In the world of investing, twelve months can seem like an eternity. That is because it only takes a year to go from one extreme to another, from bullish to bearish or a bearish to bullish extreme. Take for example the end of the first quarter of 2021 vs today. A year ago, the Federal Reserve was adding nearly $120B a month to its balance sheet and today the Fed has started raising interest rates and is on the verge of shrinking its balance sheet. Also, because the Fed failed to recognize the persistent nature of today’s inflationary environment by insisting it was merely “transitory” (a view we strongly disagreed with and warned against since April 2020 – see here), it may now be forced to raise rates by half a percent (50 basis points) at its May meeting. If implemented, this would be the first 50 basis point hike in 22 years since May 2000, the peak of the technology bubble. What could go wrong?
Housing Headwinds
The Fed is finally being forced to deal with the runaway inflation problem that has impacted every area of our economy, hitting both consumers and businesses alike. The surge in inflation is pushing not only the cost of everything higher but also financing costs with higher interest rates. The rising input and financing costs that we have been facing have sowed the seeds for a slowdown that is upon us. For example, new home sales are down double-digits from last year’s level as a 30-year fixed rate mortgage has surged from under 3% to nearly 5%. Unless mortgage rates move materially lower soon, the slowdown in housing is likely to persist.
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Manufacturing Headwinds
It's not just housing that is starting to cool but so too is our manufacturing base. The Institute for Supply Management (ISM) Manufacturing Purchasing Manager’s Index (PMI) is now softening from its 2021 highs and, based on price leading relationships, we are likely to see manufacturing soften for the remainder of this year before a possible bottom in 2023.
The slowdown underway in manufacturing is leading the FreightWaves CEO Craig Fuller to call for an imminent recession as highlighted below:
Why I believe a freight recession is imminent
I would prefer to say the U.S. trucking market was robust and the expansion will continue throughout 2022. But I can’t. Since I wrote the piece about the bloodbath, FreightWaves SONAR’s tender data continues to reinforce the perspective of a declining freight market.
Tender rejections are the best indicator into real-time supply/demand in the truckload sector. The data comes from actual electronic load requests – “tenders” in the truckload contract market.
A high rejection rate means that trucking companies have more options to choose from. A low rejection rate means carriers have fewer options in freight to pick from. Since this measures actual load activity and not load board posts or searches, it tells us what the market is actually doing.
And since it measures the willingness of carriers that are contracted to accept or to reject a load they have a contracted rate for, if the rejection rate declines, it suggests capacity is loosening.
At the start of March, the rejection rate was 18.7% – today it sits at 13.90%. Even though it has only been a week since I wrote the “bloodbath” article, the rejection rate has fallen another 1.3%. The last week of March is normally one of the best weeks of the year for carriers, but this year it has been one of the worst. Just wait for April…
Consumer Headwinds – Restoration Hardware a Canary in the Coal Mine?
On Wednesday, March 30th, Restoration Hardware (RH) CEO Gary Friedman made a series of notable comments during the company’s quarterly earnings conference call that caught the attention of investors and economists regarding the company’s challenges and outlook. While the comments section pasted below may be long, it is chalk full of insight into the plight of businesses in the current environment.
How old was everybody in this call in 1980 when the federal funds rate was 20%? I'm not trying to scare anybody. But almost everybody on this call, look, in 1980, I was a kid, I didn't know what I was doing. I didn't have wisdom then. I just don't think there's a lot of people in business today, except for Warren Buffett and Charlie Munger and I don't know, George Soros, and there's a handful…
I mean I think, I don't think anybody really understands what's coming from an inflation point of view, because either businesses are going to make a lot less money or they're going to raise their prices. And I don't think anybody really understands how high prices are going to go everywhere. In restaurants, in cars and everything. It's — and I think it's going to outrun the consumer. And I think we're going to be in some tricky space. So everything is kind of happening at once. And I think you got to prepare for war. I mean if you're going into a very difficult, unpredictable time, you just got to be super flexible, you've got to be able to improvise, adapt, overcome and kind of be ready for anything.
