Scala Private -Beyond the news- October 22- The Cost of Errors

What a terrible market! As predicted, the August rally was a fake and now, we are revisiting June lows.

We are at this point due to two American errors.

President Biden in 2021 continued stimulating the economy while it was powering up at full capacity and with a supply chain issue. He was trusting the 2007 GFC stimulus model, without understanding that in 2007 the stimulus went to the banks – while he implemented it directly to the consumer. In 2007 the banks kept most of the stimulus for themselves.

On top of this, the Fed, again independent but dominated by Democrat figures, did not realise inflation was not transitory (or transitory but on a three-year timeframe) and kept not only interest rates low, but stimulating the economy with banking redraw facilities with interest rates at practically zero.?

Let’s hope that the third democrat error is not underestimating the will of President Putin to use a tactical nuclear bomb.

I am still not a pro Trump supporter, but, aside the crazy speeches, the world and economy was in a better place. Sounds almost crazy to say it.

War in Ukraine

Russia is still clearly losing and feeling the pressure of the new US weapon systems. Even the forced conscription will not alter the situation as conscripts cannot be trained in time to be effective in the field.

My biggest worry is that President Putin, once he annexes the territories, will use a nuclear device. There is even a Russian military doctrine called “escalate to de-escalate” – meaning that Russia should escalate to nuclear attack to bring everybody at the negotiating table.

The issue with this doctrine is that other countries could use it in the future, and it will start a mad rush to acquire nuclear weapons. Just reflect on North Korea, South Korea and Japan and you will understand the issue.

The most likely scenario is that, with winter, the war will just grind forward with not much success on either side as Ukraine is starting to struggle to get more powerful weapons as the West does not want President Putin to push the nuclear button.

The Nord Stream gas pipeline has suffered a sabotage attack at circa 100 meters underwater. While we never know who was responsible, we just need to look at who profits from the damage and who has the capacity to carry out such an underwater operation.

-?????Russia Gazprom increased 300% its yearly profit in 6 months and it is one of the main revenue sources of the Russian government. No advantage here, but they do have the military capacity.

-?????Ukraine and all Eastern countries have a definite advantage as they get royalties for gas passing through their territories and not the Nord Stream. It is not likely that they have the military capacity to do it.

-?????The US always opposed the Nord Stream and on the 26th of January, Victoria Nuland (US Under Secretary of State) clearly stated “if Russia invades Ukraine, in one way or another, Nord Stream 2 will not move forward”. The US Navy Seals have the capacity and are trained for this kind of black ops. Nobody will tell you that – but just reason about it.

Federal Reserve

The Federal Reserve is creating havoc in the markets. While last week’s rate hike was well communicated, the market panicked as the terminal rate went from 4.5%pa to 4.6%pa and Chairman Powell agreed that a slump in economic activities and increased unemployment (practically a recession) was the cost of reducing inflation.

Now the market is pricing a 75bps November, 50bps December and 25bp in January. Usually, the Fed stops before its terminal rate has been reached, as it breaks something.

The biggest point of crisis are currencies (especially Yuan, Yen, Indian Rupee and GBP) as it happened before (1994 Mexico, 1997, Asian Crisis, 1998 Russia). All these events stopped the Fed in its tracks in the past.

The issue is that the risk models used by the institutional players are not programmed with such rapid swings.

The Fed has three mandates – inflation, unemployment and financial stability. When the Fed breaks something, financial stability will be again the number 1 issue.?

Interestingly, Fed speak (the various conferences in which Fed high ranking officials speak and share their views) is starting to feel more benign.?

Inflation

Notwithstanding the Fed, inflation is coming down. Most important to note is that the last data release shows that housing rental is starting to come down (from 8.2% in July to 7.1% in August). This is really important as housing rental represents 40% of the Core Inflation Basket that the Fed tracks.

US midterm elections

The US midterms are fast approaching and there are two main issues:

·????????economy/inflation which is a pro-Republican factor; and

·????????the abortion issue that is a pro-Democrat factor.

Forecasts suggest the Democrats are likely to keep the Senate (69% probability) and lose the House (74% probability) on the 8th of November. This is a positive for the market as politics will be frozen and cannot “hinder” the economy.

USA

In the US, the economy is still going well, but there are some signs of cooling off. While the employment broad figures show a resilient market, other more in detail data shows that the big employment numbers are due to many people having two jobs – not to a healthy economy. This kind of reflects my own data that shows numerous large companies starting to lay off people. Democrats clearly do not want to release this kind of information before an election.

The US has committed in excess of USD54 billion to Ukraine and this is starting to be criticized by citizens as it is an amount just lower than that allocated to Public Housing – it is the 5th largest item in the Democrat’s policy spending bill.

UK

The first moves from the new PM Truss have been disastrous for UK markets. Freezing energy bills and tax cuts have sent the GBP down and the financial market into a spin.

A dark joke in the UK is that PM Truss first took care of the Queen and then the economy. What a start!

Europe

Europe is feeling the brunt of the US-Russia proxy war in Ukraine and its citizens are starting to rebel. In Italy, the right-wing Brothers of Italy won and it is just the beginning of the second phase of the rise of populism (per se, populism is a denigratory term invested in by the old political forces). It is something to follow attentively if you remember history. In Europe there was the rise of nationalism between 1815 and 1848 that was at the end defeated by the monarchies. ?But by mid 1870s the European monarchies were all gone. In a sense the “GrExit revolution” were defeated in 2015, only to reappear in 2022 in Italy.

