2nd April 2023

March 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.

We made changes in the portfolio mid-way through the month and the performance reflects those changes in weightings.

You wouldn’t have known it from the table below, but we had the start of a full-fledged banking crisis in March.

The themes in our portfolio had mixed performance this month with gold/silver and the related equities helping the portfolio gain around 1% while our energy and commodity exposure dragged the returns down.

Please see the Themes section of the website for a breakdown of our current investment themes

We are glad we reduced our exposure part way through the month, but a couple of positions had large losses, specifically our Japanese bank position (no surprises there) and our Natural Gas fund position which got slammed together with many energy related investments.

So what happened in March?

As we noted in our mid-March update, there was what looked like the beginning of problems in the US banking system. These problems didn’t die down and there were a few  standout moves for us in the markets because of this: Gold’s move up as well as the move up in Nasdaq, while cyclical stocks and the Russell 2000 (an index focusing on smaller US companies) fell dramatically.

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.

The lack of confidence is manifesting itself in the bank failures/bailouts/takeunders we have witnessed over the last few weeks. Let us just review that quickly:

Quick summary – deposits were leaving certain US banks due to worries over losses in their bond portfolios and the fact that deposits over a certain amount are uninsured and so theoretically lost if over that amount. This caused a flight of deposits from many banks and is continuing.

As we noted in our Mid March update,  Silicon Valley Bank (the 14^th largest bank in the US by assets) was taken over Federal Regulators on the 10^th March, and the next question was what would happen to the depositors. Deposits are generally insured up to US$250K, but there were huge sums in the bank above this limit, generally held by tech companies and start-ups. For whatever reason, and we believe a lot of lobbying was done by tech companies and VCs who are big donors to the Democratic Party, it was decided to keep depositors whole. The rationale being that if they didn’t do so then there was a risk of contagion to other banks. The shareholders and the management did take the hit which is only right in the current capitalist system purported to exist in the US as that may have been a bailout too far for the public to bear. It’s a much easier sell to say you are saving a small company’s deposit in the bank rather than the reality of companies with negligent CFOs who didn’t  think to sweep deposits overnight into money market funds. Note that none of the bank management had any of their previous gains clawed back, not even the $3.5M of sales made by the CEO and the CFO two weeks before the bank failed.

Techcrunch Mar 15^th 2023

Regulators are looking harder at insider stock sales by SVB execs (which really added up)

The agencies’ apparent focus for now are on securities filings that show the bank’s CEO of 12 years, Greg Becker, and its CFO, Daniel Beck, who joined the outfit nearly six years ago from Bank of the West, sold shares two weeks ago ahead of the bank’s abrupt collapse.

Becker exercised options on 12,451 shares on Feb. 27 and sold them the same day, netting roughly $3 million. Beck sold roughly one-third of his holdings in the company, $575,000 worth of shares, on the same day.

 

In between saying depositors would be made whole and SVB going under, the regulators also took over Signature Bank the 16^th largest bank in the US, as they suffered depositor outflows too. Now if they had announced the deposit scheme first, then Signature bank wouldn’t need to be taken over. BUT, it is a crypto focused bank and with the other major crypto bank Silvergate going under the week before, you could argue that the “powers that be” took the opportunity to take Signature bank out.

 

We believe the message is loud and clear and would not be surprised to see more regulation or even legislation banning crypto. This view may be incomprehensible for many crypto enthusiasts (and I am no expert), but if the Fed doesn’t allow the on and off ramps – ie people using the banking system to get fiat currency in and out of crypto then it makes crypto much less useful. We all know central banks are experimenting with digital currencies of their own and so from their perspective, it makes sense to only have their own so they can track exactly where all the money goes. Let’s revisit this as time goes on.

 

Back to the banking crisis!

The contagion then spread to Europe where Credit Suisse (CS) started suffering huge deposit outflows and received an emergency loan from the Swiss Central Bank (SNB). These actions caused a temporary respite but again banking shares globally start falling and, in another weekend drama, reminiscent of 2008/9, a deal was cobbled together for UBS to take over CS, where a certain class of bond got totally wiped out and the shareholders got a token amount, but no vote in the matter. These two points are quite important and we will come back to them later.

Pressure then was building on Deutsche Bank, that other perennially failing European bank which also started suffering deposit outflows and share and bond price falls. Back in the US, The Fed started a new facility allowing banks to give certain bonds as collateral and receive 100% of the par value regardless of the market value. This was supposed to provide liquidity to banks so they don’t have to sell their bond portfolios to cover any deposit outflows. Deposits continued to flow to the big US banks (JPM, Bank of America etc) from smaller regional banks.

