5th September 2023
August 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.
Looking at the chart above, we can see that most markets were down with the exception of the US Dollar, in a reversal from last month’s market performances (See Commentary #17)
Our theme performance is shown below and it can be seen that themes focusing on short US equities, long USD and long energy worked last month, while everything else gave back some of last month’s gains.
Please see the Themes section of the website for a breakdown of our current investment themes.
The thematic portfolio performance is detailed below and was down 1.2% for the month.
The two main drags on the thematic portfolio were the HK/China positioning and the sell-off in US government bonds which impacted many other markets.
If we look at bonds first, it should be noted that a rating agency downgraded US debt on 1st August 2023.
Fitch Downgrades the United States’ Long-Term Ratings to ‘AA+’ from ‘AAA’; Outlook Stable
KEY RATING DRIVERS
Ratings Downgrade: The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.
Now Fitch is the smallest of the three major ratings agencies, and when the announcement first came out, bonds had already been selling off, as can be seen in the chart below of TLT, an ETF holding 20 year US government bonds. In fact, Fitch had warned about this in June but it didn’t make much headway in the press.
Despite being not that influential, Fitch had come out and said what a lot of investors are thinking. The US is on an unsustainable fiscal path, especially with interest rates rising, and there appears to be a huge divide politically in the country which as they noted has led to an erosion of governance.
We believe there are a number of things going on in US bonds (many of which can apply to other developed nation bond markets) and in no particular order, they include:
The freezing of Russia’s FX reserves and the ongoing weaponization of the USD means many foreigners are not interested in buying USD bonds. Whether by design or due to economic flows, the two biggest foreign holders of US debt, Japan and China have reduced their holdings by around 20% over the last year alone.
As interest rates have risen, the overall fiscal position becomes worse and it is projected that interest payments alone will rise to $1 Trillion dollars a year in the fiscal year 2025. (from October 22 to June 23, interest on the debt was $650 Billion dollars). This would mean the US spends more on interest than everything else apart from Social Security, and that includes defence spending.
While reported inflation numbers are coming down, we have noted previously that we are likely in a phase of secular inflation and this is a pause before inflation starts accelerating again. As we noted last month, talking about July:
“Crude oil, the core building block of most of the modern world is up 18% in the last month.
The CRB index, which measures a broader basket of commodities is shown below. Up 7% in the last month.
The price of commodities feed into producer prices (PPI) which eventually feeds into consumer prices (CPI), so while we may have some reprieve on the reported inflation numbers, it is a matter of time before they start ticking up again. “
Inflation is not good for bonds.
After the debt ceiling was raised in the US, a huge supply of bonds came onto the market as the Treasury had to fill its coffers.
As we noted in commentary #14
“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. “
The US issued around $600 Billion of bills (short dated bonds) in 2 months and it is estimated they will issue another $500 Billion in the next 3 months. Now this didn’t actually impact liquidity in the stock market, but it did appear to push bond prices down. Now usually, when there is so much issuance, it is because the US is in, or entering a recession and so there is a natural demand for bonds. Not this time. Most investors consider the US will be in a soft landing, which translates into no recession and continued growth and this is evidenced by the continued “risk-on” move in the markets. The current poster child for this, is as we mentioned previously, NVIDIA. Exhibit A showing the 255% gain in the stock over the last one year and the near vertical move in the last month.
There are also other symptoms of speculative mania in the US we have mentioned previously such as the proportion of 0DTE (same day options) hitting >50% of all options traded.
So, with continued fiscal deficits (when the times are apparently booming) and massive new bond issuance (together with the Fed no longer buying bonds and actually selling them or at least not reinvesting the proceeds when maturing) and with reduced demand for bonds from foreigners, and domestic investors focused on the current AI bubble and inflation potentially reaccelerating, the outlook for bonds doesn’t look good. When the long-awaited recession finally hits (which we think it will), there may be a short-term flight to safety to bonds but the longer-term outlook is very poor and we would not want to own long dated government bonds.
The article below spells it out.
Washington Post 3rd September 2023
U.S. deficit explodes even as economy grows
A strong economy usually reduces the deficit. Not this time.
The federal deficit is projected to roughly double this year, as bigger interest payments and lower tax receipts widen the nation’s spending imbalance despite robust overall economic growth.
