commentary #11
3rd May 2023
April 2023 Performance Review
Dear Investor,
As usual we will start the month having a quick look at what the markets did in the previous month, our themes, and the thematic portfolio performance.
It was a relatively uneventful month (compared to the last few) until the banking “crisis” reared its ugly head again in the last week of April. In Groundhog Day fashion First Republic Bank faced its own day of reckoning as deposits continued to flee. Most of the markets we tracked moved in a 1-2% range with strength in Japan offset by some weakness in the Hong Kong index.
Our themes continued to perform well with the exception of “Other Commodities” which currently consists of fertiliser stocks and a metals and mining ETF. They also performed poorly last month as many cyclical stocks are getting sold as it becomes more apparent that the world’s biggest economy will be going into recession.
Please see the Themes section of the website for a breakdown of our current investment themes
The thematic portfolio performance is below and it made 1.22% for the month, dragged down by the cyclical exposure mentioned above. Our April additions to HK and China did extremely well with the construction names up on average 20% for the month and the banks up around 3% vs the major indices which were down over 2%. 20% in a month is good performance and as we mentioned previously, the construction companies were more of a trade and would likely play out sooner than our normal investment time frame. But we are not complaining!
For the first four months, this brings the thematic portfolio’s return to 6.04%, a respectable amount given we have, on average, only been between 50-60% invested. As we have noted, during a bear market, we prefer to keep our exposures lower than normal as the key is not losing money and having dry powder to invest once the market has bottomed or stocks are so cheap they have a big margin of safety built in.
So, what happened in April?
Regional Banks in the US came under continued pressure towards the end of the month as First Republic Bank, on a 12-minute conference call explained that it had lost $100B of deposits in the first quarter and then refused to take questions. The stock cratered and confidence was gone. This is a similar story to Silicon Valley bank in that it the bank had a concentrated deposit base, focused on extremely wealthy people and offering them low interest loans. As rates rose those loans lost value and you a combination of massive unrealised losses and depositors leaving (after the SVB debacle), EVEN AFTER major US banks placed $30B on deposit with First Republic in March to calm nerves.
FT 27th April
First Republic shares continue slide with no deal in sight
Shares in First Republic dropped almost 30 per cent on Wednesday as regulators, big banks and potential bidders for its assets all held back from stepping in to help the San Francisco-based lender. Recriminations have started to fly in private as First Republic’s frantic efforts to sell assets to close the hole in its balance sheet have failed to come to fruition.
First Republic has been under pressure from deposit outflows since queues formed outside one of its branches the day after Silicon Valley Bank collapsed in March. Much of its substantial mortgage loan book has lost value as interest rates have risen and its wealthy customers feared that their large balances would not be covered by deposit insurance if the bank had to be rescued by the Federal reserve
This played out as expected and JP Morgan bought the bank from the FDIC over the last weekend in April. No doubt it will be a sweet deal for them, and any losses will be shared with the government or should I say the US taxpayer.
More importantly, you have a situation whereby the smaller regional banks will be unable to lend and these banks are the lifeblood of small business. You are not going to have JP Morgan servicing a 10-fleet trucking company in Ohio. In turn, these small businesses are the lifeblood of middle America which is being squeezed by higher rates, lower lending and, as importantly, less hiring.
WSJ March 18
Mr. Rajan has found that even though the distance between small firms and their lenders has increased over the years, it is still quite short. In a recent paper using Community Reinvestment Act data, he, João Granja and Christian Leuz found that as of 2016 more than three-quarters of small-business loans—here defined as loans with a principal amount of $1 million or less—originated in the U.S. went to borrowers that were less than 50 miles from the closest branch of their lender. The median distance between small-business loan borrowers and their lenders’ nearest branch was less than 7 miles.
Smaller banks are particularly important in lending to commercial real-estate projects, which include things ranging from office buildings to strip malls to warehouses. Banks in the U.S. outside the 25 largest banks by domestic assets represent close to 40% of all bank lending—but about two-thirds of commercial real-estate loans, according to Federal Reserve data. They represent about 70% of construction and land development loans, and more than 90% of all loans secured by farmland.
Below, we can already see the state of small businesses. The optimism index is at the same level as it was in the worst of the pandemic. Think about that. When businesses are not confident, they won’t hire or invest and are likely to “hunker down.”
