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Macro Minute: Speak Harshly and Carry a Small Stick

In the early 1900s, President Theodore Roosevelt was known for the aphorism “Speak Softly and Carry a Big Stick.” The idea behind this adage is that it is the availability of raw power, not the use of it, that makes for effective diplomacy. In the case of Roosevelt, that policy worked very well. His two terms in office had been almost completely without conflict. “He has managed, without so much as firing one American pistol, to elevate his country to the giddy heights of world power.” – Literary Digest, December 22, 1906

Possibly empowered by the policy success almost 100 years earlier, in the early 2000s, the Fed decided to embark on a policy of forward guidance. Forward guidance is the act of communicating to the public the future course of monetary policy, namely, the path of interest rates. Said guidance, which along with the control of short-term interest rates and quantitative easing, had the aim of controlling the interest rate curve without so much as “firing one American pistol.” In hindsight, it worked. Forward guidance not only kept interest rates low through the expectations channel, but also helped dampen interest rate volatility (and along with that, equity and fx volatility).

However, the deflationary forces that provided the Fed with the availability of raw power began to dissipate around 2015. Raw power allows the Fed to introduce QE and rate hikes without needing to backtrack. This was ultimately eliminated once Covid incited a degree of globally coordinated fiscal and monetary policy never seen before. Since then, the Fed has flipped Roosevelt’s policy on its head. Today, the Fed is using FOMC press conferences and governors’ speeches to speak harshly on inflation. But when the time to act comes, we believe that the Fed does not have the same firepower as before. On one hand, it cannot materially tighten financial conditions without causing an enormous problem for the refinancing of historically high levels of debt (both corporate and government). On the other hand, with inflation rampant, it cannot continue to serve as a backstop to financial markets.

Going forward we believe that the Fed will speak harshly of inflation, but will consistently be behind the curve, possibly un-anchoring inflation expectations and the long end of the interest rates curve.

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Macro Minute: Commodities in 2022

After a strong year, we believe 2022 is shaping up to be another good year for commodities. The theme across most sectors in the asset class is consistent – a fundamental mismatch between supply and demand is driving prices higher. Prices are being further pressured by increasing costs of capital for some (e.g., energy producers), higher input costs for others (e.g., fertilizer for agricultural products), and/or after a decade of underinvestment, a lack of new projects ready to boost supply (e.g., base metals mines). Any weakness in a historically strong USD will further the dollar-denominated sector’s move higher.

Looking across the asset class, one finds inventories of many commodities well below their 5-year averages entering 2022.

Concurrently, JP Morgan projects global investment in commodity sectors to be the lowest across all sectors this year. This comes at a time where the forces of ESG have driven costs of capital higher, leading major producers of commodities to hold off on investing until higher prices are sustained for a longer period.

Fundamentally, physical assets are driven by volumetric levels rather than expectations, which fuel financial assets. When supply cannot meet demand, and inventories cannot bridge that gap, only the highest bidders get access to a specific commodity. This process is called “demand destruction” and can produce parabolic price movements.

This past year, we saw an example of “demand destruction” price action in European natural gas (TTF). Weather seasonality impacted a very inelastic demand while shifting energy priorities related to net-zero goals, and regional geopolitics caused a shift on the supply side.

We expect to see more demand destruction across the commodities complex in 2022.

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Macro Minute: Cross-Asset Views for 2022

Rather than provide a classic “Here are 10 things to watch” list that will more than likely be stale by the time you hear from us next, we’ll share quick views across different markets for 2022.

Equities

At a $3 trillion market cap, Apple is worth more than two years of Brazilian GDP or about equal to the United Kingdom’s GDP in 2020. Put simply, equities (particularly in the US) screen expensive by almost any metric. There are still opportunities to be had here, especially in companies levered to commodities, but with rates rising and Fed QT on the horizon, we are cautious on the asset class.

Commodities

The 2022 Norbury Partners Annual Report will be focused on commodities and a regime shift from an equity-driven market to one driven by commodities, but in brief, we think that decades of underinvestment across the complex, coupled with an increase in demand ex-China will be a boon for commodity prices. Commodities are essential to human life in a way incomparable to other financial assets. There is a strong case to be made that the sector will be a key piece of the geopolitical framework this decade (e.g., Russia, Kazakhstan, China).

