From Pandemic to Putin to your Portfolio
What should investors do in times of peak uncertainty?
Just as the world started clawing its way out of the Covid-19 abyss, and everyone caught a slight glimpse of better days ahead, Vladimir Putin decided to shatter all our hopes and dreams of normalcy. His decision to invade Ukraine on 24 Feb 2022, plunged the world into an arguably even more turbulent and tenuous situation than the global pandemic of the past 2 years.
This article is however, not about geopolitics, but about the uncertainty investors are facing in the months and years ahead. To be frank, the Russia-Ukraine crisis is not the only source of concern and investors are grappling with numerous, tough, some existential, questions:
- Will the Ukraine war escalate and drag NATO into a kinetic conflict with Russia, and maybe even lead to nuclear war?
- Will China stay impartial? And what about a Chinese invasion of Taiwan?
- Will there be energy shortages, and will soaring food prices lead to a global uprising and revolution?
- Will sanctions collapse the global financial system, and will there be hyper-inflation?
- How far will the Fed raise interest rates, and is a stock market crash coming?
- Is there a recession or even depression around the corner?
Painting the backdrop
(7 points)
1. Shortly after the Ukraine invasion on 24 Feb, NATO countries froze the Russian central bank’s foreign reserves and removed Russian commercial banks from the SWIFT international payment system. These are the most severe financial sanctions that have ever been imposed on a global superpower and caused the Russian Rubel to plunge -30% against the USD overnight (-50% in 12 days) and led to the closure of the Moscow Stock exchange in an attempt to stem total evaporation of stock prices.
2. During this month (March 2022), commodity prices shot up to multi-decade highs, some overshooting all-time highs as the sanctions imposed on Russia caused fears of commodity shortages. This comes on top of a rising commodity price trend set in motion by the supply shocks and government stimulus during the 2020 Covid crisis.
3. During February 2022, US inflation (CPI) rose to its highest level (7.9%) since 1982 as the massive stimulus of 2020 remains in the system, supply chains remain dysfunctional and concerns over commodity shortages rise (as mentioned above).
4. In an attempt to bring inflation under control, the US Federal Reserve started a new interest rate hiking cycle on 16 March by raising the Fed funds rate from zero to 0.25%. This, just as the world economy is starting to show signs of slowing down. The previous hiking cycle started in Dec 2015.
5. Consumer sentiment surveys and PMI indices indicate that the global economy might soon start to roll over.
6. The US yield curve is very close to becoming inverted. This happens when the 2-year government bond yield rises above the 10-year yield (i.e. the 2y/10y yield spread is negative). The chart below shows that for each of the 7 past recessions, a yield curve inversion occurred 6–18 months in advance. Hence this is widely accepted as a leading indicator for recessions.
7. Major global stock indices are threatening to roll over as the momentum indicators of more and more stock markets are accelerating to the downside. When the 50-day moving average of a stock index goes below the 200-day moving average, this is seen as a bearish momentum indicator. See the chart below.
By now, you must feel like selling all investments and running for the hills, and I wouldn’t blame you. But this is usually a mistake. The old saying goes: “Time in the market is much more important than timing the market”. For the current environment, I would adapt this and say: Sticking to a proven investment strategy is more important than trying to predict the future.
Consider the following: What would your returns have been if you tried to time the market and thereby missed out on a few of the best monthly returns of the S&P 500 over the past 20 years?
If you were invested for the entire 20-year period from March 2002 until Feb 2022, your total return would have been 295% (excluding dividends). But if you missed the 10 best performing months, your total return would only have been 61%, and if you missed only the top 5 months, you would have earned 140% over the 240-month period.
So, trying to time the market could indeed be very costly. But what does an investor do? Just sit back and do nothing?
What to do?
As a full-time investor, my approach in highly uncertain times is to reduce existing exposure (and avoid new positions) in areas where the probability distribution of the outcomes is unknowable, and to focus on opportunities where I am confident that I have a grip on the risk-reward potential.
It is for instance, impossible to work out what the probability of nuclear war might be, or whether, and when the stock market will crash or not, and when it will recover. Therefore, I would not place any bets on these unknowable outcomes. That said, in times of heightened uncertainty, it is prudent to take some risk off the table, be more defensive in your investment strategy, and to build up some cash reserves.
Note that this approach applies to my core long-term portfolio where defense plays a more important role than in a high risk, maximum gain, trading account. However, volatility is also opportunity, and therefore one should be on the lookout for those rare occasions where uncertainty and fear cause markets to severely misprice good assets. More on this later.
