Scala Private April 2023- Fed Breaking things, finally

There is an old saying about the Fed: when it starts raising interest rates the Fed never stops until it breaks something. Old wise words.

The tightening ended in disaster. The Fed broke several banks triggering the worst financial crisis since 2011 (Europe crisis). The difference from the 2008 GFC is the speed of the central banks’ reactions.

-The Swiss authorities compelled UBS to buy Credit Suisse (with the special poison pill that hybrid holders lost all their money and not the shareholders!).

-Several large banks (Goldman Sachs, JP Morgan et Al) threw a USD30bn lifeline to the regional banks.

The Fed created a special facility which is practically a discount window that is QE (even if they will never admit it).

-USD international swap lines were extended from weekly to daily (meaning whoever needs billions of USD can have it in a day!). The participants are all the major reserve banks (US, UK, Canada, ECB, Japan and Switzerland).

- Warren Buffet of Berkshire Hathaway is advising the Fed. Buffet in 2008 had the idea to inject capital into the banks (see “Panic; the untold story of the 2008 Financial Crisis” which rescued the Bank of America in 2011).

Words apart, the Fed capitulated as you will see below as with Lehman, the EU Crisis, the Repo crisis and Covid.?This is practically the interbanking rate, but a bit more sophisticated.

Effectively this is a very positive outcome for the market over the long term as now the Federal Reserve is trapped.

Credit Suisse

Credit Suisse was a bank in trouble from 2008. It had so many run ins with the law that it copped billions of dollars in fines and now collapsed. Only when the Swiss government intervened and compelled UBS to buy it did the market settle.

The big issue is that the AT 1 bond got completely wiped out, while the shareholders got something back. This is contrary to logic (equity comes before debt) and sparked an intervention from other Reserve Banks that the Swiss law does not apply to in Europe, the US or Australia.

Why the importance? The AT1 bond in Australia are called hybrids.

As a note - the Swiss legislation allows the banks to use AT1 to be used before the equity component as a buffer.?This is not the case in Australia.

Responsibility for this current situation

1.???President Biden with his mega stimulus created this inflationary issue.

2.???President Trump who loosened the “too big to fail” legislation in 2018 (to be honest the legislation passed with the support of Democrats).

3.???The Fed that acts too fast without waiting to see the effects of previous rate hikes.

Consequences

The consequence of this situation is that the probability of a recession has increased.?The banks will restrict lending – so companies will have more difficulties in refinancing and refinancing will be more expensive.

The estimated impact of the event is an equivalent rise in rates of 150 bps (Reuters). Moody’s predict that the high-yield default rate will rise from 2.6% to 4.9% in November 2023.

In the stock market, the peak cash rate is now projected to decline 3.9% by December 2023 – a full percentage point less than what was expected in December 2022.?This is very positive for the share market as share valuations are based on the cash rate (in simple words the lower the cash rate, the higher the valuation of the market is).?Quality and low debt are essential.

Ukraine

Russia made minor advances at great human cost. It seems Russia is making little gains in order to prepare for the spring Ukrainian offensive – when new US weapons will arrive. Russia is planning to move tactical nuclear missiles into Belarus. It is a political move as the missiles do not need to be moved so close to be able to use them. It is a countermove as the UK decided to give depleted uranium munitions for its tanks donated to Ukraine. Those are the same munitions used against Serbia and that created numerous cases of cancer. Unfortunately, I know of Italian UN soldiers that were affected and so it is not Russian misinformation.

The war ultimately depends on the US and Western allies. The US election in 2024 is starting to be scary for Ukraine as if there is a Republican President, the support will not be as strong.

The Fed

The Fed meet and rose the interest rates another 25bps. The message was almost identical to December and actually somewhat dovish as they hinted that next hike could be the last and in May.

The market reacted very badly as also Yellen spoke at the same time and gave a contradictory message to the Fed (the Fed said that they were monitoring the banking system stresses whereas Yellen said they will see what happens and they are not even thinking about taking precautions as there is “no broad case for increasing in deposit insurances”).?Incredible.?Very weird that two such important persons have a conference on the same day in a crisis without consulting each other!?The day after, Yellen corrected her statement to align with the Fed’s messaging.

Recession Watch?????????????

