The Next 6 Months

Scala Private Wealth - July 2022 -Behind the news - The next 6 months

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We just went through the worst 6 months in over a decade and the big research houses are completely divided by all the potential scenarios – stagflation, reflation, soft landing, recession, slump.?Sincerely, it is quite a disgrace that all those extremely well-paid research people seem to have less clue than the meteorologists about the future.

?I am not that undecided. After being side-swiped due to the “black swan” event of the Russian invasion, my model indicates that inflation should decrease by August/September (also due to the current commodity slump), as a consequence there could be a strong rally from September/October.

?While July could be a positive month as expectations are low, I am worried for August that could be the low of this Bear market as in August there is very little trading volume and the market will be completely in the hands of the machines.

?War in Ukraine

The war in Ukraine is becoming more and more a meat-grinder in the style of World War I. Russia is slowly taking over Donbass by destroying everything. While the Western news always highlights the Russian losses, there is little talk of Ukrainian losses and so called “strategic” retreats.

The Russian supply chain indicates a will to keep on fighting at least until October – before the settling of winter. While it is hard to understand the objectives of Putin, my thinking is that Putin is waiting for the resolve of the West to support Ukraine to wane and annex the part of Ukraine that, at the time of Tzarist Russia, was called Novorossya, New Russia.?The will of the citizens of the West to sustain Ukraine is starting to show cracks – the US are going to the Mid Term elections and with so many issues at home from poverty to lack of infrastructure, the US alone has spent over USD53 billion to help Ukraine on the shoulder of the citizens that sees the price of everything going up. How much the European citizens are willing to endure is starting to show – an example being the French election.

In the media it will say Putin can still win – to spur citizen resilience. The reality is quite different. In the great empires war, the US is willing to sacrifice a pawn (Ukraine) that has no chance of winning, to weaken Russia as the US could never take on Russia and China at the same time. ?Once Russia is weaker, it will be able to dedicate itself to China.?Strangely enough, even the Catholic Pope declared, correctly, that not all faults are with Russia and NATO has “provoked or not prevented” an escalation.

Interestingly from Bloomberg <<The Pope had asked the leader why NATO was creating concerns in Europe, and the response was that “they are barking at the gates of Russia,” the Pope said. “That head of state was able to read the signs of what was happening,” Pope Francis said in the interview.>> . He denied mentioning the head of state he was talking about, but in the last 6 months of 2021 he met the US President, the French President and the Hungarian President.

War economy

The Russia – Ukraine war is the first peer-to-near-peer war, and it is highlighting some big issues in the West’s war preparations.?The West’s military strategists always assume that precision munitions would void the need of quantities of munitions. In reality, the “help” to Ukraine has already consumed almost 1/3 of the entire US munition stockpile. The issue is highlighted by the famous Lockheed Martin Javelin missile (destroyer of Russian tanks). Ukraine already used 7,000 of them and the annual Javelin production is just 2,100.?In a world of autocracy vs democracy challenges where China is world manufacturing leader of the world and it is in control of 80% of the rare earths market, this is a serious challenge for the West and needs a serious rethink and opportunities for the US industrial military complex.?

Sanctions have a limited effect when raised against a large commodities rich country such as Russia. While sanctions are inflicting a lot of pain to the Western nations with soaring inflation and Russian citizens with shortages, it is quite positive for the Russian state that is simply diverting its commodities sales to countries such as China, India and Brazil – at higher prices.

Wind of other wars

NATO is provoking Russia in Kaliningrad. Kaliningrad is a Russian territory that is isolated from the motherland as it is surrounded by Lithuania and Poland. With sanctions, Lithuania is isolating Kaliningrad from Russia and practically creating a siege – most items cannot go though. Even as Lithuania is just applying the Western sanctions this is a clear NATO provocation on Russia, especially as there are nuclear Russian forces in Kaliningrad.

China and the US are having another spat, with the US declaring that the Taiwan Strait is international waters, while Beijing declaring it is not. The legal status of the Taiwan Strait has never been a talking point between US and China. It is an important point as it limits the free navigation act and would allow the deployment of the Chinese Army in intervention “other than war” (for example using some weather event to take ownership of some strait islands).

