Tag: Macro Minute

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Macro Minute: SVB takeover and Credit Suisse Acquisition- Signs of a looming Minsky Moment?

In recent weeks, concerns over bank solvency have resurfaced in the markets, with Silicon Valley Bank (SVB) being taken over by regulators and UBS acquiring Credit Suisse for $3.2 billion. The takeover of SVB marks the second-largest bank failure in U.S. history and the most significant since the 2008 financial crisis.

Why it matters: While some attribute the recent events to executive mismanagement, we contend that they are symptomatic of a broader systemic issue. Rather than isolated incidents, they may represent the opening act of a potential future collateral crisis. What’s particularly worrisome is that if the collateral in question is so-called “risk-free” government bonds, we could be entering uncharted territory, leaving us with little recourse to address the issue. The short-term impact of recent events could be a significant curbing of credit to the economy, while the long-term impacts could pose an even more significant challenge to the financial system than the Great Financial Crisis.

The short-term effects of the most recent banking stress will be to reduce credit in the economy.

  • Regional banks are likely to curb credit for three primary reasons:
    • First, increasing regulation and the risk of executive prosecutions for mismanagement will create a risk-averse environment, leading these banks to reduce lending.
    • Second, the newly formed mechanism that gives these banks direct access to the Fed will increase the relative attractiveness of securities that can be posted as collateral, thereby decreasing the attractiveness of loans.
    • Lastly, the drop in deposits in these banks will create a hole that must be filled through wholesale funding provided by money market funds. While access to funding won’t be a problem, the rates charged for this funding will be higher than those on deposits, increasing costs for these banks, thereby pressuring their margins, reducing their profits, and potentially disincentivizing them from making new loans.
  • The recent events will also impact large banks, causing them to take a risk-averse stance for two main reasons.
    • First, the FDIC is not backed by taxpayer money but by the banks, particularly the well-run large banks. Apart from the direct cost of insuring all deposits of SVB, the possibility of new regulations requiring the FDIC to insure a larger portion of deposits will drive the profitability of these banks lower, reducing their willingness to lend.
    • Second, with regional banks now having direct access to the Fed, there is a new price-insensitive buyer of Treasuries that could pressure long-term rates lower while the Fed keeps the short-end of the curve higher through its hiking cycle, making curves flatter and reducing bank profits and their willingness to lend. These factors could lead to tightening credit and financial conditions, which could have significant implications for economic growth and stability.

The long-term effects of the debasement of US Treasuries could be catastrophic to the global financial system.

  • While it’s true that critics have pointed to mismanagement as a contributing factor in the sudden collapse of SVB, this only scratches the surface of a more significant issue at play. Banks were led to invest heavily in risk-free (US Treasuries) and quasi-risk-free (government-guaranteed) assets due to financial repression and regulation. “Hold to maturity” accounts further fuelled this trend by increasing the allure of such assets, leading to a dangerous level of complacency among banks. Therefore, while SVB may have been the first to fall, the underlying problem is much more pervasive and requires a more comprehensive solution. The possibility cannot be dismissed that we may be witnessing the initial signs of what could be the most significant Minsky Moment in history.

Named after economist Hyman Minsky, a “Minsky Moment” refers to a sudden collapse of asset prices following a long period of growth. Minsky believed that during periods of economic stability and growth, investors and lenders become increasingly complacent and take on more and more risk. This leads to a build-up of financial fragility, with borrowers becoming increasingly over-leveraged and lenders becoming more lax in their lending standards.

Eventually, the economy reaches a tipping point where borrowers can no longer meet their obligations, and the value of assets used as collateral declines rapidly. This triggers a panic among lenders and investors, who try to liquidate their assets, causing a further reduction in asset prices and triggering a financial crisis.

Minsky moments have been observed in many historical financial crises, such as the 2008 global financial crisis, the dot-com bubble burst in the early 2000s, and the savings and loan crisis in the 1980s.

  • It’s worth noting that the estimated losses on securities only represent a fraction of the total unrealized losses that banks have experienced due to the rise in interest rates. Loans, much like securities, also experience a decrease in value when interest rates increase. With a total of $17.5 trillion in loans and securities as of December 2022 and an average duration of 3.9 years, the total unrealized losses on bank credit amounted to approximately $1.7 trillion (calculated as $17.5 trillion x 3.9 x 2.5%). This figure is only slightly less than the total bank equity capital of $2.1 trillion in 2022, indicating that the losses resulting from the interest rate increase are on par with the entire equity of the banking system.[1]
  • While it’s crucial to consider losses incurred on assets, even if they are unrealized, the most significant issue is the impact those losses have on a bank’s ability to refinance its outstanding debt. Financial institutions rely heavily on short-term, wholesale dollar funding through collateral considered “safe.” However, a lack of such “safe” collateral can lead to a catastrophic failure of the financial system. Therefore, while the losses on assets are important, the loss of confidence in the ability to refinance their outstanding debt poses the most significant risk to the banking system.

A prime example of the risks associated with a lack of “safe” collateral can be seen in the lead-up to the 2008 Global Financial Crisis. JP Morgan provided cash to Lehman Brothers to conduct its daily business. However, as Lehman’s collapse loomed, JP Morgan began to question the value of the collateral that Lehman had pledged, suspecting that it was worth less than initially claimed. As a result, JP Morgan required Lehman to pledge more collateral as a condition for continuing its operations. This scramble for the most “pristine” collateral highlights the dangers of a shortage of “safe” collateral, which can ultimately lead to a decrease in USD funding worldwide as chains of wholesale dollar transactions begin to unravel.[2]

  • What could cause the debt of a sovereign country with a free-floating exchange rate and holds reserve currency status to become risky? Inflation. The Fiscal Theory of the Price Level suggests that higher inflation may be forthcoming, which could lead to the “risk-free” status of government bonds being called into question. If this were to occur, it could potentially leave us in uncharted territory with few tools at our disposal to address the issue. Therefore, inflation poses a significant risk to the perceived safety of government bonds and could have far-reaching consequences for the broader financial system.