With the mini banking crisis, the probability of a recession in the US is at 75%, with suggestions that it will ramp up from August. There is a funny test that is usually correct – when inflation is above 5%pa, a recession occurs 18 months after the first rate hike (November 2023). It could be even earlier due to the mad pace of hikes. Earliest call is in June.

In Australia, probably we will have a recession for the people but not for the country as commodities are still super strong. So, the government will say we avoided a recession (forgetting to give thanks to the miners).

US

I always found it funny how the media loves the Democrats even if the Democrats are driving the world to war with Russia and China. The US is trying to stave off a Chinese peace initiative in the Ukraine as peace does not suit the US.

There are signs that the overtightening of the Fed is starting to take its toll on the economy so now the question is not if there will be a recession – more if it will be a mild one or a hard one.

The mixed message from Washington is alarming. There is no doubt in weaponizing Ukraine – but plenty of doubts in saving the regional banks and the savings of many Americans.

Europe

In France, Macron just survived a no confidence vote on the pension system (raising the pension age), but violent protests keep on going.

The ECB is continuing to raise rates, notwithstanding the banking issues. Next meeting is in May and a lot will depend on the stability of the banking sector. Labour remains tight.

UK

Inflation was still rising (10.4% vs expected 9.4%) in February and that complicates the decision of the Bank of England. While a month is not a sequence, the issue is becoming a political one.

Israel

Power to the people. The protests spurred by the proposed judiciary reform by Netanyahu and the extreme right were so powerful that they had to be shelved.

I do not pretend to be an Israel expert, but I never like when the government try to shape the judiciary system. The judiciary system has its own faults, but imposing the will of the government on the legal system is fraught with future danger.

China

China’s travel rebound is gathering pace. The Chinese state is also saying that it is open for business as Jack Ma (founder of Alibaba) was allowed to reappear in public (still another billionaire tech banker disappeared from public life). China is where we were at the end of Covid-19 (2021) so the news flow is quite good, even if the flaws at the base of the Chinese model are the same.

There are no signs of an “everything” recovery - it will be a modest recovery limited to some sectors. There is no surplus savings (China did not pay workers to stay at home). The recovery will be more centred on travel, hospitality and payment systems.

What is remarkable is that President Biden will be remembered as the one that lost the Middle East to China. Apart from the reconciliation between Iran and Saudi Arabia, China convinced Saudi’s Aramco to make major investments in China and Saudi Arabia is considering the use of the yuan instead of the USD – this could be a game changer as the petrodollar as currency is one of the reasons why the USD is the de facto reserve currency of the world.

Saudi Arabia

Under President Biden, the influence of the US in the Middle East is constantly declining, worrying Israel.

The head of the Saudi government bank has had a great deal of responsibility in the demise of the Credit Suisse. He clearly said that the Saudis were unwilling to step in to save Credit Suisse and literally started the run on the bank. The Saudis lost over US$1 billion. While in the West he would move to another job (the administrator of SVB Bank that failed in the US was the CFO of Lehman Brothers in 2008), in Saudi Arabia he “decided” to retire for health reasons. Much better outcome!

Australia

The Government deal with the Greens will be a big issue for the LNG industry and will force Australian companies to spend billions on offset and low emission technologies that invariably will increase the cost of living in Australia.

Victoria – Dan Andrews has flown to China officially as it is our (his?) best partner. Unofficially, there is gossip that he went to China as most of the construction work (given to Chinese firms) have huge cost blow outs. The strangeness of the visit is that it has been hastily arranged and no media were invited and the released schedule of meetings is very skeletal. A classic Red Agent.

RBA

The RBA has clearly stated that most probably they will hit pause in the rate hikes in April 2023 to assess the effect on the economy, as predicted in January (pause in April or May) as consumption spending is decreasing dramatically. It is still possible one last rate increase could happen in June/July – but we are definitely near the end of this cycle.

Real Estate

The market is not so bad, but mostly due to a supply slump (20% less listings than the 5 year average). As the fixed interest rate cliff is coming in June, we will have to see if the vendors can postpone the sales or not.

Market 28.3.2023

This month has been probably my best ever call. The 25th of January, I sent an email to the clients telling them that there would be a March bottom between the 10th and the 21st of March around 3,800-3,820. The bottom came on the 13th of March at 3,808. I stay with my theory of the impossible rally (started in November 2022, impossible as with all the crisis one would not think we would be in a rally, but the bottom was 3,520 on the 13 October – as I say history rhymes) and I do see a non linear rally (meaning good April with extension May, bad June, good July) targeting SP500 4,300 and above by July 2023.