While Ukraine war and Russian violence is on the front page, at least another war, the Yemen-Saudi conflict – longer and more brutal – is completely forgotten. Oh wait, it is being carried out by a Western ally, Saudi, so it is good.?Other brutal minor conflicts (Rwanda/Congo, Ethiopia, Sudan, Syria) are completely ignored.

G7

The global powers met in Germany and practically decided that the Western citizens need to suffer to fund the heroic Ukrainian resistance. They did agree in a cap on Russian oil prices applicable to non-Western nations. Very weird as China definitely will not be dictated to by Western power ideas.

USA

Biden’s approval rating is always abysmal, and the Democrats leadership is trying to scramble for the 2024 US Presidential election because the VP Kamala Harris is a complete failure as a potential candidate.?The government is using the abortion rights issue to try and spur the democrat base voters for the Mid Term (November).

While inflation is still a problem, the oil fall to under USD5 a gallon gives a bit of reprieve. Notwithstanding that, the issues of this administration keep on piling. From the disastrous retreat from Afghanistan to the US oil crisis (the Democrats are against old oil – so the shale oil boom under President Trump cannot be repeated). Now the Fed’s Dallas Manufacturing Survey plunged from -7.3% to -17.7% - worst since May 2020 or the GFC. A few Americans start to miss President Trump.

The big test will be the quarter data from the US companies in July. A survey from the Philadelphia Fed shows that on average a lower growth rate is expected. Analysts decreased the target rating by an average 7% since January, which is quite a small amount. As a median, the bottom up analysis shows this decrease would bring the SP500 to 4,987. This means that, aside the inflation induced crash, analysts still see a 30% increase as a one year target (communication Services, Consumer Discretionary and IT having the best prospects -median +40%) and Consumer staples and Utilities (median +15%) the worst. Or analysts are very wrong or there is a 30% rally as soon as inflation abates.

Federal Reserve

The Federal Reserve failure has provoked another big fall in June. After declaring that the 75bps rate rise was not likely, just after 2 weeks they rose the rates by 75bps. The market reacted well to the rate rise, but badly to the implicit admission that their inflation model could not predict 2 weeks of data. Any rate hike has an effect on the real economy in 3 to 6 months. Chairman Powell is clearly the worst Fed chairman in a long while.?It seems that the Fed is just making things worse – at first it did not understood the inflationary issue and then it raises fast not to lose face, instead of being patient and data dependant.

Interestingly, the Fed is working on an obscure law that would forbid the machine-driven orders to “front run” human orders. It is a very obscure rule, but some broker platforms like Robinhood do not charge commission to retail but get commission from institutional to practically front load orders in a way called “order flow” (yes it does not sound legal). If this law will be implemented the market would immediately calm down, but it is not an easy battle.

Order Flow example: some retail brokerage platform (Robinhood, Charles Schwab) send customers’ orders to market-making firms (like Citadel Securities, Virtu Financials) and collect payments in return. Not illegal, but very prone to manipulation.

Inflation: is the FED the problem, not the solution?

Inflation is still high, but the big economists really miss a point: as this inflation is provoked by supply side issues, it is self-destroying.

Let me explain. This is supply side inflation (not enough supply). As things get more expensive, the consumer cannot afford them and consumes less and inflation will subside by its own. What the Reserve Banks are doing is just accelerating a natural process adding a lot of pain.

An easy example: in Australia now lettuce costs $12. As people cannot afford it, people will not buy it or substitute it with similar item, for example cabbage. In six months, lettuce will cost less for this natural mechanism.

Recession Watch

Depending on the firm you look at the chances of a recession are between 50% and 80%. A lot depends on China and in my opinion the chances of a recession are lower – the recession will be simply milder than the forecast.

There are quite a few (Goldman Sachs, Morgan Stanley) that sees an SP500 recession level of 2,800-3,000. The market falls we had this year have already achieved the “average recession” target: -23% is the median fall in a recession in the last 100 years.