The majority of U.S. government debt is issued with a nominal face value in U.S. dollars, meaning its real value or purchasing power is determined by dividing the value of outstanding nominal debt by the price level. The intertemporal government budget constraint stipulates that the real value of debt is linked to the real value of future surpluses. When considering the intertemporal government budget constraint as an equality, changes on the right-hand side (such as increases or decreases in future fiscal variables) correspond to changes on the left-hand side (i.e., real debt). Since the nominal value of outstanding debt is predetermined, the price level is the variable that adjusts to reflect changes in fiscal variables on the right-hand side of the constraint.[3]

Our own analysis also shows[4] that we do not anticipate the favorable inflation outcomes of the past three decades to continue over the next few decades. Apart from a stronger fiscal position, the favorable inflation environment of the past three decades was partly due to the increased global productive capacity resulting from the dissolution of the Soviet Union and the inclusion of China and India in the global trading market. Additionally, financial markets had become more interconnected, resulting in the greater deployment of the world’s savings toward cross-border investment financing. These factors contributed to lower inflation expectations and reduced risk premiums.

[1] Source: Itamar Drechsler, Alexi Savov, and Philipp Schnabl, “Why do banks invest in MBS?,” New York University Stern School of Business, March 13, 2023.

[2] Modern Macro by Zachary Cameron.

[3] Lubik, Thomas A. (September 2022) “Analyzing Fiscal Policy Matters More Than Ever: The Fiscal Theory of the Price Level and Inflation” Federal Reserve Bank of Richmond Economic Brief, No. 22-39.

[4] Macro Minute: What If (Dec 2022), Macro Minute: A Tale of Two FOMCs (Nov 2022), Catalysts Into Year-End (Oct 2022), Macro Minute: We Learn From History that We Do Not Learn From History (July 2022), Norbury Partners 2022 Annual Report (June 2022), Macro Minute: Flat as a Pancake (Mar 2022), Macro Minute: The Reflexivity of Inflation & Conflict (Mar 2022), Macro Minute: Speak Harshly and Carry a Small Stick (Feb 2022), Special Report: A Changing Paradigm (Aug 2021) – for any of these reports, please contact [email protected] or visit our website.

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Macro Minute: What If?

The consensus today is that the global economy, led by developed countries, is heading into recession in the next few quarters. The debate ranges between hard or soft landing. Bloomberg’s recession probability forecast stands at 65% today. To add to this bleak outlook, we have Fannie Mae and Visa, companies with real economy visibility, forecasting an 85% chance of recession. 

Some of this doom and gloom is based on the past relationship between surveys and hard data. Soft data points to the worst economic environment in half a century, only comparable to the Great Financial Crisis.

Financial markets are also forecasting an imminent recession when looking at the shape of the yield curve. The spread between 2-year and 10-year US Treasuries is the lowest since the high inflation period of the 1970s.

If we could point to only one data point to explain such dreary levels of survey responses and market pricing, it would be the speed and magnitude of the change in short-term nominal rates. The Federal Reserve hiked 425 basis points in nine months. This represents the fastest and largest rate-hiking cycle since the 1970s. The market and economists alike are saying that the current level of interest rates is incompatible with the economy’s structure. Markets believe that this level of rates will invariably cause the economy to contract, inflation to go back to 2% in the short- and long-term, and the Fed to start cutting rates in the second half of 2023.

The conclusion is valid if we accept the assumption that the trends of the 1985-2019 decades are still in effect, and that what we have seen over the past two years was just the effect of transitory impacts of Covid measures. 

Having said that, markets are already broadly pricing these assumptions with a reasonably high confidence level. As investors, we must ask ourselves, ‘what if?’ What if there is a deeper reason for the past two years’ economic dynamics? What if we are not living through (only) transitory effects? Then, looking at nominal rates to predict a recession and a turning point for inflation would be misguided. And if so, the US treasury market would have to reprice materially in 2023, causing a structural shift in the global economy and financial markets.

Inflation in the period from 1985 to 2019 averaged 2.6%. This is when we saw the third wave of globalization, increased working-age population, plentiful fossil fuel energy, and the unquestioned Pax Americana. With inflation at such low levels, one would be excused if all its conclusions were based on nominal rates assumptions. But inflation is only low sometimes. From 1950 to 1985, as well as from 2019 to today, inflation averaged 4.5%. When inflation is higher, nominal measures become less important and it is essential to look at real interest rates. Here, we use the Fed Funds Rate deflated by YoY CPI.

Real interest rates tell a very different story. We have seen a sharp increase in real rates since the beginning of 2022, but that move started from a historically low level. Today, real rates are still extremely negative, even after 425 basis points of hikes from the Fed in 2022. The conclusions we draw from looking at this measure are very different from those based on the nominal rate. We see a monetary stance that is not restrictive and, therefore, supportive of growth. With that, we also see the probability of recession at very low levels in the next few quarters, and little reason for the Fed to start cutting rates in the second half of 2023 (let alone the 125 basis points of cuts the market is pricing in between 2H23 and 2H24 – see graph below). This measure helps explain why the labor market is so strong, something that keeps confounding central bankers and analysts alike. It also helps explain why surveys are so pessimistic. In periods of inflation, people tend to have a very pessimistic view of the economy, even when real growth is positive. 

We must then ask ourselves. What if real rates are more important for the economy than nominal rates? What if the structural trends of less globalization, a decrease in the working-age population, scarce fossil fuel energy, and a multipolar world materially increase R*? What if the recent weakness in inflation numbers is just a transitory effect as part of a long-term structural inflationary period? What if growth surprises to the upside in 2023, even with the Fed keeping rates above 5%? What if?

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Macro Minute: Is Deep-Sea Mining the Answer?

For many decades now, world leaders have slowly come to terms with the realities of climate change. More recently, we have seen the public and private sectors starting to translate promises into actions through various investments. As we move from theory to practice, agents are beginning to run against obstacles that were not clear before.

