The Second Leg Up Before The Second Leg Down
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Hi everyone, welcome back to The Spark newsletter! The Spark team will recommence weekly articles from now onwards. I will publish my article fortnightly as usual. Also, we aim to start a members’ area in the coming weeks where readers can find additional materials, including the team’s current watchlist, a short-term macro portfolio (long/short) and more! For now, please follow our new Twitter page, where we will post all the financial research we read on a daily basis.
As mentioned in my new year’s email to subscribers (sign up to email subscription here for weekly portfolio updates), my aim for this year is to achieve a positive return, beating the S&P 500, with a single-digit drawdown. This is no small feat and means I may need to be more nimble in my tactical asset allocation as well as more diversified with my core portfolio. I also aim to be clearer and more concise with my articles this year. With a lot of the ‘educational’ content already published in previous articles, I will refer to relevant pieces rather than belabouring points previously made.
In this article, I will consider:
Current central bank actions
Current economic conditions
China and World War III
Asset Allocation for The Spark’s Portfolio
The end of the tightening cycle
This week we had all three major central banks announcing their latest changes to monetary policy. The Federal Reserve (Fed) raised interest rates by 25bps (or 0.25%) to 4.75%, the Bank of England (BoE) raised 50bps to 4% and the European Central Bank (ECB) raised 50bps to 2.5%. The BoE has signalled it is coming to the end of its rate hiking cycle, as the UK economy is predicted to enter a recession later this year. The Fed has slowed the pace of its rate increases and is signalling an end is near. The ECB continues to remain hawkish on policy and plans to begin quantitative tightening next month.
The majority of the fall in stock markets over the last year has been due to the aggressive rate increases by these three central banks, as this caused investors to reconsider the discount rate applied to future cash flows, leading to multiple compression. This was especially evident for highly valued technology companies, whose valuations have fallen significantly, having benefitted from low interest rates and liquidity in 2020-21. The market has largely reset in terms of valuations, with many companies now trading at fairer prices. However, I don’t believe this is a reason to buy.
Markets breathed a sigh of relief in the US and UK, rallying following each central bank meeting. Consumer discretionary stocks and other cyclical businesses led the rise. Every major central bank is seeking to meet its medium-term target of 2% inflation. Although inflation is rolling over broadly, it remains at 10.5%, 6.5% and 9.2% in the UK, US, and EU respectively. Have these central banks tightened enough to get inflation back to target? What implications will the aggressive rise in interest rates have on the economy? These are the most important questions for investors in 2023, which I will try to answer in this article given the current circumstances.
Global Inflation rates are high but cooling
Given that few financial commentators accurately predicted the events of 2022, whether geopolitical, economic, or market-related, I find it futile to write an outlook that is set in stone for 2023. 2022 has taught me to stay humble and be prepared to accept when I am wrong. I should also be willing to adapt to changing circumstances. Therefore, I will discuss the hard data to start with, before outlining my thought process on asset allocation going forward. Please take everything I say with a huge pinch of salt, and come to your own conclusions regarding investment decisions. This newsletter is my investment portfolio which I publish publically for educational purposes.
Uncertainty ahead
Because the Fed dictates major market movements globally, I will focus on the US, however many of these points do apply to other major economies. The labour market is still very tight in the US. Data on Friday showed the unemployment rate sunk to a 53-year low of 3.4% and non-farm payrolls rose by 517,000. The Fed wants the labour market to weaken as this suggests its interest rate hikes are taking a toll on the economy. Bad news is good news for the Fed, as it means inflation will fall faster. Once inflation is back to target the Fed can then return to its old ways of stimulating the economy through rate cuts and QE again.
Takeaway: It will take longer than the Fed expects for the labour market to weaken.
There was a further contraction in US manufacturing PMI, and new orders are falling substantially. New orders tend to have a strong correlation with the S&P500 (above or below its 200-day moving average) but this has diverged recently.
Takeaway: The market has to drop, or new orders have to grow substantially (unlikely). This leads me to believe that the recent rally is a ‘technical’ one – more on this later.
The yield curve (10yr – 2yr yields) is still deeply negative and hasn’t budged despite the recent stock market rally and predictions of the end of rate hikes by the Fed. A negative yield curve typically precedes a recession by one year, pointing to a recession beginning in Q2-Q3 of this year.
Takeaway: The bond market is giving strong signals that a recession is coming
Other data points include new home sales, building permits, house prices, Uni of Michigan Consumer Sentiment and so on. These data points indicate a growth slowdown.