UK

The price of everything is going up in the UK and PM Johnson is saying that this is the price worth paying for Ukraine. Meanwhile the UK government is in full turmoil. PM Johnson survived a no confidence vote, but his support is clearly waning.

Europe

In France there have been two elections, one for the President, in which Macron has been re-elected and then the Parliament where Macron’s party has been annihilated – with the rise of the extreme left and extreme right. Especially the rise of Le Pen’s party (from 8 to 88 seats!), a ‘not against Russia’ party, is a big deal as the platform was that France should care more about the French than risk economic depression for Ukraine. A big warning sign for all Western Democracies.

In Italy, the majority government lost some of its majority as one of the major coalition party splintered due to differences over supplying weapons to Ukraine.

China

China is starting to stimulate its economy out of Covid-19 and Xi’s war against every powerful sector (tech, real estate) seems to come to an end. President Xi’s re-election is in November, and it will have to present a rosy picture.

This is very important as it could stimulate the entire world economy. Most people do not know that more than half of the stimulus that saved the world after the GFC of 2008 came from China.

While the Chinese market is now untouchable for most people, it has the best set up in the world.

Israel

Israel is having another election. 5 elections in three years. Quite a record, beat the Italians at their own game! The next election will be in October or November.

Australia

Labor has started ruling and found a series of challenges. It is a bitter victory as they inherited a broken system and also their promises are a little excessive.

As RBA’s Lowe said in an interview, a wage increase of 5% will just entrench inflation in the economy. Australia’s economic system is broken relying on too many rules that cripple productivity. Until now the issue has been hidden as we kept importing “cheap labour”, but Covid-19 highlighted the problem.

Even energy transition is a problem as energy transmission rules are State based. While it is easy to say “it happens also in Europe”, it is just an excuse. In Europe there is no energy, while we are sitting on one of the largest energy reserves in the world and our sun energy, if harvested, is one of the most powerful of the world.

The biggest issue for Australia is the rising interest rates and the consumer leverage to real estate. In Sydney 30% of auctions have been pulled off market and market forecasts indicate a 15% to 25% real estate price fall, with a peak in 2023 when most of the fixed rates will expire and will have to increase to the new rates between 25% and 40% more expensive.

Commodities, oil, lithium

Commodities and especially oil took a beating this month and so Australian shares (pulled back by commodities and banks as a proxy for real estate). While this looks bad for the Australian share market, it is very good to find a bottom of this bear market as inflation is driven by commodities and especially oil. On average a 10% oil price increase generates a 0.4% inflation – year on year oil increased 42% as of 24 June – so it is responsible for 1.6%pa of inflationary pressures (19% of total inflation increase!).

?A special mention about lithium which had a mini crash. ?The mini crash has been sparked by two controversial reports from Goldman Sachs and Credit Suisse that seems to contradict geological studies that predict a lithium shortage. This has been enhanced by the fact that BYD, a Chinese car manufacturer, decided to buy 6 lithium mines in Africa. This looks like a concerted effort to drive down prices in order to let some late comers (Goldman and City) to buy in at cheap prices.

Tesla is making agreements wherever it can to secure supply. Stellantis (FIA, Peugeot etc) took a large stake in an Australian lithium miner (Vulcan Energy) and Volkswagen is trying to make agreements with miners. In Italy I can see the level of penetration of electric vehicles and even hybrids is very low as not many people have private garages and by 2035 the current laws indicate that all conventional engines will be banned. The demand for lithium is much bigger than the reports of two large banks that have been found guilty of market manipulation in the past (unprosecuted)

-?????Goldman Sachs say Short Gold (10 April 2013)

-?????Goldman Sachs say oil $140 (May 24 2010)

-?????Senate Panel says GS “misled the country and helped create the Housing Bubble” – 26 April 2010

-?????Citi fined $1.2 million for Japanese future manipulation (March, 2019)

-?????Citi fined $425 million for LIBOR rate manipulation (2016)

-?????Citi charged by the Commodities Future Trading Commission for violating rules and generating conflict of interest (September 2021).