It has become increasingly clear that the world lacks the investment in natural resources necessary to make the green energy transition a reality. Setting aside the requirements for building solar and wind power on a global scale, the Geological Survey of Finland (GTK) recently released a study examining the volume of metals needed to build the first generation of electric vehicles (e.g., replacing every vehicle in the global fleet today with one EV) and the power stations (e.g., batteries) necessary to store intermittent electricity generated from renewable sources. They estimate that one generation of electric vehicles (1.39 billion) will require over 280 million tons of minerals and another 2.5 billion tons of metals for power storage projects to support such an increase in electricity consumption. In sum, current estimates for global reserves of nickel, cobalt, lithium and graphite are not sufficient to support such a massive undertaking.

To aggravate the problem, investments to transform reserves into actual ore are faltering. Existing mines for copper in places like Chile have under-produced expectations meaningfully this year. Reports from the recent 121 Mining Conference in Sydney highlighted the issues of getting new projects approved and on track for production, characterizing the challenges as “multiplying” for myriad reasons, including higher interest rates, low and volatile mineral prices, and ESG concerns.

On the geopolitical front, the ongoing realignment of world power will also have a material impact on access to materials and their ESG qualities. The world’s largest nickel producer is Indonesia, where mines are developed in the most biodiverse biome on the planet—rainforests; its biggest and cheapest nickel operation is Nornickel, located in Russia. The world’s largest cobalt producer by far is the Democratic Republic of the Congo (DRC), where not only does the climate range from tropical rainforest to savannahs, but also the exploitation of child labor is a major social concern. While China is responsible for 64% of graphite mining, it also has a controlling interest in much of the DRC’s cobalt production, and maintains an overwhelming majority of the refining capacity for lithium, nickel sulfate, manganese and graphite.

The unprecedented demand for green-transition minerals meets a supply picture that is very constrained and will generate prohibitive costs to the energy transition. That happens while billions of people lack cost-effective access to the energy they need to prosper.

Deep-sea mining offers a very interesting alternative to this problem. The USGS estimates that the Clarion-Clipperton Zone, “the largest in area and tonnage of the known global nodule fields,” contains 21.1 billion tons of dry nodules. Based on that estimate, tonnages of many critical metals in the CCZ nodules are greater than those found in global terrestrial reserves. Given the high ore grades found in nodules, and the simplicity of recovery, many companies in the space estimate that deep-sea nodule recovery will be one of the lowest cost producers of critical minerals in the world. The same USGS publication mentioned above notes, “if deep-ocean mining follows the evolution of offshore production of petroleum, we can expect that about 35–45 percent of the demand for critical metals will come from deep-ocean mines by 2065.”

Like any extractive activity, this kind of endeavor also carries costs along with its benefits. However, their costs are different from what one would think at first. The vanguard of deep-sea mining does not involve drilling and mining pits. Instead, it is focused on the harvesting of nodules. Nodules are fist-sized lumps of matter that collect on the ocean floor over thousands of years when currents deposit mineral sediments. Different parts of the ocean contain nodules rich in different elements. Those found in the Pacific Ocean have been shown to contain incredibly rich deposits of copper, nickel, cobalt, and manganese with ore grades superior to many, if not all, of today’s land-based reserves. Nodule collection occurs between 4,000-6,500 meters in the aphotic zone where sunlight does not penetrate and biodiversity is faint. Its process is minimally invasive and entails the scraping of about 6 inches of the ocean floor to separate nodules from sediment, depositing most of what is not used back to its original place. MIT researchers recently published results of a study demonstrating that 92% to 98% of the sediment either settled back down or remained within 2 meters of the seafloor as a low-lying cloud. The plume generated in the wake of the collector vehicle stayed roughly in the same area rather than drifting and disrupting life above.

The benefits are potentially many. From an environmental point of view, this process has enormous advantages when it comes to the impact on deforestation, destruction of carbon sinks, and water usage. From a social aspect, deep-sea mining also appears to be superior to other extractive activities on land, with limited exposure to the negative social dynamics of social displacement, corruption and child labor. If proven to be cost-efficient, it would also promote clean and cheap energy creating prosperity for billions of people. Should the environmental studies of nodule collection continue to be positive, nodules present a promising alternative to solve our natural resource problem in the face of a green transition. As the West looks to become both greener and less dependent on “unfriendly” sources of labor and natural resources, it must take a pragmatic approach toward deep-sea mining, recognizing that there is no such thing as a perfect solution, but this could be the next best thing for achieving the future we want.

This article appeared on Forbes.

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Macro Minute: A Tale of Two FOMCs

he FOMC’s November meeting might have been one of the most important meetings in a long time. 

At 2:00 PM EST, we saw a statement that was believed to be dovish by most and confirmed by market moves. It said that the FOMC expects that “ongoing increases in the target rate will be appropriate,” which even the most dovish observers would agree, but added that “in determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”

Thirty minutes later at the press conference, Chair Powell struck a hawkish tone, focusing on the least dovish parts of the statement and provided more hawkish commentary, leading the markets to react accordingly.

He mentioned that rates would be higher for longer: “The incoming data since our last meeting suggest the terminal rate of Fed Funds will be higher than previously expected, and we will stay the course until the job is done.” There is no pause in sight: “It’s very premature to think about a pause in our interest rate hiking cycle.” And lastly, he would rather do too much than too little: “Prudent risk management suggests the risks of doing too little are much higher than doing too much. If we were to over-tighten, we could use our tools later on to support the economy. Instead, if we did too little, we would risk inflation getting entrenched and that’s a much greater risk for our mandate.”

In sum, we saw an intentional dovish shift in the language of the statement, followed by a much more hawkish message at the press conference. We have two main takeaways.

First, we might be seeing the first signs of a fracture happening within the FOMC. That is exactly what happened in the 1970s and it was the main reason that led Volcker to shift to a monetarist approach of targeting monetary aggregates, even though he was not a monetarist. Volcker was an incredible central banker not just because of his technical expertise, but also because he was a savvy politician. He understood that he could not bring all members of the FOMC along to raise rates as much as was necessary to curb inflation. In changing the way the Fed did monetary policy, he saw a way to unburden the FOMC members from this responsibility. He understood that it would otherwise be politically impossible to keep raising rates.

