Excellent, wide-ranging interview on the NZ Funds podcast with William Callanan, who discusses his outlook for inflation, commodities and geopolitical risks. He is the founder and CEO of Syzygy Investment Advisory and previously worked in senior roles at Key Square Capital and Soros Fund Management. Below are some of my paraphrased notes (these are for personal reference only and any mistakes made in transcription are my own).
As he thinks through the framing from a macro investment standpoint today, the most important parts are the trajectory of the Fed, the commodity sector and the geopolitical shifts that are occurring.
On the Fed, the imperative to restore price parity has come to the forefront. It is clear they have never been this far behind the curve going back to the 1970s, and now they need to rein in prices, even if growth could be a risk factor as a part of that. The Fed is in a race to neutral, where you have a sustainable balance in the economy between growth and inflation, but they have a long way to go from the first 25 bps they have just executed. The challenge is that they are in a race to a place where they don’t actually know where that is – we don’t know the effects of the post-pandemic labor market, the effect deglobalization is having on higher prices and also how ESG could be an inflationary force in the global economy, where every $1 of hydrocarbon spend you remove requires $25 of renewable spending in the context of a very tight commodity market.
The Fed is also up against a historic challenge to return price stability, where inflation expectations have become significantly entrenched between the corporate sector and now the household sector. If you look back, since 1951, inflation has never come down when you have had a negative real Fed funds rate and you have never had disinflation without a recession when the inflation rate is above 5%. For 2022, the narrative is going to be the inflection in global liquidity, as both the Fed and ECB move to shrink the balance sheet and hike rates, which is pivotal for risk assets globally given we spent so many years being able to go out on the risk spectrum.
The second big theme is what is occurring in commodity markets today, and that is not really a function of Russia/Ukraine. Instead, Russia/Ukraine is an accelerant of an existing issue, which is that we have had 6 years of underinvestment across the commodity spectrum. The investment required to get back to trend would be almost three-quarters of a trillion dollars over the next 5 years, or the equivalent of 33m barrels a day of oil equivalent on a 100m base. In his 25 years of trading commodities, he has never seen such tight balance sheets between energy, metals and agriculture all at the same time. This is a challenge to both DM and EM inflation.
Finally, on geopolitics – he thinks the sanctions levied on Russia in the context of Ukraine are going to force sovereigns, corporates, HNW and even individual investors to redefine what a risk free asset is. When you think that central bank reserves can now be sanctioned and you effectively have the weaponization of the US dollar payment system, the idea of what is a risk free asset is going to have seismic impacts globally on currency and fixed income flows for the foreseeable future. This will likely lead to a further decoupling across the China/Russia axis vs. the West, in the same way we had started to see the technology and trade decoupling from several years ago. The security alliance between China and Russia is also a significant challenge to the existing world order and that is quite risky in terms of not just the Taiwan Strait, but also in Eastern Europe and for NATO.
One other important aspect to consider is fiscalization, where govts are going to fiscalize commodity price inflation, either by implementing subsidies or eliminating taxes, in order to buffer the consumer against higher prices. While this might appear attractive in the short-term, over the longer term, there are only 3 ways to rebalance the macroeconomic system: incremental supply, substitution between products or demand destruction. Given that few commodities have significant flex in supply, demand destruction is the only plausible option available. If governments are fiscalizing prices, however, it means the threshold by which you will destroy demand gets moved even higher, which creates even more scope for further price pressures.
When you put all these pieces together, it creates an incredibly complex environment. In these types of environments, you really want to allow yourself as many degrees of freedom and flexibility as possible to invest across the macro matrix. It is probably as rich a macro environment as he has seen in 25 years. As the world is moving towards this inflection in global liquidity, you will start to see less liquidity in financial markets, which leads to even bigger moves, so being able to find areas were options are mispriced can really lead to significant outperformance for a portfolio.
Could the Fed have done more?
He will caveat his comments by saying that being a Fed chair is an unenviable position because of the pressures of the job, while it is easy to be an armchair quarterback. But he thinks there has been an interesting combination of endogenous and exogenous factors. The Fed wanted to make sure there would be a sustainable recovery that could build confidence in their ability to come off the zero bound of interest rates post-Covid. If you go back to Jay Powell’s press conference in Jan 2021, he said they thought the increase in consumption coming out of Covid would not be significant, it would not be sustainable and they would not do anything about it. Obviously, there was a radical revision to those statements came starting in June, then accelerating into September, followed by a re-evaluation of the Fed’s summary of economic projections in December.
