Shades of the 70's - Obsidian Capital

Q3 2022 returns:

Highlights

Exploring the 70’s inflation
Portfolio positioning

Exploring the 70’s inflation

As we enter the final quarter of 2022, it is quite clear that the primary driver of asset class performance and asset allocation has been the persistency of global inflation. Global Fixed Income and Equities have particularly been under significant pressure as persistent inflationary pressures have caused central bankers worldwide to aggressively hike interest rates.

Forecasting the trajectory of inflation is therefore going to be critical in the months ahead in order to optimally allocate assets and stock selection within our portfolios.

There is a lot to ponder when reflecting on the trajectory of inflation going forward. We have for some time flirted with the likelihood of a ‘70’s style inflationary cycle playing out over the years to come, starting from 2021. Like all investors, when confronted with a sea-change in economic fundamentals relative to the past few decades, it is typical to observe history of periods that displayed similar dynamics. Hence the comparisons of the ‘70’s may be useful to chart a way forward for financial assets. Saying that, it is important to recognise that the surge in global inflation has already taken Europe and the UK to levels of inflation exceeding their peaks of the ‘70’s inflationary period; so it’s fair to conclude at the outset that even the ‘70’s experience may not be an appropriate comparison when analysing the forces of inflation playing out today.

So, let us reflect on the journey of inflation in the “70’s” … and we say that because the journey would have been a lot more “bumpy and murky” while living it, than reflecting on it now in hindsight and regaling a “decade of rising inflation”.

In reality the inflation journey of the ‘70’s within the US was truncated by three “waves” starting earlier than most people recognise in 1967 at 2.5% and surging to a peak in 1980 at 15%. As highlighted in our chart below, the important takeaway is the fact that inflation didn’t rise in a smooth trajectory but ebbed and flowed in three distinct periods as highlighted in the chart below.

Chart 1: US Inflation trajectory in the 70’s was a “bumpy journey”

Source: Iress

Taking the observations from the 70’s on board, we need to consider a likely trajectory for inflation going forward from now (for the 12 months ahead):

We think it’s quite probable that from an inflation print of 9.1% in July 2022 the “first wave” of inflation is likely behind us. In at least the short-term inflation has likely peaked with the trajectory down from here. Why do we say that?

US monetary policy has inverted the yield curve; this was always a precursor for rolling inflation in the 70’s (as per chart 2 below).
The broad commodity cycle has peaked (in this cycle)
Lapping of highly elevated energy prices should start working in favour of disinflation, even though energy prices remain highly elevated.
We should be close or at least a few months away from a peak in the all-important shelter inflation (32% of Headline CPI and 42% of Core CPI)
Whilst food inflation is still elevated, food and oil prices combined have rolled over.

Factors that are supporting inflation that are still in place:

Red hot job market fuelling wage growth.
Apparent reacceleration of the services economy (as measured by the US ISM Services purchasing manager’s index)
Sticky, stubbornly high food (grains) prices.

Certainly, a tug-of-war ahead, but our sense is the disinflationary forces (right now) should start to outweigh the inflationary forces going into the next year.

Chart 2: Inverted yield curves ushered in a peak in inflation -1965-1985

Source: Iress

Inverted yield curves ushered in a peak in inflation -1995-2022

Source: Iress

When we reflect on Chart 2 – panel 1 above during the 70’s period – and digressing – what perhaps has been missed on history is that Paul Volcker only became Chair of the Federal Reserve in August 1979, at a point where the yield curve had already inverted! In other words, you could argue that the seeds for a roll-over of inflation had already been sown, even before he intervened with his (even more) aggressive interest rate policy! It is possible that Volker’s role in “killing inflation” may be overstated in history?

This is a worrying observation – if the Fed believes this historical narrative that the only way to curb inflation is to restore real interest rates, then we have considerably higher rates to come? (In the short term) This would be a devastating outcome for equity and fixed income investors.

So, assuming we are past the “first wave”, the million dollar question is will we follow the first wave with second and third waves pushing inflation to even higher levels each time as the years roll on from here?

Should the next several years play out as they did in the ‘70’s, then we would look something like the crude idealised schematic we have illustrated below. (Chart 3)

But importantly, under the current conditions we envisage, it’s likely the US will experience lower inflation first before experiencing higher inflation later (if indeed at all?)

Chart 3: Could the next decade exhibit similarities to the ‘70’s?

Source: Iress

So, if we are “cresting” as far as the current inflation wave is concerned, the only question remaining is: “Are rates in this wave yet high enough in relation to the prevailing level of inflation?

Chart 4: US short rates are still behind the inflation curve

Source: Iress

From the chart above it does suggest you need yields on 3-month Treasury bills to rise meaningfully further to close the gap on the prevailing inflation rate. But if we look at other duration interest rates in the US, it becomes less clear.

