Post Summer Blues?

As the summer ends, there is much to talk about on the global outlook for the economy and markets. But first, a pause to remember the sunny September morning, 20 years ago, when the United States and the world were shocked by the 9/11 terrorist attacks on New York and Washington. We mourn the lost — on that day, in the subsequent wars, and in the later terrorist attacks in Europe and Asia — and we offer deeply felt thanks to the first responders and veterans for their service on behalf of us all. In Fireside History, Michael Beschloss recounted the events that day through the eyes of the President and Congress as they wrestled with how to respond.

After the withdrawal of the US from Afghanistan in August, President Biden last week sought a reset on two key issues: relations with China and Covid-19.
Both matter for investors. Fracturing ties between the world’s two largest economies are not good for the global economy. And success in addressing global threats, whether from climate change or pandemics, requires concerted action from these two big players. A reset on Covid-19, with a bold push to vaccinate all Americans, was also needed. The pandemic recession of 2020 was only two months long. Now there are worries that the shortest ever recorded US recession could be followed by a shorter than expected recovery. The culprit: Covid-19 — again. The latest economic indicators, from August’s disappointing payroll data to consumer confidence and railroad shipments show a summer slowdown. That does not mean it will be smooth sailing to get shots into arms of the over 80 million Americans who have held off from getting vaccinated, even with evidence that the unvaccinated are 11 times more likely to die of Covid-19. Business leaders are in an awkward spot — but their difficulties pale beside those of frontline health and service workers. It is in everybody’s interest for Americans to come together to address Covid-19 at home. And the world needs global leadership to spur a more equitable and effective response. Vaccinations are climbing in many countries. But in Africa, they remain below 3 percent of the population.
Observations and takeaways for investors:
The rapid spread of the Delta variant, with a sharp rise in new infections and now deaths in the US, has dented consumer enthusiasm and thrown a wrench in the plans for a post-summer return to the office. Financial markets wobbled after the summer highs. But growth fears are likely overblown. RockCreek anticipated a slowdown from the 6.5 percent rise in US GDP in the second quarter, with a drop off in fiscal support from stimulus checks and reduced unemployment benefits in the second half of the year. Monetary policy remains supportive — even as major central banks tiptoe towards tapering asset purchases. And with consumer balance sheets swelled by government support and rising asset prices, there is not a near-term demand problem. More serious — and longer-lasting — are the supply chain issues that now plague businesses worldwide. Just when consumers have turned to buying more goods, with services spending crimped by the pandemic, companies are finding it harder to source, produce and deliver. That has changed the inflation outlook, not just in the US but beyond. Over the summer, consumer prices jumped above expectations in Europe, the UK, Japan, and Canada. The overshoot was larger in the US. As Gita Gopinath, Chief Economist of the International Monetary Fund (IMF) noted, higher price increases were linked to the degree of fiscal support during the pandemic. In regards to US fiscal policy, “Taxation is going to have a potential negative effect and infrastructure is going to have a positive impact,” said RockCreek Founder & CEO Afsaneh Beschloss on Bloomberg’s Wall Street Week with David Westin last Friday. Watch the full discussion here.

How transient is transitory (inflation)?

Headline PPI exceeded expectations on Friday, rising 8.3 percent YoY for August adding to evidence that inflation this year is running well ahead of what most forecasters — including at major central banks — expected when the year began. We will get a clearer picture of what this means for consumers on Tuesday with the latest CPI release. Even those who argue that the Federal Reserve should not be worried about inflation accept that price pressures are stronger than expected, and likely to remain longer as pandemic disruptions to supply chains take time to unravel. But there is still enough economic uncertainty for the policy discussions to remain both heated and inconclusive.

As summer gives way to fall, the debate is increasingly focused on why prices this year are surprising on the upside, after a half-decade when inflation persistently surprised on the downside. Federal Reserve policymakers remember getting their projections wrong on the high side time and again between 2015 and 2020 and, as a result, bumping up against the zero lower bound for interest rates, constraining monetary policy actions. They do not want to get back to that world inadvertently by tightening too soon. But how long can “transitory” effects last before they become embedded and permanent? Pandemic-induced disruptions to production and transport have shown the fragility as well as the complexity of today’s global supply chains. The efficiency and speed with which goods — pre-pandemic — traveled across borders to be assembled and then delivered belied the vulnerability of the interconnected global economy.

To quote Daniel Yergin, vice chairman of IHS Markit, “the spreading disruption of supply chains explains why on-line purchases are taking longer to arrive, why there’s vacant space on store shelves, and why the furniture you ordered is taking months instead of weeks to arrive” These delays will take time to unravel, just as a traffic jam caused by a single crash on a busy road can last for many hours. The impact of the Suez canal blockage by the Ever Given container ship is still being felt six months later. Port closures during the pandemic have also upset shipping. Yergin says “IHS Markit’s latest PMI survey of global manufacturing finds that the delays in delivery times are the most severe ever recorded, going back a quarter century. This unprecedented situation is causing prices to rise at one of the fastest rates in a decade.”

