Scala Private Wealth- Beyond the News - April 2022

Scala Private Wealth Beyond the News, March 22: It’s the end of the world as we know it – and I feel fine!

?Since the end of the Second World War the world geopolitics have defined eras:

1945-1947 Interim Period

1947 -1989 The Cold War

1989-2016 The US absolute Dominance

2016-2021 interim period

2022-TBA the Second Cold War

Also, in finance there have been such periods

1944-1971 Bretton Woods agreement -USD convertibility to gold

1971 -1983 the great inflation

1983 -2000 one of the greatest market rally

2008 Great Financial Crisis

2009-2021 The Federal Reserve intervention years “The Fed put”

2022 -TBA a different market

?So, this is the end of the world as we know it

Geopolitically the new world will be more focused on defence (both military and healthcare), reshoring of supply chain and energy/commodities security than growth.

?On a financial level after 40 years of low inflation and lower interest rate, we are going into a period of structurally higher inflation and with high rate of inflation speed (lower and higher inflation in different periods), there will be still growth, if lower, and much more intra year volatility.

?Why I feel fine? As a portfolio manager I am more used to this kind of situation than the “Fed put” situation where you could buy a simple SP500 ETF and be quite happy. In my career I remember in 2015 I had to modify my strategies as the portfolio defences did not work due to the constant intervention from the Federal Reserve. Now I simply go back to my past for new “old strategies” for this market, so I feel fine. Just a bit more stressed. I should add.

War in Ukraine

The war in Ukraine showed the world a massive failure of Putin. First of all, it has been a secret service failure – clearly the Russian were expecting the Ukrainian to surrender out of fear. Then military mistakes kept on piling up.

Notwithstanding the massive superiority as of numbers Ukraine did not crumble.

There are several issues and lessons.

The US Army is the only army in the world with a battle tested logistics capability.

The US army is the only army with tested multi domain (air land sea) integration capacity.

Even if the Russian army has modern weapons, like China, a good 50% of its weapon systems and tactics are still Cold War era.

The real possibility of the presence of a fifth column (a clandestine faction who attempts to undermine a nation’s solidarity) against Putin. This would explain how the Russian did not try to achieve air superiority from day one (a standard war tactic since 1939) and why Putin pro-war telecast was interrupted in mid stream.

Russia has still the power to grind Ukraine to surrender, but steps towards peace are encouraging. Ukraine has practically accepted not to join NATO. The hard point is Crimea and the Donbass region – while de facto in Russian hands since 2014, Ukraine refuses to accept it. It is always darker before the turning point.?

The West is pushing President Putin – I really hope they understand that is better to give the enemy (with nuclear weapons) an escape route than try to crush him to death.

Vaccines and Covid-19 data

Omicron variant BA2 is taking hold of various countries, but it seems just like a slightly more transmissible variant of Omicron – unless a person is immunocompromise the effects are similar to the flu or bad cold.

USA??

President Biden approval ratings have slightly improved during the Russian-Ukraine crisis, but American are strongly focussed on the economy and inflation is still rampant and the disapproval rate is 53%, but amongst the independent cohort the approval rating is just 27%. The economic data in the US are still good – logically worse than 2021, but still more than acceptable. Inflation and especially oil price are denting growth, but not enough to send the US in recession. My model indicates a 55% chance of slight economic slowdown and only a 30% chance of bigger issues (low but not insignificant).

Federal Reserve

Finally, the FED raised the interest and, at the end, was quite well communicated and the market took it well, even if it did forecast 7 interest rate hikes!

Now the next big meeting is the 3rd May. The meeting will be interesting – if the “hawks” win we could have a 50bps rise and a quantitative tightening (which is like another 0.25%) and this could cause a considerable financial tightening amidst and natural slowdown – a risk for the market. This could an over-tightening of fiscal condition that, if not reverted by September, could get the US in recession by March 2023.

The Fed has not a good track record of managing soft landing – most of the time the attempt to have a soft landing becomes a full-blown recession. Usually, the Fed embarks on tightening until something break.

Inflation

My model on inflation had to be revisited due to the Russia/Ukraine war and probably we will not see peak inflation until July 2022 in US (7.7%) and April for the rest of the world. Also headline inflation could be still around 6% by December.

In the 70s inflation came in 4 waves and very time there was a peak inflation, the shares rally. This could explain why the market is rallying as every analyst sees March/April as the peak inflation for the year (but within an higher inflation structure).

