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Current volatility ...
Given the volatility and economic uncertainty investors have experienced this year, we think it makes sense to review the state of markets, expectations, the economy, and most importantly, take a constructive view of how investors should be positioned to navigate this.
Global markets continue to be volatile. Bonds as an asset class have had their worst first 9 months to a year in history. At the same time equity markets have seen significant declines. The S&P 500 Index is down 23.5% YTD in 2022, which is close to where the market was in February of 2020, just before the pandemic-led sell-off. Adjusting for inflation (remember inflation reduces the real value of assets), and the S&P 500 is down closer to 34% so far in 2022 and is below 2020 levels.
Meanwhile inflation continues to surprise to the upside. Last week US core inflation again increased over the previous month, raising the prospect of yet more interest rate rises needed to curb inflation in the world’s largest economy. The ongoing real estate crisis and relentless zero-covid policies in China are weighing heavily on the world’s second biggest economy. Europe faces a tough winter ahead with record high energy prices and an economy already likely to be in recession.
Is there any good news here?
Well, yes, there are a couple of important factors that are easy to miss, but critical for investors to remember
First, investors are often guilty of spending too much time looking backwards, i.e., focussing on recent past performance, recent negative news, while spending too little time looking forwards. It’s easy to understand why. Looking backwards is easier, it is known information, we know what happened in the past. Looking forwards is hard, and can be scary. The future is unknown and uncertain.
Looking forward and with a long-term investing mind-set, we can say with some certainty that inflation in the US will subside (eventually), China will re-open (eventually), and Europe is already shifting away from a reliance on Russia gas supplies towards a more diversified energy mix, and as such energy costs will come down (eventually).
Investors must be careful not to get trapped in the news stories of the moment, and remain focussed on the future, which offers great investment opportunities, especially so in structural trends in the economy.
These trends are not going to be stopped by short-term factors, like inflation, pandemics, or even wars. The rise of the global middle classes in emerging markets, adoption of new technologies in healthcare, artificial intelligence, cloud computing. These are just a few examples of the incredible investment opportunities for long-term minded investors and as such should not be avoided now because of short-term concerns.
Second, as already mentioned, markets have come down a lot so far this year. Adjusting for inflation, the Nasdaq Index is down 43% in 2022! That is a major correction in prices. As painful as that is to swallow for investors with exposure to the market, it also means we are much closer to the end of the price correction than the beginning. It also means many of the stocks that offer exposure to those aforementioned long-term structural growth trends are now trading at much lower prices vs. 1-year ago. In many cases they are trading on their lowest prices ever!
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We continue with Dominion Capital Strategies series on current financial markets...
During the 1992 US presidential election campaign, James Carville, then a strategist for the Bill Clinton campaign, coined the phrase “it’s the economy, stupid.” George H. Bush was the incumbent president at the time, and the US was in an economic recession. As such, the Clinton campaign focussed its messaging on the principle of: whatever else people may like about George H. Bush’s first term as president, all that really matters is the state of the economy.
In the third part of our series on likely catalysts for the next bull market cycle, “it’s the economy, stupid!”. This phrase is helpful, as it was for Bill Clinton during his 1992 campaign, as a reminder that the state of the economy is by far the most important factor for us to be thinking about. Weaker economies tend to precipitate weaker financial markets, and vice versa. Thus, understanding the trajectory of the global economy in the remainder of 2022 and into next year, is vital for understanding the path of financial markets for investors.
The conundrum facing markets at this stage, however, is that while normally a stronger economy (all else equal) would be good for markets, at the moment the opposite is true. A stronger economy now in the short-term would be bad news. Why?
The difference today is excessive inflation.
It’s easy to forget we had rates of inflation in the developed world of less than 2% in 2019-2020, which had persisted more or less for 30 years. Today’s US headline rates north of 8% are the highest in four decades and, as such, central banks are focussed on bringing down inflation. Their fear (which is justified) is that allowing inflation to run hot for too long can embed higher inflation expectations into the economy. In other words, the population come to expect higher inflation and adjust their wage expectations and spending patterns accordingly, which further increases inflationary pressures on the economy. Such ‘inflationary spirals’ can last many years (1970s-1980s) and cause severe economic distress.
Central banks, therefore, want the economy to slow down to bring inflationary pressures under control, and they are doing this via higher interest rates. This leaves us with the aforementioned conundrum.
Good news for the economy, strong jobs data from the US for example, or higher than forecast consumer spending… this implies to markets that inflationary pressures will remain elevated and so interest rates will have to rise even further to slow the economy.
Right now, stronger than forecast economic data, without a corresponding decline in inflation, is bad news for markets, as it implies continued hawkish central bank policy and higher rates.
This makes the final of our bull market catalysts the most complex one to discuss, as it requires a period of bad news before the good news. In effect, we need the economy to slow down, first, to bring inflation under control, and it is only once inflation is back in its box, that we can interpret strong economic data as good news for risk assets.
The positive news on this front is that, as we discussed last week, there is early evidence that input prices for the economy have fallen in many cases from highs seen earlier in 2022, and as such, we should expect inflationary pressures to ease in coming months. With interest rates now much higher than they have been in well over a decade, this should (in theory at least) act as a break on the economy and bring the desired short-term slowing in economic activity needed to control inflation.
This brings us to our conclusion on bull market catalysts.
