Tuesday, November 1, 2016

Revisiting the Big Picture

I try to hold in my mind several macroeconomic scenarios that are likely to play out, as facts come in and probabilities shift, I rethink my investments themes accordingly. The most bullish scenario (for equities and commodities) is as follows. The time frame I’m considering is next 2-5 years.

The outline of a macroeconomic progression:

1. Higher inflation expectations…

Crude oil has bottomed in the $40-50 range. As energy is a key ingredient in all other commodities, this is likely the end of the commodity deflation cycle. Indeed, other commodities sectors (particularly agriculture), looks to have trough too. If the world then starts eating into the currently very high inventory levels, that would leading to inflationary pressures.

2. …leading to higher yield in long bonds…

As inflation targets are hit, the central bankers will face pressure to hike rates. But hiking short rates would lead to a flat or inverted yield curve, damaging the banking system, so the central bankers have hinted they’ll let inflationary pressure push up longer term bond yields.

In recent weeks we have seen 5yr/5yr forward inflation breaking above 1.8%, and 10 year treasury yield going above 1.8%.

At this point the impact on US equity markets is unclear. Do we have real growth? Or do we just have stagflation? If the former, then inflation expectations lead to more investment and real growth, then equity markets could look up again. If the latter, then stock prices would take a hit because the market assigns higher discount rates with little growth to offset it.

3. …But underlying GDP growth is still weak, prompting fiscal stimulus.    

With rates around the world still near 0, central banker will have a harder time inventing new monetary tricks. But that’s missing the point. Pushing people to borrow don’t work because we have industrial overcapacity everywhere so businesses don’t want to invest. Thus government has to take the lead.

Fiscal stimulus can drive inflation up further. But this time both real and nominal GDP rises. 

4. We end up with (still) easy monetary policy and fiscal stimulus. 

In this world, the US dollar would be stable, commodities prices goes much higher than today, long bonds gets crushed, and US equities go through the roof into an unprecedented bubble, setting up for the next crash.

Where Are We

We seem to be at step 2 right now. But note that step 1 & 2 does not necessarily lead to 3 & 4. Alternatively, we could have just easily skipped 1-2 and go straight to fiscal stimulus in an effort to drive inflation.

My view is that inflation cannot sustain itself given the current macroeconomic regime. This is because higher inflation drives Fed rate hike expectations, which (in today's upside down world with quantitative easing) drives the US dollar up and defeats the commodity price rally.

Regardless of how the sequence plays out though, there are certain themes here for investments purposes: fiscal stimulus, commodity price recovery, steeper yield curve, companies with structural growth prospects. 

In the past month, my research have focused on the commodity front, taking a particular interest in the agriculture space. Here the key questions are 1) can price increases sustain itself or is it self-defeating? 2) what has to happen to drive a sustained increase? These will be for another post.