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Biden’s debacle dims the outlook for higher rates

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Good morning. The disappointing economic data out of China was probably the biggest story in markets on Monday, but was not a big surprise, given the tighter credit/lower liquidity China themes everyone (including Unhedged) has been banging on about. So I am focusing on other things. Send me your thoughts: Robert.Armstrong.

Afghanistan and the future of rates

It is a standard journalistic trope to rue the fact that American policy blunders, domestic and international, don’t bother the stock market much. I experience the opposite surprise: I’m always surprised US stocks don’t go up more when America gets into an idiotic showdown over its budget, or embarks overconfidently on dangerous international adventures, or (as happened this week) head home from one, draped in dishonour and leaving instability behind. 

When America makes mistakes, the world becomes more dangerous, and when the world is more dangerous, the place to be is American assets. Bumbling it may be, but it is the richest country with the deepest markets and the strongest companies. Maybe, however, Afghanistan is small enough, and the risks of contagion small enough, that America’s botched departure and the Afghan government’s collapse are not enough to increase the premium on US assets. We shall see.

I asked Ed Al-Hussainy, an emerging market rates and currencies expert at Columbia Threadneedle, if the events of the past weeks created risks or opportunities for investors. He made two points, one long term and one short.

In the short term, the weakening in Pakistani sovereign bonds (FT story here) in response to the collapse of it neighbour created an opportunity. Pakistan, Al-Hussainy noted, is in “progress review” talks with the IMF over the country’s $6bn aid package. Now the IMF will see more reasons to support a stable Pakistan, improving the credit outlook for its bonds.

“The IMF at the end of the day is a political animal,” Al-Hussainy says, “and historically it has been in their interest [to increase support] when the foreign policy objectives align”. He points, by analogy, to the IMFs support for Argentina — despite its terrible economic fundamentals — when elsewhere in the region Venezuela was near collapse. 

In the long term, the question is how much the debacle depletes the Biden administrations’ store of political capital, and what that means for US rates.

“Earlier this year there was broad optimism that all this fiscal support would become the normal response to recessions and higher spending between recessions would become standard . . . but now everyone associates short-term stimulus with inflation and the long-term stuff [eg the ‘soft’ infrastructure spending package] is dying on the vine. If you had an optimistic case for higher rates, you have to temper that optimism now.” 

This makes a lot of sense to me.

China shipping costs

This is a hell of a chart:

The increase in shipping rates from China is important, of course, because it contributes to inflation in the prices of everything that comes from that country, which is to say, most things. Will this key price do what lumber prices did, and retrace their massive increase quickly once the various bottlenecks are cleared? Or will it be a persistent problem?

The two bottlenecks mentioned most are shortages of ships and containers (which were under-built in the panicked early months of the pandemic) and virus-driven stoppages in key ports like Ningbo

Shipping indices are somewhat notorious for being unreliable and poorly representative (pointing out the failures of The Baltic Dry index, for example, is something of a cottage industry among financial journalists). The data are imperfect and there are big price differences between different types and durations of contract.

To get some context, I spoke to my friend Noah Janssen, president of JB Metalcraft. For about 15 years Noah has been sourcing metal industrial equipment from China, and selling it to US miners, road builders, and so on. He confirms the message of the benchmark chart, and adds some new angles:

“I’ve Definitely been hearing from Chinese suppliers that everyone there is facing labour shortages, and one explanation is that the delivery economy has pulled a lot of low wage workers out the factories . . . workers would rather be on a delivery bike than in a factory.

“Prices really started to go up at the end of last year and I kept expecting them to come down and they have not . . . in June, ocean shipping was about three times normal and then it doubled in July, so for the ocean shipping [part of the equation] is about six times what it was.

“Metal parts are very heavy but not bulky, so this does not impact us as much as it would a [more volume-intensive] shipper. Previously, total shipping costs [ocean plus land] were a very small percentage of our total costs — I want to say around 3 per cent. But this month, shipping costs have forced us to raise prices to our customers. I probably should have done it in July, but I kept thinking prices would come back down, and now there is no end in sight, because we are entering the peak shipping season, which is driven by US retailers stocking up for the Christmas season, from now to October.”

Did his customers complain about the price rises? “Very little push back, because people are seeing it everywhere.”

If Noah’s experience is representative, my takeaways are (1) labour shortages in China, not related to Covid, might be a bigger piece of this story than widely thought — and this might be “sticky” (2) shipping costs are still working their way through the supply chain, and (3) relief in the next few months seems unlikely. 

Banks are the world’s worst cartel (part 2)

On Monday I wrote about the claim that banks are a cartel. Yes, very big banks can screw up catastrophically at their core jobs of managing risk and serving customers and still remain very big banks (see Credit Suisse and Wells Fargo, for example). I argued, however, that banks’ low returns and generally weak stock market performance over time suggest they are hardly a competition-suppressing cartel.

Today, two more reasons for rejecting the cartel label, especially for US banks. 

First, there are a lot of banks in America (4,987 are insured by the Federal Deposit Insurance Corporation). While there are just a few very big banks, their position in the market is not exactly dominant. Data from the FDIC:

Second, we know what a banking cartel (or at least a bank oligopoly) looks like, because there is one, in Canada, where the top five banks control something like 80 per cent of the deposits. Here’s the performance that generates (hat tip to Karl Schamotta):

All five beat the Toronto stock exchange index, and four of the five have performed better than the best performing US bank over the long term. Those are returns that a truly non-competitive market should deliver! 

But if US banks are not a cartel, why are they so resilient in the face of their own bungling? I think there are three main reasons:

  • Banking is very much a scale business. Being big confers huge economic advantages that helps poorly-run big banks keep staggering along.

  • Federal deposit insurance means that the cost of deposit liabilities do not reflect a bank’s riskiness or management competence. At the same time, pricing for assets like loans is not highly differentiated. Customers basically never switch banks. 

  • Regulatory burdens and capital requirements do keep the number of new entrants down, probably, but this is likely the least important of the three reasons. People do start new banks (nine new bank charters were approved in 2020 according to S&P Global Market intelligence).

I think these factors are enough to explain the surprising resilience of big banks. But too much is made of the third factor. The regulatory regime only looks onerous because the fundamentals of the business are not that good. Who would want to be a bank? The product is a commodity, and unlike Opec, the banks do not really have any significant control of the supply of (say) loans. The wider economy does that by supplying a certain number of creditworthy borrowers. It is very hard to make excess profits as a bank without taking excess risk, which helps explain why banks tend to get into so many messes in the first place. 

US banking — at least the vanilla deposits-and-loans core of it — is no cartel. It’s just a weird business.

Mistakes

Two errors in the past two days. In Friday’s letter, I misspelled the name of the US FTC commissioner: it is Khan, not Kahn. On Monday, I named a notorious trade finance firm as Greenhill; it’s Greensill. I feel plenty dumb about both. Apologies.

One good read

I liked Ruchir Sharma’s column in the FT arguing that, like dominant companies in the past, the vast US tech companies will be brought low by competition. I also don’t believe it for a second. Today’s economy is different. Get used to having a lot of Google, Apple, Amazon and Microsoft in your life. Their dominance may outlast you.

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