BluOr Asset Managment Market Commentary - Q4 2022

Pauls Miklasevics
Chief Investment Officer (CIO) at BluOr Bank

2022 was a year of significant upheaval. Will 2023 set a new course for financial markets?

In our Q3 2022 commentary we highlighted a number of factors that were negatively impacting financial markets – most notably inflation, fears of a global economic recession, higher interest rates and continued China COVID lockdowns. In this commentary we will address what has changed, what the market is expecting, how these factors interact with one another and how we are positioned to benefit from them over the coming year and beyond. 

FINANCIAL MARKET PERFORMANCE REVIEW

Despite a poor December, we managed to finish the fourth quarter with an average weighted net return of 4.22% and closed the year with an average weighted net return of -10.72% across all strategies.

Here is how major asset classes performed during 2022:

During 2022 central banks were determined to crush sentiment and take liquidity out of financial markets and that is exactly what happened.

The damage done to the classic 60/40 portfolio (60% stocks and 40% bonds) was the worst result for this strategy since 1977:

Was this an aberration or was the weakness in both US blue chip equities and bonds a sign that we are entering a period where something fundamental has changed?

We will address this issue later in this commentary, but first let us focus on what has gone on since our last commentary.

INFLATION

As we start 2023, Central Bank rhetoric has softened on the back of lower inflation numbers:

RECESSION FEARS

At the end of Q3 the market was quite overwhelmingly pricing in a global recession due to central bank overtightening. That risk is now dimming.

In the most recent Bank of America Fund Manager Survey recession fears have decreased from levels last tested during the depths of the Great Financial Crisis and the Covid-19 crisis.

Recently Goldman Sachs reduced their odds of a US recession
to 25%. While they are amongst the most optimistic of all economic forecasters, this chart shows the large disparity of US recession expectations among forecasters over the next 12 months:

CENTRAL BANK INTEREST RATE POLICY

The US Fed continues to raise rates, but the pace going forward looks to be at 25 basis point increments, rather than the drastic 75 basis point raises that we experienced in 2022.

The market is currently anticipating that the US Federal Reserve will raise rates over 5% before starting to cut rates on the back of lower inflation in the second half of the year:

The US Fed has communicated that they have seen sufficient progress on the inflation front to slow the pace of rate raises, but they also stated that they would be prepared to keep rates elevated so as to not risk a subsequent round of inflation. This is at odds with the market’s expectations of peak rates in July 2023 followed by rate cuts thereafter.

The foremost reasoning for rate cuts is that the Fed will not be able to keep rates elevated if inflation begins to approach the Fed target of 2%. We believe that the market is focused on the wrong variable and that inflation could stop decelerating as markets adapt to higher rates and fears of economic recession turn out to be unfounded. This could result in a reacceleration of economic growth that would be supportive of inflation at levels that are considerably above the Fed’s inflation target of 2%.

Turning to the yield curve it is clear that there is considerable confusion in the bond market.

Here is what the yield curve currently looks like:

If you do not think that it looks much like a curve you are absolutely right.

Under ‘normal’ circumstances the shorter the duration, the lower the rate, so the yield curve slopes – in a curve – from the lower left to the upper right. When yield curves invert, recessions have tended to follow.

Market participants can look at the current inverted yield ‘curve’ and interpret it all they want, but what it actually looks like is a sail that is fluttering in ‘the irons’ – a sailing term for when the wind is coming from directly in front of the nose of your boat.

So what should you do when your sail is fluttering? Try to catch wind in one direction or the other and resume a steady course.

Which way will the situation resolve itself?

First of all, we have to understand how we got here: drastic central bank rate raises. They purposefully created massive headwinds to stop inflation from continuing to accelerate. However, just because you are stuck in ‘the irons’ it does not mean you are not moving. Quite the opposite - you are at the mercy of the waves and cannot effectively maneuver the boat until you manage to catch wind in your sails.