Rates

We continue to monitor US interest rates with the view that they should persist moving higher from here and that the curve should steepen. While less clear on the number or pace of rate hikes this year, this paper from the Kansas City Fed (published October 2021) sheds some insight into how the Fed is thinking about policy normalization this time around.

Fewer hikes coupled with a bigger unwind of the balance sheet would in theory not only steepen the yield curve, but also allow banks (who borrow at the short-end and lend at the long-end) to continue making loans to maintain growth in the economy. A steepening yield curve would also help to cap the sharp rise in housing prices we’ve seen in the past year, a key goal for those looking to address wealth and asset inequality in the system.

Currencies

FX volatility screens as the cheapest among all asset classes, and we have been using this to hedge some of our high conviction positions in Equities and Rates.

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Macro Minute: US Labor Participation

This week, we will once again touch briefly on labor force participation and attempt to make sense of the US Employment Situation Report from Friday.


US labor force participation has been the subject of much discussion lately. Beginning in the 1960s when more women entered the workforce, it has steadily risen, moving from 59.1% to 66.9% by the year 2000. Since then, it has drifted lower and settled near 63% pre-Covid. A drop of almost 4% on the labor participation rate is equivalent to around 10 million jobs. At first glance this seems negative, but we find that most of this was due to strong levels of enrollment in post-secondary education among those aged 16 to 24. This trend began in the late 1980s, and accelerated into the 2000s, hence a deluge of social science majors and a dearth of truck drivers.

Turning to today, let’s analyze some of the most common arguments for explaining the slow recovery of the labor force participation rate.

(1) Self-employment is keeping labor participation low – One way to try to test for that, is to track the difference between the household and the establishment employment data. The household employment figure captures the self-employed, farm workers and domestic help, something the BLS payrolls survey doesn’t do. Here what we find is that household employment suffered more than payrolls during 2020, and still hasn’t recovered to pre-covid levels.

2) Women have been kept out of the labor force because of childcare – There is some indication this may be true. We saw nearly the same number of exits from the labor force for men and women in 2020 (3.9mm & 4.2mm in April ’20, respectively). Those aged 25-34 were the second most affected at the time, accounting for more than 1mm women exiting the labor force. By September 2021, there were still 550k less women aged 25-34 in the labor force than in January 2020, the largest discrepancy across all age brackets. With schools reopening, that number was cut in almost half to 283k in November.

(3) Retirement is keeping people out of the labor force – It is hard to see that clearly in the data. The age group 55 and over (55-64 & 65 and over), suffered the least in both genders and have the least amount of people out of the labor force (when compared to January 2020 levels). Today there is 100k more men 65 and over in the labor force than at the peak in January 2020.

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Macro Minute: What to Make of Omicron

The emergence of the Omicron variant undoubtedly increased the risk of a repeat in lockdowns and restrictions the world saw in 2020. Markets started pricing a higher probability of a significant negative impact which we experienced last Friday, November 26th.

We are tracking the developments of the Omicron variant very closely and have begun reducing risk accordingly. Having said that, we believe that there are a few indications that this new variant also increased the upside scenario for the markets, and even more importantly, for global health.


By now, most people are familiar with the downside case the new variant represents. With more than 30 mutations of the spike protein alone (Delta variant had 9), the Omicron variant could be a severe risk to global health. 8 of the Omicron mutations have never been seen before and 9 have been seen in other variants of concern. Lab data suggests that some of the new mutations are a threat and other mutations are still being examined. Some mutations have properties that lower the efficacy of current vaccines, while others show potential for increased transmissibility.

There are  also other indicators that we are currently tracking. The majority of the hospitalized cases are still in unvaccinated people (South African Health Ministry identified that most of the cases seem to be in < 50-year-olds, where the rate of vaccinations are low <20-25%, and also likely that some of these would be immuno-compromised with HIV, etc.). However, it is unclear how many had natural immunity from previous infections.


It is too early to say, but the lack of a surge in hospitalization rates in South Africa combined with early anecdotes of mild symptoms and the knowledge that this variant has had numerous mutations gives rise to the possibility of it becoming a less deadly virus. If this is the case, it could translate into much lower hospitalization and fatality rates. Combine that with higher transmissibility and increased infectivity, and we might just be staring at the light at the end of the tunnel. If this variant is less severe but much more contagious, we could quickly move toward a flu-like endemic illness.


