Posts tagged: KNG International Advisors

In last week’s episode titled ‘Are We There Yet?’, we discussed the issue of interest rate rises and specifically, whether interest rates have risen enough to slow the economy down and bring inflation under control.

We ended the episode by giving examples of the signals investors might expect to see which would indicate financial conditions are close to that point of sufficient tightening, the main example being high profile companies unexpectedly getting into major trouble.

Although we were predicting this would happen at some point in 2023, we did not expect this to happen so quickly!

The past week has seen high profile banks in the United States and Europe, most notably SVB and Credit Suisse, come under major selling pressure and require central bank bail-outs. Many other banks have seen considerable declines in share prices as questions have been raised about the strength of their balance sheets too.

What has surprised markets is how quickly this has all happened. The dramatic events impacting the banking sector of the past week are, we would argue, a classic example of what we were talking about last week. Unexpected and high-profile business failures are a major signal that financial conditions have tightened substantially.

Let’s dig a little into the current crisis in the banking industry and explain what we think is going on.

The ultra-low interest rates of the past decade and major stimulus measures of the COVID pandemic led to a big increase in cash deposits at banks in the United States and Europe. Smaller banks like SVB in the US, with less sophisticated risk management structures and less stringent regulatory oversight, were using some of these deposits to earn income by lending out money. This is how banking works, at a very basic level. You take in deposits and pay interest out to depositors, then you lend those deposits out at a higher interest rate, and keep the difference.

The very sudden increase in interest rates in the US over the past 12 months, as part of the Federal Reserve’s fight against inflation, created a major problem for banks like SVB. The interest they were paying out to depositors had to keep rising to compete with rising rates available on deposits at other banks, meanwhile the interest they were earning on the money they had leant out was not going up as quickly, significantly reducing the profitability of the bank. As more depositors started to move their cash away from SVB to find higher rates elsewhere, rumours about the viability of the bank started to go mainstream, encouraging more SVB depositors to withdraw their cash deposits. This was an old-fashioned bank run!

The Federal Reserve last week intervened and created a new facility where it effectively is promising to underwrite all cash deposits (of any size) at every US bank. This is a major intervention and appears to have calmed some of concerns that were being raised about other banks who may have similar balance sheet exposures as SVB.

This story is far from over and we may see more unexpected revelations from banks in the coming weeks and months.

The next question is, what should investors do about this risk?

We do not think, and this is really important, that we are likely to see a banking crisis like in 2008. That was a credit driven event which put the stability of the entire global financial system on the line. Major banks today in Europe and North America are much better capitalised now than was the case back in 2007-2008. Even in the case of SVB, its assets on balance sheet were still large enough to have paid back 90-95% of all depositors cash, if the US central bank had not stepped in. The bank was in trouble, but nothing like the trouble banks were in 2008.

Investors should be careful not to panic and think we’re going to see a re-run of the last crisis. That is unlikely.

We see the recent selling in equity markets as an opportunity to incrementally add to high quality long-term investment names trading on reasonable valuations.

Most importantly, though, and again to return to our theme from last week’s episode, it is precisely these unexpected blow ups that signal to us as patient investors that we are likely entering the final phase of this bear market cycle. That could mean short-term volatility and some further price weakness, but it also means the eventual market lows could be here soon, which is an optimal time to aggressively buy risk assets. Not yet, but it’s coming.

After decades of low and stable inflation, and correspondingly ever lower interest rates, 2021 saw the start of a major move up in price levels around the world. Rates of inflation had reached the highest levels in the US in forty years by June of last year.

The textbook response from central banks to elevated levels of inflation is to raise interest rates. It is by raising interest rates (and consequently the cost of debt) that acts as a break on the economy and so should cool down inflation.

Higher interest rates make capital and liquidity in the economy, all else equal, more scarce via higher cost of debt and financing capital (higher rates). This tightening in financial conditions makes it more expensive to fund capital investments, consumer spending, etc. This eventually results in a slowdown in the economy which helps to bring inflation under control via lower demand for goods and services. As aggregate demand declines, inflation comes down, and we move into the stage in the business cycle where central banks can start talking about cutting interest rates.

This is how it’s supposed to work in theory at least...

Well… it feels like it has been a while since interest rates started rising in most countries. This begs the question for us as investors: have financial conditions tightened enough yet to consistently crimp demand and bring down inflation? In other words: are we there yet?

