Andrew Pyle
November 19, 2021
Winter Limbo
I often tell investors that if someone says they know what is going to happen with certainty, then there is probably a better conversation to be had elsewhere. No one and not even the algorithms have the polished crystal ball (like the programmers at Zillo if you don’t believe it). Investing and portfolio management encompass a multitude of factors but, at the end of the day, it is a probability exercise. Gambling analogies are often used in the world of investing and, even though there is no room for speculative gambling when it comes to a family’s retirement nest egg, both investing and gambling do share that common denominator of probability assessment.
Towards the end of the summer, the odds looked in favour of a September retracement in stocks because participants were placing a higher probability that the Delta variant, China and inflation would see diminished activity. Stocks indeed fell in September; however, with expectations reduced in terms of what the third quarter would deliver in terms of company revenues and profits, there was more room for these results to surprise to the upside. They did and October went from being a scary month to a record-breaking one, because a problematic quarter suddenly turned into a shoot the lights out one. The ensuing rally in the major indices has now taken us to levels that are about 4% above the record highs that were set at the start of September. The problem is that earnings season is over and we don’t get the next dose of results until January. In between will be somewhat of a dead-air space, which means more time for investors to switch their attentions to headlines, whether they be the Delta variant, China, inflation or the direction of interest rates.
Arguably, the stock market is not priced for another global wave of the coronavirus but it wasn’t in January 2020 either. In North America, the increase in cases is still quite modest with the 14-day change around 3% in the US and 2% in Canada. Head over to Europe and it’s a completely different ballgame, with Austria up 18%, Denmark up 16% and Germany up 12%. Eastern Europe’s numbers are also climbing and Singapore’s are up 16%. This strengthens the case for boosters for sure, but it also raises the probability that North America may see a move higher. Whether that leads to tighter economic restrictions remains to be seen, but even hints of a negative progression could become magnified from an investor’s angle in this corporate news void.
China is a mixed bag at this point. Peripheral headlines of hypersonic missiles, possible aggressions against Taiwan are exactly that – peripheral. The main focus is the state of the property market and its impact on the economy, as well as developments heading into the winter Olympics. In the economics and market history books, this event will probably be recorded as a contributor to the pains of existing supply dislocations. This is because China wants clear skies for the Olympics and that wasn’t going to happen under the status quo production level of the country – especially in the area of factories and steel mills. In a democratic society, this would be hard but, in China, the prescription is easy and that is to rein back production. The problem is that this creates a major demand-supply imbalance.
To achieve its objectives in terms of cleaner air for the games, China needed to orchestrate a reduction in steel output. That is one of the reasons that steel prices have skyrocketed this year. People think that the pandemic caused steel prices to crumble, but in actual fact, the tariff wars of 2018-19 caused more damage. If we look at hot-rolled coil steel in China, spot prices have been sliding since the third quarter, although they are still up more than 20% from before the start of the pandemic and prices are also higher than the summer of 2018. Now, contrast that to the price of iron. As one of the main ingredients in steel, this commodity has suffered an understandable hit to demand because of China’s clean-air initiatives. Where iron ore prices were soaring in the summer, the futures contract is now down about 60% from where it was at the peak in July. Even if I go back to the pre-pandemic highs of 2019, we are still down more than 40%. It’s not that iron and steel follow each other with perfect correlation, but I can’t remember a time when we have seen this much divergence in the futures market. What I do believe is that once the Olympics are over, China will desperately need to get steel production back on stream to fuel exports and domestic infrastructure. The property issues alone have carved into Chinese economic activity. To arrest a growth implosion, China needs to get more cylinders firing. This ultimately could be a good thing for stocks, but maybe once we are into the first quarter. As for the gap between iron and steel, well there is a major arbitrage opportunity there.
Lastly, on to inflation. This week, Statistics Canada released the October consumer price index (CPI) data for October. I won’t say this was a huge surprise, but the year-over-year inflation rate hit 4.7%. This matched the recent peak set in 2003 which, in turn, was the fastest pace of inflation since February 1990. Now, before everyone points out that we saw inflation of almost 7% at the start of 1991, let’s remember that the surge that year was created by the introduction of the GST. CPI inflation in the US hit 6.2% last month and that was the highest seen since 1982. Ally and I still project that general inflation rates will subside next year but that probably won't happen until late in the second quarter, just based on the year-over-year comparisons.
Unfortunately, that still leaves one or two CPI reports that might look a little too sticky for some people. The ultimate concern though is that any persistence of higher inflation that crosses the line at central banks could lead to language that shifts to even more hawkish. Where the market thinks we could get a couple of rate hikes placed in the second half of 2022, what happens if data and official rhetoric advances that timeline? I mentioned in our newsletter a few weeks ago that rate hikes could start by the middle of the year. If the signals suggested early in the second quarter (along with a more rapid pace of quantitative easing drawback) I would argue the equity market isn’t priced for it.
So, we have an earnings void and we have some potential stumbling blocks, whether virus, geopolitical or macroeconomic. All of these have the capability of creating real damage to risk assets, but we have to come back to probability. Is that probable? With the data at hand, I don’t believe so. That said, do any of these have the capability of creating increased volatility and a retracement in the market over the near-term? Absolutely. For that reason, we believe a more tactical approach is warranted as we head into December.