Flows Interrupted
2022 was a rough year in the capital markets. The S&P500 lost 19% while long term bonds lost around 12% and corporate bonds around 15%. As you would expect, our accounts performed better.
In our stock picking for 2022, we enjoyed success in companies tied to the defense, food, auto supply, electric, and government supply industries. We were hurt by investments in industrial suppliers targeting the electric grid and by being too early on the semiconductor industry. The biggest losers in the market were the former high flyers such as Tesla, Google, and Amazon, companies that were heavily owned by index funds. Tesla lost 65% of its value in 2022.
You may recall some of our past analysis of the connection between index funds and extraordinary valuation of these companies. Index fund managers don’t care about valuation or company prospects; only what percentage those companies are of their index. When new money is deposited in their funds, they simply buy more of these stocks.
Unfortunately, the opposite occurs when money is removed from these funds; fund managers simply sell indiscriminately. In this way, the success or failure of an investment strategy is dependent on factors that have nothing to do with the underlying company. We try to avoid these kinds of investments as much as possible. Because of this dynamic as well as demographics, this money may not return to the equity markets as older Baby Boomers’ look for more safety and stability for their retirement funds.
We had plenty of winning stock selections in 2022 but we also had too many losers as discussed above. This is proof that it’s possible to make money in the stock market even when the stock market is falling, on average, because a changing economy creates opportunity. Our job for 2023 is to winnow out the losers before they can pull down the rest of our portfolios.
Demographics
This chart is seven years old so when you look at the age on the left hand side, you have to add seven years. The Baby Boom generation ends at the 50 to 54 tranche and the population in the tranches below fall away sharply until we get to the Millennials in the 25 to 29 tranche.
This sharp decline in people in the primary consuming and saving years between 30 and 50 is a negative sign for the economy and the stock market. It’s not pointing to a crash or a depression by itself but it does suggest marginal weakness in both the consumer economy and the stock market based on fewer buyers and fewer investors. It’s not a huge deal but it turns a former tailwind into a headwind, something we need to consider when deciding how best to invest.
In past newsletters, I’ve shown you how the rest of the world is in MUCH worse shape, starting with China but including Europe, Russia, and Japan. Among the developed nations, the US is in far better shape than the others. Where the US economy has some hurdles to clear, the rest of the world has brick walls and the greatest wall (pun intended) is in China.
China
I’ve been railing against China for more than a decade. Like Tesla’s stock price above $300 per share, China’s economic growth never made sense because they invested in the dumbest projects imaginable. Just consider the extraordinary buildout of their housing market even as they were approaching a demographic collapse among potential home buyers.
Who will they be able to sell their homes to? Who is going to work in the factories? Man the armies? Even worse, males are a higher percentage of the population than women and that spells disaster for the next generation because women are the key to population growth. China’s working population is estimated to fall by at least 23% by 2050 – and this is before the losses from Covid which appear to be significant.
China is the second largest economy in the world next to the US and they are starting to implode, made worse by weakness in their trading partners. We can see this by the sharp reversal in China’s Zero Covid Policy which had been China’s main effort for dealing with the virus. The result has been something akin to medical catastrophe as local governments were caught totally unprepared. We’ll never know for sure but the value of the Chinese yuan was collapsing in the currency markets when they reversed this policy. Was it a coincidence? I don’t think so.
The most interesting part of the above chart is that the yuan bottomed in November and has moved up 6% versus the dollar. This coincides with an odd development where the People’s Bank of China has refused to reveal how much in dollar currency reserves they held in November! In fact, they should be updating the value of their dollar reserves in December sometime in the next week. This suggests that China has spent much of their remaining dollar reserves in defending the yuan – trying to maintain its value versus the dollar. This is EXACTLY what we have been expecting at GeoVest.
Currency reserves are the funds held at central banks that are available to pay for imported goods and material. They grow when a country sells more in exports than what goes out of the country through imports. It’s somewhat akin to company earnings but on a national basis. The more currency reserves increase, the more exports are increasing relative to imports.
It may take a few more months before it’s obvious but we expect that China will be in a full-blown economic depression by the middle of the year, a depression that will prove impossible to fix. When it happens, it will have a negative impact on companies with heavy exposure to China, something which we have been steadfastly avoiding with our client portfolios.
