Debt Ceiling Takes a Turn

The Days Ahead:

• Strong week for corporate results including Google, Caterpillar, Meta and Microsoft.

This week

• Cobalt is in everything and everywhere…
• … but it’s a troublesome commodity
• The price levels are likely to remain very volatile
• We look at the Fed’s record of soft and hard landings
• It’s actually very good
• And this rate hiking cycle is likely to lead to a soft landing
• As long as there are no policy mistakes like…
• …the debt ceiling, where prices are starting to move
• We look at credit default swaps and tax flows

Cobalt Blues

In the 14^th and 15^th centuries, Ming dynasty ceramicists invented cobalt blue. It was known for its rich and enduring color and much prized by collectors, especially as there were severe export restrictions on Chinese porcelain. Before cobalt blue came along, blue paint came from lapis lazuli, which was only found in Afghanistan. It was extremely expensive to make so artists up to that period used it sparingly. If you see any painting produced before 1800 and it has a lot of rich blue in it, you can guess that the work was very expensive and rare. You’ll see it in churches or the works of Vermeer, Titian and Michelangelo all of whom had rich patrons. But otherwise, artists had to put up with paler and less enduring blues. Look at any unrestored work of art from the 16^th to late 18^th century and you’ll ask, “Why are the skies so grey?” It’s because the artist couldn’t afford lapis blues. Even today, the search for a perfect blue paint continues. This one was just invented and a 1.3 oz tube will cost you $180.

But back to cobalt.

In the 19^th century the process for making cobalt blue was independently discovered, manufactured and marketed to artists. The entire Impressionists school used cobalt blue and you can spot it in just about every major Renoir, Monet, Sisley or Cézanne painting.

Cobalt is a by-product of copper and nickel mining, so it became cheaper as mining for industrial metals grew in the 20^th century. But paint pigment was pretty much cobalt’s only industrial application until its use was expanded into animal feeds, aviation, electro-magnets, precision engineering and batteries in the mid-20^th century. And of course it’s this last product that has caused global production to rise from 107,000 metric tons (MT) in 2010 to  142,000 MT in 2020 to 190,000 MT in 2022.  

Electric vehicles (EVs) mainly use lithium-ion batteries these days but they in turn need cobalt, as well as a bunch of other stuff like graphite, manganese and nickel. Cobalt is particularly useful not just because it’s a great conductor and corrosion-free but also because it’s very heat resistant. It boils at 2927⁰C which is twice that of lithium and 50% more than manganese and nickel.

That’s a nice quality for two reasons.

One, magnets weaken as they’re heated so a cobalt magnet is the champion of retaining its magnetism at super high temperatures. Two, their heat resistance makes them safer, especially in things like EVs. If an EV catches fire, it can burn for up to 24 hours and need 20,000 gallons of water to put it out. Cobalt makes EVs safer and efficient.

So EVs need cobalt. And so do the chemical industry, precision tools, alloys, tires and just about every computer, tablet, hybrid car, airbag, smartphone and rechargeable battery device out there.

Every EV uses about 14 kg of cobalt, a laptop uses 50 g and a smart phone 20 g. Annual global smartphone production runs around 1.2 billion units, laptops at around 400 million and  EVs at 10 million. Just those three alone will consume 184,000 MT of cobalt against global production of 190,000 MT. That doesn’t leave much for the 20% compound growth in EVs expected in the next eight years to make 60% of all cars in the world electric by 2030.  

So, you can imagine what happens to the price of cobalt:

It’s all over the place. It’s not that the stuff is difficult to find or mine because it’s usually sitting right in or under a copper mine. There’s also plenty of it. Global reserves are estimated at 8.3 million MT, or 43 years’ worth of production. The problem is twofold.

The first is that one country, Democratic Republic of Congo, has 48% of all reserves and 70% of production and the second is that cobalt mining is very controversial.