By way of example, 30-year mortgage rates are now higher than they were pre-GFC and indeed 2-year interest rates are close to pre-GFC levels. Perhaps we don’t have too much longer to wait until interest rates start to “bite?”

Chart 5: US monetary policy has already tightened significantly in longer duration interest rates

Source: Bloomberg

So, let’s consider the prospects for the US housing market after the massive surge in mortgage rates. The chart below inverts the mortgage rate and leads it by 9 months (green). The ratio of US existing home sales relative to stock on the market (yellow) has been falling sharply while house price yearly growth is shown rolling over in white. The chart is certainly suggesting that Mortgage rates have already done enough to slam the anchors on the housing market?!

Chart 6: US Housing market is about to cool significantly

Source: Bloomberg

Should the explosive house pricing environment reverse going forward, we are getting very close to reaching the maximum point of inflationary delta in the all-important Shelter component of US CPI (Owners-equivalent rent). This component constitutes 32% of the US CPI basket and 42% of US Core inflation. Chart 7 below illustrates the potential of Shelter inflation nearing a cyclical peak.

Chart 7: End game in Shelter inflation is in sight.

Source: Bloomberg

The other question to ask is – what is more important? Establishing real interest rates while in a hiking cycle, or inverting the yield curve? The latter has largely already been achieved while the former may continue to lag as it did in the 70’s; but if the inverted yield curve leads to a sharp slow-down/recession, then perhaps the job has been done (from a monetary policy perspective)? This of course assumes inflation sharply decelerates in such a recession – which we believe it should, at least in the US!

So, looking beyond “wave one” of US inflation, it is still far too early to hold a strong conviction that there will be further surges in inflation as witnessed in the second and third wave of inflation in the ‘70’s period. Suffice to say, it is important to recognise three of the significant drivers of inflation throughout that period – certainly so far two of the three may indeed be reversing.

1. Oil prices rose 2000% through the ‘70’s (32% pa)

Chart 8: Oil price was a key driver of inflation throughout the ‘70’s

Source: Iress

The US dollar was WEAKENING throughout the ‘70’s: USD weakened 70% or 7% per year during the 1970’s cycle.

Further to my comments above, the USD had started strengthening a full year before Volcker became Chair, once again suggesting that the seeds for pending disinflation had been planted before his arrival!

Chart 9: Weaker dollar throughout the ‘70’s

Source: Iress

3. Geopolitical Upheavals (a fancy term that leads to war or trade-wars, or both)

The 70’s was peppered with Geopolitical upheavals that had a direct impact not least on oil prices. Today, no doubt the Ukraine War is front of mind and already has had a material impact on commodity prices. Importantly, many of which have subsequently reversed and are now lower than pre-invasion levels. But there are other simmering areas of concern, some of which were started with Trump slapping import duties on China and now with rising risks of a Taiwanese invasion by Xi Jinping. An attack on Taiwan and a resulting sterilisation of TSMC (Taiwan Semiconductor Manufacturing Company) chip production would, according to the US National Security Council, disrupt the world economy to the tune of more than $1 trillion. It is difficult to see how the loss of the world’s largest producer of semiconductors would not inject an inflationary force on the world in a similar way to that of the Covid-19’s supply disruptions.

All these geopolitical upheavals inevitably could lead to a “bifurcation of global trade” where allied partners trade with each other rather than allowing the global market to set prices. The former is less efficient than the latter and could ultimately be a significant vector for higher and longer inflation.

This third driver is very hard to “touch and feel” and this lack of tangibility makes it very difficult to have conviction on its influence. All we can conclude is that geopolitical upheaval and the risks of a bifurcation of global trade has increased in recent years relative to recent decades.

So, as we stand today, oil prices have retraced somewhat, and the strong US dollar continues to rage; two significant drivers that are doing their best to reverse recent inflation (at least in the US). Of concern is, post the recent OPEC+ meeting, the aggressive production cuts announced have put an underpin on the oil price. It is concerning that OPEC is attempting to manage the oil price at the highly elevated level of $90/bbl.

If we are correct that we are at the end of the “first wave” of inflation (since 2021), we need to steepen the yield curve, reaccelerate the global economy, weaken the USD and have rising commodities (especially food and oil) before we can contemplate the onset of another inflationary wave?

So, let’s turn to the USD; the distinction that we think needs to be made (that may indeed have the largest influence on the USD) is whether interest rates in the US continue to move up faster than competing jurisdictions.
The prevailing narrative currently in financial markets is that almost all developed market central banks are still behind the inflation curve and, therefore, higher rates should be expected going forward. Furthermore, the US is exhibiting the broadest inflationary pressure and, as such, it will continue to raise rates at a faster and longer pace than any other competing developed market. At face value this is a narrative that is very difficult to argue against.