We can already see that the international banking system is aware of China’s problems. The chart below shows the balance of short term loans offered to Chinese entities by international banks. It’s a measure of just how willing these banks are to extend credit to China in dollars. Since we know that Chinese corporations are already carrying somewhere around $7 trillion in US dollar obligations on their balance sheets, it suggests that some banks and investors are already locked into future losses they can’t escape.
Things are so desperate in China that Chinese Premier Xi Jinping flew to Saudi Arabia to meet with its de facto ruler Mohammed bin Salman (MBS) to make a deal whereby China would pay for Saudi oil using Chinese yuan. While MBS has been at odds with the US over the past few years, he was unwilling to take anything but dollars for his oil. Smart move.
The US Dollar
The media is full of analysts who are predicting the end of the dollar as global reserve currency. Some believe Russia and China will wrest control of the global financial system by offering a gold-backed currency, others opine that some form of crypto currency will replace the dollar. They’re all wrong; I can say that with almost total certainty.
The problem with the dollar isn’t that too many dollars have been “printed” by the Federal Reserve; the problem is that there are not enough dollars escaping the US into the global financial system. You can see from the chart below, which extends back to 2008, that central banks are having a difficult time keeping the US dollar from moving higher.
Why would the dollar move higher in world currency markets? The world financial markets are not getting enough dollars, neither through trade nor investment in foreign markets. You can see clearly how the technological breakthroughs that made shale oil and gas viable led to a sharp increase in the dollar in 2014. This is because the US no longer needs as much foreign oil, which means fewer dollars sent to the Saudi’s. And this means that the Saudi’s deposit fewer dollars (Eurodollars) in Swiss banks to be made available for global economic growth.
Following the outbreak of Covid, the dollar dropped briefly in 2020 as Americans, unable to move freely about the country, chose to buy imported items with their savings. The result was lots of dollars flowing out of the US to pay for things sourced in China, South Korea, and Taiwan in particular. Once the US opened back up, Americans went back to spending money on domestic products and services and the dollars stopped flowing out of the US.
Over the past six months, the dollar has weakened because we don’t need to sell as much liquefied natural gas and oil to the Europeans as was feared when Russia attacked Ukraine. In fact, the Russian army has performed so poorly in Ukraine that some analysts are starting to anticipate regime change in Russia and Russian energy to start flowing once again. This would be the best case scenario for the world economy.
When you consider the above chart and the way the dollar has been rising in value for the past fifteen years, it’s difficult to conclude that the world thinks the Federal Reserve is destroying the value of the US dollar with its policies. If anything, it appears that there are insufficient dollars in the global financial system to promote global trade.
The problem for the world is that too many foreign decision makers assumed that the Fed’s efforts to stop the global financial contagion in 2009 would ultimately devalue the US dollar so they borrowed heavily in US dollars. This is the Eurodollar market that I’ve discussed many times where dollars become Eurodollars once they are outside the US banking system. There is a massive pool of these dollars held outside the US banking system. Some say the pool of money is roughly equal to our domestic money supply.
International banks lent extravagantly to emerging markets and China in particular believing that they would be able to pay back those obligations with devalued dollars. It never happened and now large international companies and some countries owe big dollar amounts to international banks.
For this reason, we view a sharp increase in the value of the dollar as the biggest risk to the global economy. Furthermore, we believe there is a good chance we experience such an outcome in 2023. A sharp upward move in the dollar would force the Federal Reserve to reverse their current policy and return to quantitative easing. If this happens, we could see a sharp decline in the equity markets potentially followed by a sharp increase by the end of 2023.
US Economy
The US economy continues to weaken and may already be in a recession, made worse by the Federal Reserve’s efforts to stamp out inflation that appears to already be on the decline. As such, I believe the Fed is making a terrible mistake by raising interest rates. The market agrees.
The chart below shows the US Treasury Yield Curve which is the yields on Treasury securities ranging from 3 months at the left to 30 years at the right. The line from 1/3/2022 reflects a normal yield curve where rates trend higher over time but the line from 1/3/2023 shows inversion from 6 months through 30 years. Historically, an inversion of the yield curve, or short term interest rates that are higher than longer term interest rates, precedes an economic recession. The reason is that long term bond buyers are telling the Federal Reserve that they believe that short term interest rates are too high.