4,300 is like the BIG watershed between the bad market (with base around 3,800) and the good market (with extension to 4,600).

?April is traditionally a good month. Probably inflation numbers in the US will start declining and recession will look inevitable – stopping the hand of the Fed. The market (as the bond market) will start to factor rate cuts and be happy. The banking crisis that was not – will keep on being a non-event.

It is a hard call.

Bond trader versus the Fed

Another epic battle is bond traders versus the Fed. Over the last few months, bond went one direction (rate cutting of 100bps this year with even the potential of a June start) and the Fed in the other (rates staying higher for longer). Or in other words, bond traders say there will be a recession by the end of the year while the Fed says no recession.?Spoiler alert – usually bond traders win.

Consumer Confidence

US Consumer Confidence in the market is at the lowest point. In history each time the pessimism was negative for 9 months or more – the following year the market did between +11% and +36%. Now it is the 15th month of pessimism, and it is the perfect time to invest, if you are a contrarian with guts of steel.

AI and ChatGTP – Part 2.

The data on Chat GTP is quite scary – it’s clear that AI lies, it is opportunistic and potentially more similar to terminator than a benign intelligence. I tried asking ChatGTP if there was a kill switch.

Q. Can you be shut down with a single switch??

Answer: "

It is possible to shut down an AI with a single switch, but it depends on the AI’s design and the purpose it serves. For instance, researchers install a self-awareness kill switch as a precautionary measure in case the AI awakens and becomes self-aware, the machine is immediately shut down before any risk of harm. However, some AIs will have an incentive to disable any off-switches, or to run copies of themselves on other computers.

In general, the ability to shut down an AI with a single switch is a dicey proposition, including for self-driving cars."?This is exactly what SkyNet in the Terminator movies did.

The reality is more nuanced.?While the current version of ChatGTP is very good at summarizing and augmenting efficacy, it is not yet good at analysing, maths and inferring from probabilistic information.

The reality is that ChatGTP is the iPhone event (iPhone was launched in 2007 and before it there were the basic standard Nokia) for AI. ChatGTP will be embedded in your life like the smartphone now. It will come to your Word documents, to your phone and everything else. ChatGTP4, which is the latest iteration, has even shown signs of intelligence by applying lessons it learned in one field to another field.

Correctly, Bill Gates, Tesla’s Elon Musk and others have called for a 6 month pause in the “AI arms race” (their definition) in order to define parameters and safety protocols. China banned ChatGTP as it is uncontrollable by the party. The scary thing is that military technology is usually 3 to 5 years ahead of civilian development. Linger on that for a moment.

Transition to Renewable Energy outlook

Even with over USD10 trillion spent on renewables since 2005, 80% of energy comes from fossil fuels with only 5% decline on resilience on fossil fuels during that period due to increase in consumption. German studies shows that, due to EV, heat pumps and the like, electricity consumption will rise 33% by 2030 requiring to double the energy grid. McKinsey data show that in Germany, 2030, the peak load generation will fall to 90GW, while peak demand will rise to 120HW.

The road to electrification will take longer than expected and current targets, ICE cars 2035 – decarbonized economy by 2050, look unrealistic.

1984 -2023

There has been a plethora of classic books rewritten to conform to 2023 WOKE sensitivity, the last being Agatha Christie classics.

This reminds me of George Orwell’s 1984 book where classic books were re-written to suit the Big Brother ideology.?It seems that Orwell had an alarming number of prophecies coming true – he just got the year wrong.

Mushrooms

Scientists have finally discovered what earth would have looked like 270 million years ago – before the giant dinosaurs.?Trees at the time were just 70cm to 1.5 meters tall and vegetation was mainly giant mushrooms (more sticks, but without the cap) averaging 8 meters tall!

And finally… ?NOT a joke

The EU meeting in Lyon, France, ended in a farce. Due to the new green environment, it was decided that the delegates should have come with electric cars. They soon found out that there were not enough recharge points for so many delegates (about 200 cars) – so they had to buy 100 portable diesel generators to recharge the cars!

I wish this was a joke.

Now for the joke…

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