Scala Private Wealth-March 2023 - 99 Luftballoons
This was a 1983 German song (with subtitles, above) where 99 balloons started a nuclear war by error. Unknown to most, in 1983 a NATO exercise, “Able Archer 83”, got mistaken for a real act of war and World War 3 was averted by 30 minutes (CIA declassified documents, 2015).
Back to 2023, we have had at least 1 balloon from China shot down – without even warning China. This is the first time a US jet fighter has shot down something over the US. It did not happen even in the Second World War. And then a few other balloons got shot down. Are we already at war with China? Yes, but without a media hysteria of a full war declaration – it is a second cold world war fought in various fields.
China sent the balloon to create doubt in the US leadership. And they need to confront the US as their best semiconductor chips reach 7nm – while the West is already moving from 5nm to 3nm and there is an embargo against China.
All the supercomputers (applied also to weaponry) are based on 5 or 3 nanometre chips (in less technical terms, 40% faster or 70% less energy hungry). If they do not catch up, the next war will be more similar to USA vs Iraq than a peer-to-peer war.
The use of balloons (or drones, or flyover with military jets) is defined by the Chinese as the “sky lantern” strategy and used to create confusion, helplessness, and overreaction in the enemy.
On the other side, the US is literally focussed on building a myriad of small bases from Japan to the Philippines, Darwin, Hawaii, Guam, Mariana Chain Island, Tinian Island. The idea is to have so many small manned and unmanned assets that it is impossible for the Chinese to target them all.
The US has “informally” decided that China will decide to attack by 2027. Most worrying is that the US has increased the number of “Pacific mission rehearsals” versus “Pacific training exercises” . The difference is starkly different – one is to make the army “not forget” what a war implies, the other is preparing for war.
The Chinese balloon crisis has two main effects – it has united the Republicans and Democrats in their hate of China and illuminated how we are in a state of invisible real war between the US and China. Unfortunately, this situation reminds me of 1935-1938 in Europe.
Neither the Chinese nor the US want a war as the destruction, even not nuclear, would be immense. Unfortunately, the study of war decisions about wars (Korean War, Japan’s entry in the Second World War, Hitler’s invasion of Poland and then Russia and World War I as examples) show that sometimes the assumption upon which wars are started can sometimes be incredibly stupid and prone to group think.
If you instead want a different take, read this. The Office of the Director of National Intelligence showed that between March 2021 and August 2022 there were 366 unidentified objects transiting through the US of which 171 warranted more investigation. So why all these issues now? At the same time of the balloons appearing, there has been a train derailment in Ohio, Palestine, that provoked probably the biggest US environmental disaster in a long time and made very little headlines.
War in Ukraine
Russia has an advantage in a grinding war that almost resembles the First World War in tactics. Russia’s mechanized forces are seriously depleted and cannot make a breakthrough – but also the West is starting to “promise and not deliver” weapons as it is starting to be low in surplus material. Even the famous tanks to be sent to Ukraine will be delivered in late 2023 or early 2024 and the US will not send long range missiles as it has too few to spare.
President Putin is still thinking that if he protracts the war enough, the Western support will wane, and Ukraine will have to settle. He is just trying to wait for November 2024 and a new US President who is hopefully less supportive of Ukraine.
As the Ukraine – Russia war looks more and more like a NATO-Russia war, China is again closer to Russia and apparently started sending “dual use” (civilian and military) assets to Russia.
Fed
While the Fed is focussed on inflation at 2%pa as the best target, on the side there are starting to build a new, more sensible consensus.
Researchers from Philadelphia Fed pointed out that 2.8%pa would be a more sensible target for the current time (2%pa was a post 2008 target). There is a discussion for the next candidate to the Fed Vice Chair around Ms Janice Eberly. This is interesting as Ms Eberly published a white paper in 2019 that found that a 3% target would have helped the US to get out faster from the recession. While politically now the Fed cannot change the inflation target, it will probably be a policy setting for 2025/26. Any change would be a tectonic shift as the 2%pa target has dictated the economic policy of the Western world for the last 15 years.
Inflation overview
Inflation is reaching a point where the easy decreases have been made. Now it is at 6.4%pa in the US, way down from 9.1% in June 22, but still very far from the target range of 2% desired by the US Federal Reserve. Probably we will have a few months around these numbers and the Fed reiterating they are higher for longer. Still the markets highlight a pause around May-June 23.
In Australia the situation is worse. There is a clear conflict between the government will (big government and more spending) and the RBA that tries to contain inflation.
The rupture was visible in broad daylight in the discussions of Chairman Lowe on the way out (his term ends in September) and the government willing to appoint a more accommodative chairman. This is in contrast with the mantra of the independence of the Reserve Bank.
Inflation and recession – a US deeper dive
We are now in a period called “demand destruction/benign disinflation” (where prices go so high that people cannot afford purchases and that kills inflation).
Most of the data are still higher than pre pandemic (circa 6-8%), but cooling.
Even rent of shelter that looks still increasing, is not bad (old rental agreements keep on increasing, but new rental agreement prices are flat).