Cobalt is always found with copper but not all copper fields contain cobalt, at least in economical volumes. It’s also a sediment element and an easy way to get it is by artisanal mining. Artisanal mining is a euphemism for “digging it out with your hands.” In places like the Congo, the artisanal is unregulated, , overseen by armed militias, environmentally disastrous, extremely dangerous and exploitive , and uses child and forced labor. It also employs around 150,000 people, 40,000 of whom are under age 18.

A recent book, Cobalt Red, highlighted the path Cobalt takes from toxic pits to the supply chains of consumer-facing companies. It’s not an easy read and points to the human rights violations and suffering that goes into cobalt mining.

This is not one of those “big industry blind to human cost” stories. Companies are forming responsibility programs and Microsoft recently led a commitment to improve conditions and safety for all suppliers. Apple has also committed to using more recycled cobalt but has some way to go as it’s only using 13% now. No one is pretending it’s not a problem which is compounded by the fact that you can’t dig up cobalt and whack it into a battery. It needs processing and refining, and 80% of the world’s cobalt is processed in China.

So, with all that we have a commodity that is in great demand and for which there are no substitutes, which relies on two countries to bring it to market but is mined in ways that are dangerous and unregulated. It can be made safer to mine by using excavators instead of miners but dong so makes it more expensive and companies like ChemAf need stable prices to justify investment in new processes.

There are new regulations coming from the EU and corporate users but the challenge is going to be diversifying away from China for finished cobalt and alleviating the conditions of Congo’s miners. Change is coming but it means more regulation and prices settling in at higher levels than they are today. It’s going to put price pressure on EV, computer, smartphone and many other industries and it may mean higher consumer prices as well. But it seems a price worth paying.

Can the Fed Raise Rates and Prevent a Hard Landing?

Yes. The Fed is unusual in central banking circles in that it has a triple mandate: to promote employment, advance stable prices and moderate long-term interest rates. Life is simpler with the ECB whose policy it is to “maintain price stability” or the Bank of Japan, also “price stability” or the Bank of Switzerland or Bank of England, and many others, all of whom manage inflation. Normally the Fed owns to two goals as the third, “moderate long-term interest rates”, is fiendishly difficult to define. But at its core, the Fed must balance taming inflation without pushing unemployment to socially unacceptable levels. The classic economic theory is that the two are a trade-off, so if the Fed puts inflation fighting to the fore, which it has done firmly since February of 2022, the argument goes that the economy will land hard and push up unemployment.

Going back to 1950, the Fed raised rates in 1962, 1964, 1967, 1971, 1976, 1985, 1987, 1994, 2004 and 2016 without causing a recession. Forgive the messy chart but here it is with GDP in blue bars and the fed funds rate in green.

There were eleven recessions in the 73 years to 2023. There was a rate hike before most of them, but not all rate hikes produced a recession. The most spectacular hike-with-no-recession was in 1993, when the fed funds rate more than doubled to 7% but the economy stayed out of recession for seven years. The reason was the rate hike was a preemptive move as the real fed funds rate was around zero and the Fed wanted to head off the risk of inflation. At other times, the Fed hiked rates, as shown by the grey bars, and the economy entered a recession.

But if we skip Economics 101 for a minute and define a recession not as two quarters of negative GDP growth nor by the NBER definition of a “significant decline” across many fronts but as growth falling more than 1% and as a fall in nominal GDP, then we get a different view. Here’s nominal GDP growth and the fed funds rate.

Now this is definitely a lax definition of recession but bear with it because we’re trying to define a hard landing, and a drop in nominal GDP is as good as any. By this chart, then, only five of the nine recessions were hard and three of them were not really the result of any Fed actions. The Kuwait War happened in 1990, the GFC in 2008 and Covid-19 in 2022. By this measure, the Fed brought the economy into a soft landing most of the time. Below are the 11 recession periods plus the 2022 hike.

In many of these cases, the Fed’s rate increases brought growth down but not enough to cause widespread weakness. In 1966 for example, GDP was running at 8% and by the end of the tightening period 14 months later, GDP was at 2.7%. In 1969, the net decline over two years was 0.6% and that was mostly caused by a 10% income tax surcharge in mid-1967.

