Post 1/2:
Alright so things are obviously pretty f**ked up right now as inflation fears just keep going and therefore bond yields just keep rising. I'm an economics/geopolitics guy by trade so this stuff is my wheelhouse, so hopefully I can explain what's going on and why by the end of this post and also what we can expect to see in the future, but please, if anyone/any new guys have any questions or don't understand something I say in this post then don't hesitate to ask a question as I love this kind of stuff and teaching people. There are no stupid questions
For those not paying attention, there's currently a titanic fight between economic growth expectations and inflation expectations. In general, economic growth raises earnings but inflation drops price/earnings ratios. So the fight is basically whether an increase in earnings can offset a reduction in the price/earnings
ratio enough to keep the price at least steady. The maths behind this is quite simple - if you (and I'm exaggerating to demonstrate the point) doubled your earnings but halved your price/earnings
ratio, then your price would be exactly the same. It's the mathematical equivalent of going 2x1, divided by 2. Make sense?
The problem we have is that fear, irrationality, and simple incorrectness can send markets spinning over particular timeframes and this is, in my opinion, what we're seeing at the moment. Remember, only half the job is figuring out what's going on in the economy - the other half is figuring out what's going on in the
markets, which is a very different thing.
In other words, you don't just need to know what's going on, you need to know what everyone else are thinking and why they are thinking it. Perception
is reality in the market. Even if the market's wrong or irrational, it can stay that way far longer than you can stay solvent. The idea is to either get in on something about to rise or out on something about to drop before everyone else do - whether it should have been rising or falling at the time or not. If the market's wrong and pumps the price of something (or is going to pump the price of something) because of it, who cares, just buy it and then sell it
before they realise they're wrong. Conversely, sell it before they do (or just short it) and then rebuy it at a lower price before they realise it was actually something good after all.
This is exactly what happened with roaringkitty, the gamestop guy that's made his millions - he spotted something the market was wrong about (in this case, it had been underestimated/overshorted hugely) and bet on it rising once the market realised. It did, and then the price rose. Massively.
So, for all the budding economics students out there, what we're seeing at the moment is a classic case of how
opportunity cost is effecting the markets. In this case, it's a very simple case of risk vs reward, and I'll explain why:
Generally speaking, there's two main asset classes you invest in: stocks, and bonds. There's also other things like commodities but they're not typically a large part of a portfolio - we'll get to them later.
Stocks are simply shares of a company and you're expecting to yield a return on your investment each year through your share of the company profits being paid out to you. The risk you take is that the company may not make as much money next year and so you could have made more money investing in something else. Conversely, a different investment could make more money than you expected it to, and so you again have made the incorrect decision investing in what you did rather than the other thing. Thinking about this for yourself, you can see how the cost of your investment is going to be a combination of how likely you think these things are going to be - the less confidence (more risk) you have in things going the way you think they will, the more incentive (higher the possible return) you're going to need to take that risk. This higher return on the riskier option is called a
risk premium, and there's all kinds of both very complex and very simple calculations you can do to estimate it, but like all estimates, bad inputs results in bad outputs.
Again, to use a very simple example, if you were looking at an investment that now has, say, only half the likelihood of paying off that it did before, you're going to want that payoff to be
at least twice as big as it was previously. It's a very simple probability equation - getting twice the payout but only half as often results in the same amount being made.
So what does all of this have to do with bonds? Well, to understand that, we need to understand what bonds are and how they work. Bonds are
loans. Bonds are when you loan money to an entity (a person, a company, or a government) and they repay you at an agreed particular rate.
Like stocks, there is an element of risk involved with bonds but it is almost always way, way, WAY lower than with stocks.
The largest bond market in the world is U.S government debt - loaning money to the U.S government. Now, the U.S government enjoys a spectacular credit rating (risk rating). It's considered so good, so solid an investment that there is basically a 0% probability of default or to look at it another way, 0% risk for you/the market to lend the U.S government money.
So, let's think about this from an opportunity cost perspective - if we invest in stocks then we're not investing in bonds and if we invest in bonds then we're not investing in stocks, so we have to ask ourselves which we think is the best option and why.
Recall before how much I was talking about
risk. If you have one asset class with zero risk (bonds) but another with at least some element of risk (stocks) then stocks are going to need to have some kind of
incentive to take that risk. So, the way that works, is that stocks will always enjoy a higher rate of return than bonds because there's at least some probability of not getting the return whereas it is
guaranteed with a bond. This extra return is the
risk premium I spoke about earlier.
So, let's just pull some numbers out of thin air to demonstrate this: Let's say that bonds, your zero risk investment, earned you 1.4%. This gives you a price floor for all other possible investments as this is the point of zero risk.
This would mean that stocks would have to earn something above 1.4% in order to get you to take the risk of investing in a company by buying its stock. It might, for example, be 2.1% - some 50% higher than the bond rate. This gives us a risk premium of 0.7% (not factoring in anything else).