We have, you will remember, discussed three important catalysts we think would drive a new bull market cycle in stocks: (i) a pivot or pause in central bank policy, (ii) a decline in inflation, or (iii) a change in the economic situation.
It’s important to note here, that all three of these potential catalysts are linked. Inflation has a major effect on the economy and on central bank policy. Central bank policy also impacts the economy and levels of inflation. But most importantly, it’s the economy and its performance that drives everything here. Excessive economic activity relative to the supply of goods and services is what is currently driving inflation, and the continued strength in the economy through a bout of inflation is driving economic policy. It is, therefore, the economy where we must look first for evidence of a change in direction for markets.
Given the inflationary situation, this means looking for an economic slowdownfirst, before a recovery. It is the slowdown that will precipitate a pivot in central bank policy, and a reduction in inflation.
We will, therefore, over the coming weeks and months, return to the nuances of the latest economic data in an attempt to find, and report to you, evidence that our bull market catalysts are coming into play. This will, we think, when it happens, mark a critical moment for investors to consider maximising allocations to equities.
In the meantime, investors should, we think, continue to opportunistically add investments to specific strategies where valuation and quality are the primary criteria, while continuing to maintain ‘dry powder’ to further ramp equity exposure over the coming months before the next bull market cycle begins.
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This week, we continue our series on the likely catalysts for the next bull market...
It's important to recall that throughout 2022, and especially in recent months, Dominion Capital Strategies has reiterated their view that this current bearish cycle is not yet over, with more risks for investors. This will eventually end and a new bull market cycle will come for stock markets, the question is when and what will drive that sustained upward movement in stocks?
Last week we looked at Dominions first episode on "bull market catalysts" series, which includes a shift in central bank policy, and why this outcome would precipitate a new bull market cycle.
This week, the second episode of their catalysts series will explain why investors should understand what a sustained decline in inflation is.
Inflation levels remain stubbornly high around the world, near their highest readings in forty years. The wide rise in price levels is the ultimate cause of the current bear market cycle in asset prices. It was higher inflation that triggered central banks to raise interest rates and reduce market liquidity, an ongoing process that puts downward pressure on the prices of all assets.
This leads us to ask:
If there were a significant decline in inflation from here, what would that mean for markets and investors?
The answer is: it depends. It depends on the nature and causes of any decline in inflation. A significant supply-side response – that is, higher prices across the economy incentivize an increase in the supply of goods and services, thereby bringing prices back down, causing inflation to fall – would be a very positive outcome. This would certainly drive a new bull market cycle in stocks.
However, if from here inflation were to decrease because high prices destroy demand, acting as a brake on the rise in prices, the end result would be an economic recession, the decrease in corporate profits and the consequent fall of the stock markets. This result would prepare us for the next bull market cycle, given that it would still kill the inflation monster, but we would have to go through a recession first.
Which of the two is more likely? In Dominions opinion, probably a mixture of both. There will be a supply-side response to higher prices. A good example is here in the UK, where oil and gas drilling and production activity in the North Sea has increased to full capacity to produce as much energy as possible to supply the UK and Europe, in light of Russia's disconnect from its supplies to the continent. A similar activity will occur in all supply chains experiencing price increases.
At the same time, rising inflation and the consequent rise in interest rates are also destroying demand. We are seeing a significant slowdown in consumer demand in areas such as electronics, as well as clear evidence of the slowdown in the real estate market around the world. This, in turn, is reflected in a growing set of economic indicators that signal a possible recession.
The combination of these factors already translates into a drop in prices in many of the main inputs of the economy. Prices of most commodities have fallen sharply from the highs reached at the beginning of the year. Other input costs, such as freight and components, have also seen their prices fall from much higher levels in early 2022. Wage inflation remains positive, but it has not run rampant in the same way it did during the inflation cycle of the 1970s.
In real terms, the average worker in the U.S. and Europe has suffered a pay cut this year. Sharp rises in house prices in 2021 have stalled and in some places are being reversed. These are all leading indicators of official inflation data, meaning that we should start to see official inflation figures go down.
The timing of this is uncertain, inflation is slippery and has historically been incredibly difficult to predict, but there are reasons to be progressively optimistic that much of the inflationary pressures may begin to ease in the coming months. Now, it could be a slow process, with bumps in the road, but the direction of travel is becoming clearer, and that's good news for long-term investors.
When official inflation figures begin to fall steadily, this will be a strong catalyst for more stable equity markets and increase the likelihood that a new serious bull market cycle will begin. And we'll be the first to tell everybody. From here it requires patience on the part of investors, but we are getting closer and closer to the moment when we can call, with confidence, the next bull market cycle.
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Dominion Capital Strategies reiterates its opinion regarding the curent bear market:
We have, over the past two months, reiterated our view that the current bear market cycle is likely to persist until at least one major catalyst for a new bull market occurs. Over the coming weeks we will be digging deeper into what we mean by this and explaining what investors can be looking out for as early indicators for one of these bull market catalysts materializing.
First things first, what do we mean by a ‘catalyst’. This term, as with many others in professional investing, is borrowed from another industry. In chemistry, a catalyst is a substance that causes or accelerates a chemical reaction. When we talk about catalysts as investors, we are using the word to describe an event or outcome which will cause or accelerate a major change in markets. This catalyst could be political, economic, or specific to an industry or company. Whatever the case, it is the catalyst which will cause the change we are looking out for
In the case of the current market cycle, we are in, a catalyst for a new bull market would be some outcome or event which would cause a major change in markets and act to drive a new bull market cycle.