As per the mid-March update, there is never one cockroach, and we are seeing this now. All these issues now occurring are really a reflection of the same thing. People, businesses, governments have been so used to easy money, zero interest rates and a low cost of capital that they don’t have a playbook for what is happening now. If rates stay high or continue to rise, then we will see more casualties. Our educated guess is that these casualties will be in the real-estate sector, private equity and the private lending markets. Banks have been so regulated since the 2008 crisis (and this will get even worse now), that a lot of the risk has been transferred elsewhere to the aforementioned private equity houses as well as all the vehicles set up to attract money and invest in assets which no longer are commercially viable with rates where they are.

 

So for example, even if the Fed decides to insure all deposits, why would you keep your money at a bank earning 0.1-0.5% when instead you could keep cash in a brokerage account, earning 3.5-4.0%. Or in a government backed money market fund earning the same. So either banks raise deposit rates and become less of unprofitable, or they keep them low, and go out of business.  So will Western central banks continue to raise rates potentially hurting the banking system or stop, cut, and allow the inflationary mindset to run loose? This to us, is the key question. We believe eventually it will be the latter (and this may be what gold is sniffing out), but we will likely be in for some rough times before that happens.

As if to demonstrate this point, while all this was going on, you had three major central banks raise rates. The EU after the CS bailout, the US after the bank failures and the UK after its inflation continued to run hot with the latest CPI data showing a 10.4% increase year over year. This continues a global phenomenon whereby inflation has been surprising to the upside.

UK inflation rate breaks 3-month stretch of declines with surprise rise to 10.4%

CNBC March 22d 2022

Now, while these gyrations were going on, short- and longer-term bond yields were going down as many market participants assumed central banks wouldn’t raise rates further. Unfortunately for those participants, the Central Banks didn’t listen. The reduction in market interest rates, was, we believe a prime reason for the more surprising move (to us) in global markets which is the outperformance of Nasdaq. Now most other US shorts did well with the Russell 2000 being especially hard hit as it contains both small regional banks and their customers who will be credit constrained going forward, but Nasdaq actually went up. This confirms to me that the BTFD (Buy the F@@@ Dip) mentality is alive and well as Mega Cap tech stocks saw a flight to safety because that’s what you do when interest rates go down, you buy long duration companies with cash flows far out into the future. Now there is some aspect of positioning also which we discuss below.

If you decompose the return of the major US indices, it is actually due to the performance of 5-8 mega-cap tech stocks. Most other stocks were down. The tendency for investors to herd into these stocks shows the weakness of the underlying market and, as breadth deteriorates, it is a negative signal for the market.

Crisis? What crisis? US regional bank index one year chart….

Now markets have to digest the fact that rates are still being raised and will continue to hurt certain sectors of the economy. The market always leads the Fed so rates will be cut, but as we have mentioned before, things will have to get worse before that happens. The world will have to be in more pain with asset prices lower before that happens.

 

The other major move was a decline in cyclical stocks including energy and commodities. Now we did reduce our exposure because we have seen this movie before and we believe the events of the last few weeks bring forward the recession in the US and the ensuing reduction in demand. What is piquing our interest though is the supply side which we have opined on before (See Commentary #6) which, because of this move, will see a further retreat from investment (if that were possible). We think there are three possible explanations, none of which are mutually exclusive.

• Investors reduced risk and sold cyclical stocks due to fears of a credit crunch and a recession due to the banking issues.
• Funding for commodity traders was also curtailed meaning there was another source of selling pressure and this can partly be evidenced by the reduction in open interest in commodity futures markets.
• De-grossing, when funds reduce their overall exposure and, with hedge funds being the marginal trader, they will sell what they own and buy what they are short, which is another explanation of the moves in tech and cyclicals.

So to summarise, a potential banking crisis caused interest rates to initially fall, catalysing a move up in gold and tech while causing most cyclical stocks to fall. We will be adjusting the thematic portfolio to take advantage of how we think that will change.

 

What’s happening in China?

Well despite the well-publicised problems in the property and banking system and continual calls for a crash in the economy, China manages to survive. Partly due to the structure of its economy (capital controls, state directed support) and partly due to the fact that the economy has suffered its worst 3 years in the last 50 years, China has got through it and is pumping its money supply to get growth.