Two years ago, price of a container for us went from 2,400 to 4,800? Yes, yes, it's doubled. I'm not going to tell you what it just went to. But just let's say that looked like a nice increase. So — and it's not just us, it's everybody. So either people are going to do stupid things like take quality down to make their goods like — look like it's better value or they're going to not -- they're going to have to take prices up and where they won't take prices up and they'll hurt — their margin profile is going to change. But it's not just us, it's everybody I know in every industry. And I just don't think it's like, again, I don't want to scare everybody. But I talk about them, like there's the scene in The Big Short, where everybody is in that ballroom and the guy thinks it's the guy from Bear Stearns or someone is up there, one of the things, and he's saying how they are going to buy back $1 billion of their stock, this is not, and then one guy on his BlackBerry, goes, can I ask the question, sir? In the 20 minutes that you've been talking, your stock is down like 55%. And everybody ran out of the room.
I just think — we tend to just try to be transparent and honest. And look, maybe our stock is going to take a big hit because of this and people are going to think Gary Friedman wasn't excited. I've never — I told — I've never been in my 22 years here, I've never been more excited. I've also never been more uncertain, right? So — and I think you have to take a real balanced view right now.
The slowdown that Gary Friedman is seeing in his business reflects the shifting spending habits of the U.S. consumer as they face a challenging environment of skyrocketing prices. The higher inflation rates run, the more the consumer gets squeezed and is forced to reduce discretionary spending. The slowdown RH is facing was forewarned in a Nielsen IQ consumer intentions report for spending in 2022. Consumers intended to spend considerably more on non-discretionary items like food and utilities at the expense of reduced spending on discretionary items like dining and out-of-home entertainment and travel.
Liquidity Headwinds
It truly feels as though markets are being assaulted on all fronts, likely payback for the extreme stimulus applied in response to the COVID outbreak of 2020. In addition to consumer, manufacturing, and housing headwinds, markets must still contend with financial liquidity headwinds. Financial institutions here in the U.S. continue to pour capital into the Fed’s reverse repo facility, which effectively drains liquidity from the U.S. financial system. Last year the facility surged to a loss of over $1.5 trillion in liquidity, largely offset by the Fed’s expansion of its balance sheet with its quantitative easing (QE) program. Now, with the Fed ending QE last month and pledging to reverse it by shrinking its balance sheet starting in the next few months, rather than offsetting the loss in liquidity occurring in the reverse repo market, the Fed will be contributing to it. One of our concerns is that the reverse repo facility is rising again and looks set to exceed $2 trillion in the coming weeks, clearly not a favorable development for financial markets.
Not only do we have a decline in U.S. financial market liquidity, we are also witnessing the same development on a global scale. The annual growth in global money supply (as measured by global M2 money supply aggregates priced in USDs) peaked last fall and has been rapidly decelerating with no sign of a turnaround yet. Until we see a material decline in inflation trends, both US and global liquidity rates are likely to continue to deteriorate going forward.
Portfolio Strategy & Outlook
Our commentary in the Q1 newsletter voiced our concerns regarding a weak stock market and our plan to use any market weakness to increase exposure to attractive areas. That is exactly what we have done in recent months. On the fixed-income side, we made some purchases in convertible bonds that are creating attractive yields over 4% to maturity with the potential option for higher returns should the underlining stock prices recover strongly.
Looking into the current quarter and beyond, we believe that the headwinds highlighted above will create market turbulence and is why we recently added a hedge to client accounts. Our goal was to reduce our equity exposure below neutral to reflect our conservative macro-outlook. We plan to further increase our exposure to the energy sector given the large inventory shortfall and we will look to reduce our exposure to bond funds given the lack of available yields in the corporate bond space.
We correctly anticipated a rising interest rate environment by underweighting client exposure to bonds while also keeping our maturity length well below that of our fixed income benchmark. Looking at the data, the rise in rates has been so steep that the recent decline in long-term US Treasury prices is now the biggest in nearly a half century, even exceeding losses seen in the early 1980s as shown below.
We will continue to monitor the risk of a recession as that would dramatically alter our portfolio strategy with likely reductions in our equity exposure, as well as commodities since they fall the sharpest during recessions due to collapsing demand. The last two years have been volatile and challenging to say the least and we expect this dynamic to continue. During such times, flexibility in thought and portfolio positioning can be great assets.
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