ASH BENNINGTON: Welcome to the Real Vision Daily Briefing. It's Wednesday, July 20, 2022. I'm Ash Bennington, joined today by Harry Melandri, strategist at Macro Intelligence 2 Partners. Welcome, Harry.
HARRY MELANDRI: It's good to see you again, Ash, how are you doing?
ASH BENNINGTON: I'm doing well, lots to talk about here. Before we get to it, let's take a look at equity markets. A lot of green on the screen today. Dow Jones Industrial Average up fractionally, S&P 500 up about 0.60% closing out very close to 4000 at 3959. But the big mover of the day is NASDAQ Composite, up 1.6% or thereabouts closing up the day at 11,897. Once again, it's back to I guess a couple of months ago with tech leading us higher. Harry, what's your take on what's happening in markets and more broadly in macro right now?
HARRY MELANDRI: So, it all takes inevitably a little subjective and when I look at the world, I see mostly bad news. And my guess would be everybody else sees most of the same bad news. And so, I can't help but think of this move in markets as squeezy. As a short squeeze, as a counter move that's pushing people into their pain trade. I think a lot of players would have hedged, a lot of people will be underweight, and this is the most inconvenient move for them.
ASH BENNINGTON: So, what does the pain trade look like right now? How do you assess that? And where do you think we are in that cycle?
HARRY MELANDRI: So, I could go through and give you a list of bad things that are happening. My guess is everybody knows every bad thing that's happening except for COVID. I'm not sure everyone is aware of quite how bad the COVID situation is in various places and how much it's accelerated. And we don't really know whether COVID is still a significant health risk. We've got some ideas but subjectively, we're told to no longer worry about it for various reasons.
When I look at what's going on in hedge funds, I can see that hedge fund returns are way better. Recent historical events are way better than the market's returns. So, overall, our friends in the hedge fund space have hedged their books, and they've hedged their books way better than retail has, generally speaking. I can't remember the exact number, but I'm thinking down the 6% for the year in long short equity, which would be pretty heroic compared to what had been going on in that space prior.
And I think macro goes as well, it could have caught this a couple of ways. While the CTA guys have been absolutely nailing those, CTAs have caught the down move in bonds, up move in rates really well. They caught the DXY move, the move in dollar index really well. And I think that probably, it wouldn't surprise me if CTAs had chosen to reduce their positions. Because if you think about the momentum in equity indices, they've been very solidly down. And then in the last couple of weeks, it's been chopping around. So, it wouldn't surprise me if to some degree, CTAs are choosing to reduce their shorts at this point in time.
Me personally, I just see bad news everywhere I look. But of course, it doesn't really matter what the old news is, it matters what the new news is. So, perhaps the bad news is the old story, and the new story is the Fed's going to change direction. I don't buy that personally, but that's just me.
ASH BENNINGTON: So, let's walk through those important points you just made there. First on the COVID front, what do the data tell us? Obviously, we see a lot here in New York City. I've spent the last couple of days in bed just an hour or two before we went live here today. I got my COVID test back, my COVID PCR test back, negative. It seems unfortunately, to be on lots of folks' minds. What is the data telling you and what's the significance as you think about the broader macro?
HARRY MELANDRI: So, I don't have the numbers at hand right now. I didn't really think to look these up. But here's what I've been reading about up till now. There are new Omicron related strains. Those appear to be much more infectious and have broadly speaking to be less damaging per infection. So, the greater degree of infectiousness means that we're actually seeing hospital beds increasingly occupied even though the average person who contracts it probably won't get so sick.
That together with lack of mitigation means that we've got quite a big wave going through us here and now. Now, does that matter? Well, to some degree, because some people are getting sick, because hospital capacity in places like the UK is impaired partly because of so many sick NHS workers and partly because the temperature is ridiculously high in London right now. So, altogether, there are places in the world you can look at, and you can see, oh my God, there's a lot of COVID in that place.
There's a lot of COVID in Turkey, there's a big wave going through Japan. China is interesting, because they've got 700 cases over China as a whole. That's nothing compared to the rest of the world. But I thought they were meant to be zero COVID. So, will we be getting another lockdown in China? And to what degree are health systems going to be able to cope with this wave?
Because the newer iterations of these Omicron related strains appeared to be, well, let's say the vaccines don't really do much. And the previous immunity doesn't really do much, you can be reinfected. You can be reinfected according to some people within a month from the prior infection. So, I don't know how important this is, we're about to find out.
ASH BENNINGTON: But it's also interesting. Obviously, neither you nor I are immunologists. But let's talk a little bit about what you think about the potential risks to the animal spirits in the economy. How does that show up if it does show up? And how will we know?
HARRY MELANDRI: Well, my animal spirits are being crushed and I might yield. So, I get, my boss, Julian Brigden, gives me research projects. He says, go and look at this. He's got great instincts. But it's surprising how often where he tells me to go and have a look, I'm shocked by what I see after I go and have a look. So, his research project recently has been the real estate market. And I think anyone who's observing what's going on in us real estate knows that it stopped stone cold dead January, start of February, in between those.