This week...
We’ll be talking about the first catalyst we are looking out for, which (if it occurs) is likely to drive a new bull market cycle in stocks. Namely, a pivot or pause in central bank policy.
Central banks in most of the developed world, led by the US Federal Reserve, are raising interest rates. Last week, the US Federal Reserve again raised interest rates by 0.75%, bringing the US rate range up to 3.0 - 3.25%. The Bank of England raised its base rate by 0.5% to 2.25%. Rates in these and other major economies were effectively 0% at the start of the year and this rapid change marks one of the fastest increases in rates in history.
Central banks are doing this in response to the highest rates of inflation in forty years. Higher rates are the best (and pretty much only) tool available to central banks to try and fight inflation. By raising rates, access to debt capital is reduced by making it more expensive to borrow, this in turn feeds through to slowing economic activity, which acts as a break to inflation.
This process has a major effect on financial markets and asset prices. Higher rates and the prospect of slowing economic growth means, for stock markets, a higher likelihood of reduced corporate profit growth (via a slowing economy and more expensive debt servicing) and thus equity markets can often see bouts of selling. This selling can be especially pronounced when the starting position for equity markets is one of high valuations, as was the case at the start of 2022.
As such, a change (or even the prospect of a change) in central bank policy away from raising rates and towards either pausing or pivoting into rate cuts, is a big deal for markets. Equity markets have in the recent past seen very strong positive rallies simply on a hint from staff at central banks that they ‘might’ consider a pause or pivot in policy.
Currently, there is no serious talk (yet) of pausing rate hikes, let alone pivoting into rate cuts. But, we do know that there is a growing difference of opinion within central banks. Some, like the US Fed and Bank of England, hold committee meetings where members vote on what the rate decision should be. We can see, by looking at these decisions, how many members of each respective committee voted for either rate hikes, pausing, or pivoting.
In the case of the Bank of England’s most recent decision, all members voted for a rate hike, but one member did argue for a much lower hike than was agreed. This is, we would argue, an early indication that there is some resistance to the current pace of rate hikes. There is some early indication of similarly marginal but growing resistance to the current policy of big rate hikes in the United States too.
What typically triggers a pausing or pivot in central bank policies is a major slowing in the economy. The prospect of much higher unemployment and even economic recession can, and has many times in the past, force the hand of central bankers to change direction. This again is an early indicator for a potential change of policy, evidence of a dramatic economic slowdown.
We are not there yet, in either case. The economy does appear to be slowing, but not drastically just yet. And there is scant evidence of an imminent central bank policy pause or pivot in the near term, either.
It helps, however, for investors to understand that, when a pause or pivot eventually looks like a real possibility, that will be a good time to consider ramping up allocations to equities in anticipation of a major catalyst for a new bull market. We are not there yet, but it helps to be on the look-out for the early signs of catalysts like this before they occur!
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Two weeks ago, we explained our idea of ‘embracing uncertainty’...
To recap,this is the idea that investors should adopt a strategy of taking advantage of short-term market volatility to gain more attractive entry points into long-term investments.
The idea we laid out begs the question: well, how do we ‘embrace uncertainty’ in practice? In other words, how do I (the investor) apply this to my investment decisions today?
Optimism, if grounded in reality, is our friend here. It can be a very powerful force and when utilized in a balanced and thoughtful way by investors, offers us a path to solid long-term investment performance.
First, let’s start by re-assessing the current state of the global economy and financial markets for investors. Inflation continues to plague economies, with rates their highest in decades. The war in Ukraine drags on and tensions between China and the United States make a hot war between superpowers a real possibility. The economy is showing signs of slowing and ....
Europe faces an extremely challenging winter likely to include energy rationing. On first impressions, finding an optimistic take on the future could be tough.
Dominion Capital Strategies
But let’s dig into this. Because we think the long-term outlook offers grounds for optimism, we would go further and say that investors would be careless not to be optimistic about the long-term.
We have said this before but it is worth repeating...
Investors must be wary not to catastrophize, over emphasizing the importance of current events and assuming that now is especially unique as a time of crisis or volatility.
However bad things might seem, they usually are not as bad as we think. That is especially true for investment markets.
History is helpful here to contextualize the current outlook for investors. In 1919 the world had just gone through the First World War, followed by the biggest pandemic (Spanish Influenza) in more than a century. Plenty of grounds for a pessimistic outlook. But that would have been wrong. 1919 was followed by the ‘Roaring Twenties’, a decade of technological innovation and strong economic growth.
Let’s take an even more extreme example. In 1941, the Second World War was raging and it was going very badly for the Allies. The Axis powers (Imperial Japan and Nazi Germany) were making gains pretty much everywhere, Western democratic civilisation was facing imminent defeat square in the face. It’s hard to think of any moment in modern history that would better justify taking a pessimistic outlook from an investment perspective. But, again, this would have been wrong. An investor buying US equities in 1941 would have made strong investment returns over the subsequent two decades.
These examples offer helpful context...
The situation facing investors today is relatively benign in comparison. Further, if we look out beyond the short-term issues of inflation, energy shortages, and even war in Europe, there are real reasons to be optimistic about the outlook for the economy, and as such, for equity investors.
The process of the world industrializing is a story only half told. After China’s rise, we can expect India, South East Asia, Latin America and Africa, to develop over the coming decades into global economic and cultural hubs. This is not only something to look forward to, it’s a major investment opportunity for the investor who is able to harness a long-term outlook and combine it with a rational optimism about the outlook for the world.
