Red Storm Rising!
Scala Private Wealth Beyond the News: March 2022
The Simpsons did it again. After predicting President Trump, they predicted in 1998 the return of the USSR and now in 2022 here we go again!
?Russia invaded Ukraine in a similar move when Russia invaded Georgia in 2008. Even the reason is the same. Georgia wanted to enter NATO and Russia felt threatened. As we all know the West points of view, let’s play devil’s advocate (quite literally this time).
There are leaked documents from 1991/1992 where it is clear the US and NATO promised not to expand in the ex-Soviet states. We know history that NATO has encroached on most of the ex-Soviet states. Even the “democratic” revolution pro US in Ukraine, 2014, was sponsored by the US (famously there was a leaked call from US Secretary of State Victoria Nuland, intercepted by the German Secret Services, that clearly confirmed the suspicion).
In the West we are trained to see the US/ NATO as a purely defensive alliance, even if facts are not really clear about it. NATO attacked, under various pretences – but not self-defence – Serbia, Kosovo, Iraq 1 and 2, Libya, Afghanistan.
President Putin drew a red line with Ukraine as NATO missiles and jet fighters could reach Moscow in 8 minutes from Ukraine. The issue is that Putin’s red lines are really red lines – not like the Americans in Syria.
?On the military standpoint, it is again a good Russian operation continuing a string of Russian victories (Georgia, Syria). Aside the three-side invasion, from a strategic perspective taking Chernobyl as a ‘beyond the enemy lines’ base is a great tactical move. Nobody will dare bomb it for fear of nuclear pollution. As any war, there have been also errors – the Ukrainian Army did not melt away and entering an urban warfare environment would stall any advance. Interesting enough an expert can see how only the US has mastered war logistics and multi theatre combat domain - Russians got bogged down by lack of supply. Also strangely the Russian Air force is quite absent - probably as it is not easy to coordinate troop on the ground, missile batteries and airplanes.
Russia will need to agree to an armistice with Ukraine quite soon, otherwise the situation could become really dangerous for everyone.
The best outcome is that Ukraine agrees on some kind of neutrality, unless there is a coup in Russia.
?The West has been appalled by Russia’s action and has implemented sanctions, but very far from intervention as it did with lesser enemies above. The West would probably win against Russia, but losses would be huge. And President Putin would probably deploy tactical nuclear devices. Also, sanctions are growing but measured as the biggest threat in responding properly against Russia could lead to a cyberwarfare and a potential crippling blow to infrastructure.
A lot of President Putin’s justifications comes down to his own words that the fall of the USSR was the biggest disgrace of the last century, but it also shows us that geopolitics is just shades of grey and there is no good guy. In the scale of grey, he will definitely be full black.
President Putin wants back the respect and fear that the Soviet Union commanded. Most of his hate for the US and NATO stems from an episode from the Kosovo War in 1999.
Putin was a security advisor to President Yeltzin and sent a battalion of 186 paratroopers in Kosovo to help Serbia. The US Army surrounded the Russians that could not been reinforced as Ukraine and Hungary did not approve overflight. The Russian battalion was flown back to Russia in shame and Putin never forgave this outcome.
The biggest issue is that US President Biden is perceived as weak and a negotiator. Not even President Putin would ever dream of invading Ukraine if there was someone like President Reagan at the helm of the US. In reality, he would not even dare with President Trump as no one could have predicted his reaction (indeed a very scary concept).
War in Ukraine – probable outcome?
The war in Ukraine has to end pretty soon, otherwise the unintended consequences could escalate quickly – if President Putin gets cornered in a losing position the consequences could be unimaginable.
The probability set:
-50% Ukraine will agree to become neutral – or in a similar situation to Georgia where practically there is a frozen conflict since 2008.?
-30% a coup in Russia where new political forces succeed to oust President Putin.
-20% As some Western nations like Germany promised weapons to Ukraine, Russia could deem those nations as enemy combatant and escalate first of all cyberattacks against these nations. Russia alone cannot resist against the US and NATO – so President Putin is threatening the use of nuclear weapons – or China could take advantage of the situation (in the same day of the Russian invasion, 6 Chinese jet fighters crossed into the Taiwanese economic zone). In that case the stock market will not be our main issue.