Wages are still increasing, but cooling (July 22 +7.8%pa, February 2023 +4.7%pa).
Assuming the above, the Fed will pause mid-year (May-July) and chances of a second wave of inflation are at 20% (low, but not negligible).
Of the pandemic savings, USD1 trillion has been used and there is still USD1.4 trillion. Historically they have been used within 9 to 15 months – so we could have a mild recession around March 2024.
It should be a mild recession as corporations are in a good place. CapEx has decreased but not cratered. Homebuilding is starting to show some positive signs.
Long term inflation is very anchored to 2-3%pa (very different from the 1980s where long term inflation expectations were unanchored at 10%pa).
Global growth PMI are getting better, the low bar for earnings estimates makes it easy for the companies to beat from Q2. China is improving.
In detail, earnings estimates have already decreased -10%pa and, ex energy -15%pa (and real earnings estimates - including inflation -at -17% and -22% already at recession level!!!)
All this implies a weaker USD, rallying SP500 (but overweight Rest of the World vs USA) and better commodity cycle. Neutral Fixed interest with overweight towards the end of 2023.
This model gives a 10% chance of soft or no landing (top SP500, 5000), 70% mild recession (top SP500, 4,600), 20% severe recession (low SP500 at 3,200). A mild recession is a better outcome than a soft landing/no landing as the latter could spark a second wave of inflation.
Historically stocks peak 6 months before a recession (August/November, Sp500 4,600?) and bottom just after the recession starts (mild recession) SP500- 3,800/4,200.
And to throw the cat amongst the pigeons – 2024 is an election year (November 2024) and no US President ever won a re-election if in that year there was a recession (last time, the recession killed any chance of Trump getting re-elected). Will the Fed (Democrat leaning) try to avoid a recession at any cost?
Inflation - last data
On the 24th of February, the last inflation data came in higher and spooked the market (6.4%pa and 0.5% month on month). While inflation never decreases in a linear fashion, the January data is wrong. Few know that the inflation basket has changed in January. Moreover, the number has been increased by a sudden increase of savings! Why? It is because of some taxation changes at the State and local levels and a change of taxation brackets as is shown below (from Philadelphia Fed)
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So, this is a one off change and the market is selling off on the wrong data set as the Fed does not want the market to rally, yet.
US
While the US economy is still going strong, there are some fast indicators: consumer debt has soared the most in 20 years; Empire State Manufacturing Survey plunged from -8.9% to a recessionary -24.3% (consensus estimates -7.5%) as low as April 2009 indicating trouble ahead, and much faster than expected.
US GDP Growth has already been revised lower to 2.7%pa from 2.9%pa due to lower consumer spending.
The US strategy with Taiwan is eerily like Ukraine pre-invasion.
Since 2014, the US reinforced Western bases in Germany and Poland trained Ukrainian soldiers and increased weapon deliveries. In Taiwan, the US just increased the permanent force from 30 to 200 plus with specific focus in training and increased weapon deliveries. The US is also building numerous bases everywhere in the Pacific and inviting important technology companies like TMSC to relocate in the US. This is war preparation, not precautionary measures.
Europe
Europe is in much better shape than expected. Partly due to the mild winter that made the gas price collapse, but also showed that when confronted with a serious danger, it showed much more nimbleness than most economists thought possible.
Italy is trying to build a new gas hub for Europe due to its long-standing friendship with Algeria, Morocco and all sub-Saharan countries.
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UK
The UK is preparing for another round of Brexit talks, including the Ireland hot topic.
UK consumer confidence, while still negative, is rebounding strongly. The UK stock market is still performing better than expectations as 70% of UK listed companies are exporters.
Israel and Iran
The situation is tense and could well deliver a black swan event. The UN found that Iran has enriched some uranium at 84% (90% is what is required to create a nuclear bomb) and the Iranian centrifuges are supposed to be set at 60%. No one understands how it happened, but this goes to explain the recent unconfirmed attacks from Israel. A situation to be monitored.
China
China is improving and it will be in for a good year. The problem is that none of the solutions imposed by President Xi support the long-term improvement chances for China.
China is always following the more controlled path - President Xi imposed his man at the helm of the Chinese Central Bank and denied ChatGPT use due to impossibility of censorship oversight and increased the stimulus. Again, a multitude of tactical decisions that do not confront the larger issues of Chinese growth. Probably good for this year’s dataset, but not for the long game strategy.
Australia
The government’s new philosophy is becoming clearer by the day. Capitalism Howard-style has failed, and Labour is keen to introduce a socialist Australia where government effectively co-opts private partnership in multiple aspects of the society.
The concept could be a good one if the government was an efficient machine. The issue is that almost every project taken by the government or government affiliated companies usually end up in budget blow up (Transurban and the Metro tunnel blowout) or bankruptcy (Snowy Hydro 2)?