Nevertheless, one of the most interesting pieces of information that came out last week has been given little to no attention. The Omicron variant, unlike other variants, can be tracked via a simple PCR test and will not require genomic sequencing to identify. The reason this is so important requires a practical understanding of how statistics are generated during a pandemic.


The primary source of risk arising from any pandemic is hospitalization and fatality rates, but it is tough to have an accurate number as the infection spreads (and even after it is over). Let’s use fatality rates as an example. The most common approach is to have confirmed deaths associated with the virus (a reasonably reliable indicator in most cases) divided by the number of cases (varies depending on how this is captured). The denominator could be counting only laboratory-confirmed infections, all people who displayed symptoms but were not tested, or the total number including asymptomatic cases. As expected, laboratory-confirmed cases (lowest denominator) yield the highest fatality rates.


The fact that a simple PCR test can detect the Omicron variant does not completely fix the denominator’s problem. However, within laboratory-tested cases, it will make comparison with other variables much faster and efficient. If we find that this new variant has a much lower fatality rate, policies will have to adjust for the new reality, and the risk of a repeat in lockdowns and an even bigger health crisis dissipates. We will learn more in the next couple of weeks.

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Divestment Is Not The Answer: An Easy Way Out Of A Complex Problem

Divestment, the act of removing and or excluding particular sectors or segments of the market from investment portfolios, was all the rage at the beginning of the last decade in the face of climate change. Based on my perspective, however, the results of such action by institutions and portfolio managers have been uninspiring.

For citizens of a democracy, voting is the most important action one can take toward shaping the future path of economic and social policy in his or her municipalities, states and nations. George Nathan, an American editor in the early- to mid-1900s, has been credited with saying, “Bad officials are elected by good citizens who do not vote.”

A case can be made that the same level of responsibility held by voters in a democracy sits with the market when it comes to shaping a company’s business decisions. Shareholders, irrespective of size, are typically entitled “to vote in elections for the board of directors and on proposed operational alterations such as shifts of corporate aims and goals or fundamental structural changes,” according to Investopedia. When you consider the democratic tradition of voting to make a change, particularly in American culture, it is hard to “square the circle” when it comes to supporting divestment.

However, recently, the trend seems to be shifting. This year, shortly before Memorial Day, the board at Exxon “conceded defeat” to impact investment firm Engine No. 1, which drummed up (and won) a proxy fight by alleging the company was being disingenuous with its emissions targets and not taking its impact on climate change seriously enough. Through a combination of publicity and engaging with large shareholders, the newly launched firm used activism to, against the recommendation of Exxon’s executives, elect three candidates to the company’s board who are committed to pushing the company’s business model away from fossil fuels and toward renewable energy.

As an investor, one should strive to understand as many of the components of risk that will impact a company’s (or country’s) future rate of growth and ability to operate efficiently. We founded Norbury Partners, a sustainable macro fund, on the premise that it is impossible to make informed investment decisions without considering changing consumer preferences, as well as changes in the regulatory and policy environment arising from climate change mitigation and adaptation and access to basic services. However broad, certain sustainability information can be material to better understand macroeconomic variables and the idiosyncratic risks associated with countries and the future cash flows of corporations.

From severe flooding in low-lying cities caused by mega-storms to drought-stricken commodity harvests, and everything in between, it has become increasingly clear that fundamental data found on company 10-Ks, or in periodic sovereign data, does not always wholly paint a picture of the future. Like people and their voting habits, companies and countries change with the times. Look at the past six months: the United States rejoined the Paris Climate Agreement and the largest economies in the world committed to net-zero targets within the next 40 years.

Rather than divest, rational investors seeking to maximize their returns should look for companies in the early or interim stages of change that will create outsized value in a changing world energy paradigm. Often by the time companies mature, becoming renowned for their sustainability practices and stalwarts in environmental, social and corporate governance (ESG)-focused portfolios, the excess value created when a company managed its downsides and built upside has already been priced into the stock.

Furthermore, what industry is going to see a more significant shift in the changing world paradigm? Someone will have to provide the innovation and energy required to power a growing, more technology-centric world. By participating in a company that has long been called for divestment, Engine No. 1 has demonstrated that investors have a better chance of shaping the future and capturing upside for themselves as active shareholders than they do as spectators in the market.