New technologies are coming to fruition which will transform the world for the better. Artificial intelligence, materials science, quantum computing, genetic medicine. These are just a few examples of areas of innovation at advanced stages and which are already making the world a better place to live.
This is not a call to arms for investors to dive 100% into equity markets today in blind hope. Rather, this is a timely reminder in a period of elevated volatility and uncertainty, to remain focused on the long-term, where we believe that taking a grounded but still optimistic view of the future offers a path for how investors should be thinking about positioning their portfolios today.
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Equity markets hit their lows, for 2022 year-to-date, in mid-June.
The S&P 500 Index hit a low of negative 23.4%, while the NASDAQ was 32.8% down for the year. This was undoubtedly a bear market. Include inflation, running at 8-9%, and the effective real declines in the S&P and NASDAQ were negative 32% and 41% respectively.
Since those lows in June, global equity markets have seen a strong positive rally. Continuing to use US indexes as metrics here, we’ve seen the S&P 500 rise +16.6%, and the NASDAQ +21.7% over the past two months.
This begs the question: are we currently seeing the first phase of a new bull market recovery from 2022’s bear market in the first half of the year? Or is this what is known as a ‘bear market rally’, a short-term bounce that often occurs in between major moves down in markets.
The answer to this question is very important for investors today. If this is truly the start of a new bull market cycle, then investors will want to shift asset allocations heavily in favour of equities. If, however, this is a bear market rally, then a much more cautious approach is the order of the day.
There are some arguments in favour of the ‘new bull market’ position which are somewhat compelling. The market declines in the first half of 2022 were dramatic, bringing stock valuations down to levels which are much more in-line with history (assuming no major declines in earnings to come). Consumer spending remains robust, despite the deterioration in some economic indicators and high inflation, and the corporate results for this current earnings season have been better than expected.
Meanwhile, inflation looks to have peaked, with the most recent reading for US CPI in July coming down month-on-month, and many commodity and freight rates (forward indicators for inflation) falling from highs earlier in the year, indicating further falls in inflation to come. This all adds up to a likely pivot from central banks, back to interest rate cuts in 2023, supporting a sustained bull market into next year.
What if this narrative is wrong?
In other words, what if the recent rally is a bear market rally? First, it is worth noting that bear market rallies as strong as this recent rally have been common in previous bear market cycles. During the 2001 bear market, the S&P 500 and NASDAQ managed to squeeze out +22% and +43% rallies respectively, before both seeing major moves down to new lows before that cycle was over. In fact, some of the strongest short-term rallies in history have been bear market rallies.
So, what is the argument in favour of the current rally being a bear market rally? First of all, inflation may have ticked down in the US from its highs, but it is still very high at more than 8% (the highest in 40 years), and so it is unlikely that central banks can pivot quickly, rates are likely to keep going up.
Further, the US central bank has also committed to something called ‘quantitative tightening’, the opposite of quantitative easing. Put simply, this is an additional measure to reduce liquidity in the system. This has not even started yet and is still to come for markets. Meanwhile, yes corporate earnings and the consumer have held up well so far, but inflation is eating into real wages (negative in most countries), it is eating into savings, and the negative effect of the interest rate rises already put through is lagged.
This means we can expect the slowing from those first rate rises to start impacting the economy later this year. Meanwhile many economic lead indicators have worsened, especially confidence indicators which appear to be flagging a slowdown in the economy later in 2022 / early 2023.
Europe is struggling to adapt to energy costs which are not declining and is probably already in recession. But given where inflation is, the European Central Bank, like its peers in the US, Japan, and UK, is in no position to cut rates to help support the economy, not yet anyway. Looking at the recent stock rally through this prism makes it seem somewhat forlorn and likely to reverse.
So, we hear you asking, which is it? A new bull market, or a bear market rally.
The short answer is, we do not know for certain, nobody does with any certainty, but we tend to favour the latter over the former.
Have we seen enough to convince us that this bear market is over? Probably not.
It’s still too early, in our view, to call the ‘all clear’ on this bear market. We would need much greater clarity on lower inflation, a stronger than expected economy in H2 2022, or a pivot in central bank policy, before becoming more attached to any rally.
This set-up of potential short-term complacency, or over confidence, in equity markets, offers investors an interesting potential entry point soon. As we have said in previous episodes, bear markets do not typically last very long and, now 9 months into this one, we’re probably closer to its end than its beginning.
Any new pull back in prices from here is therefore likely to offer a good entry point for investors looking to increase equity positions as part of a long-term strategy.
Such pullbacks will come, and they could be violent, but so long as investors are buying high quality businesses at reasonable valuations, or investing in funds with this strategy, any new bouts of market weakness should be seen as an opportunity to raise equity exposures in anticipation of the next bull market cycle, which will come eventually!
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Pandemic, cultural and working practices changed forever, supply chain disruptions impacting food production, war in Europe
Sound familiar? Well, this is an accurate description of Europe and the Middle East in the 6th century AD, during and after the Justinian Plague.
High inflation, a slowing economy, rising inequality, speculative asset bubbles crashing, and, of course, war in Europe. Sound familiar? This could be a description of the British economy during the Napoleonic wars, or the US in 1825, or in 1875, or the US in the 1970s, in fact every modern economy in the world has been in this situation multiple times.
