It is difficult to gain alpha on dollars during a market decline as the one we are now enduring. The portfolio is down 3.9 % in dollar terms YTD. Compared to most asset classes, that is not bad. Yet, the point of investing is not to lose less than most. Obviously, I it is to raise the value of our capital. In this report, I will address the macro environment and my expectations and strategy going forward.
The macro situation
Our unelected central banking officials have finally woken up to their ignorance, admitting they do not “fully understand inflation”. It is remarkable that they believed it was transitory as late as the previous fall. Let us examine FEDs cognitive evolution the last few quarters:
- Q2 2021: Some inflation but transitory
- Q3 2021: High inflation but we are peaking
- Q4 2021: Inflation may not be transitory, but job market and wage growth are very strong
- Q1 2022: Need to hike aggressively to curb inflation but no worries. Economy is very strong and soft landing is possible.
- Late June 2022: We now understand how little we understand about inflation.
- 1st of July 2022: https://www.atlantafed.org/cqer/research/gdpnow estimates a GDP decline of 2,1 % for second quarter of 2022. Last quarter it declined 1,5 % which almost certainly leaves us in a recession!
These guys are supposed to be the smartest one in the room, and they manipulate the market based on their misguided models every day. Central bankers’ excessive money printing combined with draconian lock-down policies during the pandemic have created an economic tragedy which will continue to wreak havoc for months, maybe years ahead. The popular narrative that it is all President Putin’s fault is of course a lie as well. Putin didn’t make things better but blaming him for elevated inflation numbers are simply just propaganda.
We are supposedly still in the rate-hike phase but considering the wealth effect of the market decline thus far, and the fact that we are now almost certainly in a recession (two consecutive quarters of negative GDP-growth), I believe the bond market may soon catch a bid. That do not necessary mean that Powel will pivot anytime soon, but I think the bond market may start pricing it in. The imminent recession will most probably trigger a flight to safety and bonds may yet again be of tactical utility for investors like us. In the long run however, I remain bearish bonds as I expect inflation to persist due to populism, supply chain issues and possibly war.
Main asset classes
Thus far this year have been awful for most asset classes. Especially long dated US bonds (TLT) have had a horrible YTD performance compared to what most investors expected – and its historic return profile.
- S&P-500 is down 19,89 % YTD
- Nasdaq 100 is down 29,40 % YTD
- Bitcoin is down 59,43 % YTD
- TLT is down 21,64 % YTD
- Gold is down 1,30 % YTD
- DXY (Dollar-index) is up 9,86 % YTD
The energy crisis
Most investors have lost money YTD, and the list above serves a hint to their losses. I do however expect rates to fall temporarily due to the recession. What that do to the oil price in the near term is something my mind can’t compute. I am still bullish oil for the long term as capital spending for oil majors took a massive hit during the oil market correction of 2014-15 and another one during the Covid-lock-down of 2020. This underinvestment in oil and gas is primarily due to ESG-/climate-fanatism, and we are truly paying the price of this reckless policy as the energy crisis in my estimation have barely begun.
Since the West is so obsessed with low C02 emissions, one would expect us to invest massively in nuclear and hydro, but that is not the case. We are rather investing in intermittent solar and wind, something that is both expensive and leaves our electrical grid vulnerable to black-outs as wind and solar power fluctuate with – well, the weather…
I see nuclear and paradoxically oil & gas as the main beneficiary of this green agenda. Other commodities too, like copper and lithium may regain its momentum when the economy bounces off the current recession. Until then, I think there is likely that the oil price will remain elevated, and even rise, due to the policy errors discussed above. Therefore, I will keep most of my exposure to uranium and oil & gas and rather hedge it with shorting other sectors.
The portfolio performance
This year have been difficult for most investors. Most of my investments have performed worse than I expected. The market makers “Virtu Financial” and “Flowtraders” have not served as a volatility hedge. They are however priced very attractive with a PE of 10 and 8.
The oil exposure has paid off well. I have closed several trades in XLE and XOP with a nice profit. The current trade is in negative territory as of now, but I remain carefully bullish as discussed above.
In previous reports I have written extensively about gold and my bullishness towards the metal. One may argue it have performed well, at least compared to other assets. I do still expect gold to rise in this environment as rates most probably will fall together with growth (recession). If we’ll get a liquidation event however, gold will sell off massively together with everything else. Remember that the correlation goes to 1 for all assets during a liquidation.
That is why I believe it is so important to hedge all positions with shorts, and that is also the primary reason why my portfolio have performed better than the overall market. My shorts are the following:
- Russel 2000 (IWM)
- Nasdaq (SQQQ)
- US financial sector (XLF)
- Consumer discretionary (XLY)
- Germany (EWG)
- High yield corporate bonds (HYG)
- Micro Strategy (MSRT)
- Bitcoin
Being short these (and others previously) have served us well thus far. I expect that to continue but will refrain from being too aggressive too. We are now in the phase where risk aversion is a prudent strategy as most risky investors blows up around us.
Expectations for the future
I can see more than one possible future and tries my very best to change my mind when the facts change. The following is however what I see as most probable and how I intend to invest in the near term.
I expect the stock market do continue its downward spiral as the recession will affect corporate profits when the upcoming report-season starts. The inflation will continue to stay elevated but will most probably fall together with growth. Energy prices may or may not take a hit in the short term, but as discussed earlier, I think much higher prices will materialize medium to long term.
I am borderline bullish on bonds in the short term. Longer term I expect it to lag inflation as populism and inflation will take its toll.
China may see growth in the coming quarters as they finally seem to re-open their economy after another massive lock-down. This is also bullish commodities by the way, and I am considering to add some China-exposure to capitalize on it. China is also stimulating while most of the West is tightening financial conditions.
Tail risks for the future
This section is borderline out of scope for this report, but I chose to add it as these risks are something that I take into consideration. There are three tail risks I wish to highlight.
- If Russia decides to toughen up against Europe, the continent could be in for a horrible winter. Central Europe are dependent on Russian gas, and if Putin decides to punish EU for its support of Ukraine and sanctions towards Russia, people may freeze to death! I pray that won’t happen but fear it might. Russia’s economy is strong as China, India and several other countries happily imports their oil at elevated (but somewhat discounted) prices. Russia do not need the gas-export to Europe, the Europeans do!
- A lot of energy is consumed to produce fertilizers which have made crops more expensive. That affects the poor in a drastic way, but it may get worse as 37,6 % of Potassium is made in Belarus and Russia. Potassium together with nitrogen and phosphorus makes up the ingredients of modern fertilizers. If Russia decides to limit export of Potassium, we may have global famine!
- When Ukraine was attacked by Russia, I feared Taiwan would follow. That haven’t happened yet, but it might in the future. It is common knowledge that China sees Taiwan as a part of China, and the Chinese have increased military spending and activity around Taiwan. This could lead to a conflict with the US. Link to a recent Reuters article.
If one or more of these tail-risk events materialize, inflation will continue to soar, and the economy will take another massive hit together with the well-being of millions, perhaps billions of people. I know this report isn’t exactly a happy read, but hopefully it gives a decent assessment of the evolving risks. There is not much an individial can do about the energy crisis or the conflicts of superpowers. I despise war, famine, inflation, and depressed growth. I will however try my very best to protect and grow our capital in any environment. I believe we ought to do our very best, in all circumstances. Perhaps particularly in the tough times I fear lies ahead. As always, I wish you all the best, and thank you for reading.
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