Slightly More Confident
The market fall this year has been steady and relentless rather than a panic crash, and last month the Sell in May mantra cut through and markets switched to bear market behaviour of selling rallies and not buying dips. Much of this we believe has been associated with leveraged structures unwinding, combined with fund redemptions, especially in tech, reversing the ‘upside crash’ of last year. Confidence is picking up slightly, but the Fed is key, in particular the extent to which it actively want the markets lower. Don’t fight the Fed as they used to say. Volatility is way down, but over the summer, we are likely to see further consequences of the liquidity tide going out, with both business models (earnings) and funds (redemptions) exposed to reality and the ‘Magical Thinking’ around tech Unicorns, Non GAAP earnings and of course The Green Leap Forward all hitting harsh economic reality. While the Russia sanctions are hitting harder on Europe than Russia, the real longer term trend is to a clean break between The West and The Rest, which amounts to nothing less than a total restructure of the Global Financial System.
Short Term Uncertainties – one swallow doesn’t make a summer.
If we define risk and uncertainty in terms of volatility then it is fair to say that risk has been falling steadily throughout the second half of June, with both the VIX and the (Bond volatility) MOVE index heading lower, while commodities and especially currencies have suddenly become a lot more ‘boring’. This is consistent with an end to short covering and/or distressed selling of assets as investors and traders have moved to shrink their balance sheets. The biggest uncertainty in our view for markets remains over the Fed; specifically the extent to which they will go ‘full Volker’ and collapse the economy to achieve their inflation target. The fact that they continued for years with a misguided interest rate policy that failed to achieve their inflation target from the other direction is certainly a cause for concern, for the reality is that the rise in prices is largely a supply effect (caused by Zero Carbon and Zero Covid policies, albeit fuelled by Zero Interest rates) and that the net effect of tighter monetary conditions is more likely to be stagflation. As such, we do need to go back to Fed watching, not least the headline Consumers expenditure deflator, which interestingly looks to have peaked as we discussed in an earlier note has inflation peaked? and due to base effects may be below 3% by year end.
To that end, the release of Fed minutes implying that the Fed might pause in September after three 50bp hikes was taken relatively positively, encouraging a bounce in markets. In effect this is flattening the curve at the front end – Powell is on record as saying that the 3mth-18mth part of the curve is more important than 2-10yr spread. However, there wasn’t much impetus from short covering, (as positions were largely flat) nor any leveraged ‘risk on’ trades from leveraged traders (as nobody is taking on much leverage), but some longer term buying of the new momentum stocks (see note) as the momentum indices rebalanced from Growth to value helped steady things. The pull back in the Dollar suggested that the short squeeze associated with the widespread deleveraging of portfolios during April and May may be done for now and has eased monetary conditions somewhat.
Ironically, the delay in opening up by China has alleviated some of the inflationary pressures that would otherwise have arisen if Chinese demand had hit the fractured and fragile global supply chain at the same time as everywhere else and while the full opening up remains painfully distant compared to the rest of the world, China’s policy makers are using some of the tools they have at their disposal to support the economy more generally. This is helping to stabilise confidence in the economy – although most accept that a 5% or more growth target is unlikely to be achieved this year. However, the biggest concern for potential investors in China is also one of de-leveraging. Many of the ADRs are simply no longer allowed in international portfolios, along with a lot of US sanctioned stocks. The uncertainty on China then is less about the economy and more about the transfer of assets ‘from weak hands to strong hands’.
Overall then, while there is still much to worry about, the market confidence is modestly higher and it was thus interesting to note that towards the end of the month a number of our Confidence indicators ticked up slightly. (These are used in our model portfolios to allocate position size). In terms of Global Factors, Momentum (helped by the rebalance we discussed in A few basket cases), Value and Size all moved up, while in the thematics, EM Consumer, Clean Energy and Automation/Robotics all went up from 1 (lowest) to 2. More broadly, Emerging Markets, China, Nikkei, the UK and the equally Weight S&P500 also showed a rise from 1 to 2. Only Utilities and Energy remain at the highest confidence levels, while Materials are mid range. Everything else still at lowest levels. In Bonds, after the worst start to the year in history, just about, we have seen some signs of stabilisation, consistent with the softening views on the Fed. As such we saw a similar slight rise in confidence in Investment Grade Bonds, High Yield and Global Aggregate bonds, the first sign of improvement since December.
Medium Term Risks – magical thinking
The disappearance of liquidity has left many stocks and strategies stranded, as we discussed in Stranded in Rockpools and Turns out the Unicorns were in the wrong Ark and a challenge to the Magical Thinking not only behind the whole Crypto space, but also behind many of the stock market darlings. The Indian rope trick of blended public and private funds aggressively buying into pre-IPO rounds and then also crowding into the relatively illiquid listings to ensure both private and public arms ‘did well’ created a whole raft of Momo stocks, dragging in the Redditt and Robin Hood crowd trading from home with their stimulus checks and running aggressive short dated option strategies that we causing all manner of squeezes. As the chart from Goldmans illustrates, that crowd has largely cleared out and no doubt their Crypto has gone the same way. Tulips and the South Sea Bubble all in one season.
