the simple standpoint of, where the hell do I put my money right now, whether as an institution or a private investor,” Jim says. “And it can appeal no matter what view a person has — that we are facing Armageddon, or we are going to be fine.”
The argument goes like this. A portfolio of investment-grade corporates with an average duration around 2.5 years provides a yield of up to 4 to 4.5 per cent. “Doing the math on the back of a napkin,” Sarni says, “that means Treasury yields can move up another 180 basis points or so before total return to the investor turns negative.”
The two-year Treasury, roughly mirroring the expected peak for the fed funds rate, is yielding 3.1 per cent. Suppose that does move up to, say, 4.6 per cent. Now your basket of mid-duration corporates are barely at break even. But under those circumstances, equities and longer-duration bonds will probably be doing a lot worse than break even. Losing only a little money might have you feeling pretty good. And if rates fall (or spreads tighten), there will be bonus returns along the way.
CPI, of course, is running at 8 per cent or so, which makes a yield of half a lot less enticing. Sarni is undeterred: “You’ve gotta be somewhere. Eight per cent is not a long-term number. It’s 8 per cent coming down. Over the duration of this portfolio inflation won’t be close to 8 per cent — north of 3, south of 4, maybe?” Sarni thinks that, given the palpable slowing in the economy when the Fed is only halfway to its anticipated destination, the bet is tilted towards lower inflation and rates. And if the Fed pushes the economy into a hard landing, you could do worse than owning the debt of companies “that are going to weather the storm just fine”.
For a proxy of the kind of portfolio that Sarni is talking about, you can look at, for example, the Ice BofA 1-5 year corporate ex-144a index (yield to worst 4.25 per cent, average duration 2.7 years); or the Bloomberg US corporate bond 1-5 year index (yield 4.33 per cent, duration three years). Here is the price and spread of the latter over the past year:
Keen to hear from our readers in the bond business whether they also see value in this bit of the curve.
We’ve been asking around these parts what the next 60/40 portfolio — 60 per cent stocks for growth, 40 per cent bonds for stability — should look like if we are moving into a world of persistently higher inflation. In such a world, the glorious negative correlation of bonds and stocks of the last 30 years or so may be nothing but a memory.
We call this replacement, affectionately, the dumb portfolio. It has to generate decent returns over a long horizon, require little active oversight and can’t be too complex. There also have to be enough assets for a broad swath of investors to pile in. Inflation-linked I-bonds, for example, have less than $60bn in circulation. They don’t fit.
We noted last time that commodities looked better as an inflation hedge than as a way to grow capital. A few readers pointed out that we used an index that understates how well commodities have done by focusing only on raw price performance. They rightly suggested we try a total return index instead, which includes the extra yield earned by the collateral, usually Treasury bills, that must be held against commodity futures. The difference is noticeable:
Still, this is not a resounding growth story. The latest rally puts us back to early 2000s levels. The last sustained period of appreciation before that, from the early 1980s to early 2000s, saw commodities grow 531 per cent, versus over 2,000 per cent for the S&P 500. Unless you believe a commodity supercycle is coming (lots of people do!), expect a growth trade-off for the diversification benefit.
Another possibility is publicly listed infrastructure projects. Tim Robson, spooked by inflation a year ago, wrote that he cut out his 35 per cent bond allocation to add infrastructure and has liked the results:
This construct has performed as I hoped with significant gains and yield from this infra allocation offsetting my equity losses since the turn of the year.
In the UK this shift was relatively easy to achieve by buying a selection of UK listed infrastructure investment trusts.
Several readers suggested getting exposure to factors such as value or momentum. Here’s Caleb Johnson, formerly at AQR and now at Harbor Macro Strategies:
Investors don’t just need exposure to more asset classes, like commodities, they need exposure to factor and style premia. Yes, this has typically been available mainly through private investments . . . but they are also available through “liquid alts” in the form of mutual funds and [exchange traded funds] that non-accredited investors can access as well.
Consider a style factor like momentum. A commodities ETF treats an entire asset class like a monolith and is only going to give an investor passive exposure to it. But a factor-oriented fund is going to do more than offer long-only exposure, allowing investors to profit from exposure to individual markets across asset classes even when they are going down in price.
Along similar lines, Philip Seager at Capital Fund Management wrote that trend following, factor investing’s close cousin, looks promising:
Not only is it a diversifier (on average zero correlated with equities) but also has mechanical features that make it a hedge against long, drawn out, protracted moves down in equities (see the 2008 crisis for example). We have also shown recently that TF as applied to commodities provides an effective hedge against inflation (end 2021 and 2022 year-to-date demonstrate this). On top of all this because of its long term nature and exposure coming from very liquid futures contracts it also scales very well.
We don’t deny the proven power of trend following and factor investing (when done right) but wondered whether the underlying concept might be too complex, even if you can buy it in an ETF. In general, the point of the dumb portfolio is maximum returns given minimum trust in your fund manager. Factor investing asks for a lot of trust.
