We've heard from some of the most influential investors in the world over the past few days, as they gathered at Michael Milken's conference in California.
On the topic of rising interest rates, many of them see inflation as persistent and problematic. But few of them thought we would see dramatically higher interest rates.
In the words of one of the great macro hedge fund traders of our time, Paul Tudor Jones, "the Fed has become inflation creators, not inflation fighters." That suggests that they have been conditioned to one-sided policy making, which explains why they are already well behind the curve on responding to what has been an obvious formula for inflation.
But the CIO of Blackrock, the world's largest asset manager, said he "doesn't see rates going up much from here."
Why? Billionaire Nelson Peltz doesn't see enough incentives for the Fed to aggressively chase down and kill inflation. He says "very few people in the world, very few groups, need higher interest rates. Home buyers don't need it. Governments don't need it. And the dollar doesn't need it."
How do we interpret this view?
First, what's key in this statement is "governments." It's plural. Ballooning government debt isn't a U.S. centric thing, it's global. Much like the financial crisis, the great health crisis was/is global and the recovery is globally coordinated. And global governments, especially now, don't need capital moving out of their countries and into the U.S./the dollar in search of higher yield. Not only would it damage fragile emerging market economies, but it would threaten the global economic recovery.
And don't forget, a key tenet in the global economic recovery, is the global coordination of the clean energy transformation. They're all on the same team/in the same boat.
What about his comment on the dollar?
This looks like the easy mark. The purchasing power of U.S. consumers has already eroded. Next will likely be global purchasing power through a weaker dollar. So, in the end, the broad viewpoint from some of the most influential investors in the world seems to be consistent with: higher prices will be the solution for higher prices (i.e. at some point higher prices will curb demand, slow the U.S. economic growth, and ultimately resolve inflation). This means the pain is put on the consumer through lower quality of life.
Stocks have gone on a five-day run, to revisit record highs. Yields are on the move, trading as high as 1.67% today. And commodities continue to climb.
Is it the strong start to third quarter earnings season that's driving this "risk on" surge in markets?
Doubtful. We knew the bank earnings would be huge. The interventionist policies, combined with their war chest of loan loss reserves at the banks, have made them profit printing machines.
We are just now getting to hear from companies that are talking about "costs." So this buzz surrounding Q3 earnings should begin to wane.
Is the recent surge in markets due to the likelihood that a deal on "The Big Spend" is in the offing? Maybe quite the opposite.
As the days pass, it's becoming more believable that the two Democrat Senators opposing the $3.5 trillion plan are genuinely digging in. The headline number ($3.5 trillion) to "Build Back Better" has already been cut down. And some key pieces are being carved up. The Wall Street Journal reported this afternoon that Sinema is opposing tax increases.
At this point, with the hot inflation picture forcing the Fed to, already, telegraph a faster path to its first rate hike, the potential for this "big spend" to become less transformational, or even completely obliterated in the negotiation process, would be a positive for the economic outlook, and for market and price stability (i.e. get out of the way and let the $5 trillion already injected into the economy, combine with a returning workforce to drive growth). Perhaps some are beginning to price that scenario into markets.
We talked about the SEC approval of the new bitcoin ETF on Friday. It started trading today under the ticker BITO.
As we discussed, whether you believe bitcoin will ultimately survive government regulation or not, the introduction of an ETF that tracks bitcoin futures, creates access for a new audience. For institutional investors, now they can allocate to bitcoin, within their mandate. And it allows individual investors who may have never participated in bitcoin, to buy it in their normal brokerage account.
With that, we talked about the similarities to the 2004 launch of the first gold ETF (GLD). GLD offered a new and easy way for traditional long-only institutional investors, as well as individuals, to allocate to gold. And with that, gold prices took off. Gold was low $400s at the time, and never looked back. The price of spot gold rose almost five-fold over the following seven years.
