The conundrum;
interest rates, growth, inflation, oil, gold…and too much debt
It’s no accident that Google and Facebook have deemed it necessary to reinvent themselves as Alphabet and Meta. New name, new direction, new distribution flows. That seems to be working for Google which started life as a pretty good search engine but now has more data on your preferences, whereabouts and well being than you almost certainly realise.
Big data continues to be extremely valuable in big corporate world which just gets bigger and bigger as a result. The problem with exponential growth is the fact that it is exponential! Nothing grows to the sky and we are beginning to see the first tentative signs of a slowdown in subscriber numbers at Facebook, Twitter, PayPal, Netflix and given a hefty increase in the cost of “Prime” a similar scenario at Amazon too.
There is an argument to say that their basic businesses should be valued as utilities and perhaps they should be broken up to reflect that; something the regulatory machine of government is longing to do. In the current environment it is impossible to dis aggregate the multiple business streams within these behemoths to determine whether value is being added and to what extent they are stifling competition. Enhanced 10-K reporting is necessary to reveal the nature and extent of Big Tech’s market dominance. Only then can we see if these giants owe their continued growth to value creation or to value extraction.
The other issue facing tech is rising interest rates another environment in which tech shares tend not to perform well. And finally, volatility. When the fifth largest company by market cap, Amazon, after Apple, Microsoft, Saudi Aramco - bet that wasn’t on your list! – and Alphabet (nee Google) can close on a hard down day for the NASDAQ at minus 7.5%, yet within seconds of the closing bell rise over 12% on “OK” earnings you have to wonder why we are seem small cap low liquidity characteristics being evidenced by the big boys. Such price action tends to be a harbinger of more volatility not less.
And talking of rates, yield curves are taking on some worrying characteristics suggesting that whilst rates are certainly going up at the short end, they are rising less fast at the long end suggesting an approaching recessionary phase (when the gap between 10 and 2 year yields goes negative), another nail in the growth story.
And then we have a rapidly rising oil price which has been making a series of higher highs and higher lows since April 2020 when the front month West Texas contract went minus$40. We were not supposed to see $100 oil again; well, here it comes! High oil prices are less about inflationary pressures (which they are in the very short term) than as a tax on both individuals and corporates. A slowdown is beginning to look baked in.
Slower growth should also be a proxy for lower inflation. As demand falls competition for scarce goods evaporates and that should ultimately be good news for interest rates. The current “thinking” is that 2022 will see up to 8 rate rises each of 25 bps. Will the Fed really up the ante into an economic slowdown? Neel Kashkari an FOMC voting member has suggested “one and done” might be the best outcome. One rate rise in March and then a pause to review the incoming data something Powell has always been keen to espouse.
Another reason to think that this is a more likely pattern is the rise and rise of real interest rates which the US Treasury and much of corporate America cannot stomach for too long. The yield on the 30 year UST is now positive and the others are catching up
With potentially lower inflation and higher real yields the case for gold is diminished. The negative correlation between the two has been in lock step for much of the last 20 years. To continue higher gold needs to see declining real yields which the central bank and the US Treasury will attempt to engineer.
Tying it all together, interest rates, inflation, oil and gold there is one common theme. There is just too much debt to allow the current economic system to function properly. A recent McKinsey report on debt plainly identifies the problem. After a forty year party of debt-fuelled growth, we have the hangover of deleveraging. Historic episodes of deleveraging fit into one of four archetypes:
austerity (or “belt-tightening”), in which credit growth lags behind GDP growth for many years.
massive defaults.
high inflation; or
growing out of debt through very rapid real GDP growth caused by a war effort, a “peace dividend” following war, or an oil boom.
To quote one of our favourite commentators, Tim Price of Price Value Partners,
“McKinsey’s words, not ours. So, choose your poison – assuming you have a choice.
And therein lies the problem. The dead weight of debt was amassed in large part by politicians promising more than they could ever deliver, with taxpayers now and to be born involuntarily taking up the slack. And it was facilitated by banks, the scale of whose malinvestment excesses effectively caused their finances to be fused with those of national governments during the Global Financial Crisis. Option 3 continues to look like the most politically expedient “solution” for most of the indebted world. The business of investing involves a probabilistic quest for certainty where none exists. Hence asset diversification. But we have established to our own satisfaction a few ground rules. G7 government debt looks like a “safe haven” bubble that could end disastrously. But if G7 government bond yields really are sustainable at their current, pitifully low levels, that implies a Japanified prolonged deflation that is logically consistent with a disaster for most other traditional assets. So sensible and uncorrelated investments scream out as one solution.”
Embracing long volatility plus a recognition that trend following strategies also provide diversification seems to be the best way to tackle to the bond / alternative asset allocation conundrum. And eventually gold will have its time in the sun. You may also want to own crypto if you really understand what is going on in this market. If gold is a barbarous relic what on earth does crypto represent, I wonder?