But what happens if the returns on bonds start to go up? What if bonds increased 50% up to the 2.1% that stocks are? Well, in order to keep the risk premium of stocks we mentioned earlier, then the
rate of return on stocks will also need to go up.
So with a rate simply being a percentage, there's therefore only two ways this can happen: Either the company needs to make more profits and thus ups the earnings to a higher percentage of the stock price, or the stock price comes
down until the current profit levels reach that higher
percentage of the stock price we need to get back to our previous risk premium.
So now that we know the primary (there's more to it than I've mentioned but what I've mentioned is the overwhelmingly single biggest factor) relationship between stocks and bonds, we can take a look at some of the data over the past few weeks and know why it looks like it does:
As we can see, bonds (in blue) have been going up whilst the nasdaq (in orange) has been going down, which means that the market thinks that the rate of return on bonds is increasing faster than the profits for companies in the stock market are.
Ergo, the price of stocks has to come DOWN to keep the
rate of return higher and retain the aforementioned risk premium.
But the 6 month graph looks very different, see how stocks were actually increasing at the same time as bond yields were before about the 17th of feb:
This tells us that the market believed that stocks' anticipated profits were actually increasing way way faster than the bond yields were as stocks were actually going up at the same time as bonds were.
As we can see, this all changed at roughly the 17th of feb and I'll get to that in a moment, but there's another question we first need to know the answer to before we can actually get to that:
How do you price a risk-free investment?
Well, it's not actually very complex on the face of it. Let me ask you, what kind of reward always follows zero risk?
We all know the answer, it's the oldest life advice in history:
zero risk means zero reward.
But of course, there's always more to it, because zero reward does not
necessarily (keyword, necessarily) mean zero interest rate.
So, what then, is an actual zero reward in these terms?
Well, it's calculated with the
inflation rate. Inflation is simply how much prices of *stuff* go up in a particular time period. There's several different measures of it, but the primary one used is the Consumer Price Index or CPI.
Now let's think about this - if you stuff your money under the mattress for a year and go to spend it a year later and the price of everything is up by, say, 3%, then your money has actually
lost 3% of its value or
purchasing power over that period, hasn't it?
In fact, you would have been better off buying stuff with it and then selling that stuff on a year later wouldn't you? You haven't made any money doing that in real (purchasing power) terms, but at least you haven't lost anything.
So let's take this approach to the bond market. Why would you lend someone money at say, 1%, if inflation was at 1.1%? In real terms, you'd be LOSING money.
The answer, of course, is that you wouldn't. You would need to get at least a 1.1% return or otherwise you'd just go and buy *stuff* with your money and sell it on a year later instead.
So it's in this way that (and again, there are other factors at play here, but we're just going to focus on this one as it's the primary/most important) we can understand that the inflation rate gives us a kind of floor on the bond rate. If inflation goes down then the bond rate can and if inflation goes up, then the bond rate has to.
It's in this way that we can understand the zero risk-zero reward nature of bond investing. If bonds are zero risk, all we need to ask ourselves is what the point at which we get zero reward (in real terms) is.
That point, as I've hopefully just shown, is the inflation rate.
SO, now that we all (hopefully) have an understanding of how the bond market interacts with the stock market and inflation rate interacts with the bond market, we can start to take a better look at the data and try to figure out just what on earth has happened lately.
Recall this graph from previously:
As you might be able to imagine, ordinarily, when two curves which usually move in opposite directions to each other aren't, then there's some big driver causing that. Prior to the 17th of feb, it was quite simple - for a variety of reasons, economic growth expectations were way, way, way outpacing inflation expectations.
Ordinarily, you'd expect a very gradual easing of this. You'd basically just expect the two curves to start gradually diverging from one another and then just level out until something new happened to push them in one direction of the other. But that didn't happen here. They essentially just flipped on the spot and went in total opposite directions, in a massive way, incredibly quickly.
Obviously something triggered this. This kind of thing does not just happen for no reason.
The event which triggered it was the massive snowstorm that hit the united states. Snowstorms are not unusual there, but this one was a freak 100 year event that dumped several feet of snow on parts of the country which normally never see any snow at all. This would normally be an economic hit just through the drop in demand - snow everywhere means people stay inside/not doing stuff, so economic activity drops.
But there was far more to it than that. As I posted previously (reposting here for continuity), an enormous amount of the country's electricity and oil production was taken offline due to it simply not being built to handle cold weather, and power prices for example thus went stratospheric:
This was
bad. The storm front seized up everything. It coated wind turbines with ice, forcing 7GW—approximately 10% of Texas’s available grid--offline. It turned associated water that often occurs as part of natural gas production to ice, shutting in half of the state's production. Oil was similarly impacted, stopping some two-thirds of Texas’s output. Between these direct issues and follow-on ones – water coolant at nuclear power plants froze, forcing shutdowns; insufficient natural gas led to fuel shortages shutting down nearly 17GW--approximately 25% of Texas’s available grid; oil and power curtailments necessitated shut-downs of the bulk of Texas's refineries leading to mass gas station closures – some seven million Texans lost power. Some for days.