So, this bitcoin ETF should benefit similarly from these new flows. But there may be more to this GLD comparison. Many view bitcoin as the new gold — as a store of value and hedge against inflation. With that, in the face of the hottest inflation we’ve seen in decades, we will see if money moves out of GLD, to fund new investments in BITO.
It’s early, but so far we can see some divergence in the charts that suggest that, at least, speculators are taking bets that this “swap” (GLD for BITO) may happen.
The economic growth number in China for the third quarter came in at 4.9%. That sounds like a good number. It's not for China. It's recession territory.
If we exclude the ugly numbers from the depths of the crisis last year, this is the slowest economic growth in China since 1990.
Of course, the world continues to emerge from the disruptive pandemic, but the China data is something to keep an eye on.
We can see some similarities to 2009. Early on in the Global Financial Crisis, China weathered the storm better than the developed world. The economy quickly bounced back to double-digit growth by late 2009. And with $3 trillion of foreign currency reserves in the coffers, and beaten down global commodities market, they took advantage and started stockpiling valuable natural resources on the cheap.
China's buying in the commodity market was a huge contributor to the recovery in commodity-centric emerging markets. Brazil went from recession to growing at close to 8%.
As you might remember, many were saying that emerging markets had survived the recession better than advanced markets, and they were driving the global economic recovery. And Wall Street was claiming/cheerleading a torch passing from the developed world to the emerging world as the future of growth and leadership.
It didn't last long. It soon became clear that China and emerging markets couldn't do well, without healthy consumers in the advanced economies (namely the U.S.).
Fast forward to today, and China's economy is thought to have withstood the pandemic better than the advanced world. And again, China has taken the opportunity, with cheap commodity prices to stockpile key commodities. They had record volumes of crude oil, copper, iron ore and coal in 2020. They also imported a record amount of corn, wheat and soybeans. So they've definitely contributed to driving commodity prices higher, in a fragile recovering global economy – which creates a headwind for global economic recovery.
And now, China's economy is sucking wind.
With the above in mind, let's take a look at some of the key economic data in China overnight.
First, here's a look at GDP. You can see here, excluding the decline of last year, China hasn't had an economy running this slow since 1990 (the economy was 2% of its current size, back then).
If you don't like the year-over-year comparison with the big bounceback numbers of last year, the growth in the third quarter, compared to last quarter was just 0.2%. That would be a annual run rate of less than 1% growth.
This next chart is Industrial Output in China. Again, excluding last year, it's at the worse levels since 2002.
And here's a look at China retail sales growth …. it's hovering around worst levels of the past 30 years (ex-last year).
We should remember, prior to the pandemic, China's economy was in trouble. The trade tariffs had taken a toll, and most of these key economic measures were running at levels worse than the depths of 2009.
We end the week with a broad "risk-on" mood for markets.
This follows very strong earnings for the big banks this week.
We are in the very early stages, but thus far, Q3 earnings are looking like Q2: a lot of positive earnings surprises. Positive earnings surprises are fuel for stocks.
That said, we came into the week knowing that the big banks were going to have blowout numbers. Next week, we should start seeing a more realistic picture on how "costs" are effecting businesses across industries.
The winning sector of this week was energy.
Crude oil closed on a higher high for the eighth consecutive week. The price of oil finishes the week above $82. That means those producers that have survived the attack on the U.S. shale industry, can now sell oil for about double the price it costs them to produce it.
As we've discussed for the better part of the past year, the vow to kill fossil fuels in the name of climate action, only builds a moat around the existing producers.
Let's talk about bitcoin …
Bitcoin was up 7% today, ending the day above $62,000. This was driven by news that the SEC would approve a bitcoin futures ETF.
Now, back in 2017 Chinese citizens circumvented government capital controls using bitcoin as a way to get money out of China. And China responded with a total ban on crypto trading activities (in China). The price of bitcoin initially plunged, and then proceeded to rip seven-fold higher. Three months later, bitcoinfutures launched, which gave hedge funds a liquid way to short the madness. Bitcoin topped the day the futures contract launched. A few months later, it was worth 1/6th of its value at the top.
