By Eric Peters, CIO of One River Asset Management
“The great thing about equities is that they’re not bonds,” bellowed Biggie Too, global chief strategist for one of Wall Street’s too-big-to-fail affairs.
“The best thing about US stocks is that they’re not European or Asian or emerging equities,” barked Biggie.
“The terrific thing about equities is that they’re nominal,” said Too, repeating the lyrics traders are chanting as stocks rise in defiance of today’s inflationary hiking cycle.
“That’s where we’re at right now,” said Biggie.
“The market is trading like we gotta suck ’em all in, maybe pop to new all-time highs.”
And Biggie closed his eyes, smiling, a golden grin.
“Sell new highs, because the story we’re gonna be talking about soon is recession.”
Financial markets devalued industrialists and inflated industrial design. Consider Taiwan Semi, an important manufacturer of Apple’s ideas. Markets briefly rewarded industrialists after the March 2020 pandemic swoon. Taiwan Semi’s share price surged. The company responded with a $100bln capital spending plan, equivalent to the previous decade of investment. Apple’s share price is up nearly 40% in the past 12mths, Taiwan Semi is down almost 20%. This is a microcosm of our current macro frictions. Taiwan Semi is charged with the task of making phones faster and more energy efficient, not Apple. And they are not rewarded. The degrading of industrialists misaligns investment incentives, leading to shortages that restore balance through a pernicious vessel – inflation.
The global economy faces capacity constraints. Everywhere. Every industry covered in the ISM survey described the lack of capacity to meet demand last month. The “supply chain is still unstable” in primary metals. There is “no letup yet in supply chain challenges” in electronics. The “supply situation getting worse” in general manufacturing. The resulting macro picture is wholly unfamiliar. Demand is weakening sharply with inflation running hot; new orders plunged in March while inventory, supplier delivery times, and prices were near record highs. The resulting rises in industrial profits lead to stronger fixed investment. But given the disregard toward industrialists, it may take a much longer period or political support for industrialists to become convinced. Just ask Taiwan Semi.
How do economies respond to capacity constraints? They recess by force, by necessity, by math. Monetary policy is a footnote here. Physical constraints to production are cleared with higher prices rationing demand. The Fed is unknowingly being dragged into the new reality, having greatly reduced its real GDP estimates for 2022 with higher inflation and virtually no change to nominal GDP projections. This means a larger share of the income pie is migrating to a narrow group of goods producers. The signs are everywhere – planes, trains, automobiles. Global light vehicle production was 81mm units last year, only 5% higher than 2020 and still 10% lower than 2019. S&P Global Mobility just slashed production estimates for 2022 to be roughly unchanged from last year because of supply constraints. It is all about supply.
Details matter. Palladium is used almost exclusively for cars with 85% of supplies being the key input to converters that limit pollutants from exhaust. The world’s largest producer, Norilsk, is in Russia, and its enterprise value has vaporized. Palladium production stagnated for the decade leading into the war – the conflict is exposing globalization’s fault-lines. Ukrainian wire-harnesses are a key automotive input – disrupted. China produces 85% of global magnesium – it’s in a production deficit and impairing aluminum output. Supply-constrained inputs go to the highest bidder. It is a supply-side hot potato – capacity limitations push the burden to the most vulnerable, the economy’s weakest players. The shortages in vehicle production are symptomatic of a broader supply challenge, from food to frisbees.
Awkward outcomes follow. Higher prices and less demand. It’s already clear in US car sales. New vehicle consumer prices surged to an annual inflation rate of 18%. Since 1955, vehicle inflation has never been above 8%. Today’s situation is beyond an outlier. It’s a new order, and requires fresh thinking, alternative analyses. And total vehicle sales have slumped severely to an annualized rate of 14.5mm units. That was the volume of sales in three of the past four recessions – the exception being the 2001 downturn when sales were substantially stronger than now.
There’s no doubt in the power of market forces to adjust incentives to solve these problems. Equally, consumers and governments will be forced into harsh changes in behavior. Austerity may not be welcomed any longer in elite policy circles. But orthodoxy is being imposed nevertheless, by market forces.