The yield curve (10yr-2yr yield) - Bond investors are not buying the ‘soft-landing’ narrative Source: TradingView
I will not attempt to predict the future path of CPI (inflation) but markets don’t seem to believe the Fed will stay tight. Bond market pricing suggests inflation will fall to 2% over the next year, possibly because a recession is being accepted as reality. Markets are also pricing 0.75-1% of interest rate cuts by the Fed this year. With the labour market as tight as it is, inflation still far from the Fed’s target, and the China reopening in full swing (more below), I don’t believe current pricing is accurate. I believe the Fed will have to stay ‘tighter for longer’, which will hurt asset prices further.
World War III
I am still of the opinion that inflation will be stickier than the Fed believes, but the timeline for the beginning of the recession has been pushed further down the road due to the reopening in China. 1.4bn people being released into the global economy is likely to stoke demand in the near term, so earnings may not be as negative as expected given the current growth slowdown and monetary policy tightening. The service sector should perform especially well provided Chinese people start travelling, which seems likely. According to Ctrip, air travel searches jumped 900% the day the CCP announced the dismantling of China’s Covid restrictions, and the number of flights in China has exploded higher since then.
Chinese domestic air travel is taking off! Source: Zerohedge
The boost in demand as a result of the Chinese reopening will be reflected in inflation figures in the latter half of this year. Chinese inflation is currently 1.8%. The lockdowns have contained inflation in China and this means the Chinese central bank can now conduct quantitative easing to further boost demand. Rules on property companies brought in by the CCP that crashed the Chinese property market in 2021 have also been reversed.
In my opinion, we are in the midst of an economic war between the East and West. Russia is now cut off from the west but will be supported by India and China. The ‘Chip Act’ in the US and the movement of manufacturing out of China by many western countries have rubbed China up the wrong way and the CCP will be seeking ways to hurt the west in return. A second spike in inflation could be the plan – Exhibit A. It’s also evident that OPEC+ aren’t concerned with the west as it continues to support higher oil prices. News last night that the US has shot down a Chinese ‘Spy’ balloon could escalate tensions further.
For now, tactical shifts are necessary in order to continue to perform in the shorter term, although my opinion that we are heading for a recession still remains. Email subscribers were notified that I purchased WH Smith (SMWH) last week as a services recovery trade. The general population are still willing to travel, and the Chinese will help with that. WH Smith has significant pricing power because of its presence in airports, which is evident in its profit margins when compared to high street retailers. The recent BoE pivot has helped this position move higher so far.
Selling into strength
The cycle of investment, are we in the bull trap?
Earnings season has shown mixed results so far, but generally, profits are down, confirming we are in a growth slowdown. With the largest constituents (Amazon, Apple, Alphabet, and Meta) of the S&P 500 having now published earnings and the Fed meeting out of the way, the risk of a surprise jump in the market is reduced.
I believe the latest move upward is a ‘technical rally’ rather than a fundamental bid. This means that as the market rallied following the Fed monetary policy meeting (FOMC meeting), many traders holding shorts were forced to close positions, fuelling a further rally. In my mind, given the data and reasons outlined above, I do not see a fundamental change in the outlook for western economies, the proverbial can has just been kicked further down the road. For this reason, I am adding a small position in S&P 500 put options. The concept behind put options and risk management for portfolios will be explained in my next article.
(Put options ladder for reference), Source: IG
I am also using the latest rally to sell my holdings in Digital Turbine (APPS). The stock has rallied 70% from its low but I do not see any upside for the stock over the next 12-18 months unless I am dramatically wrong on my current longer-term outlook. Snapchat recently reported slowing revenue, and the mobile advertising industry will be the first to be cut from company spending budgets as the economic slowdown takes its toll. As mentioned in this article, Digital Turbine was a poor decision on my part (evident in the subsequent performance!). It’s a long-duration growth stock in a highly cyclical industry, the worst combination going into a growth slowdown. It was bought on valuation grounds, but as we now see, cheap can always get cheaper. Lesson learned.
Action:
- Selling 100% of Digital Turbine at $17.28, booking a 59% (£245.78) loss
- Buying 0.57% (£61.88) of S&P 500 Put options. Strike: 3720, Expiry: 21 April 2023, IV: 23.33, VIX reference: 18, Premium price: £31.94, Number of Contracts: 2
“It’s easy to be a contrarian, except when it’s profitable.”
Portfolio Return Year-to-date: 5.0% vs S&P500: 7.3%
Total Return since inception (20/09/2021): 8% vs S&P500: -5%
Let me know your thoughts by emailing me at thesparknewsletter@gmail.com
See you next time,
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.