What does it mean to be defensive?
(10 ways)
1. If you have leverage in your portfolio, it might be a good idea to reduce it.
2. If you have some cash, you might want to sit on it until the turbulence settles, unless if you have a high conviction investment opportunity (discussed in more detail below).
3. You can trim (or exit entirely) some of your shorter term speculative positions that might have done well recently. Make sure that you don’t sell your long term winners.
4. If fundamentals for some of your positions have changed, and you’ve been wondering if you should sell, now is the time. But don’t make the mistake of selling a good investment simply because of fear or doubt.
5. If you use stop losses in your strategy, this is the time to execute them with emotionless sniper precision.
6. If you are a swing trader, it is a good idea to reduce the entry-size of new positions.
7. Consider reallocating to defensive sectors such as, utilities, consumer staples and healthcare.
8. As for style factors, the emphasis should be on quality and low volatility.
9. When stock picking, look for companies with low debt, reliable dividends, strong brands and pricing power.
10. Portfolio hedging is a powerful defensive tool for investors with access to derivative instruments. Buying put options is probably the most popular hedging technique. However, if you didn’t hedge before the volatility kicked in, it might be too late now as volatility premiums have risen substantially. When everyone wants to buy insurance against the same thing, premiums rise:
Other examples of hedged portfolios are Equity Long/Short or Market Neutral strategies.
Note that being defensive does not mean you can’t take any risk, it just means that you need to think carefully about the risk to reward profile of every (existing and new) position. In volatile times, the aim is to stay in the game, rather than to go swinging for the fences.
Trends and Opportunities
(11 ideas)
Now, let’s look at some of my higher conviction trends and opportunities, where I think the risks are limited while the potential rewards are high. Some of these ideas do not yet exhibit actionable investment opportunities, but I will be keeping them on my radar for future positions once the entry setup presents itself.
1. In a world where the financial system depends on money-printing to keep it going, where ESG mandates are starving the mining and fossil fuel industries of capital while there are few scalable clean alternatives available, and where some of the largest commodity producing countries are embroiled in kinetic and economic warfare, inflation is likely to be structurally high for the foreseeable future. In this environment, hard assets such as yield generating property, precious metals, Bitcoin and quality stocks with pricing power, strong brands and reliable dividend growth, should do well.
2. The Covid-19 pandemic, geopolitical conflict, and the resultant severe supply-chain disruptions, have highlighted the vulnerabilities and fragile interdependence of all nations. Governments will likely allocate significant resources towards becoming more self-sufficient in terms of food, energy and other essentials. This countertrend to globalisation will add further fuel to the inflation fire. Infrastructure plays that could benefit from these capital inflows are: energy (both renewable and fossil), food production, agricultural fertilizer, digital connectivity, micro-processor manufacturing, defence, cyber security and medical supplies.
3. The ongoing weaponization of the US Dollar and most recently, the freezing of Russia’s foreign reserves has raised concerns among non-NATO countries about the risks involved in holding US Dollar reserves. Since 1971, US government bonds have been the preferred risk-free asset to hold by sovereigns and financial institutions, but if the US government could “confiscate” your bonds, are they really risk-free? I agree with many other analysts who believe that the USD will slowly become less and less dominant in global finance, and that countries will continue searching for viable alternatives. It is not clear what alternative will win out, but potential candidates to watch closely are: gold, currency baskets like the IMF’s Standard Drawing Rights, perhaps one of the new central bank digital currencies contemplated by authorities world-wide, and even maybe Bitcoin or some other private digital currency.
4. Notwithstanding the long-term trend mentioned in #3 above, surges in the US Dollar will most probably occur during any risk-off events such as the recent Russia-Ukraine crisis. Until another currency replaces the USD (probably not any time soon), it is a good idea to have some dollars on the side to be able to capitalize on future opportunities during such events. In my opinion, there is high risk of a liquidity squeeze due to the financial sanctions imposed on Russia, increasing margin calls on hedged commodity producers, and financial institutions holding large positions with Russian exposure.
5. As the current long bull-market (since 2009) becomes mature and approaches a potential top, as leverage (debt) in the global financial system increases, and as central banks (& governments) are unwilling to let the system reset, risk keeps building up in markets and we have probably entered a regime of higher volatility ahead. The chart below shows the S&P 500 Volatility Index (VIX) which has recently broken above its consolidation channel (since March 2020), and resumed the longer term uptrend as shown by the orange line.