There are some who worry that the Fed — and others — are already behind the curve. They fear that a price-wage spiral risks getting embedded in expectations and then behavior, so that the Fed has to act suddenly. Harvard economist (and chess Grandmaster) Kenneth Rogoff has joined those who, at one extreme, warn of a return to the stagflationary 1970s. Rogoff even drew as part of his inflation analogy the comparison between last month’s debacle in Afghanistan and US withdrawal from Vietnam.

Others worry more that the Fed may tighten too soon, in part because its projections of inflation are becoming unrealistic. Will the Fed have to act to maintain credibility? As we discussed last month, some economists now argue that the 2 percent target that the Fed, ECB and other central banks still adhere to, albeit with varying degrees of flexibility, is too low. A bit more inflation for a bit longer will allow a smoother transition from pandemic shutdowns to full employment, they say. The Fed will release its own projections after the next policy meeting on September 22nd. The central bankers are bound to raise their forecast for 2021 inflation, given what has happened so far this year. More interesting will be what they project for 2022. A forecast sharp decline over the coming year to close to the 2 percent target may look unrealistic when viewed in light of supply constraints. But acknowledging a higher forecast may be hard to square with interest rates still projected to be close to zero during 2022.

When is a taper not a taper?

The FOMC is likely to tease a tapering announcement for later this year, in the upcoming September meeting, rather than be definitive on precise timing or amounts. Disappointing payroll data for August, still-depressed labor force participation and a slight rise in Black unemployment all point to continued problems in the labor market. It will likely take time for these to sort out, as the economy’s post-pandemic path continues to be bumpy.

So far, Chair Jerome Powell has been skillful in laying out increasingly firm plans without spooking financial markets. By mid-2022, if all goes well, asset purchases will end. We will see if financial markets have internalized this timetable and its implications as the Fed spells out more details about when tapering will begin and at what pace it will continue. Markets so far may be pricing in that neither the Fed nor the European Central Bank (ECB) will pull the rug out from underneath them though recent price action still indicates investor uncertainty. Indeed, President Christine Lagarde coaxed markets last week into believing that a taper of asset purchases was not a taper. As the ECB agreed to reduce the Pandemic Emergency Purchase Programme (PEPP) emergency bond purchases in the fourth quarter, Lagarde declared, after Margaret Thatcher, “the Lady isn’t for tapering”. The reaction from analysts and investors suggested that her words carried more weight than the promised tightening actions.

Developed markets have been sensitive to news about tapering, growth, and earnings over the last few weeks with US equities off to a rocky start in September. News that 2021 growth forecasts are being revised down and many ratcheting down their expectations had a chilling effect last week. The S&P 500 closed Friday down -1.4 percent month-to-date while the NASDAQ Composite has fared somewhat better, declining -0.9 percent. Large-cap technology and other sectors relatively immune to a global growth slowdown are being viewed as a safer bet than industrials, financials, and other such cyclicals. Wavering sentiment also extended into Europe where the Euro Stoxx 50 is down -0.6 percent so far in September.

Surprisingly, Japan has been a notable bright spot with the Nikkei 225 up 8.2 percent month-to-date on the heels of Prime Minister Yoshihide Suga’s decision to step down. Despite initial optimism when he came to power, Suga’s tenure marked a prolonged period of underperformance relative to the rest of developed markets and this recent rally shows investors attributed much blame to him. Japan’s stimulus spending paled in comparison to the US and Europe even as the government struggled mightily with its Covid-19 response. Now that the latest wave appears to be subsiding and a new Prime Minister is set to come in with a fresh mandate from voters, investors are taking a renewed look at Japan’s less expensive offerings.

US-China: Mending Fences, or Airing Grievances?

Don’t underestimate the importance of last week’s call between US President Biden and China’s President Xi Jinping. After months of the White House claiming that it was smart to keep China at arm’s length, those arguing for engagement won out — although maybe only temporarily. It is too soon to know whether the call will lead to more serious — and no doubt difficult — discussions at the staff level over how to bridge differences between the two nations. But the fact of the conversation was positive.

Neither leader is inclined to back off from their previous positions, in particular on domestic economic issues. President Biden really believes that American workers have been hurt by China’s economic and trade practices. He and his close aides have sided with the US Trade Representative on maintaining President Trump’s tariffs, despite opposition from others in the Administration and from business. On the Chinese side, President Xi’s ambitions — to strengthen domestic party control over the economy, maintain freedom to maneuver and expand influence overseas — are real, although the leadership was likely unhappy that a sudden rush of lower-level regulatory actions this summer spooked foreign investors. Domestic issues aside, there is a pressing global agenda where interests of the two countries overlap, from the threat of climate change to the need to avoid Afghanistan returning to being a haven for terrorism. Before the Presidential call, strong mutual interest in combating climate change was not enough to stop the September 2nd visit of Biden’s climate envoy and former Secretary of State John Kerry from being a failure. Looking ahead, it will take a sustained effort to craft a mutually satisfactory approach to cooperation for the world’s two biggest economies.