Is the moment we are living through now especially uncertain? We would contend that the answer is a firm ‘no’!
Times are always uncertain. Recency bias, the behavioural bias which means humans tend to overweight the importance of more recent events, is partly to blame for the belief that now, whenever now is, is an especially unique moment in history, where uncertainty really is exceptionally high compared to the past.
Not too many Roman citizens in the 2nd century AD would have predicted the complete collapse of what was, at the time, the most powerful Empire in history. Neither would many of their contemporaries in 18th century England have predicted the imminent Industrial Revolution. 9/11, Pearl Harbour, we live in a world which is incredibly hard to predict. We would contend, it is impossible to predict at a macro level.
Uncertainty is almost like a drug in modern society today, the drug that fuels the fear which keeps modern 24-hour news cycles going, not to mention social media news feeds. If only we can get past this next crisis, then things will be stable and predictable! Ah, but of course, once the current crisis is behind us, lo and behold, a new crisis is discovered, which must be overcome, and the never-ending cycle repeats.
We recommend a radical approach to living in an uncertain world. Embracing uncertainty.
Dominion Capital Strategies
Acknowledgement and acceptance of the world as it is, rather than how we wish it to be, is the first step to successfully adapting to, and thriving in it. Uncertainty is core to the universe we live in. Things will always be unpredictable, we will never have certainty, in life as also in investing.
In investment markets uncertainty manifests as volatility. If there were no uncertainty, prices of assets would never move! Everything would be known and as such, there would be no need for prices of any investment assets to change.
We contend that trying to fight uncertainty is a little bit like trying to fight a war on two fronts, a very bad idea. Financial markets and the media are full of experts making predictions about inflation, GDP growth, political trends, etc. These are, we contend, effectively a waste of time from the perspective of investors. The radical truth is that nobody knows what will happen at a macro level. The world is highly uncertain.
How then, do you invest for the long-term if the long-term is so unpredictable?
Market volatility, or put more simply: changes in prices, is our friend here. Embracing uncertainty means embracing volatility. It is volatility in prices, driven by the fear of market participants reacting to uncertainty, which offers the patient investor the opportunity to make investments irrespective of the prevailing uncertainties of the time.
These are investments in companies, sectors, asset classes, sometimes specific countries, where the price of the assets in question do not reflect their true value. These are sometimes investments where the quality of the asset is something we can understand, and although we cannot predict with absolute certainty the future of this specific asset or business, we can make conclusions as investors with high degrees of confidence about the quality of the asset and, at the very least, the most likely trajectory for that business.
Will inflation rise or fall? Will there be a recession in Europe in the next 12 months? Highly unpredictable. We do not know, no one does.
Will the world’s leading digital advertising business, with a strong balance sheet, high profit margins and trading on a stock valuation 50% below the market average, continue to generate strong cash flows for the next 10 years? Probably. And if a high-quality asset like this is trading at its lowest valuation ever, that is probably enough for the long-term investor.
Embracing uncertainty means knowing what we can know and knowing what we will never know. For investors it means focussing on what you can know, with some confidence, and marrying this much narrower focus of expertise with a strategy to take advantage of opportunities provided by volatile markets.
In this sense volatility, and uncertainty, are our friends as investors, if we know how to handle them right.
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Over the past month, we have discussed false narratives we believe are predominant in financial markets today...
This has, by no means, been an exhaustive process yet, there are many other major themes which we think are misguided, not supported by evidence, and which have become mainstream thought.
However, this is probably a good time to pause and think about what we can conclude so far from our discussion of false narratives.
As we have said before, narratives are powerful devices. You can take an extremely complex system or series of events, like the founding of a country, or changes in a society, and via the power of story-telling give them a meaning which is easy to understand.
Sometimes, these narratives can stray from reality, and when they do this can have significant consequences. The pricing of assets like stocks relies heavily on narrative. What is the ‘story’ that explains the outlook for a particular company or sector of the economy? These stories then drive capital allocation decisions.
Who would want to invest in the company or sector which is destined to ‘go out of business’? Conversely, who wouldn’t want to invest in the sector that’s ‘changing the world’?
Understanding the narratives influencing capital allocators goes a long way to explaining the valuation of assets, and so understanding these narratives can help us look for investment opportunities.
Some compelling narratives are supported by evidence. ‘Emerging markets’, this is a narrative, a story that explains a complex process of industrialisation, demographic change, and the adoption of new technologies in low-income countries. The evidence supporting this story is overwhelming. The rise of China as a global economic power is impossible to argue with.
Some narratives, however, lack the supporting evidence that should be needed to believe the story. This, though, does not stop such narratives becoming mainstream. Especially compelling stories can become widely held beliefs which the majority will defend.
In financial markets, some narratives can exhibit almost religious characteristics.
These are usually narratives on controversial subjects, sometimes related to new technologies. Capital allocators and retail investors become so attached to their belief in the story that they make dramatic investment decisions based on these ideas, which in turn impacts the prices of related assets. This process is what gives rise to asset price bubbles, and their subsequent crashes.
Under the surface, this process also gives rise to ‘anti-bubbles’, a term coined by Diego Parilla. This is the opposite of the bubble, it’s the suppression of price discovery in assets negatively affected by the narrative driving the bubble. Anti-bubbles are price rises waiting to happen, the price discovery process delayed by the emotional lurches of markets in thrall to a different story. Just as bubbles can suddenly crash dramatically when reality catches up with the false narratives supporting them, anti-bubbles can very suddenly see dramatic price rises as reality catches up with the hidden value in the asset.