A lot of that, it's a very simple thing. If you add 250 basis points to 30-year fixed rates, you can expect anybody who needs to borrow 30-year fixed to buy a place is going to find themselves priced out, it's not going to work anymore. So, that's one side of that. And that's not so surprising, right? The Fed jacked up rates, it hit the long end just as much as the short end, and those purchases of real estate stopped.
From what I'm hearing from Julian, he's surprised at the extent of leverage and the extent of speculation that was happening under the radar. So, you have places like Boise, Idaho, where there's significant amount of land purchased and development, spec development going on where the pricing for that doesn't make any sense anymore. The people who are selling out of California to go to Boise are now worried they may have to go back to California to work at their jobs, that remote, distant thing maybe reducing. And we're talking about 75% annual price appreciation in these markets. It looks like we'll give back an awful lot of that. So, that's on the real estate front.
He asked me to look at private equity. When I look at private equity, the same thing happened there. Private equity financial conditions tightened really sharply at the start of the year. Valuations in recently IPO-ed stocks have absolutely cratered. You can look up Uber and you can look up DoorDash, you don't need me to tell you. But the same is true for the unlisted holdings. And the reason it's not so clear is because nobody shifts evaluation until they do a new fundraising round.
So, the most transparent fundraising we had was from Klarna. Klarna is a buy now pay later FinTech, if you will. They front money to people, you split it into four equal tranches, your payment into those tranches, and you pay the same so basically, they must have negotiated a discount somewhere down the line. Klarna did a fundraising round last year, where I think they were valued at $46 billion. They've just done another one in June, where they were valued at, I think $6.5 billion.
And if you think about how much private equity there is in the world, well, it's been growing steadily for 20 years. It's everywhere, endowment, pensions, and the more I dug, the more it seemed to me that it crept into everything. Do you remember the Jeremy Stein comment from like 2013?
ASH BENNINGTON: I don't.
HARRY MELANDRI: Oh, it may be-- yeah, this explains why no one invited me to parties, right?
ASH BENNINGTON: You're always invited in this party.
HARRY MELANDRI: Back in 2013, Jeremy Stein, he was a Fed governor, gave a speech where he said monetary policy is a pretty blunt tool. But it does have the virtue that it gets in all the cracks. And he meant that if you leave monetary policy too accommodative or if you tighten it enough, you will deal with hidden speck in the system that the Fed maybe doesn't see or can't regulate. But you can reverse that. If you don't tighten, if you have very accommodative monetary policy for an extended period of time, then why wouldn't there be the development of-- expansion in areas that are not regulated by regulators, that are not controlled by the Fed, and are not so visible to them? Well, it's private equity.
ASH BENNINGTON: It's an interesting comment, because I guess you could say it in a more cynical way, which is the downside of monetary policy is that it absolutely nukes everything. And so, it is this double-edged sword. But talking about the price pressure that seeps in across the board, I wanted to touch on something today, obviously a very big story. UK inflation now at a 40-year high, CPI coming in, this is consumer price index, coming in at 9.4% year-over-year, that's above prior, above consensus, indeed, coming in at the highest level since 1982. That's the Iron Lady era, this is the Thatcher regime, this is a very long time, it's a very ugly print.
HARRY MELANDRI: Yeah, and me personally, I don't think it's the last of them. These things are often auto correlated, one high print tends to follow another high print tends to follow another. And the phrase "second round effects", it's not so popular over here, but among European central bankers, somebody somewhere was always uttering the phrase "second round effects" for the last 20 years at the ECB.
What do they mean by second round effect? They mean that higher inflation tends to result in higher wages. People will go on strike and demand higher wages. And the way I think about this is the higher inflation has already resulted in everyone paying higher taxes. You drift into a higher tax bracket, you get that fiscal drag effect. So, one way or another, you're probably paying higher taxes because of higher inflation, to the extent that your wages have kept up at all.
But you could be getting into that phase now where you're seeing trade unions in the UK, saying, hey, I've just had a 10% real wage decrease, I'd like some of that back. I'm not putting up with that, my living standard has declined by 10% minimum. And truth is, it's probably more than that, right? The inflation statistics are probably underestimating the extent to which living standards in the UK and in the US and globally have declined because of higher energy prices and higher general inflation.
So, we're getting into that point where we're going to find out the degree to which labor can push back against that real wage decline. And my suspicion is, it's going to be a pretty bloody fight, right? Nobody wants to get poorer.
ASH BENNINGTON: talking about bloody fights here, the dilemma that central banks find themselves in the Scylla and Charybdis, I want you to talk about the other side of this equation here, which is the bottom falling out of Eurozone consumer confidence down to a minus 27% print. This is the lowest level ever on record. How do central banks begin to think about how they split the difference, evaluate this when they've got challenges on both sides of the dual mandate, at least here in the US where there is a dual mandate?