Europe

The Russian gas dependency issue will take longer to solve than most realize. Not only there is dependency, but also lack of storage facilities, just 30%. So even if somehow the US, UAE or Australia could re direct some LNG, there is no storage facility. The news are naturally dominated by the Russian-Ukraine war, but it is hard to agree on gas and oil as there is too much dependence from Russia (Germany practically 50% depends on oil). This happens as the politicians, blinded by election marketing, ditched old fossil-based technology while the renewable energy is not advanced enough to take the full load. EU proposed a Euro 500 million package to farmers to soften the fallout from the war.

China

China slowdown is starting to hurt and the Chinese Premier (second on command) Li Kequiang took the fall for President Xi, who is untouchable. While it is no surprise it was almost a pre-announcement that the stimulus is coming again as the deceleration of China has been dramatic (the government expects a GDP growth of 5.5%, Morgan Stanley 5.35 and ING 4.8% - the reality is much lower.

A few days later President Xi announced his version of the “we will do whatever it takes” of ECB President Draghi memory and not only the Chinese market took off – but the entire world.

Most people are not aware, but the saving of the world from the Great Financial Crisis of 2008 was for a good part done by China (not only the US) as it introduced one of the largest stimuli in the world, USD 586bn probably more (the US stimulus was USD831bn, but most of it never left the banks). Do not underestimate the fact that while the Fed is tightening the policy, the PBOC is loosening. There is more agreement between Chinese and American on the Chinese companies listed in US. This adds a further complication to a complicated market.

Saudi Arabia

A friend highlighted that something strange is happening in Saudi Arabia.

Biden and his minion Boris Johnson attempted to communicate with the Saudi Crown Prince Mohammed Bin Salman (MBS)in order to release more oil and they were completely snubbed. At the same time the Crown invited President Xi (who accepted, first overseas travel of President Xi since the pandemic) to discuss weapon purchases and especially oil deals in Yuan.

The importance of this move should not be underestimated as the current USD as world currency has been underpinned by the 1974 Saudi-Kissinger agreement.

?By the way the last two that tried to de-peg the USD and oil did not end up very well (Saddam Hussein and Gaddafi, both eliminated under other pretexts), but President Biden is not a Clinton or a Bush.?????

Australia

The state of South Australia fell to Labour. This is a bad omen for the Liberals in the May 2022 Federal Election. PM Morrison is scrambling a double campaign. One a scaremongering campaign about Russia and China and the other of promised support.

For example for financial advisers the Liberal took as their own the Labour proposal for recognizing previous experience and started a new enquiry on simplifying the compliance issues. Sorry, for me is too late and opportunistic – they started this mess with the Royal Commission on banking that hit financial advisers and let go the big banks with minor reprimands.

At economic level Australia is in a good position versus the world. Inflation is rising, but not excessive, wage pressure is limited, and commodities are all the rage.

ABS data up to September 2021 showed that more Australian emigrated than immigrated

Recession

The yield curve on the US Treasury bond 10 years and 2 years (and 3 years) is starting to invert. This historically has predicted EVERY recession since 1955. Even the three time that the Fed said – this time is different. Also this time the FED says this time is different. This time there are quite few real differences as it is the 2 yrs that is rising not the 10 years lowering as it usually happens.

I do not think so, unless in the September meeting the FED change idea (currently the general idea is to have 10 to 12 rate hikes to 2.60-2.75%). Or a massive Chinese stimulus.

How long after the inversion the recession happens is a much harder question. The average since 1955 is 20 months. But we are in a much shorter cycle so I would pencil it for March 2023, unless something breaks earlier.

Market March

Almost like a clock the market return to rally fit with my model of a turning point some days before the 15th March. Amazingly it was 11 March. My model did not expect such a deep sell off due to Ukraine and yes I should have sold more. I doubted myself as I was going against Goldman Sachs, JP Morgan and all the mega analyst. But I have to take account also of transaction costs and tax implication. Also, if you missed just from the 14th to the 18th (and sorry to say nobody can be that precise) you would have missed a 6.5% rally. Sorry, not possible. What started the rally? A speech from the top Chinese officials that said “government should introduce policies that benefits market”.