With this narrative in mind, will the carry-trade keep moving in favour of the USD going forward?

From the chart below, the deeply negative real rate environment is not unique to the US, so it is difficult to be convinced the US will keep raising rates faster than at least the UK or EU. Japan would seem highly unlikely to act yet, hence US rate hikes would need to stop rising before the carry trade works in favour of the Yen.

Chart 10: Negative real rates across DM’s

Source: Iress

What is interesting is that UK and EU interest rates have started holding their own relative to the US of late… Despite this the USD continues to race ahead?!

Chart 11: Interest rate differentials of EU & UK vs US

Source: Iress

Using the GBP as an example – The GBP is the most undervalued against the USD on a PPP basis in its recent history as per the chart below.

It is clear that the interest rate differential (carry trade) has been the primary driver which, since 2008, has taken the GBP from an extreme overvaluation to now extreme undervaluation. In the last few weeks, the carry trade (blue line) has shifted in favour of the GBP, but the market is currently not interested. Perhaps it is as simple as when you are hurtling towards a global recession, the USD is the only currency you can own?!

Chart 12: Supportive carry trade for GBP sterling

Source: Iress

If the world is going through an interest rate regime change a potential reversal of the Post GFC years may be in the offing. This will have implications for all developed market yields – not just the US! These are going to be very important trends to consider going forward as the “one-way bet” carry trade since 2011 may finally be coming to an end?

Chart 13: UK inflation vs 10-year government bond yield

Source: Iress

There is HUGE momentum now with a powerful narrative supporting the USD (vs competing DM FX). All we can conclude (in our own minds) is:

The USD is deeply overvalued vs all major currencies in the world (most extreme since 1985)
Carry trades need to reverse before non-USD currencies can “find a bottom”; even so, yield spreads more recently are not supporting a continued “one-way” bet in favour of the USD
The USD usually only weakens from a cyclical perspective post the trough of Global economic cycles. We may still be some months away from this point?

The above is an attempt to demonstrate the challenges of forecasting inflation beyond the short term. There are certainly many similarities to the ‘70’s but the journey of inflation will be fraught with many ebbs and flows irrespective of what the long-term view one takes. At this stage its extremely difficult to have high levels of conviction on what the next several years will mean for inflation trends; are we at the early stages of a higher for longer ‘70’s style inflation? Or are we just living through a shorter-term spike in inflation due to a confluence of events that were not least sparked by massive stimulus due to Covid lockdowns? The unprecedented levels of global stimulus coupled with Covid-related supply chain disruptions as well as an energy crisis in Europe have clearly had a role in fuelling inflation in the short term; forecasting beyond the next year is going to be fraught with challenges.

At Obsidian Capital, we recognise the unusual cycle we find ourselves in, with many countercyclical dynamics that are distorting the many relationships we witnessed in the disinflationary cycle between 1985 and 2021. It is perhaps too early to conclude that we have left the benevolent disinflationary shores of old and entered a choppier and more dangerous inflationary world akin to the ‘70’s?

When in doubt, lean on valuation and that is how we are currently positioning the portfolios.

Current Positioning

US assets are significantly overvalued, and we are wherever possible avoiding both USD exposure and US equity exposures, favouring non-USD developed market jurisdictions as well as emerging market assets. SA screens well within a relatively cheap EM universe, both in terms of fixed income and equity markets.

We continue to favour interest rate-sensitive assets within SA. Due to a slowing global economy, we have significantly reduced our cyclical commodity exposure but recognise that their valuations are very attractive while longer term supply-demand fundamentals could support a higher for longer pricing regime, despite the current weakening global demand environment.

Material changes to the portfolio over the quarter include:

A broad reduction of equity exposure. Reduction of our Energy exposure including Shell, BP, Sasol and iShares Global Energy ETF.
A reduction in Prosus and purchase of iShares China
Reduction in Old Mutual and Capco
Purchase of Woolies, Tiger Brands, Truworths and Foschini Group.

The largest positive contributors to performance over Q3 2022 were:

Thungela Resources, Metropolitan, ABSA, Tiger Brands, African Rainbow Minerals and iShares Brazil.

The largest negative contributors were:

Investec, Continental, Capco, Sasol, Old Mutual and Standard Bank.

^{PERFORMANCE TABLE DISCLOSURE}^{Source: Morningstar, September 2022

Launch dates: Balanced (01 October 2013), Equity (28 December 2015), Multi Asset Hedge (25 October 2007), Long Short Hedge (01 July 2008)}

Annualised performance since inception available on MDD’s found on website.

*Annualised return is the weighted average compound growth rate over the period measured

Income reinvested on ex-dividend date. The lowest and highest annualised performance numbers are based on 10 non-overlapping one-year periods or the number of non-overlapping one-year periods from inception where performance history does not exist for 10 years.