Finally, the nature of markets guarantees that by divesting, particularly on a large scale, prices will be pushed down with more sellers than buyers. This, in turn, increases the expected return for divested company shares where business will continue as usual, bringing non-ESG-focused investors into the fold who are less likely to make the required changes (or vote along those lines) for a sustainable future.

By last fall, more than 1,200 institutional investors, with more than $14 trillion in assets, had made commitments to the divestment of fossil fuel holdings. Yet, the way I see it, the movement has failed to bring about the change it has been lauded to produce.

As citizens of a democracy, it is our right and our duty to exercise our vote in order to institute change. As investors, we should be looking for the upside to be found in energy companies transitioning to technologies more suitable for the future that policymakers have committed to. And as students of markets, we must recognize that by divesting shares and pushing prices down, we increase a stock’s expected return, thereby inviting marginal investors less committed to ESG and a sustainable future as shareholders, and creating a feedback loop of “more of the same,” with little prospects of advancing toward our goal.

Voting should not be something we talk about every four years. Utilize your ability to be an active market participant to drive the change you want to see.

Article also submitted to Forbes

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Macro Minute: Commodity Inventories

A quick note on commodities… Historically tight inventories have led to all six base metals (Aluminum, Copper, Nickel, Lead, Tin, Zinc) listed on the London Metals Exchange to trade in backwardation for the first time since 2007.

Of those six, some of the tightest markets are in Aluminum, Copper and, especially, Nickel, which has the largest deficit in its history. Using the average daily production of each metal and aggregate inventories across Shanghai, London, and United States metal exchanges, we estimate global aluminum inventories to be approximately 5.8 days of production, copper at 2.2 days of production, and nickel at just under 13 days of production. Actual daily draws from exchange are variable, but this illustration speaks to the level of tightness in the market.

All but tin have upside to the levels reached in the last period of backwardation across the sector, after adjusting metal prices for inflation.

Bear in mind that while the price run-up in 2007 was also the result of a supply shock, albeit for different reasons, there was a sharp decline in demand caused by the bursting of the housing bubble and onset of the Great Financial Crisis, just as more supply began to come to market. The setup this time appears to be different. Persistent underinvestment in commodity extraction over the past decade, coupled with increased demand driven by government net-zero goals rather than private industry (e.g., homebuilders), suggest that this rally could be much tighter for much longer. With EV penetration increasing around the world, including in China, where nearly 20% of new car sales are electric, and the fact that those vehicles require between 5-6x more metal than internal combustion engines, we could see pressures drive prices past 2007 levels.

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Macro Minute: Fiscal Cliff vs. Excess Savings

Looking ahead to 2022, much has been written about the pending fiscal cliff and its impact on Real GDP Growth. As the impact of fiscal stimulus dissipates and the federal government mulls tax increases, analysts expect fiscal impulse to shift from positive to negative next year.

Figure 1: Effect of Fiscal Policy on Real GDP Growth (3Q CMA) [Source: Goldman Sachs]

In our estimation, given the levels of excess personal savings reached in the past 20 months, we believe there is enough pent-up savings to compensate for the forthcoming negative fiscal impact on GDP. Using seasonally adjusted personal income minus personal consumption expenditures as a proxy for personal savings, we find that from April 2020 through September 2021, Americans generated over $2.8 trillion in excess savings, amounting to approximately 12% of GDP. That compares with approximately 4% of fiscal drag projected for 2022.

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Macro Minute: What’s going on in the US Labor Market?

With job openings, participation rate, and unemployment central to the current discourse on markets, the topic of this month’s memo is the United States labor force.  

Focusing on the four largest sectors (which add up to more than 60% of payrolls and job openings in the US economy), we can see that wage inflation is a pattern that predates the onset of covid. In other words, wage inflation is not simply a result of covid supply shocks, it is based on fundamentals in the economy, and therefore it is not transitory. 

1 – Trade, Transportation & Utilities (19% of total Payrolls, 18% of total Job Openings)  In 2018, demand for work (job openings) started to grow much faster than supply (using payrolls as a proxy). As a result, average hourly earnings growth for this sector has surged from an average of 2.25% percent in 2018 to over 4% today (and 3.35% pre-covid). 

