5th June 2023
May 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 then the thematic portfolio performance.
Most of the markets we track were down for the month, with the exception of Japan, Nasdaq, and the dollar. We will discuss these later in this commentary but as we noted last month regarding the Nasdaq:
“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 and real estate. At some point, reality will hit those mega caps as well, but we will likely need more pain elsewhere first.”
Hong Kong was particularly hard hit, and the market appears to be unable to catch a bid.
Please see the Themes section of the website for a breakdown of our current investment themes
As per the markets, our themes similarly had a hiccup this month with some consolidation in precious metals, and a continued sell off in cyclical names. Bright spots were our hedge long dollar position and our US shorts (apart from Nasdaq), while Japan continued to shine.
The thematic portfolio performance is detailed below and gave up just over 1% for the month. While we would love to make money every month, it is unlikely to happen especially as we only update the portfolio every month which isn’t always suitable in volatile markets. A reminder: generally, positions should be scaled into and out of on strength and weakness, rather than in or out 100%, if one has the time and inclination to do so.
Our themes were generally down with the exception of Japan which is riding high on geopolitical concerns, an easy monetary policy (in contrast to a lot of the world), as well as decent valuations and changing corporate governance. China/HK continues to suffer negative news flow and an absence of foreign institutional investment. We still have a position but less than when we started the year as we still believe the value is there and the sentiment is even more depressed.
Gold was also hit this month after coming close to its all-time high. This, in our opinion, is normal corrective behaviour as bond yields and the dollar both rose. The comments we made in previous commentaries, still stand:
“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.”
We will be increasing our allocation to gold this month as we believe we continue to be in the bust phase of the economic cycle, at least in the West, and lower real interest rates are coming.
Oil and other Energy stocks didn’t perform that well as the ongoing recession in the US becomes clearer. As we have repeatedly said, this is the biggest risk to any commodity/cyclical position. We covered the investment case for certain commodities in Commentary number 4, but the below extract bears repeating:
“The overarching backdrop is that there has been a prolonged lack of investment in new supply for both fossil fuels and also for new mining projects. This lack of investment is due to both investors having been burnt in previous cycles as well as the ESG movement.
This lack of new supply is coupled with a huge demand for both energy and certain metals, both to keep the economy on its current trajectory, but also, somewhat ironically, to transition to a green future. On top of this is the new world order (pushed into the limelight with Russia’s invasion of Ukraine) where new alliances are being created and energy and food security will potentially trump the environmental agenda in the short term.
While long term very bullish, we are currently hesitant to make this theme a much bigger position than say 10-15% of any portfolio (at a maximum position, we would have 30% of a portfolio in energy, metals and food/agriculture), due to our belief that the US is in the early stages of, or soon to be in a recession, which could hit demand and hence prices in the short-term.”
We are still not ready to increase the allocation to energy at this time as we are waiting for a bigger sell-off and the final show to drop of it being crystal clear that global demand is dropping. As a reminder, global oil demand dropped only 2% in 2008, the biggest financial and economic crisis of most people’s lifetimes. The supply situation is very different this time around -there is very little spare capacity on the supply side and very little investment in new production over the last 8 or 9 years – which is why we have maintained a core position.
“Other Commodities” similarly traded poorly with fertilizer stocks particularly hard hit. Earnings came out below expectations but given the majority of analysts don’t actually analyse anything, this is irrelevant in the medium term as much as it hurts in the short term. Reading through the earnings transcripts, the bottom line is that prices went up a lot (partly due to the price of natural gas which is a big part of the cost of nitrogen-based fertilisers which in turn is the majority of fertiliser used globally), this hurt demand and thus prices came down. This can happen once but then the reverse happens where because of the lack of fertiliser application, crop yields come down and prices go up which means more fertiliser is demanded. This is the usual way things work.
As we said when we discussed energy earlier in the year, we are in a long term bull market but that a lot of the equities would be seeing decreases in earnings (albeit at a high level and generating lots of cash) which would not contribute to stock price momentum – the same is true here. We didn’t expect such a dramatic reaction but at a 0-5% position, it is manageable.
These stocks now trade on 5-6X earnings and are on long-term support (for those of you with a technical bent), so we will stay the course and increase slightly taking advantage of the sale.
So let us have a brief look at what happened in May.
The biggest event, if you read a lot of financial press is the debt ceiling limit in the US. In our opinion this is a manufactured crisis due to political posturing and has no bearing on the longer-term issues. A deal will be agreed which will cut spending to “only” $4 trillion and the world will move on. Will politicians in the US suddenly find fiscal prudence or will it just be a lot of talking and no action with a continuation of bread and circuses? We think it will be the latter. As we mentioned in our last commentary, the resolution of the debt ceiling will actually be negative for liquidity as the government issues lots of new debt in order to refill its coffers. Although it should be noted that this has been well flagged so may be a non-issue.
China released poor data in April which didn’t help the investment case for the country, with a recent Bloomberg article highlighting the problem:
Recent data suggest gross domestic product growth this year will be closer to the government’s target of about 5%, contrary to expectations of a large overshoot formed earlier in the year. The figures also show a lopsided rebound that’s being led by consumer services, while industrial activity lags far behind.