Secondly, Powell changed the shape of the distribution of potential rates outcomes with his comment on “prudent risk management.” If the FOMC follows Powell’s lead, we could see rates going higher for longer, but only at much smaller increments. That will be the compromise. With eight meetings in 2023, we are talking about a potential hawkish rate increase of 200-250bps for the full year (compared with 425-450 in 2022). On the other hand, if they find themselves to have overtightened, they will have roughly 500bps or more to cut, depending on when that happens. The risk of maintaining a paying rates position at the short end of the curve, which was probably one of the best risk-adjusted trades of the year, materially increased.

In A Tale of Two Cities, Dickens opens the book with a sentence that has become famous: “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity (…)” This meeting might have marked the end of the golden age of monetary policy where consensus was the norm and developed markets’ central banks did not have to struggle with their dual mandate or politics.

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Macro Minute: Dollar dollar bill, y’all

This past Friday, September 9th, Bill Dudley was on air early morning making the case that the Fed wants a strong dollar. We know very well why the Fed needs a strong dollar. We wrote on July 25th about the relationship between inflation expectations and the currency’s strength:

“The DXY Dollar index is more than 17 percent up YoY, while the US CPI is 9.1 percent. Being conservative, we can assume a short-run currency passthrough in the US at about 25 percent. This means that if the US Dollar was flat year-over-year, inflation should be a whopping +13%! This blind faith in central banks is what is keeping everything together.”  – Macro Minute: We Learn From History That We Do Not Learn From History. July 25th, 2022.

However, how long the Fed can enjoy this position is less clear. Free-floating exchange rates, as opposed to the traditional view that expects a move to equilibrium at fair value, are inherently unstable. The reason for that is the reflexive nature of exchange rates. A change in exchange rates affects inflation, interest rates, economic activity, and other fundamental factors that then have an impact on exchange rates. This effect creates self-reinforcing and self-defeating processes that are very pronounced in currency markets.

In the case of the US dollar today, the fundamentals and nonspeculative transactions point in the direction of depreciation. It is only when looking at speculative transactions that we can find an explanation for the strength of the dollar in the past 12 months. In reality, the classification of speculative and nonspeculative is much more subtle, but for the purposes of this analysis, a simplified version of the model should suffice.

Non-speculative capital flows arise from the need (not the choice) to buy or sell dollars. On this account, all the fundamentals point towards the depreciation of the US dollar. The need to finance the US twin deficits is not new, but it has increased meaningfully recently. But one component in particular is seeing the largest changes- the need for USD in commercial transactions. Charles Gave, co-founder of Gavekal, wrote an excellent piece on “Network Effects and De-globalization.” In it, he proposes that reserve currencies benefit from the network effect, and that the turning point for the demand for US dollar transactions happened when the US insisted upon oversight of all US dollar transactions anywhere in the world. He argues that the catalyst for accelerating the contraction of this network was the US sanctioning Russian assets earlier this year. This decline has so far been masked by an increase in demand for USD coming from the energy crisis in Europe. We agree with that analysis and we can see the relationship between natural gas prices in Europe and the EURUSD (inverted axis) pre and post-mid-2021 below.

Speculative capital, on the other hand, is attracted by rising exchange rates and rising interest rates. Of the two, exchange rates are by far the most important. It does not take very large movements in exchange rates to render the total return negative. In other words, speculative capital is motivated by expectations of the exchange rate, a reflexive process. And when markets are dominated by speculative flows, they are purely reflexive. This is a very unstable situation. The self-reinforcing process tends to become vulnerable the longer it lasts, and it is bound to reverse itself, setting in motion a process in the opposite direction.

This is an obviously oversimplified model, but it brings useful conclusions. When the inflow of speculative positions cannot keep pace with the trade deficit, rising interest obligations, and lower demand for trade in US dollars, the trend will reverse. When that happens, the reversal may accelerate into freefall, as the volume of speculative positions is poised to move against the dollar not only on the current flow, but also on the accumulated stock of speculative capital. Lastly, when that happens, the exchange rate will have an impact on fundamentals (inflation and inflation expectations) which in turn will have an impact on exchange rate expectations in a self-reinforcing process. All of this will make the Fed’s job that much harder.

Given the unpredictable nature of speculative flows and self-reinforcing trends, we can’t say for certain when this will happen, but if pressed for an answer, I would say in the next 9 months. If the US dollar maintains or accelerates its trend during this period, the EUR would have to be trading below 0.86, the JPY above 170, and GBP below parity. And if it doesn’t, the reversal would be dramatic, if not catastrophic.

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Macro Minute: The Changing Colors of Politics

On the artist’s color wheel, red and green are considered complementary colors, diametrically opposed from one another but known to harmonize when used together. However, for at least a decade, the biggest political proponent of green energy in America has been the “blue” Democratic Party.

The administration’s most recent spending bill, The Inflation Reduction Act of 2022, has been heralded as a huge leap forward for renewable energy in the United States by Democrats, but was opposed by every Republican in the House and Senate. A closer look at where renewable infrastructure is being built, thereby creating jobs and increasing investment, demonstrates that while on Capitol Hill, the reds may be diametrically opposed to green legislation, red and green may actually be quite complementary. We believe that green investment will have meaningful repercussions come election season for years to come.

In our 2021 Annual Report, we discussed how our most probable scenario for achieving net-zero by 2050 would require expansive transmission and generation infrastructure to be built in the American heartland, primarily in traditionally Republican states. In turn we suggested that the development of said infrastructure would result in significant job creation and local investment, that would lead to one of two outcomes – more bipartisan support for investment in green infrastructure as Republicans acted in the interests of their constituents or a change in voting patterns by those being positively impacted by investment and new jobs.

A 2014 study by the University of Maryland found that a $1 spent on infrastructure investment added as much as $3 to US GDP[1] and suggested that the effect could be even larger in a recession. Historically, state and local governments have borne the majority of costs for spending on infrastructure – since 1956, they have been responsible for approximately 75 percent of spending on infrastructure. In that time frame, federal infrastructure spending has increasingly become a smaller percentage of the overall budget.