The 1974 cycle was a “hard” landing for sure but was compounded by two rounds of Nixonian price freezes in 1973. And 1980 was hard but, again, was compounded by President Carter’s use of the Credit Control Act (long since repealed) which was specifically “designed to discourage the expansion of consumer…and bank…credit.” It was, in the words of then-White House economic advisors a “monumentally bad idea.”

There was clearly a hard landing in 2006 but the Fed started raising rates in 2004 and ended in 2006. The GDP declines started in 2008. We’d argue that the GFC was very much a regulatory and banking crisis, for which the Fed shares some blame, but it was not caused by rate increases.

So, to put all this together. The Fed has made a soft landing more often than a hard landing. When it didn’t there were other fiscal issues in play. The Vietnam War spending, the Reagan tax cuts, and Carter’s credit controls all played their part in the growth weakness following rate hikes. More recently, we’d describe the GFC and Covid-19 as genuine exogenous shocks. Or as the Fed may put it “Don’t look at us for those problems, we didn’t touch anything.”

Leading up to today. So far, the Fed has engineered a soft landing. As long as the Russia-Ukraine war does not escalate or the government trigger a spending surge or cut, or do something to shatter confidence, then this should end with a soft or no landing economy. That would be nice.

There’s more here, here and here.

Debt Ceiling

Again, this is our list of things we’re watching.

1. Thursday Bill Auctions
2. 10-Year Treasury
3. US Dollar
4. Rise of Safe Haven Assets
5. Treasury Short Positions
6. Bonds, Bills, and Notes maturing in June and July
7. Stock performance of companies with 90% of revenues from government
8. Credit default swap prices

We list them again because something is beginning to happen in the world of credit default swaps or CDS. Here is the price to insure against a default for a 1-Year U.S. Treasury and a 3-year U.S. Treasury.

The price of the 1-Year CDS has risen by 70% to 105 bps since February. This means that if someone buys a 1-Year U.S. Treasury Bill for a 4.76% yield, which was the price on April 21, 2023 and wanted to insure against a U.S. Treasury default, they would have to pay another 1.05%. The net yield would thus be around 3.71%. Another way to think about it is “How much yield am I giving up to buy insurance for one year?” For the U.S. it’s 22%. For Germany it’s 2%, Italy 9% and France 3%.

By any measure, then, the cost of default for the U.S. is high and it’s the highest of any major sovereign borrower. Even a CDS for Bulgaria costs 58 bps.

But before this doom scrolls too far, we’d note several points.

One, U.S. CDS prices fall quickly for three, five and 10-year maturities. The green line in the above chart shows a 10-year CDS at 42 bps. This is a short-term issue. It is not a fear that the U.S. does not want to or is not able to repay. Also, we’re skeptical of CDS pricing. It’s not a high-volume market and a few players taking out insurance would move prices way out of proportion to the dollar size of the transaction.

Two, the yield curve is very steep between 1-month and 6-month bills and then highly inverted from 1-year bills to 10-year bonds. Here’s what it looks like.

Basically, the chances of a default over 1-month are next to zero so investors are quite happy to buy them at 3.7%. The Treasury has also cut back auctions of 1-month bills in order to save cash. After nine month, bills start to yield more. The chart only shows the generic 3-month bill, meaning it’s a composite of bills maturing around 80 to 120 days from now. If we look at actual bills maturing every month from June to October, we see the following:

The way to read this is that concerns about the default peak in August. The Treasury’s “X-Date” of June 5^th hasn’t changed. Corporate taxes are due June 15^th so there’s very little chance of a default in June. After that, the risk increases for a few months and then drops. A November bill, which is shown, yields 4.6%. Basically, the risk premium is highest in the July to September period which ties in with when the actual “X-Date” may happen and the expectation of a resolution in early fall.

Three, tax receipts are coming in and they’re down from last year. Here:

Taxes are way down from 2022 levels, which is not unexpected given that capital gains (mostly in the non-withholding line) from the strong stock market gains of 2021, fell 25%. Earnings from the Federal Reserve are also way down. The Fed owns fewer securities than it did last year and pays out a lot more interest. Between 2021 and 2022, the Fed remitted $8,000 million to $10,000 million a month to the Treasury. It’s now around $20 million. Total receipts from all sources are down 12%.

