Economic Outlook | 3/8/2021
Bond Yields, Inflation, Interest Rates and More
The market remains in a position where it has yet to confirm an overarching trend, thus we find ourselves at an inflection point. Over the past week, we’ve seen Fed Chair Powell give sweeping warnings surrounding inflation, their complicit and acknowledgment in the current bond market yield crash, and rates pausing. These are not good things for the market, as increased inflation leads to increased rates, which affect the general macro-economic headwinds that bolster the market. Should we see an increase in the CPI print on Wednesday like the PCE did last week, which is more encompassing of the Fed’s measure of inflation, we could see jumping prices as Powell hinted in his WSJ interview last week.
Earlier today it was reported that David Tepper has a fundamental belief that the plummeting yields have served as a buy signal for different investors throughout the world. It’s his purview that treasuries will no longer make sense to be sold short but rather bought given the potential risk-reward in yields and bond prices. In particular, this would be of strategic and economic advantage to Japan given their current treasury. Furthermore, it serves the US well in seeing some stabilization of rates.
If Tepper’s thesis comes to fruition, we see the markets rebounding soon; however, the interpretations of what a buying spree in yields will do are mixed. Some, like Tepper, believe that this will continue to bolster different tech stocks like Amazon because people are forced into equities markets. Mohammed El Erian of Allianz Investment Bank on the other hand holds the view that yes, yields will be cheaper and could force people into equities markets, but the distinction as to which sectors will become the leaders and laggards is unclear. Mohammed believes that we will continue to see the shift into more cyclical sectors such as financials and energy, which historically bodes well in rising rate environments.
Thus, in discerning the viewpoint that is in fact most aligned with reality, it is important to pay close attention to the items we have coming up in regard to the markets. The Market had an incredible Jobs Report Friday yet did show a decline in the total number of hours people worked. The inflation risk is real, and we do see more investable assets in sectors other than tech which could be in fact indicative of a sector rotation. We may view the markets this year to be explicitly close to the markets during the years of 2016-18 in which we had a similar rotation. For that reason, we are starting to take a better liking in some of the DIA names as many of these equities are trading at pre-pandemic levels. We think of the DIA as a long inflationary hedge that could be used to gain some exposure to the secular shift, however, we will be focusing most of our attention on varied materials companies.
The United Steelworkers Union has made it explicitly clear that they would be pursuing the administration to uphold the tenets of the Section 232 Tariffs in order to protect American infrastructure and technology-related industrial development. We think this sentiment does hold some political weight considering the design in which the 232 Tariffs were administered, not to rectify trade imbalances but rather to create additional measures to protect national security. Yes, the Steel industry and the illicit trade of steel are classified as national security in the United States. Don’t get caught up in the policy- it is a divisive one- just make sure you know how to trade it so that you can make some real change.
Nonetheless, it is important to recognize the technical patterns of the major indices as well when looking at the market in aggregate. Both the Nasdaq and Spy fell out of their upward trending channels formed from the March lows. For them to re-enter this channel, they would need to rise in price by some 7%, and based on the shifting dynamics in trading sentiment over the past few days, this seems unattainable, but not impossible. This is a technical breakdown and each day the Nasdaq and SPY continue to fall, this belief is reiterated. It is important to see how the market reacts to the Stimulus package expected to be passed this week, but there are rumblings by investors that a sizeable portion of this has been in-fact priced in. Overall, this is a signal that times are in fact changing, the hyperinflation of tech asset classes may no longer be the underlying trend within the market. Thus, it is of paramount importance to continually adjust the framework through which you invest in accounting for these changing parameters as we are at CSS through the analysis of different drivers that are more applicable in this environment.
Geopolitical Risk
Tensions are rising in the Middle East as well as China as the Biden administration grapples with how to handle its foreign policy agenda. The United States and China are not only continuing on in their technological battle, but China has drawn increased attention from human rights advocacy groups concerning the ongoing Uyghur Genocide. Over one million Muslim Uyghurs have been detained in “reeducation camps”, with some allegedly having their organs harvested and sold to eastern China. These actions have led many to call for a boycott of the 2022 Beijing Olympics. China has also been increasingly aggressive in the South China Sea, against Taiwan specifically. It will be interesting to see if these tensions get in the way of an ongoing climate change agreement between the two countries as well as any possible sanctions that could arise. As of now, China produces 28% of global CO2 emissions, whereas the US accounts for 15%. The Biden administration appears to remain tough on China while keeping the Taiwanese “dangerously” close as described in statements from Beijing.