We were probably coming into a recovery right before Covid and now we have kind of moved to late cycle and Covid created these significant distortions in global supply chains. But the underinvestment and conservatism that had existed since the financial crisis have left the Fed in a position where they have been for decades arguably, which is beg forgiveness, not permission in terms of hiking. Now, when things have moved very quickly, they have found themselves behind the curve and an institutional bias had also formed because of the formation of average inflation targeting. When you do a constitutional change and then stop out of the trade 3-6 months later (after having spent 2-3 years developing your new strategy), it is not great for the credibility of an institution. That created hesitation as well, where average inflation targeting was challenged almost immediately after it was executed. Now, with the US mid-term senatorial elections coming up in November, the White House has said inflation is a problem, the US population has said inflation is a problem, so Powell now has the political backing to get aggressive and hike rates. You can’t run at negative real wages for very long without consumption suffering and if the Fed’s goal is to try and elongate the business cycle for as long as possible, then combating inflation becomes their primary target in their effort.
What is his view of where inflation gets to over next 12 months?
Two comments here. First, from the latest Fed meeting where they laid out their forecasts for the next 1-2 years, they are forecasting this goldilocks scenario where growth will be above trend (which will be inflationary), the unemployment rate will be above their expectations prior, but their long term median interest rate is still below what they think the neutral rate is. So this idea that inflation is going to come down in this context is ideologically and intellectually inconsistent. His second comment would be in terms of the normalization. The Fed has made a huge bet in the idea that the US consumer will shift from goods to services. When nominal wages are growing over 10%, however, the pie of income is growing quickly, so the idea that people can spend on both goods and services at the same time is a real threat to that forecast. The Fed also made a significant bet (that they have now started to back off from) where they forecasted all of these supply chain dislocations would be gone by the middle 0f 2022. But there is very little evidence that is in fact occurring. One of the reasons they think inflation will continue to be above the Fed’s forecast is all their survey/quantitative work suggests that companies and individuals are prioritizing availability over price, and especially in areas such as food.
How does he think the commodities cycle will play out?
Back to his comments earlier, there are only 3 ways a rising commodity price cycle will end. One is incremental supply. But there is very little incremental supply, particularly as OPEC is drawing down all of their spare capacity at a very rapid rate, US shale producers have taken the attitude that return on invested capital is more important than production, and then you have the broader ESG considerations that stand atop that. There is also no ability to do effective product substitution, because all forms of energy are going higher. So it only leaves demand destruction and that will take place at a much higher level than people realize. In the US, corporates and households have cash equivalent to 85% of GDP, an enormous buffer against the price shock currently.
He tries not to get caught up in whether this will be a super cycle or not but the underinvestment has been extraordinary. When he says underinvestment, it is not just on the production side, it is across the full spectrum in terms of upstream, downstream, midstream, infrastructure, equipment and personnel. What you will likely find is we will spike to higher highs but we will also have higher lows because of the underinvestment. Companies don’t invest significant amounts of capital to increase supply into substantial price volatility. What is more important is that the floor is rising and that is going to create sustainable upward pressure on baseline levels of inflation, which is a much bigger issue. So in that regard, there is a super cycle in underinvestment that will raise aggregate price levels over time and we will have to just look through the spikes because they are almost impossible to invest into.
Will there be an impact on globalization decarbonization efforts?
He thinks we may see pragmatism take over ideology. Italy is a very interesting example in this regard. They have put forward a proposal to suspend the European carbon emissions trading system for the next 6-12 months, because the carbon price has gone up so much it has created this cascading effect into higher electricity prices (obviously the gas shortages happening in Europe are also contributing to that). Thinks we won’t push the targets out, but will just see very significant shortfalls in terms of execution. He would also highlight a very important recent article in the WSJ, where an activist investor who had been very influential in convincing Exxon to cut back on their oil production, wrote an editorial reversing his view, saying the best way to get renewables is to produce clean oil and gas in the US and get US oil production up. These are just examples of the shifts occurring, where decarbonization makes extraordinary sense, but you have to be pragmatic about unique economic situations where the left tail outcomes are very fat in terms of the significance of recessions that can be created. For example, in Europe, the typical consumer used to be paying 65-70 Euros a month for electricity and now they are paying 900 Euros. Those are untenable amounts for people to pay and governments will do anything in their power, whether using their fiscal budgets or regulatory easing, to work around that.
What does it mean for politics?
What we will likely see is greater focus on self reliance and indigenous innovation. Everyone will be turning inward to fortify their companies, their military and their economies. China started its policy ~18 months ago, and in the US now, there is an unbelievable pipeline of public legislation that is coming to do that, from semiconductors to innovation and competitiveness, as well as international action against “non-competitive” behavior. Europe is looking to throw out 30 years of dogma relating to defense policy, Poland will double or triple their army, Germans becoming very focused on increasing defense spending. Technology systems will have to be more robust, resilient, more alliances with like-minded nations and different forms of remilitarization. When you think about the political manifestations that are the product of that, those are the sorts of platforms on which candidates will likely run.