Some of the important economic data is pointing in the right direction for a fall in aggregate demand. The US treasury yield curve is now as inverted as it has been since 2007. What does that mean? We’ll save an explanation of the yield curve for another episode, but the best way of thinking about ‘yield curve inversion’, is that as a lead indicator for the economy, it has a high hit rate when it comes to predicting economic slowdowns. And it is currently flashing red for a slowdown in demand.

What does this mean?

Here’s another economic data point. M2 money supply growth in the US is now negative. Again, we’ll save the detailed explanation for another episode of this metric, but suffice it to say that when this measure of liquidity in the US economy goes negative, that has historically been an indication that economic demand will slowdown in the future.

But… and this is a big but. There is evidence elsewhere in markets that financial conditions are not yet tight enough to bring demand and inflation down sustainably. Several widely followed indexes of financial conditions appear to indicate we remain in ‘loose’ territory. These indexes measure a range of data points to try and show how tight or loose overall financial conditions are in the wider economy. We would expect to see these indexes clearly moving into ‘tighter’ conditions if the interest rate rises of the past 12 months were fully flowing through into the economy.

Further, there are other important indicators in markets which further support the view that conditions remain ‘loose’ and have not tightened all that much just yet. Speculative manias in asset prices of the past have usually coincided with very loose monetary and financial conditions, only ending when financial conditions tighten. When we look at the most recent speculative bubbles, in some areas of the stock market and crypto-currencies, we see that prices have risen year-to-date in 2023. And they have risen by a lot! Bitcoin is up +31%, Tesla share price +68%, so far in 2023 (just over two months). That does not sound like a major tightening in financial conditions to us.

Further, there are other important indicators in markets which further support the view that conditions remain ‘loose’ and have not tightened all that much just yet. Speculative manias in asset prices of the past have usually coincided with very loose monetary and financial conditions, only ending when financial conditions tighten. When we look at the most recent speculative bubbles, in some areas of the stock market and crypto-currencies, we see that prices have risen year-to-date in 2023. And they have risen by a lot! Bitcoin is up +31%, Tesla share price +68%, so far in 2023 (just over two months). That does not sound like a major tightening in financial conditions to us.

Further, there are other signals of a major tightening that you should expect to see at that stage of the business cycle. Businesses with high levels of debt having to file for bankruptcy, for example. There is a notable dearth of news stories like this.

The short answer to the leading question in the title of this episode, therefore, is a resounding ‘no’. We’re definitely not there yet on financial conditions in the economy to be able to confidently say that we are ‘tight’ enough to have confidence in demand declining and bringing down inflation.

Recent hot inflation data releases in Spain, Australia, and the US, support this view.
In fact, current financial conditions are still loose. It takes time for higher rates to feed through into properly tight financial conditions. It will come though, the US Federal Reserve is telling us that a major tightening will happen.

We can hear you asking the next question: how will we know when are there?

There will be some big clues to watch out for. Bitcoin and other crypto-currency prices are a good place to start. So long as those prices are going up or staying flat, we’re still in ‘loose’ territory. Watch out for those prices dropping dramatically as an indicator that we may, finally, be approaching ­an end game for tightening in financial conditions, and as such, an end game for higher inflation and higher rates.

The rate of change in technology has been astounding over the past 200 years. Since the dawn of the industrial revolution in the late 18th century, humanity has moved from using horses and sail ships as a primary means of transportation, to mile-long diesel powered super container ships, cars, and jet powered aircraft. Even in the past 30 years, communications and IT technology have changed dramatically. A mobile phone or desktop computer more than 10 years old today is not just outdated, these products are often now incompatible with the latest generation of software and operating systems.

Change in any system creates risks and opportunities. Risks for those that were beneficiaries of the system before the change, opportunities for others. When it comes to modern technology investing, the risks and opportunities are magnified by the rapid rate of change and the scale of the market opportunity for the winners.

It is easy to see today’s technology champions as being immune to change. They appear to us as so dominant in technologies we use every day, it’s hard to imagine a new competitor or technology replacing them. But the history of capitalism is, if anything, a history of competition, innovation, and of today’s champions becoming tomorrow’s has-beens.

Kodak was once a technology champion in the United States, considered to have a dominant market position in the industry of photography and photographic film. Polaroid was considered a technological marvel in the 1970s, at its peak it employed 21,000 people and had $3 billion in annual revenues. Instantly capturing an image on film was, in the 1970s, truly revolutionary.

