Speakeasy

During the U.S. Prohibition era, there was always a place to get a drink, for anyone willing to flout the rules. The restrictions imposed were more of a nuisance rather than a deterrent. The 'Speakeasy' was a convenient haven for those willing to risk ignoring the approbations of polite society.

Now, that place, for the modern investor, is the stock market.

The Bronfman family, Canada's booze titans of those times, made more money in the prohibition than during the unrestricted 'Roaring Twenties". When you restrict the supply of something, those producing that commodity will benefit from increased pricing power. The 'bootleggers' of today are the major energy and mining firms that are increasingly benefitting from the ESG related capital starvation.

ESG guidelines being followed by many institutional investors have prohibited allocations to resource stocks perceived to be complicit in accelerating CO2-related global warming. It represents the new 'prohibition' for climate change foes. Unfortunately for such investors, they risk missing out on one of the most lucrative segments of the market - resources.

Vanguard Funds this morning announced a further push into the ESG segment with their 'SustainableLife' brand of funds. Their mandate eliminates all allocation to resource stocks deemed to be culpable in the destruction of the planet. Perversely, many of those same inputs are critical in the capital spending required to retool the global economy in a carbon-free reincarnation. But never fear, fund managers are sensing increasing demand for 'green' products from clients. Retail investors are getting on board the bandwagon of shunning the resource sector, further reducing capital to the sector.

The difference between the inflationary forces of the past and today could not be starker. In the past, we used to believe in the maxim that 'the cure for high prices is a high price'. But this current inflation impulse is not driven so much by demand, but by supply. Unlike the previous commodity booms, price increases are now prevented from signalling for increased supply by regulatory and social forces beyond their control. The new roaring twenties of goods inflation is upon us.

As we gradually (glacially?) transition from the Covid era to something that approaches normality, there will be persistence to cost pressures on the economy that has been conditioned over the years to falling costs and productivity gains from cheap inputs. Corporate profitability has, so far, held up as prices have risen commensurate with costs. The game is now over. Profits have peaked for businesses that are price takers and can't control costs. Starbux - I'm looking at you.

Labour costs, as well, will be an increasing irritant for many companies, as the supply side is being similarly challenged. Lower participation rates, demographics and a growing skills gap in the tech segment will drag profitability lower for industries looking to expand production as they pay more for labour. There is a feedback loop developing for cost pressures, as we have seen in the recent supply chain mess. The message of the Ten Year bond yield, now weakening far sooner than had been expected, is telling.

What I take from the flattening yield curve and the negative real rate environment is clear. There is not a return to 'normal' anytime soon. Less credible is the view that we will have boom conditions for many years to come. Despite Wall Street's bullish 'look-aheads' a policy error is now possible. Should the Fed (who have stopped driving in the rear-view mirror and are now fixated on the hood ornament of reported inflation) keep responding to the cost-push signals from a supply-side problem by increasing rates aggressively, the curve will likely invert. Readers of this space know my opinion of risk assets should that happen. SELL!!

The boom in global savings rates and lower per-capita spending levels that have resulted from the sudden appearance of an existential health shock are not unwinding as quickly as we hope. Sudden appearance of new variants such as Omicron don't help matters either. While monetary policy is still supportive of higher stock prices, many consumption patterns have permanently changed. On Bay Street, real estate is still running at about 40% of capacity 2 years after the first shutdowns. A weaker than expected 2022 is not out of the range of possibilities, especially for corporate profits.

Meanwhile, back at the commodity markets, the slowing demand resulting from Omicron and China's real estate collapse is being taken in stride. Maybe long term industrial users are loading up in an effort to rebuild stockpiles. Or perhaps the low real yields are supportive of increased allocations by investors to 'alternative' managers who own commodities. Whatever the reason, the elevated price structures of earlier this year have yet to fully return to their lows of last year. The intransigence of these costs increases will continue to bite into profits for months to come.

Most calls from the strategists' community have been for higher rates as the Fed exits the QE business. To create a soft landing for markets they will need to be governed by the 10yr yield so as not to suddenly invert the curve. Reported inflation will continue to print higher for the next six months from low base rates but will the Fed respond? There is actually a chance that they will finally get the "transitory" inflation that they hoped for this year as the 'second derivative' of inflation dampens down. That will allow them the cover necessary to slow a premature onset of tighter money.

Tricky markets and elevated volatility will be a distinctly different environment from 2021. The BTD (buy the dip) pavlovian response this week is perhaps the last one we will see for a while, especially as corporate profit estimates get revised down due to cost pressure. The favoured hyper-growth stocks that led this bounce are likely to, one-by-one fall to the wayside as multiples slowly contract in a rising rate environment. A narrow advance that leaves out many segments of the market is not healthy and corrections could reappear periodically. Ultimately the economy and market will live or die on the Fed's 'threading the needle' approach to normalizing policy next year.

The pricing power in certain segments of the economy will drive sector rotations and leadership switches. Providers of scarce resources will continue to enjoy 'bootlegger' style profitability for years to come. Conversely, companies that show an inability to adapt will falter. A flat year overall is the most likely outcome as we transition away from emergency level liquidity provision to self-perpetuating global world growth. Trading the swings will be the way to play it and I am staying positive for the year ahead despite the negative skew in market sentiment. An with all the challenges we are facing, that is not something that I speak easy.

Risk Model: 2/5 - Risk Off

My second-guessing of the Model last week worked quite well it would seem. The message of the model this week, although mechanically still in risk-off mode, is more encouraging. It will likely be in risk-on mode by Friday.

Both components of price, RSI and 200DMA are now neutral and unchallenging to the market after a quick bounce off of the deeply oversold condition.

AAII Sentiment levels are likely to recover this week and will generate a positive signal next week. This morning's Pfizer announcement of vaccine efficacy is likely to support such a recovery.

Volatility is still elevated after the Omicron spike. This will take more time to calm down but is likely to signal risk-on shortly.

As for Copper/Gold (below), the jury is still out. The jagged whipsaw action of the last year has told a story about an uneven economic path battered by Covid related successes and setbacks. A definitive break from the pattern, one way or the other, will tell us much about the year ahead.