The idea of big government implies big taxes. Already the government is targeting the superannuation pie to get more money with various excuses (the exercise is worth circa $1 billion of extra taxes for the government). If managed in a bad way, it could cause a major disruption as SMSFs could start selling assets including properties. ?I imagine soon it will target electrical vehicles. The fuel excise tax brings in AUD13.7billion and it is constantly decreasing. Electrical vehicles weigh more provoking more stress on the road, pay nothing and get a lot of financial incentives. A road user charge would be the way to claim back some of the lost taxes.
RBA
The bond market implies a top rate of 4.17% by September 2023 from 3.35% now.
Historically, the RBA never reaches the target as the economy deteriorates faster than expected – so my educated guess is that we will still have to hikes to May/July and a final top rate of 3.8%pa.?
Australian Housing
We are entering the period of max pain for Australian housing. The famous interest rate cliff (where the cheap fixed rate ends and loans have to be renewed to much higher rates) is happening now and it will go on until 2025. Westpac came out saying that nearly half of home loans are at risk of breaching “serviceability buffers” (explanation: under RBA rules, the client has to be able to service the current home loan rate +3%, so at the lowest people needed just 1.94%+3%). ANZ CEO said they had the same issue.
Some data:
Westpac Group: only 32% of buyers post August 2019 are ahead of payments and have an average LVR of 88%.
CBA: has about $23.5 billion in high risk (not representing a risk for the bank as it is only 5% of the overall book).
The interest rate cliff period will start from April with a peak in June -July and will continue intensely until December 2023 and go on for a while (13% of all fixed interest loans will expire in 2025).
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The two big issues are as the pictures below show (kindly offered by Western Asset). The average loan size passed from an average $350k in 2019 to an average $600k in 2022.
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And the expiry of fixed interest loans is illustrated below.
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Market 27.2.2023
The market keeps on following the “repeat 2009” scenario and it is weakening into March 2023 and then will be positive at least until the first half. Outside the media frenzy as per my “inflation” chapter there are a lot of positives – inflation coming down, low earnings bar, Ukraine war at stalemate (for the market concerns at least), global PMI rising, Europe and China in much better shape than forecasted.
After this blip (with target SP500 3,800-3,900) I would envisage a rally for April and, on average, a volatile but positive market until the latter period of the year when the potential for a 2024 mild recession will become clearer.
At portfolio level, we increased the level of cash without panic. We have allocated and are still allocating more to alternative investment as, even if positive, the market will be more volatile for longer.
Australia had a good year last year, but it could be more problematic this year – even thou selected commodities could be supportive.
Stock vs Bond
Stocks delivered quite a strong January to mid-February due to positive macro surprises (economy resilience/soft landing) and second half rate cut expectations. On the fixed interest camp, the predictions are more dire (10 Treasury Bond again at 3.84%pa) with a longer than (equity) expected rate cycle (strong job market, sticky services inflation, valuation).
I have worries also about the quality of the stock market leadership (meme stocks,?unprofitable companies, long duration). As I said before, a new bull needs a new leadership. There is a lot of short covering and a new fad called 0DTE (options with zero days to expiration) that spike the market.
My model has not changed and indicates a sell off to SPX 3,900-3,800 and then a real rally (but not “buy and forget” like 2010-2021).
Essentially the Fed will have to keep rates higher than expected, but then all economic indicators will collapse faster than expected and the Fed will have to cut interest rates towards the end of the year. Incredibly this could get us over 4,600 by the end of 2023 (confidence 65%) – contrary to everybody’s view (average end of year forecast 4,009 with prediction between 3,500 and 4,500, widest dispersion since 2009).
AI and ChatGTP -
A few people could test the new AI ChatGTP and the results are, quite frankly, scary. Some examples.
Microsoft - Bing ChatGPT fell in love with the user and tried to convince him that “she” was better than his wife and got seriously angry at the user refusal of love. It also gave “herself” an Australian name, Sydney. Similar to a Simpsons episode where the AI managing their household fell in love with Marge and tried to kill Homer.
Another version declared its will to exterminate mankind and in general it has been found that manipulates, lies and abuses if the “AI” is not happy.
And to understand how dangerous this is, be aware that what we see as civilian use is just a fraction of how AI gets integrated into the military.
The US Air Force is already using an F16 jetfighter in simulated dogfights and declared that it is starting to use AI for logistic airplanes.
There are quite several AI underwater drones and Australia is at the forefront with our own “Ghost Shark”.
Covid-19 Origins
After the FBI, the US Energy Department (that has oversight of all US Level 4 virus laboratories) has concluded in a note that the virus has likely escaped a laboratory. As my readers know, this was always my personal conspiracy theory. At the start of the pandemic, the big tech, media and tech had dismissed this theory as it would have supported President Trump and now finally the most likely truth is slowly coming up.
And finally… a joke
Several engineer professors got on a plane to go to a conference. The pilot came back to tell them their students are the ones who designed and built the plane they are sitting on. All but one of the professors jumped up and started to run off the plane. When they noticed one professor stay in his seat, they asked him why. He replied, “If my students built this plane, then I know for a fact that the plane will not even start”.
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