The guest commentary below was written by Joseph Y. Calhoun, III of Alhambra Investments on 4/24/21. This piece does not necessarily reflect the opinions of Hedgeye.
Well that was an ugly week.
Of the six major assets we track only one was up last week – REITs. Large and small cap stocks – down. General commodity indexes – down. Gold – down. Bonds – down.
The early part of the week was actually pretty calm but Thursday and Friday – especially that close on the low Friday – were just awful. Why? Well, the popular explanation was Fed jawing but I’m not so sure. There were some negative developments that might explain the selling (emphasis on might).
Jerome Powell got the blame for a lot of the selling Thursday and Friday for essentially confirming what the market already knew – the Fed will almost certainly hike by 50 basis points at its next meeting.
Personally, I’d put that in the big yawn category. But James Bullard talking about a 75 basis point hike was new and I think probably a more likely culprit if you want to blame Fed talk for this little mini-crash.
And apparently I wasn’t the only one who thought so since Loretta Mester suddenly felt the need for an interview late Friday just to refute it. Stocks rallied as Mester countered Bullard with an “I don’t think so”, but the rally didn’t last and we got that ugly close just about an hour later.
The negative developments were primarily outside the US, namely in China, where the harsh COVID responses continued and Shanghai remains shuttered.
Fears are spreading that the shutdown remedy will soon be applied to other cities. The impact on the global supply chain is obviously negative but may not have much immediate impact due to the recent inventory building by US companies.
Whether they were built as a precaution or by happenstance, it will reinforce the idea that the proper level of inventory is likely higher than pre-COVID.
Last week I said that if the weakness in China’s economy persists it will eventually have an impact on the value of the Yuan. Eventually apparently arrived last week with the Yuan trading at 6.56 as I write, down from 6.37 about 10 days ago.
That isn’t a huge move and certainly not in comparison to the 7.13 or so it hit in the summer of 2020. But if it’s sustained, it is a directional change and just one more thing with which the global economy must contend. As I said last week as well, the impact on other EM currencies will be interesting and probably of more import.
Commodities, one of the crowded trades I wrote about last week, took a pretty big hit as well with the GSCI down 2.6%. That in turn impacted the commodity dollars, Aussie and Canadian. The Brazilian Real is also dependent to a large degree on commodities and it was down a tad too.
But the Real is still up considerably for the year (almost 14% YTD) and the commodity weakness is just a correction of a longer term uptrend at this point. The Canadian and Aussie $s are basically flat on the year.
With the drop in commodities and fears about the impact of the China slowdown, the immediate effect should be for inflation and growth expectations to moderate. We didn’t see that in bonds last week but we are starting to see it this morning.
The 10/2 curve flattened last week as the rise in the 2 year rate was quicker than the 10 year. While a flatter curve is indicative of slower future growth the fact that both rates rose shows that the fears about growth are not immediate.
Or at least not last week.
This morning though both rates are adjusting lower by about 8 basis points. The negativity on bonds, expectations that rates will keep rising, was another of the consensus trades I pointed out last week and that too seems to be correcting.
For now though, the fears about economic slowing are still focused on next year. That could change if the Fed starts to sound less urgent about rate hiking but that will likely require a more definitive moderation of inflation expectations.
Despite the commodity sell off last week – that is continuing this morning – we haven’t really seen that yet. Real rates – TIPS yields – have risen but mostly in lockstep with nominal yields, meaning that inflation expectations haven’t really come down much.
That may start to change and we’ve already seen gold come down significantly with the rise in TIPS yields.
During the first phase of this correction – or whatever it turns out to be – our portfolios outperformed because we owned commodities/gold and held mostly short term fixed income.
We also focused our equity exposure on value and dividend factors. We have since rebalanced our commodity exposure to take profits and shifted our bond exposure to intermediate. We continue to emphasize the value and dividend factors, although selected accounts did take some profits on the dividend ETFs to rebalance.
As I said last week, defensive shares, which the dividend ETF owns, have become more expensive because of their recent outperformance. But we still think the equity portion of your portfolio should remain focused in value and dividend still fits that bill.
In the next phase of this correction we expect bonds to act in their more traditional role as a hedge to any equity and commodity weakness. We don’t think it is time yet to shift to even longer duration bonds; that would come if recession becomes more imminent.
There was no place to hide last week as basically everything went down. I don’t think that will continue as bonds are poised to rally.
How far that rally runs and how helpful it is in offsetting equity weakness will depend on how quickly inflation expectations – and therefore the Fed’s path – moderate.
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EDITOR'S NOTE
Joe Calhoun is the President of Alhambra Investments, an SEC-registered Investment Advisory firm doing business since 2006. Joe developed Alhambra's unique all-weather, multiple asset class portfolios. This piece does not necessarily reflect the opinions of Hedgeye.