Under normal circumstances the yield curve is shaped like a functioning sail that propels global financial markets. At the present juncture, in order to restore its normal function a combination of the following has to happen: rates at the short end have to fall and/or long rates have to rise. Currently it looks like markets are expecting short rates to fall and long rates to stay more or less unchanged.

We disagree with this consensus. The US Fed has declared war on inflation and though inflation has been falling, the confidence generated by what not too long ago seemed to be an impossible ‘soft landing’ is not something the US Fed will want to encourage. Moreover, some market commentators are boldly stating that there will not even be a ‘landing’ and that the Fed will be powerless to stop a resumption of higher inflation if economic growth surprises to the upside. Supply constraints in key commodities could also re-emerge as an inflationary factor, but more on that later.

Hmmm. Seems complicated. And it is. This is why we try to seek glimpses of clarity in sectors that are impacted by interest rate policy and are not doing what they are supposed to on a theoretical basis.

Let us take a look at the relationship between homebuilders and mortgages. Most people finance homes through mortgages. Lower mortgage rates are supportive of higher home prices and higher rates make buying a home less affordable due to higher interest payments.

Therefore, higher rates should be bad for home builders.

When the US Fed declared war on inflation at the start of 2022 home builder share prices plummeted (white line) by 40% as it became clear that the Fed was not bluffing about raising rates and the fixed 30 year mortgage rate continued to increase (blue line).

Not long after the start of Q4 2022 Fed rate hike mania reached its breaking point. Mortgage rates stopped accelerating and began to fall. Sure enough, that also marked the local low for the home builders’ shares and they have since rallied 40%. They remain below their previous highs but perhaps not as much as might be expected given that mortgage rates are still double the level they were at a year ago.

This could be telling us something important. Perhaps the current ‘higher rates’ are not the aberration from the norm. Maybe the real outlier is actually the period of extreme low rates over the past decade. Here is a long term chart of 30 year fixed mortgage rates:

As you can see, prior to the Great Financial Crisis and Covid, 6% mortgage rates were actually on the low end of the historical scale. This chart also implicitly reminds us that it is not the nominal level of rates that effect financial markets, but pace of change and how it impacts or deviates from expectations.

So if we begin adapting to higher rates, what could that imply?

It means that the yield curve will resume its shape by billowing out the back end of the sail.

Translated into financial market terms: long rates will rise. If this occurs, given the inverse relationship of long duration asset prices to higher rates, you will want to run as fast as you can from long duration assets. Long bonds and technology companies that are priced based of discounted future earnings will be hit hardest.

We believe that there is a larger possibility of this happening that the market is currently expressing. Also, given the current overweight of long bonds and tech stocks in the traditional ‘60/40 portfolio’, this could be very damaging to passive investors.

Why would we take such a contrarian view? What is the basis of our stance?

Let us first move onto the fourth factor that we examined in our Q3 2022 commentary: China’s zero Covid policy.

CHINA’S REOPENING

In our Q3 commentary we mentioned that an easing of Covid restrictions in China would be supportive of higher oil prices.

At the end of last year, China shocked the world by abruptly halting its zero tolerance Covid-19 policy. China’s economy is now reopening after three years of rolling lockdowns. What worked early on in the first few waves of Covid-19 - to briefly lock down and contain the spread - ceased to be effective with the more virulent Omicron strain of the virus. Politics and policy lag failed to react to reality. As a result the lockdowns in 2022 were worse than in 2020 with regards to the economic and psychological impact of the virus. Spending was extremely depressed domestically, which also hurt European exporters. The extent of disruptions to supply chains also greatly contributed to inflationary pressures on goods, but alleviated many of the upward pressures on commodity prices. This is no longer the case, and there is no going back.

As such, we cannot overstate how impactful China’s reopening will be for world economic growth and commodity demand in 2023. We do however caution that this process will not be smooth and that some demand components will take time to reemerge.