Given the unsustainable fiscal situation and the political divide in the US as well as the inability of politicians to take any short-term pain (like cutting expenditures), we believe the likely outcome is either a fudging of the inflation target so rates can be held steady not continue rising or we have a Japan like situation where yield curve control is instituted. Neither of these is good for bond holders but extremely positive for precious metals.
One immediate impact of higher bond yields is strength in the US Dollar. We discussed this last month after noting the following Bloomberg headline on the 16th July:
Dollar’s Busted Bull Run Has Bears Calling End of an Era
As we noted at the time
“Of course, when these kind of headlines come out and everyone turns bearish, it usually marks a short-term bottom at least. As shown in the chart above, the dollar subsequently rebounded above previous support, now resistance. False breakdowns such as the above are usually a reliably bullish signal so we expect the dollar to rally against the Euro and likely the Pound as well.”
The dollar continued to rally as shown below and the green arrow marks the date of the article.
One of our themes is that we believe the USD will have one more major bout of strength in response to a credit event that is coming as a result of higher interest rates. This is taking longer to play out than expected as some “terming” out of debt happened over the covid years, but it will likely happen. The US housing market is frozen as no-one wants to move and give up their 3% mortgage for a 7% mortgage.
Mortgage Bankers Association 30th August 2023
“Mortgage rates were mostly unchanged last week, with the 30-year fixed rate remaining at 7.31 percent – the highest since December 2000. Treasury yields peaked early in the week and did move lower by the end, which may have spurred some activity,” said Joel Kan, MBA’s Vice President and Deputy Chief Economist. “Mortgage applications for home purchases and refinances increased for the first time in five weeks but remained at low levels. Purchase applications increased but were still 27 percent lower than a year ago, as elevated mortgage rates and tight housing inventory continue to weigh on home buying activity.”
Consumers are taking out record credit card debt
US credit card debt tops $1 trillion, overall consumer debt little changed
Aug 8 (Reuters) – Americans borrowed more than ever on their credit cards in the last quarter, the New York Federal Reserve Bank said on Tuesday, with balances surpassing $1 trillion for the first time even as overall household debt loads were largely unchanged.
Credit card balances rose by $45 billion to $1.03 trillion in the second quarter, the regional Fed bank said in its latest quarterly household debt and credit report, reflecting robust consumer spending as well as higher prices due to inflation, researchers said.
Meanwhile, credit card delinquencies are at an 11-year high, as measured using a four-quarter average, the data showed.
The average interest rate for US credit cards in August is 24.37%. (Source: Lending Tree)
We have also repeatedly discussed the private lending area previously where we believe problems will surface.
So we are content to hold our UUP position as this unfolds.
Higher bond yields and a stronger USD are a traditional headwind for precious metals, commodities and emerging markets. Other than energy, which we comment on below, the traditional effects were felt in those markets!
One Emerging Market in particular was a big drag on performance and it is, drumbeat roll…. China. Now, the constant negative news headlines and economic data continues apace and on social media and many of the “leading” financial news outlets, China is one moment away from imploding due to the real-estate bubble collapsing. Now, really this is not the same as the global financial crisis kick started by the widespread dissemination of subprime mortgages and the associated derivatives. That market collapsed under its own weight.
In China, debt limits were imposed on developers in August 2020 in order to try and slow the expansion of debt and hence risk. They started easing back from those rules in 2021, but with Covid restrictions in full force, not much impact was felt.
Most global investors are used to the big bang fiscal and monetary stimulus measures which have become commonplace in the West (another reason why there is an issue with bond markets there), and so are disappointed with every incremental announcement out of Beijing, as there is no “shock and awe” value. As we have stated, this is by design and whatever one thinks of the Chinese leadership they are acutely aware of the dangers of increased unproductive debt issuance, as well as the Western playbook, which they haven’t followed of stimulus cheques and handouts to people. They have also seen inflation rear its ugly head globally. They, like many developing nations, know the impact of inflation, especially food inflation. People can accept a lot but when people are hungry, they get angry. Examples abound from Tiananmen square (where protests were triggered due to high food prices) to riots in Middle Eastern countries as bread prices rose. So, the Chinese are unlikely to replicate this model.