Anti-bubbles are underappreciated narratives with strong supporting evidence. The exact opposite of bubbles (over appreciated false narratives with weak supporting evidence).
Every ‘anti-bubble’ has a corresponding ‘false narrative’ which keeps the price of the asset in question artificially low.
Dominion Capital Strategies
Identifying anti-bubbles requires us to first identify the false narrative, then work back to where the anti-bubble opportunities may be. Investing in these before their stories become mainstream and accepted as reality can offer very appealing investment returns over the long-term.
Let’s go through an example of what we think is a major anti-bubble today
Climate change is a subject which, outside of racial politics or abortion rights in the United States, probably engenders the most extreme emotional responses from people when discussed. Financial markets have not escaped this.
The ESG movement, divestment from fossil fuels, ‘ethical investing’, these are themes which have changed the structure of asset management and dramatically impacted asset price performance in sectors linked to these themes, especially so in energy.
A fundamental misunderstanding of the global energy system and the most pragmatic ways to de-carbonise it, is the ‘false narrative’ here. It goes something like this: fossil fuels are ‘bad’, the companies that produce them are sinister, and renewable energy sources will soon edge them out of the global energy mix.
This false narrative has had dramatic effects on the global energy system. ESG investing and fossil fuel divestment have shifted global capital markets away from investing in fossil fuel producers.
Fossil fuel producing companies today trade on their lowest valuations in history, in some cases pricing in an imminent collapse in demand. Some coal mining stocks trade on valuations so low, they are producing the equivalent of the entire value of the company in free cash flows in just 12 months of operation (i.e., they could buy 100% of the company back from the market with the profits of 12 months business operations).
Many oil and gas companies trade on valuations implying they will effectively go out of business at some point over the next 5-10 years, with little or no value ascribed to their assets beyond that timeframe.
What is the reality?
Looking at the raw data helps here. As investors we need to try and be as emotion-free as possible when assessing structural themes.
It might surprise you to learn that global coal demand is currently the highest it has been in history. Global oil demand is not far off hitting new all-time highs. Meanwhile wind and solar power, combined, generate just 1% of global energy.
Fossil fuels, therefore, may offer an anti-bubble opportunity at current valuations. They are far from dead, despite the fact that financial markets are pricing in imminent collapse.
Even on a very generous set of assumptions for renewable build outs in the future (assuming a 4x increase in current annual run-rate of investment for the next 30 years) and assuming that de-carbonisation efforts in industries like agriculture and construction go to plan, global oil and gas demand still only declines by 15% from current levels by 2050.
What many commentators on this subject miss is that emerging markets like China, India, South East Asia, and Africa, will see major increases in demand for energy as they industrialise, and a lot of this will come in the form of fossil fuels.
Dominion Capital Strategies
Meanwhile, the false narrative of the imminent death of fossil fuels has starved fossil fuel producing companies of capital,meaning investment in new producing assets to supply global demand is at its lowest level in well over a decade. Lower supply combined with higher demand gives you higher prices, this goes a long way to explain the current inflation in energy. There is no incentive for these companies to invest in new supply now, markets and the wider society will only punish them for doing so.
Add to this the Russian invasion of Ukraine and sudden realisation in Europe that relying on a neo-fascist dictator for its energy was a mistake, there is now a major wave of demand coming from countries like Germany to get their energy from anywhere other than Russia. This will mean, in the short-term, coal from countries like Australia and LNG (gas) from the United States, Canada, and Middle East. There will be no other way to keep the lights on in Europe over the next two years, it simply is not possible to build out renewables fast enough in the short-term.
¿How are oil and gas contributing to this?
Oil and gas companies today are trading, as already mentioned, in-line with the false narrative that they are likely to not last very long as profitable companies. They trade at a 60% discount to their long-term average valuations. The energy sector trades at close to the lowest % value vs S&P 500 value in history.
Exploration and investment spending in energy is at its lowest in more than a decade (implying little new supply coming online), while demand is rising and close to new all-time highs. This quarter, Exxon Mobil ($16 billion) generated more free cash flow than Alphabet ($13 billion). Chevron ($10 billion) was not far off.
After being demonised for the last 20 years, some very ‘unsexy’ stocks are now in vogue. Western defence contractors, for example, long vilified and excluded from ESG mandates are now cheered on across the Western democratic political spectrum, as they supply Ukraine’s armed forces with weapons which are exacting a heavy toll on the Russian military. Funny how quickly things can change.
Similarly, we would argue, contrary to its negative reputation, ‘big oil’ is a critical asset to Western democracy, supplying the energy needed to maintain our economies. The alternative to ‘big oil’ is not more wind turbines and solar panels. The alternative is a world where fossil fuels are controlled only by dictators, who are not beholden to ESG mandates, and who can name their terms to a Western democratic order that got its energy strategy catastrophically wrong.
This is, we propose, an ‘anti-bubble’. As the false narrative of the ‘end of fossil fuels’, epitomised by ESG investing, collapses in the face of real-world events, the anti-bubble of high quality, Western owned fossil fuel producers whose asset values have been supressed for years, may be on the cusp of an unexpected return to prominence, fortune, and high investment returns for shareholders.
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This week, the false narrative we want to challenge is on the topic of inflation.