Thus although the distress is probably over and although confidence is picking up slightly, it is still unclear how much stress both portfolios and companies are still under. Fund redemptions, cash flow problems and profit warnings are all hurdles the markets need to clear over the next few months.
The next issue for markets we think will be earnings themselves, not just from the perspective of slower economic activity and operational leverage (always tricky to forecast) but also from the regime change in terms of no more cheap capital, be it in the form of cash or high priced equity. This has echoes of the 2000 dot com bubble bursting, NASDAQ fell sharply in the spring but the S&P stayed up as investors rotated into the big cap stocks, only to realise that a combination of Y2K bringing forward sales and the disappearance of demand from Dot Coms meant that 2001 earnings estimates were in need of being reduced aggressively. This time around, something similar may be happening. For Y2k, read Work (and Learn) from home, causing a sharp increase in demand for Ipads, Laptops etc (and the associated chipsets) and for Dot Coms, read Unicorns spending all their pre-IPO money. Another lesson that we learned back then was another type of magical thinking; a business model that depends on using equity to buy companies and pay staff can appear very profitable on non GAAP earnings, but when you can no longer use Equity, the truth is revealed and earnings can drop precipitously.
The War in Ukraine is being blamed for many of the inflation problems in the west, although in reality it is largely a matter of exaggerating problems that were already there. As such, even if it were to finish quickly, many of the issues would remain unresolved. In particular, the problems imposed by ‘The Green Leap Forward’ – underinvestment in reliable energy, ‘growing’ fuel instead of food, deliberately making energy more expensive – will continue to burden developed markets more than many emerging economies. On the other hand, the need to pay debt interest as well as find money for food and fuel is going to present a challenge for a lot of EM debt come the Autumn.
Meanwhile, the fact that the 80% of the world population that has not imposed sanctions on Russia (and by extension penalised themselves) is delivering a huge potential competitive advantage. The spread between Urals and Brent Oil is now at $28 (white line), while the ‘Crack Spread’ being earned by refiners is at record highs, (yellow line) as shown in the Chart. Not only is the oil made more expensive by sanctions, but the margin on turning it into products has exploded to the upside. Turns out yet more Magical Thinking that by not investing in Oil and gas, shutting refineries and denying permits in the name of Climate change you were saving the planet, but in reality it means that banning Russian gas leaves you nowhere to go.
EU’s self harm. If you still buy oil from Russia, life is a lot easier
The crack spread shown is over Brent Crude, just imagine if you are importing Russian Oil, then refining it and selling it back to ‘The West’ at the elevated Brent based prices? Nice work if you can get it.
Long Term Themes – the West v The Rest
The biggest long term theme is about as big as it gets; not just de-dollarisation but the complete reset of the Financial markets in the wake of the confiscation of Russia’s FX reserves. As we discussed in “Is it time to repeg the HK$?” , this is at least as big as the 2008 Global Financial Crisis (GFC) and in fact is equivalent in our view to the shock of the US taking the $ off gold in 1971. We have seen the Petro-$ replaced with the Petro-Ruble, the world’s strongest currency last month and also some accelerated moves by ‘The Rest’ to bypass using ‘The West’ for its trading – just as the GFC encouraged China in particular to develop its own financial sector infrastructure rather than outsourcing it to the west. Bi-lateral deals with India and Russia, and likely Saudi Arabia and Iran significantly reduces the need for China to earn $s to pay for its commodity imports – especially energy. In a world where your asset is another person’s liability and they have shown a willingness to ‘cancel’ that liability at their own discretion, it raises a question about where to hold your assets.
Thus it seems clear to us that the world is rapidly splitting into two blocs – The West and The Rest – pretty easily defined by the countries supporting US sanctions – basically Canada, UK, Australia, NZ, EU, Singapore and Japan and The Rest, who are neutral at best, or else increasingly aligned to a China/Russia bloc. The issue here is that, while the former group may have a much larger GDP, there are also some large current account deficits – i.e they are in savings deficit. By contrast, the Rest has all the savings, just that currently too many of them are in The West. Bringing those savings out of the $ zone is going to be a clear long term theme. The only question is how they will do it?
Rhetoric from China and Russia about the US is hard to find in our world of propaganda and blocking ‘dis-information’, but there two good recent examples here and here – illustrating how they are both increasingly no longer pulling their punches in discussion of their disapproval of US behaviour. As investors, it is important that we recognise that what people say they believe is a better guide to their subsequent actions than what other people (in this case their opponent) says that they should believe. The interesting thing about these two press conferences is that both China and Russia appear to be wanting to still use the UN and other existing ‘World’ organisations for a rules based international order where the US is not the only one allowed to set (or ignore) the rules. This fits in with our theory that a parallel ‘Bancor‘ type Reserve Currency for trade settlement could be structured around the IMF basket of SDR. Going forward, $ loans to emerging countries could easily be restructured into SDR and bought by ‘The Rest’, thus not only reducing the volume of $FX by around half ($ is 41% weight in SDR, but currently almost 90% of trade activity), but also collapsing the $3tn in offshore $ Sovereign and Corporate bond markets.
