3rd November 2023
October 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.
As can be seen above, it was generally a sea of red across most markets and asset classes. The exceptions were gold and the US Dollar.
The comments from commentary #20 still apply:
“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 50 years. *“
*Corrected from 100 years.
What didn’t happen this month, as opposed to September, was that there was no gold and precious metals sell off, even as real rates rose. Now partly this was due to a reversion of the sell-off it endured in September and partly due to the war going on between Hamas and Israel. Usually, a war premium doesn’t persist for gold but given the oversold nature at the end of the September, the picture is more muddied.
Please see the Themes section of the website for a breakdown of our current investment themes.
In terms of themes, our US shorts, precious metals and energy made money while the equity markets we are long got hit and “Other Commodities” got really hit.
The thematic portfolio performance is detailed below and we had some single stock hits which meant we lost 0.52% for the month. We wrote the below last month (and in hindsight we should have been more aggressive in reducing our positions or increasing our shorts):
“Right now, we believe equity risk is very high, so we are not increasing our exposure to any other sector.
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.”
However, despite not shifting as quickly into a defensive posture as might have been warranted, being long nearly 80% when most markets are down 3-5% and losing 52bps is manageable.
Hong Kong/China did its usual thing and sold off, but at least it was in good company this time with Japan and India, two top performing markets this year, also selling off. We discussed Hong Kong/China again in commentary #21 as part of reassessing all our current themes. After listing out all the reasons to be negative on the market, we said:
“Reading all that and one couldn’t be blamed for not wanting to invest in China, but at some point the pendulum swings too far the other way. Looking at the 20 year chart of the Hang Seng Index below, we could make the assumption that a lot of the above is priced in. You have a very interesting set up where sentiment is extremely pessimistic, the valuations are very supportive (though of course it could get cheaper) and a lot of capital has already fled the market. Any change in the above list or even less bad economic data could trigger a sharp rally.”
We stick with this view.
In Japan, we had one stock, Komatsu perform very poorly down 14% for the month and 22% since its mid-September peak. which was a big drag on the thematic portfolio. It appears that the company didn’t increase its earnings forecast as much as analysts’ estimates. We will monitor this but it looks like the damage is already done and the underlying thesis of a company leveraged to mining spend is intact, but we will adjust Japan exposure this month and remove the stock.
Fairfax India fell 6% which was also unexpected but as a holding company for private and public Indian investments it may be hard for many investors to understand. They recently announced a buyback of just under 5% of the company saying the shares “represent an attractive investment opportunity and that purchases under the bid will enhance the value of the subordinate voting shares held by the remaining shareholders.”
They also bought back just under 3 million shares in the last 12 months.
We discussed India in commentary #12 and Fairfax India in #11
Energy as a theme performed well for us this month despite a couple of hiccups with XLE down 5.8% and our offshore drillers down 11.7%.
We wrote the below when we discussed the latter sector in commentary #19 and it was truly evidenced this month!
“This is a volatile sector so will have big swings up and down but the end result should be rewarding. A less volatile way of playing this sector is the ETF OIH but is dominated by a couple of big onshore players like Haliburton and Schlumberger which make up 30% of the ETF.”
XLE is dominated by Exxon Mobil and Chevron which make up 40% of the ETF and Exxon Mobil announced a takeover of Pioneer Natural resources an independent oil and gas exploration company for $59.5B in stock and this may have been the reason for the weakness.
Conversely, this helped our Natural gas positions as investors speculated that these smaller companies would get taken over. In fact, we believe that this will be the case. The impact of making it harder for energy and mining companies to explore means that larger companies will buy smaller companies to add reserves. We believe this is likely across many commodities. It should be noted that this does not increase overall reserves or supply.
Barron’s 11th October 2023
Acquiring Pioneer will jumpstart Exxon’s U.S. production growth, more than doubling its output in the Permian to about 1.3 million barrels a day. Exxon’s U.S. production has declined recently.
“U.S. production volumes have actually been negative for the past four quarters–a stretch not seen since 2018,” noted Peter McNally, global sector lead for industrials, materials and energy at Third Bridge.
Reuters October 5th
Teck aiming for coal, metals business separation announcement by end of 2023, says CEO
Teck has been weighing a sale of its coal business as part of a comprehensive business review, which was sparked by a takeover bid by Glencore (GLEN.L) earlier this year. Among suitors for a stake in Teck’s coal unit is India’s JSW Steel Ltd (JSTL.NS), Reuters has reported.
Australian Financial Review October 12th 2023
Exxon’s historic shale deal signals new wave of oil mergers
The shale sector is a hotbed of consolidation talk as cash-rich oil companies compete for the best drilling portfolios in the Permian Basin, North America’s biggest source of crude.
“People are definitely going to run out of inventory over the next several years,” Pioneer chief executive Scott Sheffield said during a conference call just two months before details of the Exxon deal surfaced. That dynamic “should lead to extreme consolidation”.
“We’re going to be very cautious on M&A,” Cotera Energy CEO Thomas Jorden said during a May conference call, adding that the company “would love to find a transaction” that adds value. “But quite frankly, a lot of the assets out there have peaked production.”
We are going to add PSCE to the model portfolio this month, replacing XLE. This ETF tracks the performance of the S&P small cap Energy index and is effectively a double play on higher energy prices and consolidation in the sector.
Turning to precious metals, we wrote last month:
“… 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.”