It’s hard to miss this issue, which is now increasingly becoming a part of everyone’s daily life, as well as impacting investment markets significantly. After remaining largely dormant in the developed world for the past 30 years, inflation has very quickly risen to its highest level since the 1980s, taking governments, central banks, and everyday consumers by surprise.
Large sections of populations in the developed world now face a ‘cost of living crisis’, as their incomes are not keeping up with inflation in energy, food, and other living expenses. The situation facing those on medium and lower incomes in the developing world is even worse, with real risks that many will not be able to afford food and other basic necessities.
High inflation is bad news for everybody...
Understanding the cause of the current inflation is therefore, very important. Mis-understanding its causes is risky, as we may enact the wrong policies in response, exacerbating the problem. The stakes are high.
This brings us to our third ‘false narrative’, which we think is critical to de-bunk given the immediate threat to livelihoods and lives posed by the current inflation.
This false narrative goes something like this:
Russia’s unprovoked invasion of Ukraine is the primary cause of high inflation today. Both countries are major commodity exporters, especially so in the case of energy and food.
As the war continues to interrupt the supply of these commodities to the global market, prices have been pushed up and will remain elevated until the war ends.
Given that this war is, ultimately, the responsibility of one man (Vladimir Putin) and his obscene ideology, and the war has caused the inflation, then ultimately this inflation is his fault. If only he hadn’t invaded Ukraine, inflation would still be low and stable, and we could continue on with our lives. It follows therefore that, if the war ends, inflation will also come down significantly and, potentially, stop being a problem.
This narrative is wrong, plain and simple. The Biden administration’s un-ashamed parroting of this narrative for political gain is, to be kind, outrageous and symptomatic of a presidency that has lurched from one crisis to another, without ever taking responsibility. But this is a discussion for another day.
The task at hand is to understand where currently high levels of inflation came from. Was it Putin’s fault?
Well, let’s look at the numbers. Inflation levels had remained at or very close to 1-2% in the US and Europe for nigh on 30 years leading up to the 2020 pandemic. Many economists, political leaders, and leaders within central banks, concluded that low inflation was now a permanent fixture of the modern economy.
But this started to change in 2021. US inflation rates jumped above 4% in April 2021,the highest reading since 2008. And inflation kept rising, well above 5% in July 2021, north of 6% by October, hitting 7% by the end of the year (the highest readings in 30 years) .
Russia’s full-scale invasion of Ukraine started February 24th 2022.
Inflation was already hitting its highest levels in decades before the invasion started. Yes, inflation rates have continued to climb since, moving above 9% in June this year. And, yes, higher food and energy prices as a result of the war are almost certainly a contributory factor to current inflation levels.
But, and this is the critical point, the war was not the cause of high inflation. We already had a serious and growing inflation problem before the war started. All the war has done is exacerbate a pre-existing inflation. The war ending, therefore, doesn’t necessarily solve the underlying inflation problem.
What, then, did cause this inflation cycle, the worst since the 1970-1980s?
In response to the pandemic the world’s central banks printed a lot of money. Money printing, historically at least, has been inflationary. Close to 30% of the dollars in circulation today in the global financial system were printed in the last two years
It’s no coincidence, we would argue, that many of the 2 year inflation numbers for assets like housing, or even personal consumption goods like cars or eating out, have seen prices rise by about 30%. All of that new money had to find somewhere to go.
Then, with the economic recovery from the COVID pandemic already well underway last year, labour markets in the developed world very quickly moved close to full employment. Labour shortages were already becoming a problem in some sectors of the economy early last year
Into this hot economy with limited capacity to increase supply, the US government decided to pump a $1.9 trillion fiscal stimulus (funded with debt and money printing by the US central bank). Further pumping up an already hot economy at close to full capacity.
The major central banks, led by the US Federal Reserve, were too late in their response to this. The usual playbook for reducing inflation in a hot economy is to raise interest rates. The timing of this is critical, wait too long and inflation can get out of control as it starts to change expectations of economic participants
If people start to think inflation will remain high, they will demand higher wages and change spending habits, thus entrenching inflation for longer and creating an ‘inflation cycle’. The best answer to this is for central banks to raise interest rates early.
Unfortunately, central banks were late to the party, again, led by the Fed, who kept rates at their lowest levels in history through 2021, effectively continuing to stimulate the economy via monetary policy despite the fastest rise in inflation in the US in more than 40 years. This complacent response is now costing us.
Over-stimulus into a hot economy, followed by a slow response from central banks, was probably the cause of the 1970s inflation cycle too.
Dominion Capital Strategies
We always try and end these messages with an optimistic note, but sadly in this case, the message is one of economic mismanagement causing high inflation, with political leaders in the West refusing to take responsibility and instead passing the buck.
Esperemos que la tardía respuesta de los bancos centrales para combatir la inflación funcione. Hemos visto que los precios de las materias primas y otros insumos han bajado significativamente desde los máximos de los últimos meses, y esto puede indicar que pronto habrá un descenso de la inflación.
But investors should also be prepared for inflation to continue to be a problem for longer than expected, as history shows us that these cycles of inflation can sometimes continue.
The trick here is to focus investments into assets where inflation, high or low, is not a major issue for the long-term value of what you are investing in. We continue to think high quality, growing businesses, trading at reasonable valuations, offer a safe harbour for investors to wait out this storm.
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Last week, we introduced the first of our ‘false narratives’ in financial markets, de-globalisation...
