David Einhorn comments that the Federal Reserve now realizes that it has an inflation problem. Greenlight Capital commentary for the first quarter ended March 31, 2022.
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Dear Partner:
Greenlight Capital’s Performance
The Greenlight Capital funds (the “Partnerships”) returned 4.4%1 in the first quarter of 2022, compared to a 4.6% decline for the S&P 500 index.
Q1 2022 hedge fund letters, conferences and more
To start with a quote for a change, Vladimir Lenin said: “There are decades where nothing happens, and there are weeks where decades happen.”
A lot happened this quarter, culminating in an unexpected bout of violence, which frankly, we thought society had evolved beyond and we would not witness again in our lifetimes. Millions are focused on analyzing what Will Smith did.
We joke, of course. But if you look at everything happening in the world, it would just be pure tears without a little humor. Russia invaded Ukraine and we have war, pestilence, famine and plague. There is a decent risk that Pax Americana has come to an end, along with the 13-year-old bull market.
The common refrain about COVID was that it sped up changes and trends that were already happening. We believe the same is true of the war. Inflation, supply chain problems, and shortages of energy, food, raw materials and labor were already issues that the war has now accelerated. Stocks had already begun to decline as well.
The Fed's Inflation Problem
There is some evidence that inflation is destroying demand, which is slowing the economy. For many, paying higher prices for food, gas and rent means fewer resources for discretionary purchases. The question isn’t whether the Federal Reserve will cause demand destruction and a recession; inflation is likely to do that all by itself. And while government policy is not responsible for every supply chain disruption, extremely aggressive monetary and fiscal policies have facilitated embedded inflation.
Yes, the Fed now realizes it has an inflation problem. And it sounds serious about fighting it. But talk is one thing and actions are another. If the Fed was SERIOUS about stopping the inflation problem, it would be as aggressive and creative in tightening as it was when it was easing.
Q1 2022 hedge fund letters, conferences and more
In a 2018 speech, Federal Reserve Chairman Jerome Powell highlighted that “doing too little comes with higher costs than doing too much” when “inflation expectations threaten to become unanchored. If expectations were to begin to drift, the reality or expectation of a weak initial response could exacerbate the problem. I am confident that the FOMC would resolutely ‘do whatever it takes’ should inflation expectations drift materially up or down or should crisis again threaten.”
But is the Fed doing whatever it takes or is it just talking tough, while in reality implementing a weak initial response that could exacerbate the problem?
We think it is clearly the latter. In the Fed’s Monetary Policy Report to Congress from February 2021, it highlighted something called the “balanced-approach (shortfalls) rule” that is designed to calculate what an appropriate Fed Funds rate would be given various inputs including unemployment and inflation. Currently, this would indicate an appropriate rate of about 7%.
There is endless debate about raising interest rates by a quarter percent or a half percent. With the Federal Funds Target Rate still at 0.25%-0.5%, this feels like trying to figure out whether it’s best to clear a foot of snow from your driveway with a soup ladle vs. an ice cream scooper. This certainly isn’t doing whatever it takes.
The market is beginning to price in its doubts about the Fed’s resolve and likely failure to return inflation to its 2% target. Even as the Fed resets the market’s expectation to a faster tightening cycle, inflation expectations are increasing and long-term bond prices are falling.
The good news, to the extent there is any, is that year-over-year inflation will likely fall for a bit from the current 8.5% rate. Some goods that saw prices spike rather dramatically, like used cars, are already declining. At the end of the quarter, the inflation swap market projected 5.3% inflation over the next year followed by 3.3% the year after. However, this is up from year-end expectations of 3.6% and 3.0%, respectively.
We believe the policy response to high energy prices is likely to lead to even higher energy prices. The U.S. government has chosen to subsidize demand by granting gas tax holidays and releasing strategic oil reserves, while continuing to thwart supply by demonizing producers, criticizing windfall profits, stifling investment in energy infrastructure and threatening extra taxes. Notably, energy prices feed into food prices. Agriculture is quite energy intensive and natural gas – which is at elevated prices and in short supply – is a key input into fertilizer. So, we remain bullish on future upside surprises to inflation.
Q1 2022 hedge fund letters, conferences and more
Portfolio Holdings
For the quarter, our long portfolio lost 7%, which was almost completely offset by gains on our shorts and index hedges. Macro, led by inflation swaps and gold, generated slightly more than all the return.
The long portfolio attribution bifurcated into Green Brick Partners (NYSE:GRBK), which fell sharply and was responsible for much more than all the loss, and pretty much everything else, which did quite well.
The largest winners were Rheinmetall (ETR:RHM), Teck Resources (NYSE:TECK) and CONSOL Energy (NYSE:CEIX). When we rhetorically asked the question in January at our 2022 Virtual Partner Meeting whether there would be peace in our time, we certainly didn’t expect war to break out within weeks. The war dramatically changed the outlook for European defense spending, which caused RHM to surge from €83.06 to €190.20 during the quarter. TECK (up 42%) and CEIX (up 66%) both advanced following surges in metallurgical and thermal coal prices, respectively.
Homebuilding stocks de-rated as a consensus formed around a pending collapse in housing. The narrative is that house prices have risen, interest rates (and therefore mortgage rates) are rising, sales and housing starts are slowing, inventories are building, and cancellations are rising. Supposedly, this implies that house prices are about to collapse, leaving homebuilders in a precarious position. Everyone remembers what happened when the last housing bubble popped. The market appears to be saying that it is about to happen again and that the sector is now un-investable at pretty much any valuation.
We added small new positions in International Seaways (NYSE:INSW), Ryanair Holdings (Ireland: RYA), TD SYNNEX Corporation (NYSE:SNX), Southwestern Energy (NYSE:SWN), and Weatherford International (NASDAQ:WFRD).
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