HARRY MELANDRI: So, I think it's a boiling frogs metaphor, what you want to do is to persuade people that the inflation is temporary. you want to reduce the effort to repudiate the declining living standards. Workers are going to push for higher pay raises, you have to tell them it's temporary, it may not be as temporary as you tell them. And the same is true for companies, right? There's upward movements on profitability at the moment, then that will switch to downward movements on profitability. There'll be attempts to call that back by pushing those price increases on to consumers.
Personally, I'm surprised by the resilience of consumer confidence. Have you seen the heating price races they're talking about in the UK? And obviously, we're aware that there are things going on with respect to the Russia-Ukraine war and gas supply in Europe, which may result in significantly higher heating prices across the entire continent. None of this is good.
ASH BENNINGTON: So, let's talk about it particularly for an American audience who may see those headlines but not really understand the significance of nat gas, the geopolitics behind it and the implications for the economy in Europe and also the animal spirits. You're reading these articles, some on the right, some on the left that suggest that we're looking at a potential, potential to see people dying this winter because of inadequate fuel supplies or because of rises in prices. These are truly horrifying commentary at the human level as well as at the economic level.
HARRY MELANDRI: So, I'm going to come across terrible when I say this, but actually, people die every winter because of insufficient heating. The question is how many. And yeah, there'll be more, there'll be a lot more. And this problem, I look at this, and I think to myself, what we've got is a perfect storm for industrial relations all over Europe. You're seeing political pressures, you're seeing bigger and bigger demonstrations.
The ones in Italy, I don't know if you saw the ones they had demonstrating against Mario Draghi. I don't know how good your Italians swearing is, I think your Italian swearing is pretty good. But even I recognized what they were saying. And it wasn't very sweet of them. So, what shocked me was when I was looking at that coverage, I saw a lady complaining that she could not buy bread in Rome.
So, when you get back that kind of pressure, the political pressure becomes impossible to resist. So, me personally, I think the second-round effects are going to be meaningful that we probably haven't got inflation under control. And we haven't got it under control, because we don't have the politics under control.
ASH BENNINGTON: Sobering commentary.
HARRY MELANDRI: I didn't mean it to be. I think a lot of people get it. And a lot of people are disconcerted by what they're seeing. That doesn't mean stocks have to go down, because I think people have understood how bad things aren't positioned accordingly. So, actually, temporarily, until we get-- if we don't get a continual flow of bad news, I don't see why things can't bounce. But the thing that I never get out of my head is I don't really understand why the Russian supply of natural gas to Europe is not further restricted.
Why would they allow European gas storage to refill before the winter? If they do that, their leverage over NATO and over Europe is much reduced. So, I don't get why that would actually happen. I don't know why people would assume that that outcome is the most likely outcome.
ASH BENNINGTON: By the way, for people following this, there was a fascinating chart in the Wall Street Journal yesterday that showed the curves of the capacity of fill in natural gas storage across Europe. And essentially, it's just a curve, it looks the same every year. They call summer the filling season. So, what you can see is how these supplies are building up, how the inventory is building up or not building up as the case may be across these months as we head into the winter season. It's an interesting story. And it's something that there are datapoints around.
HARRY MELANDRI: Absolutely. If you're looking for data porn, you should take a look at baseload electricity prices in France or Germany. They are absolutely terrifying. Both one year forward and spot. One day forward in France hit a new record, I think yesterday.
ASH BENNINGTON: And is it percentage of spot or in absolute terms?
HARRY MELANDRI: No, one day forward in absolute terms. Basically, there's a deficit of electricity supply in France, because they have commitments, they are a big exporter of electricity. And there's a shortage of nuclear at the moment in France for various reasons. So, the high temperatures combined with the lack of gas have pushed up the demand for electricity relative to supply and there's a problem. And that price increased. It's a factor of 10 from memory. It's effective about 10 higher than it was last year.
Can you imagine a 10 times higher electricity bill? How does any industry operate under those conditions? So, that might just be a function of the weather at the moment in Europe, but there's a chronic energy supply problem. Now, me personally, I'm way too invested in things like Argentinian restructured debt. Why do I mention that now? Argentina imports LNG, right? There are hundreds, hundreds is an exaggeration, but there's a lot of countries particularly in the third world that are dependent on LNG for their energy supply.
Pakistan, Argentina, almost every country in Asia, frankly, imports large quantities of LNG. Well, it hasn't helped that Europe is now a huge LNG importer, and you've seen price increases up in order of factor of 10 in LNG prices globally. Argentina's bidding $40 to $50 as tendering for LNG contracts for five or six loads or something. And they're paying 10 times more than they were a year ago. No wonder that they had fiscal problems.
ASH BENNINGTON: Well, this is obviously an important story, a serious story. It would be great to have you back to do more of a deep dive. Perhaps you jump on here and interview someone about this.
HARRY MELANDRI: This is not my specialist subject, God knows what is my special. But I had a--
ASH BENNINGTON: But this is what made you a great interviewer on this topic. Get someone in to scratch that