Monday, April 4, 2022

Financials Mock Portfolio Outperforms S&P 500 Index In the First Quarter (And Other Updates)

Financials Mock Portfolio Quarterly Performance Update

In January, we published a mock financial stocks portfolio. For the quarter, the portfolio returned +1.9%, which compared favorably to the S&P 500, which returned -4.6%, as well as the Financial Select Sector SPDR Fund (XLF), which returned -1.5%.

As a reminder, these results assume dividends are reinvested.

One of the positions, MoneyGram International (MGI), accepted a buyout offer from a private equity firm. We will assume a sale of that as of March 31, with the proceeds evenly reinvested in the portfolio.

2s/10s Yield Curve Inverted

We have written multiple times about the flattening yield curve, that is actually starting to invert. Historically, inverted yield curves have proven an indication of elevated risk of recession, and we argued that a contributing factor to this was Uncle Sam's large budget surplus in January. This is an unfortunate development from the Biden administration, which recently released a statement estimating a $1.3 trillion reduction in the deficit for 2022. That is an alarming amount, as it represents nearly 5% of US annual GDP. 

As a reminder, when the US Treasury runs a surplus, the net effect is a removal of reserves from the banking system, and our contention is that this is causing stress in the markets. Last week, the 2s/10s curve officially inverted for the first time since the summer of 2019, and remains so as we write this:

It's worth pointing out that in the Fed's latest weekly statistical release, it reported a $3.830 trillion reserve balance held at Federal Reserve Banks:

This represents a $286 billion reduction in reserve balances since the beginning of the year's balance of $4.116 trillion: 

One doesn't need a PhD in economics to understand that fewer reserves in the banking system leaves fewer dollars available to purchase securities. Is it any wonder then that US government bonds had their worst first quarter in nearly half a century? This has real economic consequences, average 30-year fixed mortgage rates exploded higher in the quarter, reaching their highest level since December 2018:

Liquidity Is Drying Up

Lack of liquidity in US Treasury market is also a major concern. Per Reuters:

"Some measures of liquidity have shown stress.

Bid-ask spreads -- a commonly used indicator of liquidity -- widened significantly in March on short-term Treasury notes, Refinitiv data showed.

Data from CME Group showed order book liquidity for Treasuries has declined since Feb. 24, when Russia began its invasion of Ukraine, and volatility has increased.

Cash contracts volume in terms of the daily average top of the book bid/ask quantity for five-year Treasuries declined to $10 million in March from about $25 million in February.

For the benchmark 10-year notes, order book liquidity went down to an average of $14 million in March from about $20 million in Feb."

And daily US Treasury FTD's (industry parlance for "Fail To Deliver") reached their highest in a year on March 31:

Source: DTCC

This further supports the assertion that markets are becoming stressed. It shows that financial intermediaries are having a difficult time sourcing and delivering Treasury securities that they are legally obligated to deliver in order for trades to settle and clear. It shows that collateral chains are being stretched and are at risk of breaking, which could be a precursor for a risk-off, flight-to-safety event. Certainly, the extreme activity in commodity markets due to the COVID-19 pandemic and the recent Russian invasion of Ukraine has sent tremors through financial markets. Talen Energy, a PA-based power producer owned by PE company Riverstone, is seeking DIP ("Debtor In Possesion") financing for a potential bankruptcy, thanks to commodity hedges that went against them and drained their liquidity. Altera Infrastructure (f/k/a Teekay Offshore) is another PE-backed company that is having liquidity issues; they have hired advisors for a potential restructuring.

Consumer Price Inflation Is Crushing Consumer Demand

Indeed, the current high prices for goods is weighing on demand. Consider last week's statements from RH CEO Gary Friedman:

Yes. All of a sudden, that hits. And then all of a sudden, boom, we've got a war. Russia invades Ukraine, boom. Yellen says interest -- inflation is going from 4% to 2%, and then it goes to 7.5%. And Powell says, we're behind. I think there's a lot of -- everybody thinks supply chains are getting better. I don't think they've gotten better at all. I mean, it is what it is. I mean, product is on the water for a long time. Getting ships into port is taking a long time. We've got generally about 5 extra weeks in our supply chain right now. That's a lot of time. It's a lot of money, and that's the average. So that means some steps coming on time and some steps 10 to 12 weeks behind.