Fast forward to today. China has, as of September, declared bitcoin trading, or mining, illegal. The initial move on the news was down, to below $40k. But now its up over 50% from the lows of three weeks ago. And now we have the announcement that the first bitcoin futures ETF was approved by the SEC and will begin trading on Tuesday. Is this another catalyst for a bitcoin crash?
Not likely.
The ETF structure will enable a large institutional audience to allocate to bitcoin. This looks like it may be another GLD like moment (spot gold chart below). When the gold ETF, GLD, launched in 2004, institutions piled in. It offered a unique way to allocate to gold, within the mandate of the long-only equity crowd. We will see if this plays out in a similar way.
So the big four banks have now all reported — kicking off the third quarter earnings season. And all have beaten earnings and revenue expectations.
As we discussed the past few days, business is booming for the banks, and not only are the fundamental tailwinds very, very strong — but the banks will continue to juice earnings by “releasing” the war chest of loan loss reserves.
With the above in mind, if we took a straight average of the trailing twelve month P/E of the biggest four banks in the country, we get about 11 times earnings. That’s well less than half the P/E of the broader market. As I said yesterday, the bank stocks are cheap (dirt cheap).
Adding to the tailwinds for the banks, will be the rising interest rate environment.
On that note, the inflation data we’ve see continues to point to a scenario where the Fed’s hand will be forced — to quickly pivot from emergency mode into inflation fighting mode. That pivot will likely be quicker and more aggressive than the majority of Fed officials have publicly projected.
Just in case anyone thinks the U.S. inflation data might start petering out, let’s take a look at what’s happening in China, where the products are made that we will be buying in the many months ahead…
Overnight, China reported the hottest prices for producers in 26 years …
And when the producers get those final products on a ship, you can see in the next chart, what has happened to freight container prices coming from China …
So, if you are lucky enough to get your product on a ship, you’re paying nearly fourtimes as much to get it here, compared to a year ago.
We looked at these same charts in my June Pro Perspectives notes, when the Fed was successfully convincing Wall Street that inflation would be temporary. The price signals from China were telling a very different story. And here we are four months later, and that story continues to be a “hot inflation” story. And not a temporary one.
As expected JP Morgan crushed earnings expectations this morning. The biggest bank in the country has now beat on earnings and revenues for six consecutive quarters, since the depths of the pandemic economy.
We talked about the war chest of loan loss reserves the banks are sitting on, all at their disposal to turn into net income at their discretion. JP Morgan moved another $2.1 billion to the bottom line for Q3. And they still have another $6 billion remaining, to move to the bottom line, before these “loan loss allowances” return to pre-pandemic levels (of Q4 2019).
With that pre-pandemic comparison in mind, JP Morgan has now generated $50 billion in net income over the past four quarters. That’s $14 billion more (about 38% higher) than the record level profits of 2019.
So, business continues to boom for the banks. At JPM, deposits are up 20% compared to the record levels of last year. Investment assets are up 29%. Investment banking fees are up 60%. And wealth management assets are up 17%.
This is all thanks, in large part, to this chart (a deluge of new money), and a Fed that has been the backstop for risk taking for the past nineteen months.
Bottom line: The banks are profit printing machines, and will be for the foreseeable future. And bank stocks are cheap.
As earnings kick into gear over the next few days, the expectations are for another big quarter of earnings growth, just shy of 30% year-over-year growth.
That's a big number, but no where near the 90%+ (yoy) earnings growth of Q2. But as time passes, the numbers are (and will be) measured against a higher functioning economy of a year prior.
The key spot to watch in this earnings season will be margins. The record level margins of Q2 of S&P 500 companies (which was 13%), are expected to come in slightly lower (at 12%). That's the vulnerable spot, for companies that are NOT having success in passing along higher costs to customers.