Paul O’Brien, a 60/40 optimist, suggested a simpler change:
The key premise of the 60/40 is not the negative correlation of stocks and bonds. It is the low covariance of stocks and bonds. Bonds are less volatile than stocks and so will diversify a stock portfolio (lower portfolio volatility) even if the correlation is [positive].
Rather than ditching the 60/40, investors may want to hold lower-duration bonds, or [Treasury inflation-protected securities].
Could building the inflation-proofed dumb portfolio be as easy as take 60/40, sprinkle in some Tips and small caps, and call it a day? (Ethan Wu)
Is the Fed tightening faster than it thinks?
The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
The markets are evolving their minds about US economic prospects just as the Federal Reserve has been scrambling again to catch up to developments on the ground.
This risks yet another round of undue economic damage, financial volatility and greater inequality. It also increases the probability of a return to the “stop-go” policymaking of the 1970s and 1980s that exacerbates growth and inflation challenges rather than addressing them.
Good central bank policymaking calls for the Fed to lead markets rather than lag behind them, and for good reasons. A well-informed Fed with a credible vision for the future minimises the risk of disruptive financial market overshoots, strengthens the potency of forward guidance on policy and provides an anchor of stability that facilitates productive physical investment and improves the functioning of the real economy.
Coming into the second half of June, the Fed had already lagged behind markets twice in the past 12 months and in a consequential manner. First it stubbornly held on to its “transitory” mischaracterisation of inflation until the end of November, thereby enabling the drivers of inflation to broaden and become more embedded. Second, having belatedly course-corrected on the characterisation, it failed to act in a timely and decisive manner — so much so that it was still injecting exceptional liquidity into the economy in the week in March when the US printed a 7 per cent-plus inflation print.
These two missteps have resulted in persistently high inflation that, at 8.6 per cent in May, is hindering economic activity, imposing a particularly heavy burden on the most vulnerable segments of the population, and has contributed to significant market losses on both stocks and government bonds. Now a third mis-step may be in the making as indicated by developments last week.
Having rightly worried about the Fed both underestimating the threat of inflation and failing to evolve its policy stance in a timely manner, markets now feel that a late central bank scrambling to play catch-up risks sending the US economy into recession. This contributed to sharply lower yields on government bonds last week just as the Fed chair, Jay Powell, appeared in Congress with the newly-found conviction that the battle against inflation is “unconditional”.
The markets are right to worry about a higher risk of recession. While the US labour market remains strong, consumer sentiment has been falling. With indicators of business confidence also turning down there is growing doubt about the ability of the private sector to power the US economy through the major uncertainties caused by this phase of high inflation.
Other drivers of demand are also under threat. The fiscal policy impetus has shifted from an expansionary to contractionary stance and exports are battling a weakening global economy. With all this, it is not hard to see why so many worry about another Fed mis-step tipping the economy into a recession.
In addition to undermining socio-economic wellbeing and fuelling unsettling financial instability, such a mis-step would erode the institutional credibility that is so crucial for future policy effectiveness. And it is not as if Fed credibility has not been damaged already.
In addition to lagging behind economic developments, the central bank has been repeatedly criticised for its forecasts for both inflation and employment — the two components of its dual mandate. A recent illustration of this was the sceptical reaction to the Fed’s update on monetary policy released on June 15.
The scenario that worries the market — the Fed aggressively hiking rates only to be forced to reverse by the end of this year due to the threat of recession — is certainly a possibility, and it is not a comforting one.
There is another equally possible alternative, if not more likely and more damaging economically and socially: A multi-round flip-flopping Fed.
In this scenario, a Fed lacking credibility and sound forecasts would fall in the classic “stop-go” trap that haunted many western central banks in the 1970s and 1980s and remains a problem for some developing countries today lacking policy conviction and commitment. This is a world in which policy measures are whipsawed, seemingly alternating between targeting lower inflation and higher growth, but with little success on either. It is a world in which the US enters 2023 with both problems fuelling more disruption to economic prosperity and higher inequality.
Manufacturers and retailers are bracing for chaos as US Customs begins to enforce a ban on imports from China’s Xinjiang region from June 21 in response to reports of forced labour.
Companies are scrambling to gauge how the new rules could affect their business and supply chains, with Asian clothing suppliers, international retail chains, US solar-panel makers and Chinese floor tile material makers among scores of groups that could see US-bound shipments seized.
The ban intensifies pressure on Beijing over allegations of widespread human rights violations — including torture, arbitrary detention and forced labour — against Muslim Uyghur and other minorities in the country’s far-western Xinjiang region. China denies the claims and has warned of retaliatory measures.
Signed into law by president Joe Biden at the end of last year, the Uyghur Forced Labor Prevention Act presumes that all US-bound imports traced to Xinjiang, from cotton and tomatoes to floor tile and solar panel materials, were made using forced labour and brands them as “high priority” for seizure.