And this:

Yes. Well, look, I mean, it's probably one of the most difficult guides since 2008 and '09 because we're right in the middle of this disruption from Ukraine and Russia, which I think -- I don't think it's all Ukraine and Russia. I think it's triggered a greater awareness. Like it's like someone -- I think this was ring the bell, everybody pay attention. And then all of a sudden, everybody started talking. Yes, all of a sudden, the Fed's off to the races, and that creates concern. You've got housing prices at all-time highs. I mean, is it sustainable? I don't know for how long the math. Yes, doesn't make sense on kind of what's happening in the housing sector and other places that -- you've got inflation like I've never seen.

Now I was telling people when Yellen said, "We're going back to 2%," we were just signing our new freight contracts, ocean freight contracts. I just wonder if anybody -- the Fed has picked up the phone and called a businessperson and said, "Hey, what do you think is happening with inflation? How's ocean rates? How is this? How is that?" I mean, I think -- I don't think anybody really understands what's coming from an inflation point of view because either businesses are going to make a lot less money or they're going to raise their prices. And I don't think anybody really understands how high prices are going to go everywhere, in restaurants, in cars and everything. It's -- and I think it's going to outrun the consumer. And I think we're going to be in some tricky space.

And how about this - Big Short/Bear Stearns reference:

But it's not just us. It's everybody I know in every industry. And I just don't think it's like -- again, I don't want to scare everybody. But I talked about the theme, like there's this scene in The Big Short where everybody is in that ballroom and the guy -- I think it's the guy from Bear Stearns or someone is up there, one of those things, and he's saying how they're going to buy back $1 billion of their stock, this, this and that. And then one guy who's on his BlackBerry, he goes, "Can I ask a question, sir? In the 20 minutes that you've been talking, your stock is down like 55%." And everybody ran out of the room.

I just think we tend to just try to be transparent and honest. And look, maybe our stock is going to take a big hit because of this, and people are going to think Gary Friedman wasn't excited. I've never -- I told my team, I've never been -- in my 22 years here, I've never been more excited. I've also never been more uncertain, right? So -- and I think you have to take a real balanced view right now.

Full disclosure - I own RH stock and have been following the company for years. I can confirm Friedman is very smart, capable, and tells it like it is.

I think there is a strong likelihood that consumers start pivoting away from spending on goods and instead increase spending on services such as travel and hospitality. This does not bode well for the goods economy, as inventories are high:

Source: Logistics Managers' Index

...and there are signs the trucking market is starting to roll over. The CEO of logistics data provider FreightWaves (highly recommend you check out their services) just wrote a piece predicting an imminent recession, which followed a piece written a week earlier calling for a repeat of the 2019 "bloodbath" in the trucking market:

We think another sharp, painful downturn in the U.S. truckload market is imminent, and it could be as bad as 2019.

March has been unusually soft in the truckload freight market, according to the SONAR Outbound Tender Volume Index (OTVI). Because this index measures actual truckload tenders in the contract market, it provides a very reliable indicator of market direction. 

March is typically a strong month for trucking, as shippers start to stock their shelves in preparation for summer. And late March normally gets a reliable end-of-quarter boost in volumes as shippers pump sales and reduce inventories. This year, we are not seeing that surge. In fact, March volumes are softer than at any point in 2021 (other than holidays). 

Outbound tender volumes are down:

Additional commentary from the same article:

More than likely, the lower volumes are due to a major consumer slowdown. Inflation that began in 2020, combined with the surge in fuel prices related to increased inflation and the Russian invasion of Ukraine, have made consumers move to the sidelines. In addition to monitoring SONAR data, FreightWaves analysts also conduct channel checks through our network. Market participants are confirming what FreightWaves analysts are seeing in the data. Spot rates are falling fast and volumes are dropping.

There are many reasons to believe that the freight market slowdown will continue, and that an oversupply of trucking capacity – particularly in the spot market – will pull rates even lower.

Freight is all about the movement of physical goods. Travel and entertainment do not drive (much) freight, so any dollars spent on “experiences” means money isn’t spent on cargo. 

After two years of massive consumption of physical goods, consumers are pausing their spending. The COVID surge is largely behind us and people are starting to shift their spending away from physical goods to travel and entertainment, which will take a much larger percentage of disposable spending than we have seen over the past two years.