When the federal government does spend, it is typically through capital investment for new projects or modernization. The nonprofit, nonpartisan Tax Foundation estimates $116 billion of new energy and climate spending, excluding tax credits, from the newly passed legislation.[1] Including leverage available through components of the bill like the Energy Infrastructure Reinvestment Financing program, which provides $5 billion to finance up to $250 billion in projects for energy infrastructure, including repurposing or replacing energy infrastructure, takes new spending to more than $300 billion over 10 years. The last Congressional Budget Office estimate for federal government infrastructure spending was approximately $98 billion per year, meaning the bill would increase spending by around 30% annually, excluding tax credits that will encourage more private investment. Why is this important? Using percent changes in GDP, inflation, and the S&P 500 as barometers for economic conditions, Lewis-Beck and Martini[2] demonstrated the existence of a map from real economic conditions, to voter perceptions, to vote choice. Put simply, voters’ evaluation of the economy is real, and they punish or reward the incumbent candidate based on these conditions.

Bloomberg recently ran an article titled ‘Red America Should Love Green Energy Spending’, showing where a bulk of renewable infrastructure is being built. There are 435 congressional districts in America. 357 have planned or operating solar plants, with 70% of the power capacity found in republican districts. 134 have planned or operating wind plants, with 87% of the capacity found in red districts. Lastly, 192 have planned or operating battery storage facilities, with 58% of the capacity in right-leaning districts. Of the top-10 districts with planned or operating renewable infrastructure, nine are currently Republican-held seats, and within that group, 86% of total capacity is found in Republican districts.

So why might Republicans who are overwhelmingly benefiting from job creation and investment in green infrastructure be against such legislation? First, some of the capacity listed is planned, and has yet to filter through into the local economies they represent. Second, there are elements of both NIMBY-ism and extreme partisanship throughout the country on both sides that lead people to immediately dismiss ideas from “opposing” parties. But most obvious to us is that Republicans also overwhelmingly represent areas with the most emissions. 80% of the top-100 emitting districts are represented in Congress by Republicans, including eight of the top-10.

n the 2020 election cycle, fossil fuel companies spent $63.6 million lobbying Republicans compared to $12.3 million for Democrats, and since 1990 the industry has spent approximately 4.3 times the amount lobbying for Republicans than Democrats. In other words, support for green investment will ultimately come at a cost for the party. However, a myriad of studies have demonstrated that infrastructure investment boosts productivity over time and the literature shows that this will ultimately have an impact on voter preferences. Voter preferences fundamentally drive political rhetoric, so as green infrastructure investment becomes more pervasive, particularly in red states, we expect an increasing impact of renewable energy development on elections. 

[1] Werling and Horst. “Catching Up: Greater Focus Needed to Achieve a More Competitive Infrastructure.”

[2] https://taxfoundation.org/inflation-reduction-act/

[3] Lewis-Beck C, Martini NF. Economic perceptions and voting behavior in US presidential elections. Research & Politics. October 2020. doi:10.1177/2053168020972811

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Macro Minute: GDP Deep Dive

Last week, just before the end of the month, we got the Second Quarter Advance GDP Estimate from the US Bureau of Economic Affairs (BEA). The quarter-over-quarter annualized number for real GDP printed a disappointing -0.9%, compared to a median expectation of +0.4%, but still better than the 1Q number of -1.6%. 

GDP releases are very important events for markets. Companies use them to help make investment decisions, hiring plans, and forecast sales growth. Investment managers use them to refine their trading strategies. The White House and Federal Reserve both use GDP as a barometer for the effect of their policy choices. 

These numbers are especially important for turning points in the economy. For some (but not the National Bureau of Economic Relations – the US agency responsible for classifying recessions), two consecutive quarters of negative real GDP growth is defined as a recession. If we took the early GDP releases at face value, this would imply that we are in a recession today, dating back to the first quarter. For all the above reasons, it is worth digging into how the BEA derives this number and how reliable the early releases are.

One of the tasks of the BEA is to calculate US GDP, measured as the total price tag in dollars of all goods and services made in the country for a given period. It is the sum value of all cars, new homes, lawnmowers, electric transformers, golf clubs, soybeans, barbeque grills, medical fees, computers, haircuts, hot dogs, and anything else sold in the US or exported during the period. When calculating current (or nominal-dollar) GDP, the agency adds the value of all goods and services in current dollars. But this herculean task does not end there, because what matters for most people is the real growth in the economy. And so, after tallying up everything in current dollars, the agency has to then make adjustments to try and come up with an estimate of the value of what was actually produced in the economy (e.g., ex-inflation). 

Imagine an economy that only produces two things, potato chips and mobile phones. Suppose that the economy is selling $1.1 million of goods this year, an improvement of 10% compared to the $1 million from last year. That $1.1 million number represents the nominal GDP for the economy this year. But that number does not tell us how much of that 10% increase is due to more goods being sold and how much derives from price increases. 

If last year there were 50,000 bags of chips sold for $10 and 500 mobile phones for $1,000, and this year there were 55,000 bags of chips and 550 mobile phones sold for the same price as last year, the economy had real growth of 10% and zero percent inflation. 

Alternatively, if this year the economy sold the same number of chips and mobile phones as last year but did so at a price of $11 and $1,100, respectively, the economy had zero real growth and 10% inflation. 

However, things are not so simple, for the methodology is designed not only to remove price inflation but also to adjust for the quality of the goods being sold. Let’s assume that this year the economy sold 55,000 bags of chips for $10, and 550 phones for $1,000 (the same as the first example). But in this example, the bags of chips sold this year only contain 40 chips versus the 50 chips in each sold last year, and the mobile phones sold this year have better computational power and an extra camera versus last year’s. In this case, the agency would have to account for those changes by calculating a positive price increase for the potato chips and a negative one for the mobile phones, even though the number consumers saw on the price tag did not change. Now imagine that the BEA must do this not just for all the goods sold in the US economy, but also for every service provided, and to deliver an advance estimate one month after the end of a quarter. 

Which brings us to the question, how reliable are early GDP estimates? The answer is… it depends. Each revision incorporates more and better data and is believed to be a better estimate of the true value of GDP. For example, comprehensive data accounts for only 25.5% of advance estimates and 36.8% of second estimates, but it accounts for 96.7% of what we can call “final” estimates[1].