Safeguarding wind turbines so the events of this past week can never happen again only requires some built-in heating elements or a few drone ports to manually de-ice. Once (or maybe twice) and done. But safeguarding more conventional power generation? Insulating every above-ground oil, natural gas, and water pipe in a state that's bigger than France? Building out internal storage for coal piles at coal plans? Developing natural gas storage depots rather than relying upon just-in-time fuel deliveries? Insulating the country's largest concentration of petroleum refineries? Each incremental improvement might be easy, but Texas will need to upgrade everything. The cost will easily run into the tens of billions, and those costs are going to have to be passed on to the consumer.
In other words, the price of electricity will go up. Significantly.
Inflation.
So the market lots its collective mind. Everyone panicked thinking that this is going to increase the inflation rate massively (rather than just a little bit because all the states which do regularly see snow have already winterised their power and oil production and it is actually going to be quite easy for texas to do) and so bond prices shot up in anticipation of that increase in the inflation rate and stocks therefore dropped as we finally had a point at which the market believed that economic growth would be lower and inflation would be higher on account of the snowstorm both being very economically costly and very inflationary
at the same time.
Perception is reality in the market
Now it's pretty obvious that I think that the market has way, way, WAY overreacted to this and it's going to be a zillion times easier to fix than they think, but that doesn't mean that the market agrees with me yet.
But the key takeaway here is if inflation were to increase in response to this storm it would have been caused on the
supply side because demand will be the same but supply will be more expensive on account of all the costs of winterisation needing to be covered (winterisation effectively raises the cost of producing electricity). Keep this in mind for the next section.
So the market lost its collective mind on inflation concerns, only for the next batch of inflation data to actually be
below expectations and therefore cause a massive flip right back in the complete opposite direction to how the market has been moving lately. Just look at how much and how quickly the market moved once the data was released:
And here's the data itself:
As you can see, the inflation rate of all items less food and energy actually
dropped. The reason why there's a metric with and without food & energy is because food and energy are such fundamental/important/large parts of the cost of living that one could argue that they're almost the only inflation metric which actually matter on account of their prices effecting the price of
everything else. Everything requires energy to produce (energy as an input) including the production of food itself and this is why everyone lost their minds with the texas snowstorm - generally speaking, if energy cost moves, then the price of
everything else moves with it.
You can therefore see why it was so significant that energy shot up but inflation of everything else actually moved in the opposite direction - this is incredibly rare.
But then by the next day the market realised that the winterisation of the southern grid hasn't even started yet (and the prices therefore haven't actually really been passed on to the consumer) and went right back to absolutely bricking it about future inflation numbers.
Whilst all this was going on, the same supply-side issues that the entire world has been struggling with for over a year now have only been getting worse and worse and worse. As I demonstrated in another previous big post, shipping, for example, is now at the point of not the 12 ships backed up at anchor outside the L.A ports we saw back in november but rather, 36:
And the problem is so bad that even the suez and panama canals have become shipping chokepoints as companies diverted shipping through them to reach ports that they could (even if the over-land transport costs ended up being higher) actually unload their cargoes at:
And the result is, unsurprisingly, a massive increase in shipping costs (so the costs of actually supplying whatever has been bought):
inflation.
However, this shipping problem is double-edged because a supply choke point doesn't just mean that prices go up (meaning inflation) but it also means that companies literally cannot get (sell) their products to their end consumers, which means lost income.
So you have upwards pressure on inflation and downwards pressure (or at least, a choke) on economic activity/growth
at the same time.
The reason isn't complex at all: Everyone are off work sick with coronavirus and so there simply isn't enough able-bodied people in the united states or panama or wherever to actually get the ships unloaded. This is by no means unique to shipping either - any industry which requires in-person work has been absolutely ravaged by coronavirus, shipping is just the easiest demonstrable example.
But thing to remember is that this is yet another
supply side problem which is both raising inflation and decreasing economic activity
simultaneously.
So we have an enormous amount of supply side restriction in the market at the moment and at the same time, the giant 1.9 trillion stimulus package was just passed, which is expected to increase demand even further (which is, after all, the entire purpose of stimulus) at a time when supply cannot even begin to keep up as it is. Is it little wonder there are inflation concerns out there?
So, am I concerned with inflation (and therefore stocks dropping) like the rest of the market is?
YES.
But my concern is only
short term because as I hope I've pointed out, whatever inflation we're going to see is almost entirely caused by a whole series of both supply side inflations and economic growth restrictions
at the same time, which I'll get into in the next post.
Post 2/2 continued below.