If traffic is any indication, consumers are on the move right now and this requires fuel. Except for the 3% of the U.S. population that have electric cars, any money spent on filling up the gas tank will mean less money going toward discretionary spending. 

Everything is more expensive than it used to be and consumers are starting to be more cautious about the future. High fuel prices and runaway inflation sap consumer confidence and will be a drag on discretionary purchases

The trend toward intensive goods spending has taken longer than many initially expected to reverse itself, but consumer spending data confirms that a material shift is taking place. February retail sales were nearly flat at 0.3%, missing expectations.

Over the past two years, shippers were short of inventory. In an attempt to prevent stock outages, they ordered more than they needed and now are faced with a hangover from ordering too much. Key transshipment infrastructure like ports, warehouses, transloading facilities, and intermodal ramps were clogged, slowing freight velocity, reducing sales, and increasing inventory levels. FreightWaves’ view is that shippers will compensate by slowing their purchasing and working off inventory when opportunities with acceptable margins arise.

Trucking spot rates are under massive pressure, caused by too many trucks and not enough freight.’s truckload spot rates peaked at $3.83 per mile in January and are now down to $3.42 per mile. Spot rates will fall further and could hit $2.50 per mile by mid-year.

Trucking has enjoyed the largest number of new entrants in its history over the past two years. New fleet registrations were up to 20,166 last month alone. This is unprecedented. The last peak was in August 2019; there were 9,511 new trucking fleets and that was in the middle of one of the weakest freight markets in history. New trucking registrations tend to lag market conditions, so we can expect new fleets to continue to enter the market, even after things soften. This will make the downturn that much worse.

Many of the operators are unseasoned and inexperienced. They are unlikely to have ever seen a market downturn, much less run a business in the middle of one. They also bought their trucks and hired their drivers at the top of the market. 

These same drivers that were chasing high spot volumes will find fewer and fewer opportunities in the market. They will either leave the trucking market or move to trucking companies that have more consistent freight, leaving those trucks unseated. 

With falling spot rates, declining volumes, surging fuel prices and inflation across the board, it will get ugly, very quickly for many of these operators. Back in 2019, FreightWaves reporters wrote about trucking bankruptcies almost every day. I expect this will become reality for us once again.

We Should Stop Talking About Wealth "Redistribution"

One of the most common disagreements I hear in political discussions is over the notion of wealth "redistribution." See the NY Times article from over the weekend: Thomas Piketty Thinks America Is Primed for Wealth Redistribution. I think it would be best to avoid this phrasing, for several reasons. First, it gives the impression that wealth is zero-sum. MMT shows us that when the government runs a deficit, it creates non-government surpluses that are commonly thought of as wealth. When the government spends money in a non-inflationary manner, it creates financial wealth for the recipient. The wealth didn't have to "come from" anywhere. We can all be collectively wealthier without taking anything from anyone. Additionally, "redistribution" is generally used in a context where someone "earned" that wealth fair and square, only to have it confiscated by the evil, power-hungry government. We need to remind people that the government is the original source of their wealth, both financially (government is the original source of our modern money) and by virtue of granting property rights and enforcing contracts, which forms the basis of our modern capitalist system. Finally, talking about "redistribution" makes it seem like we need billionaires for essential funding. We don't. It's actually the other way around: they need us to buy their products and tolerate laws that allow them to accumulate their fortunes.  

ECASH Act: A Step In the Right Direction

I'd like to end this post on a positive note. A bill called the ECASH Act was recently proposed in the US House of Representatives. The bill "directs the Secretary of the Treasury to develop and pilot digital dollar technologies that replicate the privacy-respecting features of physical cash, in order to promote greater financial inclusion, maximize consumer protection and data privacy, and advance U.S. efforts to develop and regulate digital assets." (For more information, see here

This is a great development for civil liberties, right to privacy, and financial inclusion. It makes sense to have the Treasury pilot the program given its history of rolling out products designed for individuals. Physical cash is a different "form" of money than ledger cash, which requires maintaining a historical record of transactions. This bill essentially gives the Treasury a green light to create digital dollar that is more compatible with today's digital world.

On Inflation

[Note: I originally started writing this piece on December 23, 2022, then got held up with holiday festivities. More posts for the new year ...