While China markets were generally up last week, foreign investors are cautious and not generally adding to their allocations. For a third consecutive week, Chinese equities outperformed the rest of emerging markets last week. Led by a rebound in technology stocks, the Hang Seng Index rose 1.9 percent, taking the three-week rally to 5.5 percent, while the Shanghai Composite Index was up 0.3 percent, reaching a level not seen since August 2015. A combination of stock buybacks (Tencent, Xiaomi), foreign capital flows, and the fact of the Friday phone call between President Xi and President Biden were possible positive factors. Last week also saw the unveiling of the Wealth Management Connect program, opening another avenue for two-way investment flows between Hong Kong and the mainland.

Although it still pays to be cautious and selective, given the increasing role of political forces and even possibly government ownership in private companies, it remains to be seen if last week’s developments may yet have a longer half-life. For instance, history suggests that stock buybacks signal a bottoming out of the market and the beginning of a sustained rally. Likewise, foreign direct investments and capital flows tend to pick up after periods of sustained underperformance, particularly if investors find high-quality companies at low valuations. If, and admittedly this is a big if, these market technicals are further underpinned by a thawing of US-China relations, all the better.
Elsewhere in emerging markets, we are still over a year away from Brazil’s presidential election but one could be forgiven for thinking the vote was imminent. President Bolsonaro deserves credit for making waves by first, unashamedly (he is, to put it mildly, a Covid-19 skeptic) taking credit for Brazil’s spectacular progress on the vaccination front and second, conveniently announcing a temporary ban on social media platforms’ ability to remove users and content that may be misleading or false. Incidentally, in case one was tempted to file the latter under “things that only happen in Latin America”, here in the US, Texas just passed similar legislation and other jurisdictions may soon follow. And yet technology companies in Brazil are fast becoming a critical part of the country’s growth trajectory. The number of planned tech IPO’s (beyond the market darling NuBank) reflects a new record in demand for innovative companies with a better mousetrap for capturing and propelling Brazil’s future growth. In the decade leading up to 2020, just two of the fifty-six IPOs in Brazil were technology companies. In the last eighteen months, Brazil has seen at least sixteen technology-related IPO’s up from just four in 2019. It seems, perhaps, that Brazilians have indeed already voted.

The tech IPO frenzy has also reached India, where 2021 is shaping up to be the best year on record for new public offerings, already exceeding the prior record of $11.8 billion. Much of the activity is being fed by the country’s booming venture capital industry with Indian unicorns such as Zomato, MobiKwik, and Paytm leading the charge.

SEC Subtweet

On Wednesday morning, the SEC Investor Ed Twitter account posted a rather mundane 30-second primer on bonds and how they work. The teaching mode may have been channeling new SEC leader, Gary Gensler. He has spent the last few years at MIT, teaching about cryptocurrency, blockchain and fintech. His approach to regulating these new markets will be active, not mundane.

It’s probably no coincidence that the post followed a tweetstorm from Coinbase’s CEO Brian Armstrong in which he unleashed his frustrations with the agency for threatening to block the release of Lend, a product that would pay users four percent interest on USD Coin (USDC) deposits, without providing what he believed to be an adequate explanation. It’s unclear whether the tweet sufficed.

Is it a security? This is the essential question in crypto and the case the SEC is trying to build in many different areas of this nascent industry. In this case, Lend sounds a little like a bond (a security) but maybe a note (sometimes a security) or it could be a syndicated loan (not a security). Coinbase though seems to be framing it like a savings account. An attractive offering for customers given how deep into negative territory real interest rates have fallen but would invite even more regulatory scrutiny than a security offering.

It’s probably not just the opacity of securities law or government bureaucracy that’s chafing Armstrong though. There are many of these crypto lending schemes available to investors but mostly through DeFi platforms or offshore exchanges. He wants to be in on that very lucrative action while remaining the trusted partner for uncertain, law-abiding investors. He’s fighting an uphill battle though. Comparable to the crackdown on ICO issuers in 2017, this may be the beginning of the end of crypto lending in its current form (watchout DeFi lending protocols).
RockCreek Update
RockCreek Founder & CEO Afsaneh Beschloss discussed Wall Street’s bond-buying binge, the ECB policy meeting, and the ongoing effects of COVID on markets and the global economy, and more on Bloomberg’s Wall Street Week with David Westin. Watch here.

Afsaneh Beschloss also appeared on BNN Bloomberg, where she discussed rapid growth in ESG and impact investing. “The market has changed so much. Even a few years ago, the words ‘sustainable’ or ‘impactful’ investment used to get a lot of people to roll their eyes,” she said. “It has become a very integrated concept for many investors, whether they are students, young people, or big institutional investors in Canada, the US, or the rest of the world.” Watch here.

The RockCreek Book Club (RCBC) met to discuss Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor by Seth Klarman. This month, join us in reading Bad Blood: Secrets and Lies in a Silicon Valley Startup by John Carreyrou.

Team RockCreek

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