2 – Education & Health Services (16% of total Payrolls, 18% of total Job Openings) Hereto the story is very similar, but it started even earlier. In 2014, demand for work accelerated faster than supply of workers, driving an increase in earnings from 1.5% to 3.4% today (and 2.5% pre-covid).

3 – Professional & Business Services (14% of total Payrolls, 18% of total Job Openings) In Professional & Business Services, we saw two waves. The first in 2014 and the second in 2018, causing an increase in earnings from 1.5% to 2.3% in the first wave, and from 2.3% to 4% today (and 3.3% pre-covid).

4 – Leisure & Hospitality (10% of total Payrolls, 14% of total Job Openings) Leisure & Hospitality is the only sector in the top 4 that has gone through two opposite cycles since 2014. The first was with the demand for work growing faster than supply starting in 2014, increasing earnings growth from 1% to 4% in 2017. The second cycle took place starting in 2018, with labor supply growing faster than demand, and earnings growth falling to 3.5%. Today we are back at 4% growth, last seen entering 2018. It is worth noting that today, the demand for work in this sector is at historical highs while supply is back near the levels of 2010.

Labor Supply Shock

The last point has to do with the temporary labor supply shock that happened due to covid. Comparing jobless claims numbers between states that ended extra unemployment benefits before the September 6th deadline and those that adhered to the target, we see that the states that finished earlier have a much more accelerated and consistent contraction in claims across latter weeks. With this in mind, we expect some of this labor supply shock to normalize as we get farther from the deadline. However, when we look at the pre-covid trend, we believe that this will not be enough to avoid wage inflation.

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Special Report – A Changing Paradigm

As an investment philosophy, we believe that the best way to deliver above-market returns is to find something cheap, take a position, and hold it for the long term. We tend to avoid market timing and “short-term” investments.

Looking across asset classes, we find that many equities are overpriced on a historic basis by virtually every metric and expect future returns to be much lower than in the past decade, save for a couple of undervalued sectors like energy and materials. When the stock market is on fire, as it has been almost non-stop since 2008, investors ignore companies that specialize in raw materials and other goods. With investors too distracted by their ever-increasing portfolio of technology companies, there was a loss of interest in investing any money in increasing the productive capacity of raw materials, agricultural products, and other hard assets.

In real estate, housing around the world is already too expensive to represent a compelling investment. In the US alone, the S&P Case-Shiller Home Price Index sits a lofty 26 percent above its 2006 peak, with a 17 percent increase year-over-year for the nine US Census divisions. To put this in context, housing prices have been rising more than 5 percent above inflation for the past decade.

Products like copper and lumber seem expensive but as an asset class, commodities are the cheapest. When you factor in inflation, even after the recent run up in prices, most commodities are trading closer to their historical lows. We will further explore this asset class in detail in future reports.

Figure 1: Inflation-Adjusted Commodity Prices

Bonds have never been this expensive in history and are clearly in a bubble. As we write this letter, 10-year real yields in the United States are at their historical lows of -1.2 percent. With the Fed’s new inflation targeting policy of slightly above 2 percent, real rates could still theoretically go down to somewhere slightly below negative 2 percent, assuming the Fed cannot reduce nominal interest rates meaningfully below zero. However, for that to be true one needs to accept that we are living through some type of global secular stagnation[1] process, from the demand or the supply side.

Herein, we hope to show that such a scenario is extremely unlikely. First, we believe it highly probable that the environment of slower growth and inflation from the past few decades has more to do with a series of temporary “headwinds” arising mostly from consecutive deleveraging processes caused by the fact that almost all recent crises were balance sheet crises, and therefore deflationary. Secondly, we argue that even if we were living through secular stagnation before, we are not anymore. The underlying forces in play for the past few decades began reversing around 2015, and the Covid crisis created a catalyst for an acceleration of these forces.

If you wish to receive a full copy of this report, including our directional views across asset classes, please contact [email protected].

[1] Secular stagnation is defined as a prolonged period of low growth. While prolonged and low are not further specified, many economists define low as an average annual real output growth rate of no more than one to 1.5%, and prolonged as covering at least several business cycles. The term secular does not require stagnation to persist forever.