What does that portend for hiring? We can see hiring intentions below:
The slow-motion credit crisis in the US continues to unfold. We need to see where it strikes next but as we have postulated in recent commentaries, it is likely to be in the private markets and ancillary areas. In the meantime we will increase our short exposure to the US this month as the recession becomes more apparent as time goes on.
Across the ocean in China, it is a different story. Earnings have been coming out and there have been many massive year over year increases in sales and profits. Now the initial up move in HK/China indices from November to January had already reflected this which is why we are not so surprised that we have not seen more of an impact in the market. But we still see very little signs of positivity from global investors on China despite many positive economic releases like the below.
Reuters 17th April
China’s March industrial output rises 3.9%; retail sales up 10.6%
Retail sales rose 10.6%, beating forecasts for a 7.4% increase by a large margin. It was also faster than the 3.5% increase in January-February.
We are not sure if it is a lack of patience that China doesn’t have the same level of bounce back that Western economies had (as we have discussed previously vis a vis the lack of Covid handouts in China) or the continued geopolitical tensions. Probably both. There have been continued verbal sparring between the two powers and a continuation of economic “measures” to impede China’s development (from China’s perspective) and to protect US security (from the US’s perspective).
The US also cannot be happy with all the alliances China is making in the Middle East, as noted last month. China is pulling nations together that have been enemies for a long time. Who knows what is being offered but, whatever it is, it is working.
With the Shale “revolution” in 2014, the US effectively discovered an additional Saudi Arabia worth of oil and gas. This made them energy independent and so the thinking was that there was not so much need to cultivate the region which had previously supplied them. In our view that is a mistake and with another such “discovery” unlikely, together with supply constraints, means the picture is very bullish for energy longer-term. This is why we have a position even though, it is not necessarily the best sector to own in a cyclical slowdown which we see as imminent, if not upon the US already. We will increase our position in energy as this unfolds, but not right now.
Oilprice.com
Pioneer CEO: The Shale Boom Is Over
Mar 09, 2023, 5:00 PM CST
- EIA forecasted that U.S. oil production will grow by 590,000 bpd to a total of 12.44 million bpd.
- WSJ data: big wells in the Permian are becoming harder to find.
- Pioneer Natural Resources CEO Sheffield: “The aggressive growth era of US shale is over,”
Returning to China. On top of being a peacemaker in the Middle East, Xi recently visited Putin at the end of March and, in showing public support for him, has bound the two countries closer together. Now Putin really needs China as it is the main major power which continues to give him validity. We are sure that Xi is extracting his pound of flesh in return for this support including buying cheap oil in yuan, rather than US Dollars.
Xi also had a surprise call with President Zelensky of Ukraine and if Xi manages to bring Russia and Ukraine to the negotiating table, it will be a huge diplomatic coup for China and raise its standing globally. We have mentioned before that certain parties did not seem to want the war to end or to have a negotiation so we shall see how this offer is received. While a small probability, let’s hope for something to end this stalemate so people can stop dying.
BBC April 28th
Ukraine’s Zelensky holds first war phone call with China’s Xi
Ukraine’s Volodymr Zelensky says he has had a “long and meaningful” phone call with China’s Xi Jinping, their first contact since Russia’s war began.He said on Twitter he believed the call, along with the appointment of an ambassador to Beijing, would “give a powerful impetus to the development of our bilateral relations”.
China confirmed the call, adding that it “always stood on the side of peace”.
Unlike the West, Beijing has sought to appear neutral on the Russian invasion.
He referred to President Vladimir Putin as his “dear friend”, proposed a vague 12-point peace plan and insisted that China stood on the right side of history.
Within days of the visit, President Zelensky invited the Chinese leader to visit Kyiv for talks, noting they had contact before the full-scale war but nothing since it began in February 2022.
In a readout of Wednesday’s phone call, China quoted President Xi as saying that China, “as a responsible majority country”, would “neither watch the fire from the other side, nor add fuel to the fire, let alone take advantage of the crisis to profit”. That statement appeared to be a swipe at China’s biggest international rival, the US, which has provided the most help towards Ukraine’s response to the Russian war.
In Japan, we had the new BOJ’s Governor’s first policy meeting. Prior to the meeting, he dampened any chances of a change in policy but left the door open to changes if inflation picked up.