Long volatility trading strategies can generate gains from volatility regardless of the direction of the underlying market. You are essentially betting on the magnitude of a market move, not the direction. Examples of such strategies are systematic trend following strategies or option strategies such as long Straddles or Strangles. In both these option spreads, you buy at-the-money or out-the-money call and put options, which makes money if the market moves either up or down, while your downside is limited to the premiums you paid for the options, which you will lose if the market ends up going sideways and your options expire worthless.
6. The dual mandate of the US Federal Reserve is to 1) ensure price stability (guard against inflation) and 2) to target full employment. With the strong US labour market, having fully recovered since the 2020 recession, inflation at multi decade highs (7.9%), and the US electoral base feeling the sting of high prices, the Fed is determined to bring inflation under control by draining liquidity (money) from the financial system through raising interest rates and by reducing their balance sheet (Selling debt-assets into the open market). However, given the extremely high debt levels in the US economy (see chart below), it is questionable as to how much they can raise interest rates before triggering a liquidation cascade. Some analysts estimate that this critical point will be reached at a US 10-year Treasury yield of 2.5% — 3.5%. At that point, they might have to dramatically reverse course and start to stimulate again in order to avoid a large-scale collapse of liquidity and asset prices.
I will maintain my defensive positioning until markets have corrected significantly, or once the Fed pivots and starts to open the liquidity spigots (print money) again. When this happens, it will be because their focus has once again shifted away from inflation and towards economic and financial stability. In this environment, deeply negative real yields will persist — fertile ground for a secular gold bull market. The chart below shows the strong inverse correlation between real yields and the gold price.
7. The sharp increase in oil and gas prices since the lows in 2020, recently exacerbated by the Russia-Ukraine crisis, is a strong incentive for western governments to accelerate their efforts to replace fossil fuels with renewable green energy sources. As mentioned before, renewables are simply not at a stage where they can viably take the place of oil, gas and coal. See the chart below.
In the short run, oil, gas, and coal producers will benefit from the higher commodity prices, but in the long run the winners will be renewable energy, battery technology and battery material producers. I am also expecting that the world will realise that nuclear energy is the best immediately actionable solution to the problem. This is already visible in the uranium market with uranium price and volumes breaking out of multi-year consolidations. See the chart below.
8. The Chinese technology sector has fallen -80% from its highs in February 2021. This sector includes many highly profitable companies such as Tencent, Alibaba and JD.com. However, due to the Chinese government’s tightening of regulations around these companies, they have been derated significantly below my estimates of intrinsic value. Last week, the Chinese government released a statement indicating that they have concluded their regulatory overhaul and that they are supportive of the technology industry which is key to the country’s future economic growth. This statement seems to have put in the bottom for stock prices in this sector, with a high-volume capitulation candle as indicated in the chart below:
Although this might only be the start of a long consolidation and prices could still fall further, I think the downside risk is limited here, while upside is potentially huge.
9. To add to the bull case for Chinese stocks in general, China seems to be the only country who is starting a new credit expansion (monetary easing) cycle while the rest of the world is in tightening mode. See the chart below. This should be a tailwind behind Chinese stocks in the months ahead.
10. The IPO bubble of 2020/2021 has now unwound completely and has also marked the top of the “unprofitable innovation tech sector”. I use the ARK Innovation ETF (ARKK) as proxy for this sector.
ARKK has corrected 65% from its highs in Feb 2021. I think it might be time to start looking for bottoms. Note that a breakout from a base formation could still be months away.
11. In the late stages of a secular bull market, when valuations are high (See chart below), capital flows are less predictable, and industry rotations are frequent, skilled active managers will outperform passive indexing strategies. It might be a good time to start researching good discretionary money managers to allocate some funds to. Choosing a money manager is however not an easy task as the recent best performers are usually the future worst performers. The emphasis here should be on long term track records and quality of process, rather than recent returns.
To summarise:
We are in a time of extremes: Extreme geopolitical tensions, extreme economic and financial conditions, extreme monetary policies, and extreme uncertainty. Make sure you stay in the investment game by being defensive. Do not make bets on unknowable outcomes. Don’t act out of fear or doubt. Be on the lookout for low risk, high potential return opportunities in areas where you feel confident that you have a handle on the probability distribution of the potential outcomes.
I’ll close with these wise and comforting words from Warren Buffett: “What you really want to do in investments is figure out what’s important and knowable. If it’s unimportant or unknowable, you forget about it.”
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Disclaimer
The views expressed in this article are the views of Johan Kirsten and are subject to change at any time based on market and other conditions. This is not financial or investment advice, nor a solicitation for investment funds and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
