Inflation & Recession: Strategic and Tactical Reads
It’s probably safe to say that most people who play in any capacity in the markets right now, regardless of discipline, are feeling unsure. That’s why cash levels are so high. Treasuries and money market accounts are a go-to.
While at the same time, equity markets are resilient. Bond volatility is moderating, while liquidity is getting soaked up. Precious metals may be in for a breather right in time for everyone to lose temporary faith in the dollar. Could be more downside in oil and copper.
But not much. Oil has been consolidating in a tight range for what feels like forever, but $65-$70 should serve as a new long-term base for some time with plenty of macro-factors as tailwinds. Copper danced along $4.20 and appears to be correcting in time around that number. Everyone sees and understands what’s going on in copper, but it sure doesn’t feel like real capital gets it yet. The banks and trading houses will force a change of perspective for everyone as supply/demand fundamentals begin to grind the price higher for the “greening” of the world.
We’ve got the rest of Spring and the Summer for economic activity to surprise to the upside in the US, just like Q1. I think the positive animal spirits of consumers are going to catch a lot of investors sideways. Between low unemployment, the wealth-effect on a continued equities rally (after a pause), and the amplification of credit card usage, the US consumer is just going to want to enjoy the Summer with a sense of normalcy. That normalcy will translate to surprising economic strength through the Summer and into the Fall, despite all the leading indicators showing recession is baked in but not sharing when.
I surmise the end of Q3 or Q4 is when the consumer retrenches. And if that ends up being the case, forget about Santa’s rally. It feels like the Fed has reached it’s last increase to the critical 5% rate. Now it will sit on that to let the lag continue to wend its way through the economy. My guess is that the recession rears its head in the Winter.
However, since we only identify recessions after the fact, I suspect the Fed will sit on its hands to stimulate the economy via it’s usual methods until sometime in Q2 of 2024. Banks’ asset quality reserve the right to interfere with timelines. If West Texas crude is north of $90/barrel and copper north of $4.5/lb. then the Fed will be pulled in both directions. The pending elections will ensure that monetary stimuli are chosen over inflation abatement, as behind closed doors, one has to believe that “they” know inflation will not be curtailed but instead wash over the world in rolling waves for the rest of the decade.
That cat’s out of the bag. Actually, it’s more like a boxer trying to wrangle a chicken in a pen. Central bankers and politicians may nab it at some point, but not before a whole lot more price pain in commodities which should co-lead US Dollar repudiation as a reserve asset. Geo-politics will take care of the rest.
So 2024 brings potential recession and definite US elections. While the banks bring their exposure to CRE and an incomprehensible lack of cognizance around rates sensitivity to their credit portfolios. Should make for some spicy times that long-term, large capital probably won’t have the tactical agility to operate effectively in. This will present a constant stream of opportunities for prepared traders.
I thought the environment we’ve been in since inflation took off was going to happen after 2008. Many did, hence gold’s run after the GFC. Even though I wasn’t even born when the 70’s inflation kicked off and was only a toddler when it was finally snuffed out, I’ve been preparing for this investment environment that the world currently finds itself in.
In order for long-term capital to outperform during the rest of this decade, I think strategic hedging via tactical trading and exposure to less traditional asset classes will be critical. Despite their tough year in 2023, CTAs should continue to be a top performer through the 2020s.
All capital has to independently quantify what that looks like for portfolio construction. Basically, if a portfolio manager is sitting on long equity positions where basis and dividends say to hold and if their long RE holdings or other real assets that must be held during inflation were purchased with low WACCs, then it will be critical to allocate capital to volatility strategies where the asymmetric returns offset paper losses of the long-term holdings.
This mindset will not take hold en masse by nearly enough asset managers, but those that do take this approach will probably see their AUM thrive while others are bleeding.
The volatility has to be embraced, not forsaken, as it is a critical component in understanding capital flows.
So what does that mean for portfolio construction? Hold equity in high-quality, cash-flowing businesses with resilient brands and position at opportune times. No shit, right? Save yourself some time using YCharts visualizations of valuation-ratios. Between the financials and the trend(s) of of EV/EBITDA, P/S, P/B, P/FCF, etc., one can save a ton of time on due diligence. One could have picked up some CLX and CRM several months ago right before 40% and 60% runs, respectively.
Novo Nordisk and Eli Lilly look like no-brainer long-term holdings and the hard/soft cycle of P&C insurance continues to present good opportunities, especially with rates stabilizing.
I like productive land or land with high optionality over buildings, but obviously buildings provide more consistent cash flows. The yield in multi-family will persist as supply/demand fundamentals in housing virtually guarantee it as long as the cost of capital was or is reasonable.
The recent action in precious metals has a hint of USD repudiation behind it. It just has that musk. Can’t explain it. Can’t quantify it. Just a feeling. But it looks and feels like precious metals time may have finally arrived. Riding shotgun will be crypto assets. Whether one believes it or not, the progress and development in Ethereum-based projects appear to be leading ETH to a potential seat at the table of reserves. Impossible to see how the protocol’s adoption rate develops, but between freedom of choice and potential ease of commerce, I can see how ETH’s price goes significantly higher from its relatively recent low of $1000/coin with the network effect already in place.
And of course…commodities. I think copper is the easy play here to have meaningful exposure. Between futures, trading houses, and large miners, there’s plenty of high-liquidity options that will allow one to capitalize on copper’s potential price rise.
The world is only at the early phases of inflation and electrification. It doesn’t feel like enough capital believes copper prices can move meaningfully higher. And that may be the case. Maybe copper just peaceably stays between $3 to $5/lb. for the next several years, but I don’t see it. The supply/demand fundamentals certainly don’t say it.
I like to rationalize copper’s potential against oil’s price action. In just the last 3 years alone, we’ve seen crude oil go from a negative price, where one was paid to take the most critical commodity on the planet off of the hands of others, to a high of $130/barrel. Everyone, everywhere uses oil and look at that volatility.
And yet somehow copper won’t be able to double? Or copper couldn’t move 50% higher from it’s high of $5/lb.? To me, these price moves seem very plausible. Very feasible. Exposure to this asset class appears poised to continue its outperformance in the coming years.
I contend that electrification and the build-out of infrastructure across the US will be how Main Street gets bailed out during the next crisis. Taxpayer dollars will be used to develop projects around these two key areas in order to provide critical jobs to large swaths of the population at a time when jobs may be hard to come by. Demand for copper should be even more inelastic and at higher prices. Then economics plus greed should take care of the rest in copper.
Elections. World war. Dollar repudiation. Inflation. Societal strife. Lagging and inconsistent monetary policy. Embrace volatility or potentially watch your return-profile lag this decade.
Margin Rich 