Covid restrictions in developed markets and western democracies were often accompanied by some form of financial aid. This was not the case in China. There was considerable suffering and we must make allowance for the psychological impact that might linger from this horrible experience. This is certainly not a case of flicking a switch and everything being right in the world.

However, it is embedded into human nature for a free person to do the things they were prevented from doing when under confinement such as travel, consume and invest for a more prosperous future.

Under lock down, household loans collapsed and savings skyrocketed. There are two things you can do with savings: spend them or invest them - both are bullish for the global economy:

China’s consumption will recover strongly. For example, ‘The Economist’ writes: “China’s splurge will make a welcome contribution to global growth. According to the IMF’s forecasts, released on January 30th, the country’s economy will grow by 5.2% this year, accounting for two-fifths of the expansion in the world economy. Together, America and the euro area will contribute less than a fifth.”

We have positioned our portfolios to benefit from China’s reopening through energy producers and copper miners.

Both of these sectors had an eventful year last year. Putin’s invasion of Ukraine sent energy prices soaring and copper was a beneficiary of strong global growth (ex-China) until fears of a central bank induced economic recession crushed copper demand forecasts and prices dropped substantially. Copper miners were hit hard.

However, since China’s reopening, copper prices have recovered strongly as have copper miners. As can be seen, copper prices actually bottomed before news of China’s reopening:

With all the macroeconomic drama going on, a critical component of copper pricing was put aside: medium to long term copper supply.

Copper is THE key factor input into the electrification of the global economy and the reduction of carbon emissions.

As such, it is forecasted that more copper will be needed over the next thirty years than has been mined in the history of the world. But there is a slight problem: a lack of copper supply.

Here is what the future copper supply/demand forecast looks like, as well as the long-term prices necessary to begin to encourage new supply:

As any first year student of economics will tell you, when demand exceeds supply prices rise and if this dynamic holds, copper prices will skyrocket. Given that copper supply in the short to medium term is inelastic, the only real variable to keep prices down is a collapse in demand. We do not think this will happen.

Investors tend to focus on the here and now and thrive on immediate gratification. In so doing they tend to miss larger more powerful trends.

There is no stronger trend in the history of the global industrial economy than the upcoming transition to green energy and there is no component that is more critical than copper.

Why is that? Because there is no such thing as a low-energy rich country:

Unfortunately proponents of green energy tend to be opponents of the sourcing of materials critical to green energy infrastructure. As such, under the most optimistic of timelines, it takes around 10 years to permit and develop a copper mine. This is troublesome in that we have already entered a copper deficit before we have begun to get serious about building the infrastructure that will be necessary to enable carbon neutrality. And now the world’s largest consumer of copper over the past twenty years – China - has re-opened their economy at a time when global inventories are low and already inadequate copper supply forecasts continue to weaken.

Here is the production profile of the world’s largest copper producer Codelco:

Why is Codelco’s production falling? One possible explanation is that the average age of the world’s 10 largest copper mines is 95 years, which means that the highest quality ore was mined long ago and continuing to mine lower grades adds cost and technical complications.

They are not alone if buffering these challenges.

When China was building its industrial economy from 2001 to 2011 copper prices quadrupled.

Over the next ten years China will be competing with the US, Europe, Japan and the rest of the world for copper to build out green energy infrastructure. There is no precedent to such a wildly bullish dynamic.

So the biggest investors in the world are poised to benefit right? Not so much. The only component of the S&P 500 index that is involved in copper mining is Freeport McMoRan. It has a 0.18% weighting. This size of weighting is usually referred to as a ‘rounding error’ in most investor portfolios. It is clear that investors are not yet taking this issue seriously. We are and with patience will benefit accordingly.

During 2022 we held our course through a difficult year and fared much better than most.

As we begin 2023, we are ready to catch the next, decisive wind of change and charge ahead as a new cycle of opportunity continues to take shape.

On behalf of the client portfolio management team at BluOr Bank I thank you for your continued trust and support.

Yours truly,
Pauls