Market April

I am constructive on April. Especially if there is a peace deal there could be up to a 6% rally to 4,700 to 4,800 on the SP500 – not that much on the ASX200 as commodities would ease off momentarily. But my philosophy is changed from buying the dip to selling the rally (typical strategy for inflationary periods). Naturally there must be a breather at the start of the month due to ferocity of the rally since mid March.

What we will do: we move up the ladder to quality business (dominant position, low debt, a lot of free cash flow) and value , but also, we would add a selected number of alternative managers to deal with a possibility of a sharp and short recession.

Australian Dollar

In the last 20 years the Australian Dollar was weaker during any crisis. In this commodity led inflationary environment also the Australian Dollar behaviour is changed and usually it will be stronger than the previous years.

Crypto ANZ

ANZ is the first bank, possibly in the world, to launch its own stable coin (a crypto coin pegged to the Australian Dollar), the A$DC. It is a great as the main issue of using crypto it is making sure that the crypto exchange and storage facility is secure.

Portfolio Construction -The issue with risk profile and compliance

As advisers we are bound to the rule of compliance – if the client has a risk profile as growth – automatically we have to allocate 30% to fixed interest.

With high inflation and such a low starting point of interest rate traditional fixed interest is more akin “return free risk asset” than a “risk free” asset.

The issue is that while compliance is static, the market is not.

In the last three months if you had allocated to classic fixed interest, your supposedly defensive assets would have lost between 3% and 10% - without even the chance you have in the stock market of a fast recovery.

There are few places you still can go

-private debt funds – they do provide better yields, but at the cost of liquidity.

-Unconstrained bond funds that aim at returns Cash Rate +3%. At the moment they are still more a “not losing money” than a “make money” strategy as inflation is higher – but by the end of the year with inflation calming down and interest rates going up, they should provide a better alternative.

- quite a few alternative strategies could provide a defensive strategy as adopted by the government Future Fund (approximately 40% allocation to alternative), but compliance would not allow such an exposure.

The reality is that compliance and best interest for the client in the market do not mix well as one is static and the other is definitely not static.

Cuban Crisis 1962

It is a famous historic time that when the USSR tried to put nuclear missiles in Cuba, the US threatened to invade as missiles could reach the US in few minutes (like from Ukraine to Russia.

What people do not know is that we “lucked out” (Gen R. McNAmara memoirs) from a nuclear war. The US did not know that the USSR had tactical nuclear devices installed in the Foxtrot Soviet sub B 59 and the Soviet nuclear chain of command left the ultimate decision of the commanding officer (not the USSR President). The B 59 was chased with low intensity depth charges and the commanding officer Cpt Savitsky ordered to load a nuclear armed torpedo. The launch required the political officer to agree (which he did) and the second in command, Arkhipov, disagreed.

If Arkhipov disagreed, it would have?been the end like the movie 1959 “On the beach” with Gregory Peck and Ava Gardner?(From KGB archives released in 1991).

Errors can happen and better not play with nuclear devices.

Non Fungible Tokens (NFT)

Courtesy Mason Stevens

NFT is the latest internet mania that most people do not understand, but a few are prepared to pay millions of dollar to own.

NFT’s are verifiably scarce, portable, and programmable digital assets – distinct from our copyright and patent laws.

Their key value lies in being able to establish digital provenance, and authenticity of ownership.

It is not a fad. The question of why you should pay for a unique piece that can be replicated forever is the same question of why a piece of the original Mona Lisa is priced at USD870 million (insurance price), while with current technologies you can buy a good replica for approximately $1,000.

Oil and fuel prices

This is a perpetual issue as price at the pump reaches AUD$2.20 with oil price at approximately USD$110.

The highest price of oil ever recorded in recent times was in 2008, USD147 with fuel price AUD$1.60

The difference is +37%. And by the way the USD 147 price should be USD201. So there is a massive price gauging somewhere.

Electric Cars

As petrol goes up, people are thinking to switch to EV – but they find a bad surprise also there.

As all renewable material are soaring the cost of EV is soaring.

Tesla announced it is increasing by 5 to 10% prices across the range due to material input.

Also the cheap Chinese brands like BYD, Xpeng and MG are increasing the prices as prices on battery material is soaring.

Teacher: "Anyone who thinks he's stupid may stand up!" *Nobody stands up * Teacher: "I'm sure there are some stupid students over here!"

Little Johnny stands up Teacher: "Ohh, Johnny you think you're stupid?" Little Johnny: "No... I just feel bad that you're standing alone...

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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.