Don’t fight the Fed!

Some contrary evidence on inflation emerges

For those of us who have been following the exploits of financial Twitter (FinTwit to its devotees), the year 2021 brought us no end of postings about the burgeoning inflation of the late-pandemic era. In some posts, a wild-eyed Jerome Powell stands astride an archaic printing press and furiously cranks out greenbacks to the delight of laser-eyed commentators with “takes” on our inevitable path towards Weimar-style inflation. Anything, one supposes, is possible, but the month of January saw a certain amount of evidence that doesn’t fit neatly into a simple narrative in which both rates and inflation are straight lines that go up and to the right.

Take, for example, the curious case of hot-rolled steel. As pandemic-era commuters chose private automobiles over public trains and buses, the price of used cars and new cars pushed higher. As a result, a lot of the inputs into these vehicles’ manufacture, such as hot rolled steel, climbed significantly in price. From a pandemic low of $470 per ton in the summer of 2020, hot-rolled steel shot to $1,960 per ton in September 2021. However, since that date, we have seen a decline in steel prices of more than $500 per ton.¹

While inflation in steel prices in still positive on a year-over-year basis, on a sequential basis, we have seen four months of significant decline. Part of the explanation for this may be found in relatively muted recent orders for consumer durables such as cars and appliances. But consumers are fickle beasts. When you raise the price of things they want to buy, they want to buy less. And it is, perhaps, this dynamic which is at work in the steel market.

Across the Pacific, it has been hard to ignore the ongoing financial implosion of many of the largest Chinese property developers. Take, for instance, the now flailing behemoth, China Evergrande Group. Five years ago, the company’s equity was capitalized at over US$45 billion, and the entity sported a further $100 billion of bond debt trading at par. Now the company’s equity is virtually worthless, and its debt can be purchased below 20 cents on the dollar.

Evergrande is hardly a one-off. Excess production of residential towers by a variety of developers has put one of the world’s largest industries (by one count, China’s construction firms employ over 50 million people) into a period of financial distress and activity contraction that calls to mind the American experience of 2007-09. While bailouts and stimulus programs could possibly improve the situation, Chinese property development does appear to be entering the hangover phase after an extraordinarily long and wild party.

Investment implications

A couple of industries in contraction amongst many experiencing rapid growth does not necessarily spell an immediate end to inflationary pressures. However, the recent tightening actions of the Federal reserve – and, quite frankly, almost every other central bank save China’s – should exert a cooling effect on inflation, given time. How much cooling and when it arrives are a matter of some conjecture. But there are enough governments, industries, and individuals with significant financial leverage acquired at extremely low interest rates for whom even a relatively small number of rate hikes may have a significant effect.

Sometimes the pain of financial loss takes from investors the full use of their senses. Investors in high-grade bonds may still be recoiling from the shock of drawdowns in a place where they least expected. It is tempting in the circumstances to run wildly towards anything that is working. A fog of loss-induced anxiety may still prevent some from reading the writing on the wall. But we have seen that wall, with its letters coming ever more clearly into focus, and it says, “Don’t fight the Fed.” Thus, we continue to add high-grade credit as part of our evolving mix.

1. Bloomberg, January 31, 2022

Geoff Castle is Portfolio Manager of the Pender Corporate Bond Fund at PenderFund Capital Management. Excerpted from the Pender Fixed Income – Manager’s Commentary – January 2022. Used with permission.

Notes and Disclaimer

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in net asset value and assume reinvestment of all distributions and are net of all management and administrative fees, but do not take into account sales, redemption or optional charges or income taxes payable by any security holder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. This communication is intended for information purposes only and does not constitute an offer to buy or sell our products or services nor is it intended as investment and/or financial advice on any subject matter and is provided for your information only. Every effort has been made to ensure the accuracy of its contents. Certain of the statements made may contain forward-looking statements, which involve known and unknown risk, uncertainties and other factors which may cause the actual results, performance or achievements of the Company, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.