To assess the reliability of the GDP estimates we can look at revision patterns to understand if there is a bias in these revisions and how large they can be. To assess bias, we calculate Mean Revision (MR) where components tend to be offsetting and a large positive or negative number would indicate bias. To understand how large revisions can be, we calculate the Mean Absolute Revision (MAR) and the standard deviations, which are both complementary measures of the distribution for the revisions around their mean. We calculate these revision metrics for the Advance release that comes out one month after the end of a quarter, comparing with both, the Second releases (two months after the end of a quarter) and what we here call the “final” estimates (also called, comprehensive revisions, which are released approximately five years after the advance release).

What we find is that inflation has a meaningful impact on reliability. More specifically, it creates a pronounced bias for advance releases in underestimating real GDP growth. This makes intuitive sense. The task of calculating real GDP becomes even more challenging during inflationary environments. Looking at the numbers, we find that in periods of low inflation [3,4], bias is virtually inexistent with MRs for Second and Final at +0.10% and -0.01%, respectively. While during periods when US CPI is above 7%, MRs are +0.40% and +0.80%, respectively. That means that, on average, in high-inflation environments, Advance GDP numbers are underestimated materially. It is also important to note that MARs and standard deviations are essentially unchanged from one environment to another. This means that the size of revisions is similar in both circumstances. 

To clarify the point, let’s look at last week’s 2Q 2022 GDP Advance release of -0.9%. We can say that the second estimate will be between -1.5% and +0.4%, while the final estimate will be between -2.6% and 2.4%, with 90 percent confidence. This distinction between inflationary and non-inflationary environments is important because if we used the low-inflation scenario numbers, we would say that the second estimate would be between -1.9% and +0.2%, while the final estimate would be between    -3.6% and +1.7%, with 90 percent confidence. [5]

One way to increase the reliability of activity numbers is to look at the average of GDP and GDI. In theory, GDP and GDI should be equal, but in practice, GDP and GDI differ because they are constructed using different sources of information – both are imperfect in different ways. If both GDP and GDI are interpreted as the sums of unobserved, true economic activity and measurement errors, it is possible to infer that the weighted average series of the two is a more reliable measure of activity than either GDP or GDI alone, assuming some of the measurement errors are averaged out.

In short, calculating GDP is a mammoth undertaking, early estimates of real GDP tend to underestimate growth in inflationary environments, and you are better off taking a holistic view of the economy when data is as volatile as it is today. 

P.S. We talked a lot about real GDP, but we should not neglect nominal GDP. Historically, S&P earnings growth tended to stay in line with nominal GDP. And that is how corporate sales, revenues, and profits are recorded. In the second quarter of 2022, nominal GDP in the US was approximately +7.9% QoQ annualized.  

P.P.S. For a depiction of how and when GDP revisions and their vintages are made and maintained by the BEA, please see below.

[1]  Comprehensive revisions are performed every five years and include major updates to classifications and definitions for the entire GDP time series – for more information, please see the endnote

[2] Holdren, Alyssa – Gross Domestic Product and Gross Domestic Income – Revisions and Source Data (June 2014)

[3] Fixler, Francisco, Kanal – The Revisions to Gross Domestic Product, Gross Domestic Income, and Their Major Components (June 2021)

[4] Using 1996-2018 period used in above paper, when US CPI inflation averaged 2.2%

[5] Revisions follow a normal distribution and therefore we can calculate the combined probability that the true value of real GDP growth in the 1Q and 2Q was below zero, i.e., two consecutive quarters of negative GDP growth. P (2Q < 0% | 1Q < 0%) = 36%.

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Macro Minute: We Learn From History That We Do Not Learn From History

Despite all the efforts of the most brilliant economists and analysts in the world to build models mimicking the methods of physics that follow their own self-contained logic, rules, and patterns to predict outcomes, when faced with failure, they dismiss it by claiming that “random shocks” had somehow disturbed equations and did not need to be explained since they are “nonrecurring aberrations.” War, pandemics, and politics are not abnormal historical events, only in economics.

However, many questions in economics can be approached more simply through history. In the most recent record, from 2010 to 2020, US CPI YoY averaged only 1.7%, below the Fed’s target (how much did that play a role in the recent late response from the Central Bank is anyone’s guess). However, in the history of the US, there are only a handful of times that the inflation picture could be described as stable.

Looking back at American history, we find six inflationary spiral events. The first occurred in the late 1700s just after the Revolutionary War; the second in 1813 after the War of 1812; the third in the 1860s during the Civil War; the fourth in the late 1910s after World War I; the fifth around and after World War II in the mid-1940s; and, the most current one in the 1970s associated with the Vietnam War. These periods were always followed by long periods of deflation. Evidence would point to politics, not economics, to explain inflationary spirals, and war looks like the common denominator. War in itself has many different impacts on inflation (as we discussed in this Macro Minute: The Reflexivity of Inflation and Conflict). Still, it is really the increase in money spent by the government, above what it collects in taxes, that makes inflation and negative real rates an attractive solution to the debt problem.

Looking back to the latest inflationary cycles of the 1970s, we find a few similarities and one significant difference. [1]

Similar to the present day, in 1975, the government balance sheet resembled conditions only tolerated during periods of war. And in the preceding years, just like recently, conservative governments that were supposed to be fiscally conservative were actually accelerating the deficit. In today’s world, for example, if interest rates rise above inflation, the Treasury’s interest expense goes up as debt rolls over, and the Fed reduces remittances to the Treasury. The Congressional Budget Office calculates that a 1% increase in real rates increases the annual deficit by $250 billion, about 1% of GDP, planting the seeds for an explosive debt dynamic.

In the 1970s, oil price inflation was a big problem, increasing to around 6 percent per month. More recently, on average, oil has been growing at 4.2 percent per month since January 2021. That includes the price corrections we saw in the last couple of months. The contribution to the CPI is still high at 47% YoY at current gasoline prices.

In the 1970s, real interest rates reached -4 percent. Today, we are living through the most extended period of negative real rates, currently sitting at -6 percent. That is before factoring in what can happen with nominal rates in a recessionary scare. We calculate real rates by subtracting the US Treasury 10-year yield by the current CPI YoY number. We believe this is a better indicator of real rates on Main Street than the real rates derived from the TIPS markets on Wall Street. This is the rate that alters the lives and actions of people who are not traders or advisors and who do not follow the FOMC decisions or read the Wall Street Journal. Different from the previous cycle, when the Fed was focused on impacting asset prices, to have an impact on goods and services prices, the central bank needs to focus on the decisions in the real economy and not in financial markets. 