Vaccines and Covid-19 data
Omicron is continuing to fade fast. Already Britain, Denmark, the Baltic states, France, Spain and other states are starting to treat Omicron like an influenza. This is the same pattern of the Spanish flu 1918. It lasted two years – the third year was almost like a flu. Covid 19 started in 2020 and in 2022 most symptoms are like the flu. The difference is that the world was not so connected, so we have just to hope that there are no surprises from other variants.
USA
President Biden polls are terrible, even in Democratic states like New York and California. California is an example. In 2020, Biden won by 60% and now just 47% approve. His approval rate is the same of President Trump after one year and the polls show the Democrats headed for a disaster in the Mid Terms. The US after a madman, elected a weakling. Terrible error.
At corporate level, the US is slowing down from a formidable 2021 with the obvious market repercussions – it is not retreating just slowing down from a rate of profit increase impossible to sustain. So, while the corporate situation is not as rosy as 2021, it is in no way a bad situation.
Federal Reserve
Much of the mayhem in the market has been provoked by the bungled communication from the Fed. Various Fed members take turns to predict various hikes. The market is confused and cannot price the economy and goes into wild swings – a classic policy mistake as I was affirming in my January newsletter. The market usually does not react bad, at least initially, to rate hikes – but it does react bad to the speed of rate hikes. In January and February there has been total confusion. The market is swinging from 2 rate hikes to 6.5 and it passed from having a 90% confidence in a rate hike of 0.50% (versus the normal 0.25% in early February) to the current 10% confidence in a 0.5% rate hike.
It looks like a policy mistake to me.
Inflation
My model on inflation is that it is starting to stabilise now and will start decreasing soon (not disappear) - unfortunately the effect of the war in Ukraine are not in it - but they are inflationary - Russia export a lot of commodities and Ukraine is the major exporter of wheat.
-?????Fast data shows that inflation is decreasing in UK, Germany, plateauing in US and still increasing in Australia. In China, it is slightly increasing, but from a much lower base than the West.
-?????The stimulus that the Democrats put in the economy was excessive, but now has almost wearied off with the help of high fuel prices.
-?????Data from Maersk (world’s largest shipping company) shows that the supply chain issue will mostly disappear by June 2022 (this would be reflected in the September data).
Logically the big unknown is the price of oil. The fact that at the height of fear it went up to USD100, but could not sustain a move over that probably indicates that its fair value is about USD80. Elevated but not critical.
My model is that from a US inflation of circa 7%pa, we will go back to a 3% to 4%. Again, elevated – but not critical.
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Europe
Europe is dealing with quite a few shocks. Inflation, Russia, gas shortage (50% of European LNG comes from Russia) are just a few of the issues in Europe. There are also the French elections in April at the moment Macron seems clearly ahead even if 47% of voters are undecided.
China
China is stimulating the economy as clearly after the crackdown on everything, everything is slowing down. While President Xi dominates the Party, interestingly on the internet there are glimpses of forms of dissent. China is really struggling to contain Covid-19 and for the first time it approved the Pfizer pill – a clear sign of desperation. According to the IMF even the politically approved economic growth could slip to +4.8% by the end of 2022.
The most interesting point is that China is looking with interest at the Ukraine/ Russia situation as a potential model for a takeover of Taiwan.
There are great differences:
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-Ukraine does not have a defence pact with the US
-Ukraine strategically is not important – while Taiwan is the world producer of semiconductors.
- The fall of Taiwan would cut off the energy supply chain of Japan and South Korea and would be viewed as a precursor of a Chinese Pacific Ocean takeover.
-Ukraine is the easiest nation to take over - close by, easy terrain and army that is just beginning to renovate. Taiwan is a nightmare. 150km of rough ocean, very few landing beaches and a Taiwanese Army that is preparing for 50 years to a tech- Vietcong style war.
-China is quite careful not to look too aligned to Russia, but it is increasing Russian imports to soften the impact of Western sanctions.
Australia
PM Morrison is scrambling to try and recover ground before the May election and is using Ukraine and every other occasion to show that he is a leader. His strong anti-Chinese rhetoric could be a double edged sword as there are circa 1 million Chinese descendant voters. Labour platform is also non-partisan and appears well balanced – so there is no scare factor in a Labour government.