BOJ’s Ueda vows to keep rates low for now, signals chance of future hike
Reuters 25th April
TOKYO — Bank of Japan (BOJ) Governor Kazuo Ueda on Tuesday stressed the need to keep monetary policy ultra-loose for now, but signaled the chance of raising interest rates if inflation and wage growth overshot expectations.
Ueda reiterated the need to keep Japan’s monetary policy loose to achieve the BOJ’s 2% inflation target in a sustainable, stable fashion accompanied by wage hikes.
“But if wage growth and inflation accelerates faster than expected and warrants tightening monetary policy, the BOJ stands ready to respond such as by raising interest rates,” he said.
Lo and behold, three days later we had the following economic news:
Reuters April 28th
Consumer inflation in Japan’s capital accelerates, keeps BOJ under pressure
- Tokyo core CPI rises 3.5% in April yr/yr, beats forecast
- Core-core CPI rises at fastest annual pace in four decades
- Data highlights broadening inflationary pressure
The core consumer price index (CPI), which excludes volatile fresh food but includes fuel costs, for Tokyo rose 3.5% in April from a year earlier, government data showed on Friday, faster than a median market for a 3.2% rise and well above the BOJ’s 2% target. It accelerated from a 3.2% increase in March.
The core-core CPI, which strips away both fresh food and fuel costs, rose 3.8% in April from a year earlier, pacing up from a 3.4% gain in March, the data showed.
The core-core index, which is closely watched by the BOJ in gauging trend inflation, rose at the fastest annual pace since April 1982, when it rose 4.2%.
It is clear, to us at least, that Japan is fighting a losing battle. We have stated our view that inflation is structural not transitory, and it is difficult to see how the Bank of Japan will get out of this conundrum where their stated inflation target is 2% while inflation is printing at 3.5% and accelerating. Something will have to give, but it may be that the cyclical downturn in the US and the resultant drop in global interest rates will buy some time for Japan temporarily. In the meantime, we continue to like Japanese stocks as the constant intervention in the bond market creates liquidity for the stock market. (See Commentary #2 for details).
Finally, Gold. The comments we made in our last two commentaries bear repeating:
“Now Gold’s move is not surprising to us. As we have mentioned before, gold performs well in the bust phase of the economy as two things usually happen, the first of which is an increasing lack of confidence in central banking and the financial system while the other is a reduction in real interest rates.”
“gold continues to do well, in fact close to going to new nominal highs. We repeat: Buy more if there is a correction to USD1900-1930 and you do not have your required weighting.”
The main changes to the thematic portfolio for May will be an increase in the type and number of shorts in the US. We believe people will continue to crowd into US mega cap tech stocks in the short term so we will spread our shorts out into financials, industrials and real estate. At some point, reality will hit those mega caps as well, but we will likely need more pain elsewhere first.
There are a number of potentially negative catalysts on the horizon for the US economy with a recession being sped up by the banking issues, earnings reports from some of the mega cap tech companies, as well as the debt ceiling and government spending cliff which, as previously noted may get down to the wire. If/when the debt ceiling gets raised in the US, this will result in the Treasury issuing a huge amount of new debt which will draw liquidity from US markets as the Government fills up its coffers, the reverse of what happened in January when liquidity was released and provided a boost to markets.
We will also take note of the continued geopolitical tensions and reduce HK and increase Japan – please see Commentary number 2 for the reasons we like Japan
We recently returned from a visit to India after a 4-year hiatus and we liked what we saw. We will discuss this in the next commentary, but we will start a small position in India. Small, because as per usual the market is expensive because it has a great story and fundamental backdrop. We talked about the huge outperformance of India vs China in an earlier commentary and the potential for rotation by Emerging Market Specialists into the latter out of the former, which is partly why we hesitated to be invested in this market.
We will choose an ETF which is mid and small cap focused as we believe there is more value to be found there. In addition, after discussion on this topic with an old colleague and very good investor, we have added a position in Fairfax India. This is a holding company listed in Canada which invests in public and private companies in India. It is run by the so-called “Warren Buffett of Canada.” We would normally avoid any person or stock being “the next…” or the “Warren Buffett of…” as these kinds of labels can be poisoned chalices as they are given usually at the peak of someone’s success, but he has been labelled this for a long time and we like his investment approach.
As usual, changes are highlighted in red below.
Until next time,