More than 900 shipments from the region were seized in the last quarter of 2021 by US authorities under earlier trade restrictions.
But trade and business groups said the new legislation’s vague wording threatened to put the bulk of China’s $500bn in annual shipments bound for the US at risk.
“The way the law is written could be interpreted as applying to other kinds of goods from other parts of China that allegedly involved forced labour at some point along the supply chain,” Doug Barry, a senior director at the US-China Business Council, told Nikkei Asia in an email.
This article is from Nikkei Asia, a global publication with a uniquely Asian perspective on politics, the economy, business and international affairs. Our own correspondents and outside commentators from around the world share their views on Asia, while our Asia300 section provides in-depth coverage of 300 of the biggest and fastest-growing listed companies from 11 economies outside Japan.
There are reports of detainees being moved out of Xinjiang to work in other parts of the country, while components produced in the region have been traced to US-bound exports shipped from elsewhere in China.
Barry warned that the law could heap more pressure on pandemic-hit supply chains and stoke US inflation, already running at 40-year highs.
Companies are still awaiting clear instructions from US Customs and Border Protection, Barry said.
“They have released little information beforehand, and companies won’t know many of the details of what they must comply with until the date they must comply,” he said. “We are expecting implementation to be messy.”
US-based Mission Solar pledged to follow the new rules, but the equipment provider said it was “difficult to know what effect it will have at this point”.
Hong Kong apparel supply chain manager Lever Style, whose clients include Fila, Hugo Boss and Theory, said it was pivoting to fabric made with Indian cotton for American customers ahead of the ban.
“We still buy most of our cotton fabric in mainland China, but we can quickly switch to buying fabrics in other places,” said Stanley Szeto, the company’s executive chair.
Xinjiang has a booming industrial, mining and agricultural sector. Everything from peppers and walnuts to electrical equipment and polysilicon, a key material for making solar panels, ship to the US from the region. It also accounts for 20 per cent of the world’s cotton and 80 per cent of China’s domestic production.
In the week before the ban, US customs issued an operations guide for companies looking to prove their products were not made using forced labour, including supply chain maps and purchase orders.
A new list published on June 17 bars goods that are produced by or contain material parts made by over 20 companies including Baoding LYSZD Trade and Business, Changji Esquel Textile and Hotan Haolin Hair Accessories.
US customs said it would strictly enforce the rules, which threaten to aggravate already tense relations between Washington and Beijing.
China’s state-owned Global Times reported that American shoe company Skechers organised an independent investigation of its supply chain after goods manufactured in China were seized by US customs. Companies including Nike and H&M previously faced questions about Xinjiang cotton used in their products.
“If the act is implemented, it will severely disrupt normal co-operation between China and the US, and global industrial and production chains,” said Zhao Lijian, Chinese Ministry of Foreign Affairs spokesperson, the week before the ban. “If the US insists on doing this, China will take robust measures to uphold its own rights and interests as well as its dignity.”
Concerns also exist that US agencies lack the resources to properly vet imports and enforce the new law. But authorities say they will use a multi-layered approach tapping information from vast systems.
“We don’t stop shipments just on hearsay or on one piece of information,” JoAnne Colonnello, centre director at Customs and Border Protection, told a business briefing. “We look in total at the situation, and all of the evidence involved, to ensure that we have efficient and effective targeting.”
Britain’s Sheffield Hallam University released a report in mid-June documenting the use of forced labour in Xinjiang to manufacture polyvinyl chloride, a core component in floor tiling. Academics and media organisations have published reports detailing systematic use of forced labour among Uyghurs held in what critics describe as internment camps.
China, which initially denied the existence of such facilities, later said they were vocational training centres designed to combat the rise of religious and separatist extremism in the region.
A sweeping crackdown in Xinjiang over the past few years has repressed cultural and religious practices and prompted allegations of forced sterilisation and arbitrary imprisonment — conditions that some western governments say amount to genocide.
Rights groups have urged for years that companies and brands linked to shirts, trousers and other Xinjiang-made goods be held accountable for labour conditions in the region.
“If governments make it mandatory for corporations and companies to conduct meaningful due diligence — which is not easy to do in China — before they engage in their activities, I think that is something we would welcome,” said Alkan Akad, China researcher at Amnesty International.
But some major corporations including Apple and Coca-Cola lobbied against the Biden administration’s import ban, saying they found no evidence of forced labour in Xinjiang’s manufacturing or supply chains.
Japanese retailers Muji and Uniqlo say they expect little impact on their operations.
“We do not export any products made in Xinjiang Uyghur Autonomous Region to the United States,” said a spokesperson for Muji owner Ryohin Keikaku, referring to the region’s official name. “In our business activities, we comply with the laws and regulations of each country and region, and strive to respect human rights and manage labour standards.”
Additional reporting by Rurika Imahashi, Peggy Ye and Jack Stone Truitt
A version of this article was first published by Nikkei Asia on June 20 2022. ©2022 Nikkei Inc. All rights reserved.
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