Expectations were formed that China would rebound like a lot of Western economies but as we said earlier in the year and repeated below:
“It may have been that the market ran ahead of itself, and investors have been disappointed by the “reopening recovery in China.” There are a few things to note here, however. China didn’t follow the Western playbook of giving much financial support to businesses or stimulus cheques direct to consumers, or paying furloughed workers to keep businesses afloat, so after three years of lockdowns, the proverbial Mr. and Mrs. Wang are not in the best of spirits, and it will take time to get those spirits back up especially given the speed of the change from total lockdowns to zero restrictions.”
Consumer activity is doing much better than industrial and as the latter is a much larger part of the economy and there are worries about a Western recession, the overall outlook for China is not positive in investors’ eyes:
WSJ. 15th May 2023
Why Some Investors Are Betting on China’s Recovery but Avoiding Chinese Shares
Foreign luxury-goods makers are among those getting a boost from the country’s reopening
Global investors wanting to profit from China’s economic recovery are increasingly turning to companies in Paris, Las Vegas and beyond.
They are loading up on shares of European, American and Japanese companies instead of Chinese stocks, as high geopolitical tensions between Beijing and Washington have made it unpalatable for some international money managers to invest in Chinese companies.
“We are seeing an intense focus on buying into the China recovery story, including through European and U.S. companies with revenue exposure to that recovery,” said Jonathan Garner, Morgan Stanley’s chief Asia and emerging-market equity strategist. He said hedge funds overall have been reducing their positions on China as geopolitical risks have risen.
On the other hand, Western business leaders are still going to China to kiss the ring, so they see something there despite the geopolitical tensions:
CNN 31st May
From Elon Musk to Jamie Dimon, CEOs flock to China as risks to trade and investment rise
The CEOs of some of America’s biggest companies are in China this week to take the pulse of one of their top markets after the country reopened following nearly three years of pandemic restrictions.
Elon Musk of Tesla (TSLA), Laxman Narasimhan of Starbucks (SBUX) and Jamie Dimon of JPMorgan (JPM) are among the big names in town.
They follow a string of visits in recent months from the leaders of Apple (AAPL), Samsung (SSNLF), Aramco, Volkswagen (VLKAF), HSBC (HSBC), Standard Chartered (SCBFF) and Kering.
The CEO parade in the world’s second largest economy highlights the importance of China for many blue-chip firms.
The bottom line is that the market is telling us we were wrong, or at least early, which we have to respect and technically, it looks like the Hong Kong market could revisit the capitulation bottom in October 2022. In hindsight, we should have reduced more last month, especially as we entered the lower volume summer months, but at this stage we will keep our allocation and increase it a little.
Japan, on the other hand is in a sweet spot. It is not raising rates and running easy monetary policy, despite inflation running higher than expected. The key here is that the Bank of Japan is focused on real wages, and they are not at their target yet, despite unemployment going lower:
Mainichi Daily May 30th
TOKYO (Kyodo) — Japan’s unemployment rate in April fell 0.2 percentage point from the previous month to 2.6 percent, the first improvement in three months, in a sign of a continued recovery from the coronavirus pandemic, government data showed Tuesday.
Bloomberg May 9th
Japan Real Wages Drop for 12th Straight Month, as BOJ, Kishida Scrutinize Pay
Another weak result in wages adds to BOJ Governor Kazuo Ueda’s argument for maintaining easy policy for now. Falling real wages also point to declining spending power for voters as speculation continues that Kishida is mulling the possibility of an early election.
Clarifying the importance of pay for the central bank, the BOJ added a reference to wages in its policy guidance at the April meeting, Ueda’s first at the helm.
Japan also gets the best of both worlds in that it is a geopolitical ally of the US yet is also seen as a way to play the Chinese recovery (without actually investing in China) and has also not been forced to divest its oil and gas JVs with Russia.
It also is a very cheap developed market (blessed by Warren Buffet himself), with improving corporate governance and shareholder friendliness, albeit at the glacial pace most Japanese observers are familiar with. Hence headlines like the below:
Japan’s Nikkei at 33-year high has more wind in its sails
SINGAPORE, May 23 (Reuters) – As Japan’s stock market sits atop 33-year highs last seen during the country’s ‘bubble” era, investors are bullish that the rally in the world’s third-largest market has only just begun.
Global investors are returning to Japan in 2023 after three straight years of pulling out, with foreign flows into Japanese equities and futures at $30 billion so far this year, according to UBS.
We will stick with our Japan allocation and add on any weakness.
We will increase our allocation to India this month as the continued weakness in China will draw investors there. We will add the India ETF INDA to the thematic portfolio, which covers the blue-chip large caps where foreign investors will go to get exposure to the country. The weakness in oil is also a benefit to India given its large importer status, although as we noted previously, they are buying discounted Russian crude anyway. To that point, it was rumoured that India was paying for oil in rupees which again is very positive for India and we now have confirmation of this.