Not very trustful organizations!

Market 27 June 2022

Another challenging month has passed with several rally attempts immediately curtailed like typical Bear Market rallies. Not noted by many is that things are changing.

The recent weakness in banks and commodities is a positive sign as it looks like capitulation (a Bear Market cannot end without capitulation). Last week there were some institutional buyers only long-only (not covering shorts). This is because the Michigan inflation expectation report came in lower than expected. This is very important as the data from the previous Michigan report was the one that spurred the Fed to raise rates by 75bps and not 50bps. This does not mean that we will rally from here – nobody can promise you that – but the base for the end of the current Bear market is building.

Index issue

For the last two years, the rise in IT is creating some issues for technical analysis. Everybody is focussing on indexes to see when a bear market ends, but there are great disparities in the sectors. For example, IT is down approximately 50% (same level of the GFC) so probably it has bottomed/ it is bottoming. In contrast other sectors like energy and commodities are far from being at recession level.

This means that even if in August we reach the bottom at SP500: 3,600-3,400. It is possible that IT would not crash further – but other sectors (especially energy) could crash if oil falls to USD95. Also, consumer staples, a typically defensive positioning, looks overstretched.

Lockdown consequences

An interesting study (US only) from the National Bureau of Economic Research shows that in the US there have been 170,000 excess -not Covid 19 - deaths. Similar numbers repeat around the world (approximately 105 excess non-Covid deaths per 100,000 in Europe). This is because a lot of non-Covid 19 sicknesses went untreated. The excess death by Covid-19 were approximately 300,000 – but a lot of cases had co-morbidities. So, I wonder if lockdowns were effective.

Do not buy Chinese

There has always been a suspicion that everything to do with Chinese electronics is controlled. Now a few details start to leak showing that this could be true.

TikTok, the hugely popular short video app has been found to be one of such tools.

The US has found evidence that at least between September 2021 and January 2022, Chinese engineers had access to TikTok internal data and US TikTok staff had to send all data to China and that there is a “Master Admin” that can give access to everything to someone in China. In China there is a law that compels any Chinese company to give data to the Government if it is of national interest.

It is not just TikTok. A top of the range Chinese coffee machine in Germany has been found to send data to China too.

While China is the master at this game, everyone plays it. Notoriously Teslas have been banned from Chinese military installations and currently have been banned entering a Chinese coastal town where a super-secret Chinese party meeting has been held.

The man most feared by President Xi and President Putin: Elon Musk

Elon Musk is almost the typical bad guy in the James Bond movie. While on the surface he is famous for Tesla, Twitter and philanthropy (he donated almost USD6 billion in 2021), he has a very scary dark side.

-?????He is driving the US hypersonic development and a rocket base rapid deployment system for the US military

-?????On his own, he decided to give back the internet to Ukraine, by moving part of his Starlink satellites.

-?????In another episode, a solar storm knocked out 40% of the satellites deployed and impressively the network continued working flawlessly.

-?????Elon Musk just presented his Tesla humanoid robot called Optimus (like Optimus Prime of Transformers) and already the US miliary is showing interest. The first prototype will be released in 2023. The characteristics are 173cm tall, 45kg, max speed 8kmh and carries up to 20kg. Naturally he said it is built to be easily overpowered by a human. Well, there are countless movies to show us how it ends. Probably just starting not to put American lives at risk will be started to be used in the US military non-combat roles.

The biggest fraud

Data from Europe, but it is the same

Oil price 2008: USD145

Fuel price 2008: EUR 1.3

Inflation rate 2008 -2022: Fue1 2008 equivalent to Eur1.36

Oil Price 2022: USD110

Fuel Price 2002: Eur 2.36

No comment.

A joke

An accountant is having a hard time sleeping and goes to see his doctor. “Doctor, I just can’t get to sleep at night,” he says. “Have you tried counting sheep?” inquires the doctor.?“That’s the problem — I make a mistake and then spend three hours trying to find it.?“