“At 15 percent inflation, an investor lending $1 million at 10 percent ‘loses’ $50,000 a year. You cannot count on the lender being a complete idiot, sooner or later, he will stop lending at low-interest rates and invest the money himself in commodities or real estate.” – Senator William Proxmire. October 1979

Another interesting observation from looking at real interest rates is that every recession is proceeded by positive real rates. More importantly, real rates tend to turn negative to help the economy once a downturn starts. This brings us to the recessionary debate. Like today, in 1979, most economists, including the Fed, were forecasting a recession. They had been wrong for many months, and in September, data showed the economy was not tipping over; it was accelerating again. This was true even with a deceleration in housing and autos and the fear of recession. “A Gallup survey found that 62 percent of the public expected a recession sometime in 1979.”

In an inflationary economy, people behave differently. Inflation doesn’t slow people down. With inflation at 16 percent, borrowing at lower rates seemed like a good deal. Bank credit was expanding at an annual rate of 20 percent. Most consumers did not care about what the higher interest rates were, as long as the monthly payments could fit their incomes. This is not a foreign concept for Latin Americans.

“Lenders were still surprised at how many families were willing to take on home mortgages at 13 percent or even higher. ‘ Perhaps it is not so hard to understand,’ Volcker said, ‘when you realize that the prices of houses have been going up at 15 percent or more.’” – 1979

Today, bank credit is growing at +12% for consumers and +8% for Commercial and Industrial clients. We’ve been following bank’s earnings calls very closely and we find that all the major banks see strong balance sheets, very low forward-looking default rates, and expect credit to grow in the mid-teens for the next few quarters. This past week, American Express reported that overall cardholder spending rose 30% from a year earlier.

Even when the Fed was finally able to create the presumed remedy, a prolonged recession that endured for 15 months with unemployment rising to 9.1 percent and industrial production shrinking to roughly 15 percent, as soon as the economy recovered, inflation came roaring back, rising even higher than before even with employment never getting close to its natural rate. With the supply of commodities constrained, even a short-term decrease in demand does not fix the inflation problem; it only postpones it to the following part of the cycle when policies revert to accommodative.

Lastly, the Fed genuinely did not know how much interest rates would have to rise to break inflation. If record levels of rates were not fixing the problem, how high would rates need to go to do it? Nor did it have the political capital to do what was necessary. Volcker acknowledges, ‘We could have just tightened, but I probably would have had trouble getting policy as much tighter as it needed to be. I could have lived with a more orthodox tightening, but I saw some value in just changing the parameters of the way we did things. (…) it would serve as a veil that cloaked the tough decisions.’”

“There is a wide concern about the Fed’s resolve in adhering to this policy in the face of an election year and the increasing likelihood of a recession. If strong words and actions are not followed by results, then holders of dollar-denominated financial assets in the US and abroad will conclude that the recent changes are no more significant than the statements and policy changes of prior years which did not reduce inflation. When rhetoric sufficed several years ago, tangible proof is now required of the Fed’s intentions.” – Federal Advisory Council 1979

The similarities are striking.

The main difference between the 1970s and today lies in the credibility that central banks around the world collected during a period of global deflationary forces that made them look like they could bend prices to their will and achieve their dual objective effortlessly, giving rise to the mantra “Don’t fight the Fed!” On July 14th, 2022, Governor Waller said, “The response of financial markets to the FOMC’s policy actions and communications indicate to me that the Committee retains the credibility and the public confidence that is needed to make monetary policy effective. (….) lenders and borrowers are still doing business at these rates, which indicates that they believe the FOMC’s policy intentions are credible, as broadly reflected in the interest rate paths in the Summary of Economic Projections (SEP).” Today, markets price the Fed’s projections to perfection.

What does history tell us about that? StoneX’s Vincent Deluard shows us that using post-war data from the World Bank of more than 350 events when inflation spiked above 7%, only 1.4% of the time, inflation slows to less than 3% in each of the next five years. Markets are pricing 1 in 70 odds as if it were 100 percent certain.

“Acting hastily is essential to [a trader’s] profitability. If today’s quickest-to-the-keyboard move makes little sense according to some notion of ‘fundamentals,’ who cares? Overshooting is a feature, not a bug.” – Alan S. Blinder, July 2022.

“Traders must and do therefore respond literally instantly to all news to which they think other traders might respond. Whether the news is considered economically significant or even true is immaterial.” – Albert Wojnilower, Chief Economist at First Boston 1964-1986

This confidence also has an impact on the USD. With the expectation that inflation will converge to 2% in the next 18 months, interest rate differentials make the currency attractive. That, in turn, keeps inflation in the US in check. The DXY Dollar index is more than 17 percent up YoY, while the US CPI is 9.1 percent. Being conservative, we can assume a short-run currency passthrough in the US at about 25 percent.[2] This means that if the US Dollar was flat year-over-year, inflation should be a whopping +13%! This blind faith in central banks is what is keeping everything together. But history also tells us that after a long deflationary cycle and the build-up in credibility, what comes next is the drawing down of goodwill until there is nothing left.

