2022-11-01

Has the time come for corporate debt to have its time in the sun?

SOM Macro Strategies argues in its latest newsletter that higer rates will benefit corporate credit. The idea seems to be that interest cost is fully allowable, and that as CBs pause the current tightening cycle, corporate debt will start to benefit. I am still nervous about going long debt into a recession, but I guess that it is logical that in a recession rates collapse, and that equity takes the first hit. SOM points out that in inflation-adjusted terms, debt in SP500 companies isn’t particularly high. It suggests that as rates come back down, firms will start to buy back debt, supporting the price.

While I sort of understand the thesis, the $AGG ETF, which is a portfolio of corporate credit, does not look too healthy:

Lula wins

Lula is the new president of Brazil. Let’s hope he does a better job than last time. Maybe the stockmarket will bounce with a sigh of relief.

IMF warns Europe that it’s in deep trouble

In this blog post the IMF points out that Europe is in a very bad place.

However, our latest Regional Economic Outlook shows that the pandemic and Russia’s war in Ukraine might have fundamentally altered the inflation process, with rising input and labor shortages contributing notably to the recent high-inflation episode. This suggests there may be less economic slack and, accordingly, more underlying inflationary pressures, than commonly thought across Europe.

These results highlight a risk to our forecasts and those by others that inflation will fall steadily next year. Other wild cards include a de-anchoring of medium-term inflation expectations, or a much sharper acceleration in wages that would trigger an adverse feedback loop between prices and wages.

A lot of commentators have been predicting mean reversion in terms of returns to labour as a factor of production. Maybe it’s really going to happen.

Worth following

Lykeion produces amazing stuff. This monthly summary is amazing.

Wrap

• Weak ISM and PMI data, indicating a recession, were ignored in favour of good JOLTS data, which has pushed up the expectations for further tightening. The peak seems to be around Mar next year, at 5.325%, which you can infer from the Eurdollar futures curve.

• WTI was strong, because of strong demand and a big ‘draw’. See ZH for more detail: https://www.zerohedge.com/energy/wti-holds-gains-after-big-unexpected-crude-draw

• ZH had an odd story:

There was one weird headline today (that sparked consternation among many Fed watchers) as White House economic advisor was interviewed on Bloomberg TV and told the anchor that “President Biden has endorsed The Fed’s policy pivot.” Did Bernstein just front-run tomorrow’s announcement? How does Bernstein know that Powell is pivoting given that the FOMC meeting just started? Is Bernstein explicitly signalling to pressure Powell and the independent Fed to ‘pivot’?

No, none of the above, Bloomberg headline writers ‘corrected’ their report to note that Bernstein was merely confirming that Biden endorsed The Fed’s pivot to tightening this year. Pretty big difference there, Bloomberg!

• The Brazilian Real did very well, on a daily move basis, presumably relieved that the election was over and everyone (except Bolsonaro himself) seems to accept that Lula has won.

Image

Where will interest rates go next?

An ageing planet and the future path of interest rates

The Economist has a special report about ageing societies and mounting public sector debt.

It’s hard to summarize fully, but the argument is that it’s hard for governments to contain spending when their populations are ageing and demand more pensions and health benefits, but produce very little and therefore do not contribute much in taxes (certainly net of what they receive).

Historically, ageing populations have been able to get away with this by lending to younger countries to allow their growing populations to combine with a growing capital stock to boost the world’s output (especially of tradeable goods). Sadly, that doesn’t work if all countries are getting old together, and the big one, China, is well down that path. A path which, surely, Xi Jin Ping will fail to block off, in spite of his attempts to make citizens produce more children.

The conclusion is that interest rates are going up. Of course, demographics is only one of many reasons for this. It’s seems impossible to think they won’t and yet this has been true for a long time, and long-term yields are still very low.

The conclusion many people drew from the experience of the last 40 years of fixed income markets was that central banks had finally found a way to tame inflation and could always be relied on to prevent another 80s style inflation (or emerging market style hyperinflation, of the sort that we regularly see in Latin America and Africa). This is explained in various ways, but a favourite approach is to invoke the ‘safe asset shortage’ hypothesis. There are numerous papers on this, but I found this explainer a good explanation on my level. The idea is that, in the real world, savings flow from emerging markets to developed markets, even though you’d think the demand for capital would be the other way around (because labour, the complementary factor of production to capital, is relatively abundant in emerging economies).

Well, it’s not really a theory, it’s just an empirical observation, or really a conundrum. Clearly, the legal and political frameworks in many developing countries do not put property rights at the heart of everything as they do in the West, and so the wealthy in those countries much prefer to put their savings in London houses than Zimbabwean factories.

I do not think that this will reverse very soon, but China, the elephant in the room, does not export much capital now, and with the pandemic and raging inflation everywhere maybe it will not be the only country to suddenly stop running a trade surplus. I think this is true of Japan now too. Of course, the UK does run a large trade deficit, which it needs to balance by exporting a lot of capital, but it seems to me that it can only do this if it starts to offer some juicy returns, especially if GBP continues its downward trajectory against more or less every other currency.

So, I’m bearish on bonds, but I have been for a long time, and I’m still waiting for the market to catch up with my way of thinking.