Bloomberg 1st June
Russia’s Rupee Trap Is Adding to $147 Billion Hoard Abroad
A lopsided trade relationship with India is forcing Russia to accumulate up to $1 billion each month in rupee assets that remain stranded outside the country, swelling the stockpile of capital it’s amassed abroad since the invasion of Ukraine.
A top priority for India is to promote the wider use of the rupee in international settlements. The central bank has suggested that countries accumulating excess rupees from exports can put the funds in local securities including government bonds.
The two countries are discussing various payment mechanisms including investments in India’s capital markets by Russian entities.
It’s an option that initially didn’t find favor with Moscow but is now back on the table as billions of rupees pile up in Indian banks, officials in India familiar with the details said, asking not to be named because discussions were private. Other possibilities include channeling the accumulated rupees into Indian infrastructure projects in exchange for equity stakes.
For Russia, the only acceptable option is to use currencies of a third country, such as China’s yuan or the United Arab Emirates dirham, said people familiar with the deliberations. An agreement is far off since Russia has limited sway in a situation with few alternative buyers to India, they said.
Changing tack, it would be remiss of us to not to mention the latest, (in our opinion), bubble concept in the US. NVIDIA and the whole AI revolution!:
Reuters 30th May
Nvidia briefly joins $1 trillion valuation club
The stock’s value has tripled in less than eight months, reflecting the surge in interest in artificial intelligence following rapid advances in generative AI, which can engage in human-like conversation and craft everything from jokes to poetry.
Last week alone, Nvidia’s shares rose about 25%, sparking a rally in AI-related stocks and boosting other chipmakers. That helped the Philadelphia SE Semiconductor index (.SOX) close at its highest in over a year on Friday.
Now, this together with the continued popularity of zero days to expiration options tells me speculation continues to run rampant in the US market. The stock could well go up a lot more – it probably will, but when it is priced at 37x sales, there is little room for error. Below is a quote from the ex-CEO of Sun Microsystems which was a darling of the 2000 tech bubble, which peaked at 10x sales:
“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”
The stock started at $5, ran all the way up to $64 and then completed the round trip to $5 from 1996 to 2002.
Before we go, just a reminder of how we think things will play out as the slow-motion credit crunch continues its inexorable path. We continue to believe that stress will show up in the private debt markets as well as private equity and venture capital where lots of investments were made assuming zero or very low cost of capital. With easy credit, it is easy to boost returns for equity holders in PE & similar structures. But as we are starting to see, the bodies are coming to the surface. We previously highlighted the gating of Blackstone’s real estate fund, but we are likely to see more headlines like the Envision story below. When you cannot refinance your debt and the value of your assets has gone down, that’s where the rubber meets the road….:
FT 30th May
Private equity-backed Envision Healthcare files for bankruptcy
Envision Healthcare filed for bankruptcy on Sunday just five years after it was taken private by KKR in a blockbuster leveraged buyout that valued the physician-staffing company at $10bn
As capital dries up amid sharply higher interest rates, companies have been increasingly forced into court-led restructurings. KKR’s initial $3.5bn equity investment is expected to be wiped out in the restructuring as senior lenders take over the company, according to the terms of a settlement agreement reached between Envision and its creditors.
S&P Global Market Intelligence March 23
Private equity portfolio companies on track for most bankruptcies since 2020
Private equity portfolio companies in the US are on track in 2023 to see the highest annual number of bankruptcies since 2020, as rising interest rates and an uncertain economic outlook force tough decisions.
There were 143 US companies that filed for bankruptcy protection in the first 75 days of the year, including 16 companies with private equity or venture capital backing, according to an S&P Global Market Intelligence analysis.
If the current pace continues, bankruptcies by private equity portfolio companies will be on track to total nearly 78 by the end of 2023, more than double the totals in 2021 and 2022 and the second-highest number of portfolio company bankruptcies in more than a dozen years.
This will take time to play out as many companies would have (or at least should have) termed out their debt, meaning they would have refinanced in the heady days of zero rates and easy credit in 2021 and 2022. But the clock is ticking….
WSJ May 16th
Venture-Fund Returns Show Worst Slump in More Than a Decade
For the first time in more than a decade, returns for venture funds were negative for three consecutive quarters last year, according to research firm PitchBook Data, as investors finally began to mark down startups that had ballooned in value. Initial data for the fourth quarter also show a negative quarterly return.
The data also show that the yearly internal rate of return hit minus 7% in the third quarter—the latest data available for that measure—the lowest value for those three months since 2009. The internal rate of return is used to measure the profitability of venture funds on an annual basis and is a key performance metric used by the industry.
The decline marked the fifth consecutive quarter of deteriorating yearly rates of return—the first time this has happened in a decade—and was also the only negative rate of return among seven investment categories tracked by PitchBook, including private equity and real estate.
In terms of portfolio changes, we are going to make a slight increase in other commodities and remove IPI (a lower quality fertiliser stock) while increasing our allocations to precious metals (adding physical platinum) and an increase in India by adding a large cap ETF. We are also a glutton for punishment so we will increase HK/China a little as the valuations are just too cheap to ignore. Changes are highlighted in red below:
June Thematic Portfolio
Until next time,