Tax levels are probably enough to push the X-Date out to August. Earlier this year, most people, including us, thought it would be September.

Four, we also looked at our own index of companies with 90% of revenues coming from government contracts. The idea is simply that they have the U.S. government as their sole customer so is there a risk they won’t be paid. Our index is made up of companies like Huntington Ingalls (defense), Booz Allen (consulting) and Oak Street (a Medicare play). They’re performing below the S&P 500 but we’d not put too much emphasis on that because there are many other cyclical, pricing and growth issues that work on stock prices.

Finally, in the news-moves-fast-these-days category, we’d note that a House bill appeared on Wednesday that would increase the debt ceiling by $1.5 trillion for about 11 months. It’s a monster 320-page bill called the “Limit, Save, Grow Act of 2023.” It repeals a lot of clean energy, zero emission and renewable credits from the Inflation Reduction Act (IRA) bill from last year. It also cuts the IRS budget and adds work requirements for Medicare and SNAP (the old food stamps) recipients and does away with student loan forgiveness. It also has some regulatory relief for oil and gas producers and refiners.

It intends to cut spending by $4.5 trillion. But note that government spending is always expressed in total amounts over 10 years. The U.S. economy will produce around $286 trillion in the next 10 years, assuming a modest 2% nominal growth rate. The cuts thus amount to around 1.5% of GDP.

We’re not political types but we do know the House speaker can only afford to lose four votes in the House or else the bill won’t pass. It also probably won’t pass the Senate. So, on we go.

The debt ceiling issue was always going to come back. It’s been pushed to the back burner in 2023 by the Fed, the economy and the bank problems. Now that we’re into tax season, it’s back. Normally government policy does not play a large part on financial markets, although Brexit, trade deals and the Covid-19 money dump were exceptions between 2016 and 2021.  We expect more brinkmanship. Some  days will be better than others. Markets are clearly saying that U.S. creditworthiness is not an issue. Nor its ability and willingness to pay. The issue is timing.

The Bottom Line

We’d not let the debt issues weigh down the good news coming at us. We are seeing a slowdown in the economy but it’s manageable. We saw the Fed’s Beige Book, which surveys all 12 Fed districts, report lower credit demand but we’d put that down to the effects of a year’s worth of rising rates, not fears of bank problems.

April’s Beige Book noted “…that banks tightened lending standards amid increased uncertainty and concerns about liquidity.” In March, before the bank problems, it said “on balance, loan demand declined, credit standards tightened, and delinquency rates edged up.” I dunno. Those sound almost identical to me, suggesting no accelerated slowdown from March to April.

We’re also seeing wage growth moderating across the board, whether we look at hourly or weekly earnings and the various wage of job stayers, switchers, and full-time or part time workers. Here’s a sample:

Slowing wage growth usually accompanies lower inflation expectations which should start showing up more in the surveys and data in months ahead. As we discuss above, the odds of a soft or no landing remain high.

This week is about earnings season. We were short on big, market moving data, which is why we ended up diving into the normally ignored Beige Book. Next week will be a black out week for the Fed ahead of the next FOMC meeting on May 3^rd. We’ll be spared dueling comments from various Fed regional Presidents but, in the bond market we’ll probably see more trading around technicals and debt ceiling.

The S&P 500 remains around 8% above its start for the year. Small cap stocks, with their larger regional bank exposure, have lagged. European stocks are up nearly twice the S&P 500 so far this year. Some of that is down to a weaker U.S. dollar, which is down 13% against the Euro since last October. We don’t see that reversing.

Finally, an astute colleague reminded us about this graph:

The market can be maddening sometimes but it generally comes good with time and patience. In the 94 years since 1929, there have been only four times when the market has fallen two consecutive years (shown grayed out). The two most recent were the 1970s inflation and the end of the tech mania in 2001. Both were the unwind of excess. We do not have “excess” in markets today.

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Art: Zoey Frank (b. 1987)