The Italian vote is very disruptive - first time since World War 2 that a right-wing party wins and first time there is a female Prima Minister in Italy.

In Sweden, another traditional left-wing country, elected a right-wing government.

There is also outrage as the non-elected EU Chief Ursula von der Leyen has been accused of political interference as she warned “the EU has tools to fight Italy if things go in a difficult direction.” (hinting she would cut funding). It is a direct threat to democracy.

China

China did not come short of surprises – in the weekend the web had whispers of a potential coup against President Xi. Not many took that seriously, but it shows the fragility of …everything.

President Xi started a new crackdown within the party against anyone who dares think against him – the latest victim is the ex-Justice Minister who has been sent to jail for life. President Xi is cleaning up the party before the Communist Party Congress. Since 2020 over 17,000 officials and police officers got arrested!

China is still in all sorts of trouble, especially the real estate sector. Goldman Sachs cut the GDP forecast for FY2023 from 5.3%pa to 4.5%pa. Quite a few investment banks are reconsidering their position in China due to the aggressiveness of China versus Taiwan and a potential Russia-style fallout.

Hong Kong will most likely enter recession by the year end and it is losing its financial and aviation hub status in Asia.?The biggest issue is the weakening of the Yuan – as the US Federal Reserve is rising rates and the PBOC is loosening them, the yuan is falling and increasing unintended consequences for all of Asia.

The real estate crash and demographic patterns are eerily similar to the Japanese crash of the 1990s as Andy Xie, analyst of Société General, points out.?

Reserve Bank of Australia

The RBA is caught between a rock and a hard place. The market predictions are for a final cash rate of 3.6%pa (up from 3.1%pa in August, current 2.35%pa) – meaning a 25% fall in housing prices.

At 3.6%pa, the rate would be one of the highest in recent memory as the banks did not pass all the rate cuts by the RBA to confront the Covid 19 emergency.

The RBA would like to slow the pace of hikes, but – with a hawkish Fed – the Australian dollar is falling – now targeting USD64c/61c. Such a low currency “imports” a high level of inflation.

Australia

Labour surprised the market by aiming at franking dividends. It is very targeted – when there is a capital raising special dividend franking credits cannot be paid out. The proposal would be retrospective to December 2016 – especially Industry funds could have a shock tax bill.

Queensland tried introducing a new Land Tax that is hitting hard the Queensland rental market – but all over Australia the property rental market availability year on year fell nationwide by 30.9% as property investors offload their investment houses.

Market 27 September 2022?

Unfortunately, I was correct again in my previous newsletters and the market tanked to make lower lows (I was expecting higher lows but the difference is 1%). Is this the bottom? Only a madman could call the bottom in this market – but let’s say we are within 4% from the bottom (SP500 3,580 - 3,500 let’s say). Finally, most people are panicking, and the retail market participation is at the lowest since 1950 (an exceptional contrarian indicator). Now a powerful oversold rally could ensue to bring the index back almost to 4,000. October will be an “up and down” market where the market tries to find a bottom.

This outcome has a 70% probability. The other probability is that the FED breaks something big like Lehman Brothers in 2008. They say they always look at history – let’s hope they learned their lesson. The graph 2008 and 2022 comparison looks scary indeed.

?The nuclear bomb?

What if President Putin launches a nuclear attack? On the market this will provoke a -13% sell off similar to 1987 (the market sold off in a day 22% - but people forget to mention it recovered all the selloff in less than a month and continued rallying until 2000). Now the stock exchanges have circuit breakers (trading halt 7%, 13%, 20%).

Then if it is just one bomb, probably there will be some negotiation and the Fed will have to stop and assess and the market will rally.

If there is a second and third bomb – well let’s say that your portfolios will be the last thing to worry about.

On a military side, if Putin launches a bomb let’s say on Snake Island (island in front of Odesa, Ukraine, but inhabited) it would be just a warning with probably little consequences.

If the bomb hits a military logistic compound just behind enemy lines – the US will have to send a strong message – probably hit the Russian missile silos that launched the bomb – hoping that President Putin does not escalate.

If the bomb hits a major centre like Kiev, let’s say hopefully it will never happen.

Curiosity – Genova flag and England

The famous English flag of St George Cross (red cross on white background) in reality is from Genova, Italy. The English struck a deal with Genova, one of the most powerful maritime powers of the time, in 1190. The Genovese ships were considered such a fierce enemy that no pirates would try and board them, so the English monarch paid a fee for the use of the flag to ward off potential hostiles.

As a quirky side story, the English stopped paying in 1771 when the Genovese republic was in decline and the current Genovese mayor is asking the UK to make payment towards historical palace restoration expenses in lieu of overdue fees.

NASA -DART

?As most of you probably know, NASA smashed a satellite against an asteroid launched in 2021 to see if it is able to avoid an extinction level event. The satellite was as big as a bus travelling at over 22,000 km/h, and the asteroid of circa 170 meters diameter (the size of the biggest Egyptian pyramid).??A mini satellite built in Italy, LiciaCube has been launched 10 days pre-impact to see the effects of the impact for the next months and in 2024 there will be a follow up mission to study the aftereffects.

Finally, some money spent for a good cause.

?And finally…a joke

The asteroid event that ended dinosaurs was technically the highest ratio of killing birds to one stone.

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