The RBA is treading very softly on the inflation issue. The RBA knows how much the real estate industry is in a precarious situation if interest rates rise, so it is taking a cautious approach. Any rate hike would be after the election between June and November.
Market Update 28 February 2022?
After a mild February recovery, the Russia/Ukraine issue has spooked the market again and reignited market fears. In the last days of the month, we saw an incredible reversal as the market sees past episodes as “sell the trumpet of war, buy the whistles of bombs” mantra. This is what happened most of the time (aside the Arab wars in the 70s that provoked an oil embargo) and valid if the war settles soon.
The biggest issue for the market is not war, but inflation and the outcome of the Open Market Federal meeting scheduled for the 15th March. Technically speaking the bottom could be already hit or close by. Usually the Fed talks aggressively before the first hike and then becomes more careful with its communications – even more if there is an event like the Ukranian/Russian issue that is completely unpredictable. Effectively we could see a nice rally in February/April. A very needed one.
Portfolio Construction
While I am not altogether extremely worried of the current sell off, this sell off is a re-set to a new investment world.
I looked at the market since 1997 and looked at a lot of portfolio managers – the few that are outstanding recognize when the market changes and take the opportune steps to tackle the changing macroeconomic environment.
We can look at three different eras since I started managing portfolios in Australia from 2008 (yes I got hired in 2008 in the midst of the financial crisis as the previous manager went into panic mode and quit).
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Phase 1 post GFC – 2010-2019 Reserve Banks very supportive – direct equity (style growth) and fixed interest as rates were going down (and bond rallied). Vanilla ETF are hard to beat.
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Phase 2 Covid -19 – 2019-2022?Reserve Banks very supportive, but interest rates close to zero - direct equity (style growth)?and mainly short dated bonds or Private Debt. Vanilla ETF are almost impossible to beat.
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Phase 3 2022 - ? Inflation, tentative exit from fiscal stimulus and a weak US Government - equity (quality), alternative assets and private debt. Vanilla ETFs are the last place you want to be.
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You can see from the efficient frontier analysis – below – it indicates how you should mix assets to obtain the best performance.
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In this macro condition a mix of alternative and equity increases performance and decreases risks.
The issue with alternative assets is that they come with a cost as they are managed by a professional fund manager utilizing instruments like private equity, private debt, options and futures that are not available more generally.
I am keenly aware that the government and the media have made a relentless campaign that paying high fees is bad for your portfolios. While this is true if you look at mediocre investment managers, a superior alternative fund can make all the difference even if their fees are higher than what is usually expected. The issue is that manager analysis and selection is critical.?I learnt this from my alternative investment years in Europe as I was Panellist in the “Financial News Awards- Excellence in European Alternative Institutional Asset Management” held in London and arranged by Financial News (London based financial services magazine) and after having worked for an asset consultant specialized in alternative assets in London.
Industry funds usually perform quite well not because of low fees (the average real fee for a $200,000 portfolio is 0.9%pa Font CANSTAR), but because they allocate a great part of the portfolio to unlisted assets – between 20% and 30% (Font Price Waterhouse Cooper, 2021). The Australian government owned Future Fund allocates almost 44% to alternatives (including infrastructure, 37% excluding) (Future Fund asset allocation 31.12.2021).
Patterns
I find patterns in this century quite interesting.
2001, September the Al Qaeda fear braces the world. 2011 Osama Bin Laden is killed and the threat recedes.
2013/2014 the rise of Islamic State and the fear of widespread terror attacks. In 2019, Islamic State gets defeated.
2020/2022 the Covid-19 pandemic storms through the world. It starts to end in 2022.
2022 Russia attacks Ukraine and the world again is braced by fear again. Also, there are a few parallels between China and Russia.
If it was a spy book, all of these patterns could not be naturally occurring. Or they could be natural, but exaggerated by external forces for ulterior motives.
?A relevant Simpson episode…
Information contained in this newsletter is general advice only.?It does not take into consideration your personal financial situation, goals or needs. You must consider the appropriateness of the advice prior to acting on this information. Please seek advice ?from us or your financial adviser and read the Product Disclosure Statement/Financial Services Guide of the product you are considering prior to investing in that product.