The United States has directly implicated Mohammed bin Salman, the crown prince of Saudi Arabia, in the killing of journalist Jamal Khashoggi in 2018. This is important news not only because Saudi Arabia is the world's largest oil exporter and a central ally of the US, but they have been diversifying their own investments in the US as well. They are heavily invested in companies like Tesla, Uber, and Virgin Galactic and are one of the main customers for global US defense products. Therefore, the opportunity cost of the United States distancing itself from Saudi Arabia is very high. Losing an ally in a region with an increasingly aggressive and noncooperative Iran does not seem like the right thing to do at the moment. Recent rocket attacks on US contractors by Iranian-backed militias in Syria have been met with airstrikes from the US in return. Iran has also rejected nuclear talks with the US and is only open to doing so if sanctions are lifted within the year, something that is unlikely to happen. It is crucial that the Biden administration does not do anything that will distance the US from Saudi Arabia and remains obstinate against Iranian aggression.
Semiconductor Chip Shortage
As the U.S. is expecting to gain more economic traction in 2021 with more people being vaccinated, some of the biggest questions still lie behind whether supply chains will be able to keep up with the rebounding demand. The major issue is semiconductors. To a certain extent, the semiconductor chip shortage has been a cumulating problem since late last year due to a few (unrelated) supply-chain disruptions. However, the Covid-19 pandemic is what ultimately caused a hasty drop in vehicle sales during the spring of 2020. Many automakers then decided to reduce orders of all parts and materials; of which include the chips that are needed for functions ranging from touch screen displays to collision-avoidance systems. But when demand for passenger vehicles rebounded, chip manufacturers were already committed to supplying their big customers in consumer electronics and IT. Now, automakers and medical device manufacturers have asked the Biden administration to subsidize the construction of a new U.S. semiconductor manufacturing capacity.
Unfortunately, semiconductors are devices that need to be built in a highly controlled and clean environment, known as "Fabs". These chips are so sensitive that specks of dust or even static electricity can damage the inner workings of the device. Meeting the exacerbating demand is not as easy as it seems. New chip Fabs cost billions of dollars and can take years to build. Even so, Fabs are operating at maximum capacity and we expect it to take multiple months before demand is met. Today, we have seen how shortages of semiconductors have been impacting manufacturers of automobiles and other correlated products. This event illustrates the need for companies to ensure that their supply chains are resilient and more readily prepared for disruptions. Such shortages, on top of all the other pandemic-related supply disruptions, have undermined the value of mitigating supply chain risk and developing robust strategies for weathering similar future events.
In regards to trading the semi-conductor chip shortage trend, it is incredibly important to consider the different catalysts and fundamental moat factors that drive the asset prices of these manufacturers up. While we maintain the purview that there is a Semi-Chip Shortage and unprecedented demand in some part ignited by the pandemic, we view the subsequent price action and technical analysis of such companies to be quite bearish which means that the bullish fundamentals are being over-ridden or powered by some negating factor. This could be the Secular Rotation we aforementioned above. If that’s the case, this sets off glaring alarm bells in our thesis surrounding the tech sector. Whenever you get Bullish tailwinds, bullish fundamental drivers, and bad price action, something isn’t adding up, it means there likely is a problem within the industry or the shortage and demand has already been priced in and is not enough to keep the valuations at their current levels. This will be something to pay keen attention to in the coming days, specifically tracking SMH and the different leaders and laggards of the semi sector as a whole.
Bitcoin Tether Risk
Tether is a 36 billion market capitalization Stablecoin used to directly assist in the funding of cryptocurrency transactions, similar to a treasury for foreign reserves. The primary purpose of a Stablecoin is to be a digital asset that is directly tied to currency on a 1:1 basis, such as the US dollar. Banks can now borrow and loan money in two conventual methods as opposed to the old system, opening a new secondary market. Demand has been high for Stablecoin, as banks have been using the service more and more to fund cryptocurrency investments. Much of the risk surrounding Tether and other Stablecoins is the potential for a digital version of a bank run. Unlike a regular bank run that can be more preventable with frequent bank stress tests, Stablecoins tend to have heavily volatile premiums that can create unforeseeable risk. For example, Stablecoin premiums have proven in the past to be very susceptible to negative price shocks. The pandemic was a good example of this because people were paying a higher gas price to liquidate their positions. In many ways, the most recent crash of Bitcoin and other cryptocurrencies again combined with rising gas prices could bode poorly for the long run of cryptocurrencies in general. Central banks also have less authority and power to intervene in the stabilization. The development of Stablecoins is still a long way from being fully fleshed out; the creation of forward and futures contracts have yet to be developed and this will bring in a deluge of financial institutions looking for arbitrage capital.
It is quite possible that the risks associated with Tether not tracking the U.S. currency on a 1 to 1 ratio have been realized in the crypto markets. As more institutions continue to add crypto to their treasury, and prices contracted from the onset of the initial news. Since then, Bitcoin has bottomed and is tracing back towards its former highs which is something that is inconsistent with the first asset bubble created with Bitcoin. This could in fact be a validation that its utility is ready for the market today. Given the increased utility and applicability of cryptocurrency and blockchain in the pandemic economy we live in, we think it is probable that we continue to see a more adopted use of fiat across an assortment of industries. Whether it be as an inflationary hedge on institutions’ treasury or balance sheets, or a mechanism to promote different networks and payment systems, there is a lot of bullish catalysts surrounding cryptocurrency.