We explained why we think ideas like this in markets can be so appealing, offering simple explanations for what is going on in a complex, often random, world. The risk of false narratives is that they can lead investors astray, allocating capital to what they think is a major trend but what could be, in fact, an overbought trade with significant hidden risks.
Parsing out the true from the false narratives is critical for success for long-term investors. Spotting false narratives can also offer investors unique investment opportunities to bet against them.
This week, the false narrative we want to challenge is a controversial one (to say the least). Fossil fuels, most notably oil, gas and coal, are increasingly considered ancient history by many participants in financial markets.
This idea spreads beyond finance even, to politics and the wider media, where the growing consensus is one in which fossil fuels will play no role in the future global economy.
The argument ...
The argument goes something like this: the burning of fossil fuels to generate energy is causing climate change and as such, the only solution is to accelerate the transition away from these sources of energy. The latest generation of renewables, solar and wind power, are now much cheaper than fossil fuels, while battery storage and energy efficiency (better insulation in homes, for example), together can replace the energy we derive from burning fossil fuels.
Thus, given the green alternatives are now cheaper than fossil fuels and readily available, their days are numbered, oil, gas and coal are going away as an energy source and we can expect to see their demise in the next 5-10 years. Put more simply, fossil fuels are ‘bad’ and we just need to replace them, simple.
This is, no doubt, an appealing prospect from the perspective of anyone who cares about solving climate change. It’s a story we would love to believe, if only it were true. Solving climate change in less than a decade, and with alternatives sitting on the shelf ready to be rolled out at scale. It sounds great!
The draw of this narrative is powerful. So powerful in fact, that most major market participants have bought into it. Many of the world’s largest investment and pension funds have committed to fully, or at least mostly, divesting from fossil fuel stocks and avoid investing in the sector altogether.
Millions more retail investors have become engaged in investing ‘ethically’, with oil and gas stocks often top of the list of investments to avoid. This ‘divestment’ movement, driven by the narrative of fossil fuels being ‘bad’, has been powerful enough to starve the fossil fuel industry of investment capital over the past decade, making it increasingly difficult for those companies to raise capital on international markets.
What’s more, it has sent a strong signal to the management teams of fossil fuel producers that investing in new supply will not be rewarded, in fact it may even be punished by markets. So that is what pretty much every major fossil fuel company has done. They have restricted investment in new supply and instead re-invested cash flows into renewables projects or in returns to shareholders.
The idea that fossil fuels are ‘bad’, and will go away soon, is probably the most consequential and potentially pernicious false narrative in markets today.
Dominion Capital Strategies
Firstly, energy is good. It facilitates improvements in quality of life. Around 800 million people today have no access to electricity. 2.4 billion people generate heat for cooking and hot water by burning biomass (wood, animal dung, crop waste) on open fires. This alone causes 3 million premature deaths every year in low income countries from household air pollution. Bringing electricity to those without it, bringing safer forms of energy for cooking, these are not trivial matters but transformational for half of the world’s population. And as things stand, renewables cannot do it.
It is no coincidence that the countries where these populations reside are continuing to invest heavily in fossil fuel power generation. Bringing electricity and safer sources of energy, to lift hundreds of millions of people out of poverty, requires vast amounts of reliable, low cost power.
Coal, oil and gas, still offer a relatively cheap and quick way to bring large amounts of energy to large populations, reliably. Renewables can be low cost, but only in certain places at certain times, while power storage is at least a decade away from being a meaningful place to store excess renewables power for use when the sun isn’t shining, or wind isn’t blowing.
Whether we in the West like it or not, developing countries are going to keep developing, and this means vast amounts of new energy demand coming from billions of new, emerging, middle class global citizens. Renewables will play a part in this story, but so too will fossil fuels, and so too will technologies like nuclear power.
Further, the concept that fossil fuels are ‘bad’, is so oversimplified it’s arguably infantile. The fossil fuel industry powered the industrial revolution and the twentieth century, the single biggest leap in human living standards in the history of our species. Those who think that was bad are welcome to prove it and try living without electricity, modern healthcare, etc.
The end result of this powerful false narrative is the energy shortages we are currently experiencing globally today. Years of underinvestment by fossil fuel producers in supply, in response to their demonisation in modern culture and divestment by ESG-minded investors, means that there is very little new supply available to meet global demand.
Meanwhile renewables, with all the will in the world, are nowhere near being in a position to take up the slack and replace fossil fuels in a significant way. We’ll have to wait another decade (at least) for that.
The truth is, a transition of this scale away from fossil fuels was always going to take a long time. And we needed fossil fuel companies to come along on the journey with society, maintaining supplies of the fossil fuels we still need as we steadily shift to alternatives.
Sadly, this more pragmatic approach is unpopular, it doesn’t fit the ‘good’ vs ‘bad’ false dichotomy and so we appear to be continuing down the same road, which will likely only lead to even worse energy shortages than we face today.
There are two very important takeaways here for investors. First, be careful with investment products labelled as ‘green’ or ‘ethical’. These can often by invested in overcrowded investments which could fall dramatically if the false narrative of the imminent adoption of new energy technologies is not realised.
Second, fossil fuel companies are not necessarily the bogey-man, and the general dislike of them by investors and modern culture could actually offer a once-in-a-generation opportunity to invest in assets which will be producing strong cash flows for a couple more decades at least.
Taking a contrary view here could be very rewarding.
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