They are taking incremental steps, as highlighted below but as we have noted previously, it is now about confidence after the lockdowns. That will take time to come back. We don’t believe China is on the verge of imminent collapse, but we believe growth will be slow if not non-existent in the short-term. The question is whether this is all price in or not. We continue to believe a 10-12%% position of HK/China stocks in a portfolio has a good risk-reward at these levels with valuations so low and sentiment so depressed. We will adjust some of our sector picks as the construction and banking sectors this month have been taking the brunt of the sell-off as it is believed the debt hit will be taken by the banks and construction will slow. Some headlines out of China:
BEIJING, Sept 1 (Reuters) – China has rolled out a series of policy measures in recent months to revive a stumbling economy after its post-pandemic recovery fell away quickly, and more steps are expected.
Sept 1. – China is set to take further action including relaxing home-purchase restrictions to try and stabilise its debt-riddled property sector, four people familiar with the matter said.
Sept 1. – China stepped up measures to boost the country’s faltering economy, with top banks paving the way for further cuts in lending rates.
Aug. 31 – China’s central bank and financial regulator issued notices to ease some borrowing rules to aid homebuyers, including lowering the existing mortgage rate for first-home buyers and the down payment ratio in some cities.
Aug. 31 – Major Chinese cities say they will allow people to take preferential loans for first-home purchases regardless of their credit records.
Aug. 25 -China’s cabinet on Friday approved guidelines for planning and construction of affordable housing at a meeting chaired by Premier Li Qiang.
Aug. 21 – China cut its one-year benchmark lending rate but surprised markets by keeping the five-year rate unchanged amid broader concerns about a rapidly weakening currency.
Aug. 15 – China’s central bank unexpectedly chopped one set of key interest rates, and followed it with cuts on other rates hours later.
Aug. 2 – China’s finance ministry unveiled a package of tax relief measures for small businesses and rural households.
July 31 – China’s cabinet issued measures to boost consumption in the automobile, real estate and services sector, aiming to give full play to the “fundamental role” of consumption in economic development.
July 28 – State media quoted the housing minister as saying that China needs to effectively take steps to lower home mortgage rates and down payment ratios for first-time buyers to help spur home purchases. Borrowers in some cities are still waiting for that to happen.
July 24- China’s top leaders, at a Politburo meeting, pledged to step up support for the economy, signalling more stimulus steps. A rare omission of “housing for living, not for speculation” in the official readout fanned expectations of more measures to boost activity in the property market.
July 24 – China’s state planner unveiled measures to support private investment in some infrastructure sectors and said it will strengthen financing support for private projects.
July 21 – The cabinet approved guidelines on transforming “urban villages”, or underdeveloped areas, in megacities, which will help underpin property investment.
July 19 – The Communist Party and the cabinet issued guidelines to support the private economy, pledging to make the sector “bigger, better and stronger” with a total of 31 policy measures.
July 18 – China’s commerce ministry announced a series of measures aimed at boosting household consumption of goods and services.
July 14 – China’s cabinet approved guidelines for improving the building of public infrastructure in megacities, to help support the economy and cope with future public health crises.
June 30- China’s central bank increased its relending and rediscount quotas by 200 billion yuan ($27.86 billion) to support the farm sector and small firms.
June 20- China’s central bank cut its key lending benchmarks, or loan prime rates (LPR), for the first time in 10 months.
Moving onto the thematic portfolio, energy continued to do well with only energy shipping stocks losing ground. This has happened previously when countries have announced production cuts. Less oil produced means less oil transported etc. As we said the last time, this happened, it is a short-term phenomenon and we continue to like the sector (see commentary #7). We prefer oil product tankers based on orderbooks, valuation and earnings outlook so we will remove Golar LNG and add two product tankers North American Tankers and Scorpio Tankers to the thematic portfolio
We now believe the second wave of energy price rises is here and so we will move out along the risk spectrum to invest in offshore drilling rigs and related industries. We will discuss the rationale next time but for now we will add Transocean, Valaris and Tidewater as a sector, while removing UNG.
We will slightly increase Hong Kong/China and add back retail/reopening plays including a cosmetics retailer (Sa Sa), a hotel group (Shangri La) and a jewellery retailer (all of which have been smashed recently as China has disappointed.
Right now, we believe equity risk is very high so we are not increasing our exposure to any other sector, but making the sector changes as highlighted in red below.
September Thematic Portfolio
Until next time,