Nokia in the more recent past was the world’s dominant technology player in mobile phone handsets. Pretty much everyone who had a mobile phone in the early 2000s had a Nokia handset. They were the best mobile phone handsets at the time.

In the late 1990s, the dominant internet search engine was AltaVista, a mainframe computing company which used its tennis-court-sized computers to deliver what would now be considered quite poor internet search results.

What unites the companies we have mentioned here, Kodak, Polaroid, Nokia, AltaVista, is that they were all once dominant players in important technologies, and today hardly anybody uses their products or services. In the case of AltaVista and Polaroid, the companies no longer even exist.

Technological change and innovation are fantastic for the consumer and for the progress of human civilisation, but incredibly risky for investors in the companies who own and develop technologies. The next innovation may be just around the corner, and your once mighty and ‘safe’ investment in a business may soon be under pressure, or worse, go to zero.

We emphasize topics covered in last weeks news report...

Last week we referenced the incredible new language model technology supplied by OpenAI (part-owned by Microsoft), ChatGPT, which is now connected to Microsoft’s internet search engine Bing. Language model driven AI functions like this are likely to disrupt many industries, and generate the change that creates those dreaded risks and much longed-for opportunities for investors.

Dominion concluded last week’s episode by saying that taking a bet on who will have the best intellectual property, the best technology, is very difficult. To go back to the 1990s example of AltaVista, there were at the time dozens of internet search engines and it was not obvious to anyone that Google would come to dominate internet search with >90% market share today. Similarly today, it is highly uncertain as to who will win in the race to develop language models or text and speech driven AI support. For all we know, this may be a relatively easily replicated technology and it quickly becomes commoditized. Or there may be one dominant player who takes most of the market.

We also concluded last week that one good way to play a technology innovation trend like AI is to invest in the suppliers of products needed to power the trend. In this case with AI, the data centres running the computing power needed for AI require a lot of computer chips, so investing in those suppliers of computer chips trading on reasonable valuations today still offers the tailwind of the trend without taking the risk of betting on the IP winner.

"But there is another way to play a new technology trend without taking the risk of betting on winners or losers."

Dominion Capital Strategies

New technologies are typically adopted by people and businesses, and those new technologies can often-times change their nature, especially in business. Just as the internal combustion engine transformed logistics and transportation, so too AI-driven language models are likely to transform industries today that rely on interactive communications with people to solve problems.

The businesses who adopted the internal combustion engine to transport goods in the early 20th century had a major cost and business advantage over those who did not, those who still relied on horses and sail power were doomed to fail. The businesses today who adopt language model driven AI systems into to their businesses, we argue, might similarly have a major advantage over those who do not. This advantage could show up in much lower costs and higher returns vs. the competition.

Dominion Capital Strategies believes that this is another very interesting hunting ground for investment ideas where new technology (in this case, AI language models like ChatGPT) has opened up the opportunity to invest in companies set to be transformed by new technologies.

In the 1983 science fiction thriller WarGames, the movie’s lead character and amateur hacker David Lightman (played by a young Matthew Broderick) uses his desktop computer to attempt to connect to the computer systems of a gaming company. David manages to connect to a fictional artificial intelligence (AI) system which does not identify itself.

In a now famous scene in the movie, David and his friend have a conversation with the AI via a basic chat function. The human-like responses of the AI astonish the human characters in the scene. Eventually the AI asks David: ‘Shall we play a game?’.

David asks for a list of available games, and then tries to convince the AI system to play the last game on the list, called ‘Global Thermonuclear War’. Initially the AI is reluctant to play, suggesting: ‘Wouldn’t you prefer a good game of chess?’.

After some more back-and-forth between the AI and David, the AI system eventually relents and agrees to play a game of ‘Global Thermonuclear War’.

Unbeknownst to David, the AI system he has been communicating with operates the nuclear attack early warning system for the Unites States military. The game David starts to play with the AI system almost triggers a real-world nuclear war between the United States and Soviet Union.

When our investment team first trialled OpenAI’s ChatGPT, we could not help but recall the aforementioned scene from the movie WarGames. We were just as impressed as the characters were in this 1980s science fiction movie, when we started to engage with ChatGPT’s AI system via a chat function.

ChatGPT is undoubtedly a remarkable technology which could change the world...

