5th October 2023
September 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.
The big story was the continued sell off in the US government bond market. We discussed the state of that market in Commentary #18 and we won’t repeat it all here, but this is now the third year in a row that bonds are down, which is unprecedented, going back 100 years. There are many implications of this, and we shall discuss some below but the sell-off in the world’s “risk-free rate” obviously impacted our themes and portfolio performance with precious metals getting sold off hard as real rates rose.
Please see the Themes section of the website for a breakdown of our current investment themes.
US equities finally felt the effects of gravity and sold off also in September as rates rose. Emerging Markets were hit, but interestingly by less than the US, while energy continued to perform well, even as the USD rose (which traditionally impacts commodity prices).
The thematic portfolio performance is detailed below and was up very slightly for the month. As we said at the beginning of the year, bear markets are hard, even if you recognise that one is occurring and so not losing money in a month like September is satisfactory for us.
The main drag on the thematic portfolio was the precious metal positions. We were too sanguine on the impact of higher rates on that market as we thought that the metals would see through rates today and note the inflation returning and look at the future. As we noted previously:
“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.”
We still believe that, and we will be increasing our allocation to precious metals over the next month if they get sold off more. If we had to guess the next outcome, we would envisage some sort of corrective bounce in bonds and then an increase in inflation expectations which would reduce real rates and put a bid under precious metals..
The below chart shows the performance of US 10 Year bonds (yellow), Gold (blue) and the Nasdaq (red). Circled are the highs in bond yields and the concurrent lows in Gold and Nasdaq in October 2022. We can see that during September bonds fell below that level and this really started to impact gold especially but also equity markets.
Now Nasdaq itself is holding up better than the broad market indices as people are moving into the safety of the “Magnificent Seven”, which is the current buzz word for describing the tech giants, but the other rate sensitive parts of the US stock market are getting hit as can be seen in the thematic portfolio, where we are short real estate and financials.
The impact of the top 7 stocks mean that the S&P 500 is up around 11% for the year. An equal weighted index of those same stocks which reduces the impact of the bigger stocks is actually down for the year, showing once again that the average stock is not doing well. This can also be demonstrated by looking at the Russell 2000 which is an index of smaller domestically focused names. From the peak for this cycle in November 2021, the Russell 2000 (blue) is down over 28% while the S&P 500 is down “only 13%”
The average stock is down a lot more than the headline indices. We think this will get worse over the following weeks. It seems that more investors are starting to see the cracks in the US system, as we pointed out previously:
“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.”
As we have also been noting, the USD is continuing to strenthen against most other currencies and as we commented in #19:
“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. So we are content to hold our UUP position as this unfolds.”
Our dollar position helped defray some of the losses from the precious metals.
Now what about energy? Part of the strength in the energy complex are the production cuts by Russia and Saudi Arabia.
Saudi Arabia extends oil production cut even as US gas prices hit nine-month highs
CNN Thu August 3, 2023
New York CNN —
OPEC leader Saudi Arabia is extending its oil production cut for at least another month in a move that threatens to drive gasoline and other energy prices even higher.
An official source from the Saudi Ministry of Energy told state-run news agency SPA Thursday that the kingdom will extend this voluntary cut of one million barrels per day for the month of September.
The source told state media the cut could be extended further and the move is aimed at supporting the stability and balance of oil markets.
It’s the second time the kingdom has extended the cut, which was first announced in June after a meeting of the alliance between Organization of the Petroleum Exporting Countries, Russia and other smaller producers.
At almost the same time, Russia announced plans to cut oil exports by 300,000 barrels per day, in September according to Reuters.
Now production cuts have been announced earlier in the year and yet had limited impact on price beyond the very short term, yet now the situation is different. For a start, the US relentless selling of oil from its Strategic Petroleum Reserves (SPR) is coming to an end. We can see that levels are back to 1985 levels when they were just starting to be built up after the 1970’s oil shock. The consensus is that this oil was released to reduce inflation and the political noise it was creating as well as potentially to reduce revenue going to Russia.
In our opinion, all it did was allow China and India to buy cheap oil and build up their own reserves.
Looking at the one-year chart of oil below, we can see that since bottoming at the end of June, it is up approximately 20%. Now the risk is that Biden has shot his load as 2024 is a Presidential election year and it will be difficult to replicate the massive amount of oil that has been released from the SPR so gas prices and inflation may be higher than he or the American public would like.
Now, the general view is that oil demand will drop in a recession and indeed we have shared that view which is part of the reason we didn’t have a bigger allocation to energy despite being extremely bullish for the reasons mentioned in previous commentaries. It may be that due to the differing dynamics this time around, oil will increase as money moves into hard assets. It was no coincidence that as the US market started pricing in no rate increase in September, that oil started moving up even as bond yields and the dollar moved up.
Turning to Hong Kong/China – for the first time in a while the markets were hardly down which in this environment is pretty amazing. We have noted previously on many occasions the constant negativity on China from the Western media and indeed Western investors with the issues being thrown out ranging from China collapsing due to its property bubble bursting to China invading Taiwan. In 25 years of following Asian markets, we have never seen such negativity all while the biggest benchmark in the financial world, US bonds are down 19% from their recent peak in December 2022, down 50% from their 2020 peak, and exhibiting a lot of volatility which they are not supposed to do.
This will or already has created a lot of issues for any investor who owns long term Western government bonds. Think pension funds and insurance companies. This to me is the bigger story. As an example, if China was really collapsing, that would unleash a deflationary wave across the world which is maybe what the West wants? If China really were to invade Taiwan, together with the subsequent sanctions against China, would the US stock market be as strong as it has been until recently? In our opinion these are just strategies to force investors not to invest in China and it is currently working while creating an opportunity in undervalued assets. It may just be that there are very few international sellers left for those markets and October may be the capitulation flush.
Portfolio changes? This is what we said last month:
“Right now, we believe equity risk is very high so we are not increasing our exposure to any other sector”
This still remains the case and there are more flashpoints now with the Japanese yen close to 150, a level which has forced intervention by the Japanese authorities previously. Japanese Government bonds are following their global counterparts higher although at 0.77%, they are not yet breaking the “bank.” Still the direction is unnerving for the Japanese which have the highest debt to GDP ratio at 230%. Any moves to let rates rise further would cause the yen to strengthen and capital to be repatriated to Japan causing mayhem in global markets.
As risk has ramped up we will increase our short positions in the West, increasing the US shorts and adding some European names to spread the risk. We anticipate lower prices this month and depending on how things pan out we will likely make changes mid-month. In a full-blown sell-off, many if not all stocks will get sold off to differing extents given the inherent beta in equities. This includes Energy, Japan and India which we will increase on a deeper sell-off as we have already mentioned for precious metals. Changes highlighted in red.
October Thematic Portfolio
Until next time,