As we mentioned at the beginning of the commentary, we believe there is some war premium in the gold price which usually gets unwound and so we will wait for that to happen to buy more, but if it doesn’t happen, we will increase our already decent position after it breaks to an all time high in nominal terms.
Looking at the 5 year chart of gold below you can see it has hit $2030-$2070 three times already. There is a saying in markets that there are “no triple tops”, which generally means that the more times a resistance level is tested, the more likely it is that it will break through that level.
Now what will it take to propel gold to a new all-time high? As we stated a few months ago:
“…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.”
Two things happened this week which are key to this.
Firstly, the below from Bloomberg:
Powell Hints Fed Is Done With Hikes in Pivot Cheered by Markets
Federal Reserve Chair Jerome Powell hinted the US central bank may now be finished with the most aggressive tightening cycle in four decades after it held off on raising interest rates for a second consecutive policy meeting.
Secondly, the below from CNBC regarding US Treasury debt issuance:
On Monday, the department said it would need to borrow $776 billion in the current quarter and $816 billion in the first quarter of calendar 2024.
This was lower than market estimates and they also said that would be it for the time being taking some pressure of bonds. The Treasury then announced a change in the mix of longer dated bonds and shorter dated bills, meaning less issuance on the long end while more at the short end.
What this means in the short-term is that the pressure on the equity markets from higher bond yields will abate for the moment and together with the sell-off in September and October, means we will likely get a rally into the year end, before economic reality hits next year as the long-awaited US recession finally come home to roost.
On that note, most of the increase in GDP in the US over the last few quarters has been due to government spending, while your average consumer is struggling. We can illustrate this in a few charts:
The retailers ETF, XRT, down 40% in two years:
The Russell 2000 index, representative of the domestic US economy, down 30% over 2 years
As we said last month:
“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…”
“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.”
You can see credit card delinquency rates rising from a low level but the trend is clear as rates have risen (the below chart is until April 2023)
We believe that short-term flight to safety in bonds is either beginning or starting soon and as stated above, will cause a relief rally in equity markets.
We will make some tactical changes in the portfolio, reducing our shorts in the US and Europe especially interest rate sensitive shorts of real estate and financials. We will cut overall exposure to Japan a little by removing the more cyclical Komatsu and will increase our “Other Commodities” exposure with MSOS.
MSOS, is the ETF covering Cannabis shares in the US. There was a craze for these stocks at the same time as the SPAC boom as states started legalising recreational Cannabis and dispensaries opened up to service this legal demand.
You can see below how this ended up. The sector as represented by this ETF is down 90%. Now whenever a sector is down 90%, it piques our interest and it is worth at least a look.
Let’s look at a shorter 1 year time frame below:
The ETF was trundling along around $5 and then in the space of 1 month, it rallied 80% to $9, before giving back most of the gains. So what happened? Two related things. The first is related to the fact that cannabis is still illegal at the Federl level and so these companies are not allowed to use the traditional banking system. In addition, many institutions cannot own these stocks because of the Federal illegality.
There have been waves of hope that this would change and actually in September the below happened:
Cannabis banking legislation moves forward in US Senate
Sept 27 (Reuters) – A U.S. Senate committee on Wednesday voted to advance a marijuana banking bill, raising hopes for the cash-dependent cannabis sector to get access to regular banking services.
The Secure and Fair Enforcement Regulation Banking Act (SAFER) bill, introduced by a bipartisan group of senators last week, will now move to the Senate floor.
Most banks in the country do not service cannabis companies as marijuana remains illegal at the federal level despite several states legalizing its medicinal and recreational use.
The new bill seeks to ensure that all businesses — including state-sanctioned cannabis businesses — will have access to deposit accounts, insurance and other financial services.
The usual politicking means back and forth as different senators stick their noses in the trough, but the legislation moves on…
Forbes 3rd October
A bill to give the regulated marijuana industry access to basic banking services was amended before being approved by a Senate legislative panel last week, with several of the changes designed to appease opposition from Republican lawmakers. The legislation, known as the Secure and Fair Enforcement Regulation (SAFER) Banking Act, was introduced on September 21 and was approved by the Senate Committee on Banking, Housing and Urban Affairs with amendments on Wednesday.
The second (we believe related) event happened in September
Bloomberg August 31st
US Health Officials Urge Moving Pot to Lower-Risk Tier
US health officials are recommending easing restrictions on marijuana, a move that sets the stage for potentially expanding the cannabis market across the country.
A top official at the Department of Health and Human Services wrote Drug Enforcement Administration head Anne Milgram calling for marijuana to be reclassified as a Schedule III drug under the Controlled Substances Act, according to a letter dated Aug. 29 that was seen by Bloomberg News.
A DEA spokesperson confirmed the department had received the letter with HHS’s recommendation. With final authority to reschedule a drug, DEA will now initiate its own review, the spokesperson said.
Biden rolled out new initiatives focused on easing penalties associated with marijuana use in October, pardoning all prior federal offenses of simple possession and urging governors to do the same with state offenses. He also asked the HHS secretary and the US Attorney General to review how marijuana is scheduled based on its medical use, potential for abuse, safety and potential for dependence.
We are not here to debate the ethics or morality of these moves and frankly we are extremely surprised this is going on, given how politically charged the issue is but with the sector down 90% and two very important catalysts potentially happening, it is worth a speculation at this time.
Thematic Portfolio changes highlighted in red as usual.
November Thematic Portfolio
Until next time,