Microsoft has been quick to capitalise on the success of ChatGPT, announcing it will be integrated into Bing, Microsoft’s internet search platform. The strategy was announced by none other than Microsoft’s CEO, Satya Nadella, in a bullish presentation where he openly called out Google Search as the first major target for the AI tool. Microsoft thinks more advanced AI language models like ChatGPT, when connected to the internet, will radically improve the capacity of its search engine to assist users and thus take market share from Google Search.

Google responded quickly with an announcement that it too would be embedding an AI system into its search engine. Google and Microsoft are tooling up to fight over dominance in artificial intelligence.

This fight for AI supremacy in internet search mirrors similar battles underway in cloud computing, cyber security, social media, and even between major governments. AI and the computer systems they run on, are now advanced enough to offer meaningful advantages to the companies and governments best able to master and utilise them.

Is there a way to play this trend from the perspective of investors?

One way would be to make a call on who has, or is likely to have in future, the best AI technology in a specific field where this will generate significant returns on investment. The winners in the AI wars, in the business field and at the geopolitical level, will yield considerable rewards. But this is an investment strategy fraught with risks. Given the relative infancy of this investment trend, and a lack of understanding of the technologies involved, we as investors would be gambling on an outcome we are in no position to accurately predict. Does Microsoft win in the AI search engine war? What about in social media and digital advertising… what about between the US and China?

As things stand, we’re currently in no position to make an accurate call on how that plays out.

But we can make one prediction which leads to a very interesting investment opportunity.

In any war, whether it be a real-world shooting war, or a technology-led war for business supremacy, the belligerents require weapons with which to fight. And those belligerents are willing to spend a lot of money on those weapons to give themselves the best chance of winning.

In real-world shooting wars, this means tanks, fighter jets, bullets and artillery shells. There’s a reason why the share prices of defence companies have risen since the War in Ukraine started… wars mean more orders for military weapons.

In the AI wars, the hard weapons required to fight are data centres and computer chips. CPUs, GPUs, memory chips, a lot of them, are the hard real-world war materiel required to fight. And in this case, the belligerents (big tech, large governments) have a lot of spending power.

We may not know the outcome of the coming wars in AI, but we do know the weapons with which these wars will be fought: data centres, computer chips, and their related supply chains.

As investors, we can invest in the owners of the manufacturing capacity and intellectual property needed to produce advanced semiconductors and computer chip designs needed to power the computer systems running advanced AI.

There’s an old saying that goes something like this: ‘during a gold rush, sell shovels!’ This very much applies to the coming global competition in AI. As investors, we can own the ‘shovel makers’, the suppliers of the tools needed by all participants, and benefit from the big increase in spending on AI compute that’s already underway, without taking the risk of trying to pick a winner.

The outlook in 2023 for most sectors in the economy remains highly uncertain and difficult to forecast. In electronic goods, for example, and the associated supply chains (semiconductors), the pandemic saw a major pull-forward of demand as people who were stuck-at-home in lockdowns decided to upgrade home PCs, tablets, smartphones, TVs, etc. Now with most countries having fully re-opened, that demand has understandably declined as consumers switch to spending money on services and other activities. Trying to predict the timing and shape of a recovery in these sectors is now very difficult. We’re seeing a similar pattern in many other consumer spending-led sectors too.

In renewable energy and related industrials, the pandemic interruption to supply chains, combined with input cost inflation, and the effects of the war in Ukraine, have conspired to cause a major slowdown in demand. The long-term story of high demand levels for renewables to combat climate change is clear, but predicting the short term is much harder. Again, we see a similar pattern across many sectors in global manufacturing.

This uncertainty is mirrored in the macro economy too. Will the US enter a recession later in 2023? What about 2024? Will Europe make it through next winter without going into recession… what if it’s a cold winter?

The honest answer to these macro questions is, we don’t know. Nobody does. Trying to predict the outcome for an individual business 1-2 years into the future is extremely complex and fraught with risk. Map that up to an entire economy and accurate predictions become impossible.

Dominion prefers to shy away from making predictions they have no chance of getting right. Much better, to focus on predictions where the probability of success is much higher.

These opportunities do exist, and if we look at the state of play for the global economy today, there are a couple of areas where we think the outcome seems to be much easier to predict. We can have much higher confidence in making calls on those specific sectors, given the information we have available today.

A good example here is Chinese consumption. Rather than make specific predictions about growth rates or levels of inflation, we can make confident predictions on the short-term direction. We know the economy there is re-opening after a long bout of pandemic-induced lockdowns. Anecdotal evidence suggests city centres, shopping malls, etc. are packed. We’re also seeing global jet fuel demand rise substantially, as millions of Chinese consumers look to travel abroad again on holiday for the first time in years.