“We’ve lost that euphoria that we had fifteen years ago, that we knew all the answers to managing the economy.” – Volcker 1989

[1] A good friend of the firm and fellow investor, knowing of our quest to understand history, pointed out to us that the team at MacroStrategy research was studying a book written in 1989 by William Greider called “The Secrets of the Temple” about the Fed’s fight against inflation under Volcker to help them with a similar pursuit. This book has been invaluable in our understanding of the period, and all quotes in this letter are from the book. https://www.amazon.com/Secrets-Temple-Federal-Reserve-Country/dp/0671675567/ 

[2] Campa, Jose Manuel, and Linda S. Goldberg. “Exchange rate pass-through into import prices.” Review of Economics and Statistics 87.4 (2005): 679-690. (https://www.nber.org/system/files/working_papers/w8934/w8934.pdf)

Exchange Rate Pass-Through and Monetary Policy, Governor Frederic S. Mishkin, at the Norges Bank Conference on Monetary Policy, Oslo, Norway. March 07, 2008 (https://www.federalreserve.gov/newsevents/speech/mishkin20080307a.htm)

Takhtamanova, Yelena F. “Understanding changes in exchange rate pass-through.” Journal of Macroeconomics 32.4 (2010): 1118-1130. (https://www.frbsf.org/economic-research/wp-content/uploads/sites/4/wp08-13bk.pdf) 

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Macro Minute: The Ides of June

When looking at the return of assets for the first half of the year, we find that US bonds posted their worst first half-year performance for over 100 years, while the S&P 500 declined 20.6% year-to-date, recording the worst first half of the year since 1970 and its 4th worst start on record. More broadly, the MSCI All Country World was down 20.9% for the period. Institutional investors are having one of their worst performance periods on record with the trusted 60/40 portfolio declining by 17% YTD, making it the second-worst start since the 1900s.

The month of June was marked by a sharp repricing of recession fears along with a VaR shock that led to risk reduction and high correlation across markets, providing very few opportunities for hedges and diversification. During the month, 10-year treasuries increased +16bps, with the difference between the 10 and 30-year bonds flattening by 3bps. The 2-year bond yield increased by almost +40bps for the month and jumped +54bps in two trading sessions, the largest move since 2008 when it moved +55bps. The S&P and Nasdaq were down -8.4% and -8.7%, while Energy and Materials sold off -18% and -15%, respectively. Commodities were down across the board, ranging from -10% to -40% in agriculture commodities, and -22% to -57% in industrial metals. In other words, you could not make money in June by being long.

Looking at the long-term we believe that commodity and commodity-related equities exposed to the green energy transition have an exceptional demand backdrop that arises from decarbonization initiatives that will only increase going forward while also possessing major supply challenges. As an example, the average EV consumes five to six times more copper than a combustion engine vehicle. Conservative estimates of EV production put copper demand, just from this source, increasing 20-25% over the next two decades. This does not even account for the increasing demand for copper arising from other electrification needs like batteries and cables.

This is happening against the backdrop of virtually no production increases and very low inventory levels. Mining companies learned from their mistakes in the previous CAPEX cycle of the early 2000s, and along with the more recent price declines and volatility, board members will not be in a rush to invest in capacity. Rather, they will prefer dividends and share buybacks. 

On a March 1st podcast interview with Eric Mandelblatt, he says “(…) three of the largest copper mines in the world were developed over 100 years ago. There’s been only one of the 10 largest copper mines in the world that’s been developed this century since (2001). So, you have this situation where supply in the near term is highly inelastic.”

Reflecting on the recent commodities drawdown, we put too much weight on the probability that markets would realize early that the Fed won’t be able to run the level of positive real yields required to bring down inflation to its target. Rather, when looking at prices, it appears markets are pricing the Fed outlook to perfection. We are now accounting for that and expecting that the crucible moment will occur after the Fed reaches their expectation of terminal rate, or just above, and inflation is still above target. At that moment, the Fed will either have to prove credible, or the market should then realize that the Fed will let inflation run above target for longer. It is worth pointing out that history is not on the Fed’s side. Vicent Deluard from StoneX shows that, historically, central banks only manage to bring inflation down to 3% in each of the next 5 years, following a spike above 7%, in less than 1.4% of the time. What we see today is a market that blindly believes in the Fed and prices that 1.4% probability scenario with full certainty, while completely dismissing the other scenarios. 

Also, we did not expect the market to aggressively price in a deflationary bust scenario so rapidly after a higher-than-expected inflation print and still extremely negative real rates. We expected that during this secular bull market in commodities, we would see some ups and downs in prices, but the speed and magnitude of these moves only compare to 2008, which was a massively deflationary bust period. We assign a very small probability of that scenario (for a detailed analysis on this, please see our recently published annual report), and we believe that if a recession is around the corner, it would be an inflationary bust instead. 

With the supply of commodities constrained, even a short-term decrease in demand would not fix the problem of inflation, it would only postpone it to the following part of the cycle when policies revert to accommodative to shore up demand. We know from history that during inflationary busts, commodities have two-thirds of their upward move after a recession begins. 

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Macro Minute: Flip or Flop

With so much talk about a recession lately, it is hard not to look for clues in housing numbers. This past week, we had numbers for US housing starts and building permits. While homes only directly account for roughly 5% of GDP, related goods and services can account for nearly 20%. Aside from 2001, the US has never gone through a recession when housing is doing well. Conversely, the US has never emerged from a recession without the help of housing (2009 being the exception with a rebound while housing was stagnant). Fort these reasons, it comes as no surprise that so much attention is given to the release of housing data.

Housing starts record how much new residential construction occurred in the preceding month, while building permits track the issuance of construction permits. The number for both releases is reported in number of units, with the latest number for housing starts and building permits disappointing the Bloomberg median survey at 1.549 million and 1.695 million, respectively. But how disappointing are these numbers, if at all?

First, let’s look at housing starts. The month-over-month number came in at -14.4%, and comparing the latest release with the same time last year, the number of starts contracted by -3.5%; however, these numbers are very volatile and prone to significant revisions. When looking at the rate of change of the 12-month moving average in May versus the previous month, we encounter only a -0.28% contraction, and when comparing the average with the same period last year, we find a growth of +9.5%. Building permits decreased by -7% MoM and increased +0.2% compared to last year. Using the same 12-month moving average to smooth volatility, the rates of change from the previous month and last year are +0.2% and +6.4%, respectively. We can see some deceleration, but we are still at very healthy levels compared to the past.

One thing to keep in mind is that looking at housing starts and building permit numbers only gives us an idea of the real component of the economy. But for prices and company earnings, it is Nominal GDP that matters. Therefore, we have constructed a nominal index for housing starts and building permits using the S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index. When looking at that number, we see some deceleration, but in aggregate both starts and permits are still running at very high growth rates.

We cannot draw firm conclusions from a single piece of evidence, but what a closer look at housing starts and building permits shows is that the probability of recession may not be as high as one perceives from reading headlines.