We also had the National Peoples Congress meeting in the middle of March. The NPC is, (as per the South China Morning Post):

China’s top legislature. It holds one full session annually to vote on new laws and amendments, and review government’s work and policies. The NPC has about 3,000 members who are elected for five-year terms. 

In reality, power is concentrated in one man who in October was “reappointed “as President for a third, unlimited term. Prior to this, there was a trend of separating the Party from the government but that has not been the direction of change over the last 4 or 5 years. It is still interesting to see what comes out of these sessions to assess the direction the Party wants to go. The biggest take away we had from this session was the support stated for State Owned Enterprises (SOEs) and how they were considered undervalued.

 

SCMP 7^th March 2023

China must boost battered valuations of SOEs, says Shanghai Stock Exchange general manager in proposal to ‘two sessions’

• The undervaluation of state-owned enterprises risks eroding their ability to raise funds via the markets, says Cai Jianchun
• His bill urges the finance ministry and the securities regulator to help SOEs tap the capital market for fundraising
• China should use a variety of capital-market tools such as funding and restructuring to boost the valuations of publicly traded state-owned enterprises (SOEs), according to the general manager of the Shanghai Stock Exchange.
• Listed SOEs now trade at an average 14 per cent discount to book value, while the broader market is valued at a 60 per cent premium to net-asset value, Cai Jianchun told journalists in Beijing, according to media reports.
• This undervaluation risks eroding the ability of state-owned companiesto raise funds via the markets, which in turn destabilises the economy, he said.

 

Coming out of the Congress, it was clear that continued SOE reform is part of the agenda and concentrated around improving returns on capital, not growing for growth’s sake.  Now when these sorts of pronouncements are made, it is good to take notice (ask anyone who didn’t notice Xi talking about the property and tech sector before they got decimated by the government). We have been paying attention and there are some very cheap China SOEs with big dividend yields, low PE ratios and not excessive debt. We are even looking at the banks after a former, very smart colleague bought them up when we were discussing this earlier.

I will go into more detail on why these sectors later this month but we will be adding some Chinese construction names and banks to the thematic portfolio this month and will remove the Chinese tech stocks which had a good month after Alibaba announced a restructuring, splitting up into 6 smaller units. Now, do I think this will create value (other than for the investment banks)? I don’t know, but it does signal that they will no longer have the foot of the state on their neck. The smaller they are, the less power they have and that was what it was all about.

We reduced the thematic portfolio to only around 50% invested and the remainder earning a safe yield.  As we said, there is going to be an inflationary bust coming and we don’t see a way out of it and we will want to own all these commodities and certain cyclical stocks but we don’t believe there is any way that this credit event is over. So we will only increase slightly both Hong Kong/China by 5% as well as energy by 5% given the hit this month. We also added some other fertiliser names but didn’t increase the weighting to reduce the single stock risk.

We should have owned more gold and gold stocks, but we will keep it as is for now as we believe we will get a chance to increase at a lower price. If you don’t want to be too cute, you can increase now as I believe it will be a lot higher 12 months from now.

We will remove our Russell 2000 short given the move down and add XLB which is an ETF covering the industrial sector. This will be a partial hedge to our energy positions.

 

As usual, changes are highlighted in red below.

Until Next Time,

Some interesting snippets on the New World Order this month:

SCMP 10^th March 2023

China helps broker Iran-Saudi diplomatic agreement, calling deal ‘a victory for peace’

• Officials from Tehran and Riyadh sign deal in Beijing to resume ties between the two Mideast countries
• China’s top envoy says Xi Jinping ‘guided the talks from the beginning’ while the US questions the ‘durability’ of the deal

SCMP 14^th March 2023

Putin hosts Syria’s Assad as Kremlin seeks to mend ties between Syria and Turkey

• The meeting follows a surprise announcement last week of a Chinese-brokered restoration of diplomatic ties between Saudi Arabia and Iran
• Bashar al-Assad, who arrived in Moscow on Tuesday, voiced support for Moscow’s military campaign in Ukraine

 

 

SCMP 15^th march 2023

China, Russia, Iran launch five days of navy drills in Gulf of Oman, close to US-led Middle East sea exercise

• ‘Security Bond-2023’ drills from Wednesday based on similar three-way manoeuvres in 2019 and 2022, Chinese defence ministry says
• The US is hosting the Middle East’s largest maritime drills in the region, an 18-day event involving 50 countries and international agencies