It’s possible, but unlikely that the Chinese government would risk reversing this re-opening decision. This looks to be a one-way bet.

We also know, based on pre-pandemic trends, the categories in the global economy which benefit the most from Chinese consumption. Travel related industries, luxury goods, these are two large sectors which have historically benefitted from rising Chinese consumer spending, at home and abroad. We think it’s a fair call to make today, that the first half of 2023 is likely to see a major uptick in demand in travel related sectors and in luxury consumer goods, because of China’s re-opening.

This is a good place to be looking for potential outperformance vs. expectations in what is, otherwise, a very difficult starting point from which to make predictions for short-term performance.

As of Friday morning, equity markets over the past week have jumped sharply. S&P 500 is close to its highest levels in 6 months and is now +17% up from its lows in October. It is easy as an investor to submit to market sentiment shifts like this, especially when they happen quickly.

The ‘fear of missing out’, or ‘FOMO’, is a powerful force in explaining global capital flows during periods like this. Just as a severe downturn in equity markets can result in widespread fear among market participants, which itself feeds back into the decline in prices, the opposite can also be true. A sharp move up in prices can start to feed itself, as market participants extrapolate the recent price moves and improved sentiment out into the future. The simple act of prices moving up itself feeds more positive sentiment, which leads to more buying and even higher prices. Nobody wants to be left out of the rally.

When prices move like this, an obvious question to ask is: why? Or better yet…

What are these prices reflecting in terms of expectations for the future?

Markets look forward. That means that the price of a liquid financial asset you see today, say for example, the stock price of a technology company, or the price of a government bond, those prices reflect market expectations for the future. If expectations improve, i.e., they become more optimistic about the future, all else equal, the price of the asset should rise. And the opposite is true too, if expectations deteriorate, all else equal, the price of the asset should fall. A sharp rise in prices of risk assets, as we have experienced since October, reflects improved expectations for the future.

This is what is meant when people talk about ‘what the market is pricing.’ What version of the future is implied by the current prices of stocks, bonds, etc.

Sometimes, those expectations for the future (bullish or bearish) can diverge from reality. The collective expectations for the future in January 2022 were overly optimistic relative to what actually happened. Reality caught up with market prices, and reality usually wins in the end. The collective realisation by market participants that the expected outcome (reflected in asset prices) is different to the realised outcome, can result in sharp changes in prices. This is often the fundamental underlying driver of sharp moves up or down in markets.

If we look at markets today, what are they pricing in?

Let’s start with equity markets. Last year saw a sharp decline in developed world equity prices, led by the US, as the economic reality of 2022 (higher inflation, slowing economy, raised geopolitical risk) triggered a negative change in expectations and thus in stock prices. The recent rally in stock prices implies an improvement in outlook. In other words, equity markets are telling us that talk of recession is premature, meanwhile risks of inflation and higher interest rates are now less of a concern.

Bond markets, meanwhile, are telling a somewhat different story. The shape of the yield curve tells us that bond markets expect a sharp decline in inflation and a potential recession. We’ll skip an explanation of what yield curve inversion means this episode, but suffice it to say, whenever it has happened in the past, there has been a recession. It’s been a very reliable lead indicator of an economic slowdown, and right now it is inverted (and has been for some time).

So… to risk oversimplifying: the equity market is telling us to worry less, 2023 will be fine, meanwhile the bond market is suggesting a recession is probably more likely than not. Both do agree on one thing though, both agree on a rapid decline in inflation.

This, we would argue, is the risk investors need to be thinking about.

If all market prices are pointing in one direction (in this case, to disinflation) and reality moves in the other direction (higher than expected inflation), that is where price dislocations can be their most severe.

How should this affect portfolio decisions in 2023? We continue to stand by our previous view, that pockets of value exist which can immunise investors from needing to think too hard about macro-economic outcomes.

If you’re buying expensive assets (expensive = high price relative to profits / income generated by the asset) then you do need to worry about inflation, interest rates paths, economic outcomes, etc. But if your portfolio is weighted toward owning assets trading on more reasonable valuations (low prices relative to profits / income), those concerns become much less relevant to your investment return outlook.

Rather than committing to one economic outcome over another in 2023, we prefer to defer on economic predictions, and stick to what we know works over the long-term, a deep focus on asset valuations and asset quality. This is also helpful advice for investors who want a good night’s sleep!