The Birdseye View – June 2022

Volatility made its way back into markets this week after an unsurprising surprise CPI print of 0.8% left economists scratching their heads and investors running for cover. Mr. Market was quick to set-off a chain reaction across sectors and asset classes as US treasury yields rose while the curve got cheaper and steeper, with buyers only emerging once 10y yields reached 170bps at the highs on Weds. Equity markets followed and finally broke below the 4200 level in ES [June S&P futures] and were only able to retrace the move on Friday’s recovery trade. This inflation number seemed to be a scapegoat for many to take profits and make their tax payments to the IRS (recall interest on 2020 taxes start accruing on May 17th) as there have been no material changes in tone from the Federal Reserve who have been telegraphing a temporary inflation overshoot for some time now. This thought, or perhaps the re-realization that near zero rates in the US are naturally supportive of risk assets, was partially confirmed as markets strongly recovered on Friday to close just shy of week-on-week levels. For rates however, this CPI print will likely keep any upside in yields limited, particularly in the belly of the curve as the FED has now shifted to a FAIT strategy (flexible average inflation target). The bulk of core inflation this time around was made up by used car sales, which makes the average itself easier to sell into as many of the localized inflationary effects are expected to be transitory. In risk assets, we view the implied vols in high flyer names as a sign that multiple-compression is underway, we witnessed many companies report earnings this week and get absolutely pummeled when unable to back their helium rich valuations with real $ and growth. We continue to look for “real value” assets in the marketplace and remain agile to capitalize on dislocations and other opportunities as they present themselves.

We’ve found there to be plenty of chatter but no much content around the inflation narrative that keeps making the rounds as of late. The general rhetoric points to a “transitory” effect due to the global supply chain meltdown, general staffing slowdowns, an ever-supportive Federal Reserve yet talking heads continue to suggest the recovery and aggressive growth rate for 2021/22 will be nothing short of a prolonged Richard Branson like extravaganza. These inflationary effects are evident across sectors and felt deeply by many companies, a few of the pain points have been brought to our attention by other MBC members as these “transitory effects” have already began to impact their businesses. For example, the price increases in metals and building materials have led to 3-5% reductions in net profit on jobs that were priced and bid 90 days ago, and given the nature of these construction contracts those increases are not retroactively passed back to the end customer. Should prices continue to rise companies stand to see margin compression which will ultimately have to be passed onto clients through. Additionally, the higher costs now also are accompanied by extended delays at mayor shipping ports, with average freight weights times of up to 7 days before being able to unload product. Further delays are to be expected until we have fully returned to normalcy, bid to execution times can be pushed 3 to 6 months due to staffing, government, subcontractor availability, permitting and client internal timing. Thanks to Bryan for the input and reference data provided here. So how long is “transitory”? The consensus response is 6 to 12 months, but only data and more time will tell. There are a few considerations to be made here, starting with the fact the we’ve only had one CPI data point which shocked markets, however, recall the drivers were goods, transportation and travel (unlikely to persist in the long run). Supply chain shortages tend to be short-lived as higher prices tend to lead to greater supply and it’s premature to assume we have built in inflation as services and rent increases were only modest in April. Also, the integrity of the data reported is still in recovery mode, the pandemic introduced plenty of noise in the data collected and revisions to official publications have been abundant since then. Under normal circumstances, we would expect summer seasonality to take some pressure off of commodity prices, but we believe this will be offset by the catchup to current lag times and inventory replenishing in these sectors along with a new factor that is not directly captured within CPI itself; consumer behavioral changes. Recall the March 2020 Toilet Paper Craze, recent East Coast Gas Hoarding with the Colonial Pipeline hack or buying stock in companies that are headed towards bankruptcy (that’s a jab to movie theater lovers btw). Irrational or not, the point is post pandemic consumers are different and we expect goods and services pricing to be exacerbated. We are considering the possibility for a front-loaded inflationary overshoot which will spread across areas of the market and ultimately prove to be stickier than “transitory effect” the FED has agreed to deal with in their general dovishness. When we underpinned this thought to proposed infrastructure plans, job creation efforts, increased fiscal spending, the current recovery lag time by global economies to the pandemic, and changes in consumer behavioral patterns, we anticipate upcoming data releases to continue to surprise and for pricing pressure to exceed what markets are currently pricing in. In response, we continue to trade rates from the short side, particularly in the belly of the curve. And have favored micro flatteners in the very front end (3yrs in) as we believe the market overstated the FED’s supportiveness into 2024 after the past FOMC minutes. In risk assets, we continue to keep exposure in value names within oil, shipping, construction and distribution sectors. And remain well weighted on digital transformation stories that present low multiples as the rotation into value names continues to play out (as highlighted on the May14th flyer).

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