So there will be winners and losers in this earnings season. And this underpins the regime change underway, from a passive investing market, to an active investing market – where there are winners and losers, sector to sector and within sectors. It's (finally) a stock picker's market.
With that, we enter Q3 earnings as the broad market has continued to stair-step lower over the past month. Let's revisit the chart …
The broad market still looks like a deeper decline is ahead. We've been watching this 200 day moving average, which now comes in about 4% lower (about 8% peak to trough decline). And if history is a guide, we should expect a 10% decline in the S&P 500 about once a year, on average. The decline thus far, by comparison, has been shallow.
This all aligns with a broad market that is overly top-heavy with big tech stocks. The valuation models on Wall Street aren't nearly as friendly to the high growth-tech giants, when a higher interest rate (discount rate) is plugged in.
Thus, those stocks become vulnerable to a significant valuation adjustment in a higher interest rate outlook.
As we discussed Friday, we should expect the earnings calls to be heavy on inflation talk. And we should expect the conversation surrounding these calls to be about, what appears to be, success companies are having in passing along costs to consumers.
The banks will set the tone this week. We'll hear from JP Morgan on Wednesday. The other three of the big four banks will be on Thursday.
On the topic of "costs": The head of JP Morgan, Jamie Dimon, said today at a conference that consumer demand is "extraordinary," even in the face of the supply chain disruptions and higher prices. He says consumers are spending 20% more today than a year ago.
On the one hand, he's talking about the total dollar value of spending (which means there is, at least, a fair amount of higher prices represented in that statistic). But it also means that consumers have the confidence to spend. That's a big deal. That's underpinned by a higher savings rate and a job market where employees are in a position of strength to command higher wages.
So, a strong consumer should fuel plenty of positive talking points for the banks this week. In the case of JP Morgan (the biggest bank in the country), it has already been an embarrassment of riches, as they've beaten revenue and earnings every quarter coming out of the pandemic, with record profits in the first half of 2021.
Also remember, as we've discussed over the past year, the banks have a war chest of loan loss reserves (set aside in the depths of the pandemic) that they will continue to move to the bottom line at their discretion. That means they have a large inventory of positive earnings surprises they will present to us for several quarters to come. Add that to a (coming) rising interest rate environment, and the bank stocks are in the sweet spot.
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The big jobs report came in this morning. The payroll number was weaker than expected. That number gets a lot of attention. And with that, there was some debate over whether or not it would dissuade the Fed from "beginning the end" of QE, at their November meeting.
But there should be no debate. The unemployment rate is now below 5%. Wage growth came in last month at an annual run rate of over 7%. Both the August and July numbers for "jobs added" were revised UP. And if we look at the jobs report from ADP on Wednesday, the number was hot. With that, by this time next month, we'll probably find this payroll number reported today will have been revised higher too.
Bottom line: The Fed is managing against a mandate of full employment and price stability. They've nearly won the battle on employment and they are losing the battle on price stability. So, not only is it time to end emergency level policies, they should be farther along than they are in the process.
As we've discussed throughout the year, the Fed has positioned themselves to be behind the curve on inflation, which means they will be chasing it. And that means inflation will likely run hotter, maybe much hotter through next year.
On that note, third quarter earnings will kick into gear next week, when we hear from the big banks. We've already heard from 21 S&P 500 companies, and most are talking about inflation. They're talking about labor costs. They're talking about supply chain disruptions. They're talking about freight costs. They're talking about commodity costs. And they're talking about covid costs.
As we've discussed, while the supply chain bottlenecks will clear at some point, much of these costs are sticky, particularly labor and commodity costs.
With that, we should expect the conversation surrounding these earnings calls to turn to, "passing along costs." Are companies successfully passing these costs along to consumers? The answer seems to be yes.
That means wage inflation will have to keep pace with these rising costs (unlikely). Or quality of life goes down.