You can also see from this chart just how aggressive the Federal Reserve has been at raising interest rates over the past year despite clear signs of weakness in the economy since the summer. I think it’s a mistake that we’ll pay for through most of 2023.
We can already see evidence of a recession from major companies. Federal Express has warned about a sharp decline in delivery volumes. Amazon will cut 18,000 employees. Salesforce.com intends to cut 10% of its workforce. Through November, the tech industry had already cut 80,000 jobs with more planned for 2023. These are formerly high growth industries.
The chart below shows the auto market. Typically, car makers sell between 17 million and 18 million cars per year but we are nowhere near that level.
Part of the problem was an inability of car makers to secure computer chips when the industry experienced a supply shock in 2021 but those problems have been fixed. Today, the problem seems to be a combination of higher interest rates, high fuel costs, and new car lineup that doesn’t meet consumer tastes or needs. This has resulted in sharply reduced auto sales.
Housing has also weakened after a sharp rise following the outbreak of Covid. Back then, cities experienced a wave of departures to the suburbs. That wave seems to have crested thanks to higher interest rates.
With evidence from autos and housing pointing to economic weakness, it’s reasonable to ask why the Fed continues to raise interest rates. The simple answer is that they are putting too much stock in a lagging indicator – employment. The employment numbers have been good and for a time, companies were experiencing difficulty in filling all of their job openings. You can see from the chart below that employment levels are back to pre-Covid heights.
For a short time earlier in 2022, employees were able to push for wage gains but those pressures have subsided over the past six months.
Secular Changes
Besides higher interest rates, there may be a secular problem working against the economy and that is the aforementioned demographics chart. As the population ages, people require fewer material goods as well as fewer services. Since our economy has been optimized for consumption, this change could prove difficult, especially since the economy will need to move away from big box retail stores and vacation properties.
The supply chain was moved to Asia in order to maximize volume production to create economies of scale that allowed for lower consumer prices. Demand was formerly predictable which allowed for efficient transportation from the other side of the world. We’ve enjoyed the benefits for the past twenty years but it’s increasingly looking like the best is in the past. China has turned into an unreliable trading partner. This suggests that we’ll return to producing more of what we consume in the US.
The problem is that those factories have been closed for a couple of decades and it’s going to take time to restore balance between what we produce and what we consume. Government spending has made up the difference over the past ten years but we’ve reached a point where government spending to help consumers maintain consumption is proving inflationary. The only option left is to embrace efficiency and capital investment to restore vigor to our economy but that won’t be politically popular in the short run.
Stock Market
Despite the 19% drop in stocks in 2022, we never felt comfortable with the prospects of using bear funds or inverse funds to hedge our portfolios like we did so successfully in 2008. There were too many professional investors calling for a stock market crash. Since 2009, it has become evident that attempting to hedge market risk when everyone else is hedging market risk is a recipe for losing money.
You can see from the chart below that there were four periods where we could have lost a LOT of money for clients by using inverse funds.
There are still too many professional investors calling for a crash for the markets to actually crash. This is the paradox of modern markets and the reason we had four tradable upside rallies in 2022. Besides, while the US economy is slowing, there is nothing indicating a sharp drop in the next six months. Instead, I expect the markets to drift lower until international pressures shake the global financial system.
That said, we may get a few opportunities to trade both inverse and long ETF’s during 2023. These moves would be purely for profit opportunity.
We still like the sectors we favored in 2022. Defense should continue to perform well as the war in Ukraine will require the US and its allies to replace the equipment and munitions donated to Ukraine. In conjunction with replacing munitions, the cybersecurity element of defense company revenues is still very attractive and valuable.
Food is still attractive but valuations aren’t as appealing as a year ago. The same can be said for auto suppliers.
Electric utilities are pretty attractive at the moment with dividend yields above 3%. The industry also has the potential for some growth if our nation ever gets serious about energy and the need to upgrade our electric grid regardless of energy source.
Industrial suppliers are a mixed bag. These companies are attractive longer term but they are fully valued at present and likely to experience some earnings variability as the economy continues to weaken. This could be made worse by weakness in China and Europe.
When we consider the implications of aging Baby Boomers moving savings out of stocks for safety, global economic weakness, and the vicissitudes of moving from the old economic cycle to a new one, it behooves us to maintain valuation discipline when investing client funds. Unlike the past forty years, we won’t have economic growth to bail us out of timing mistakes.
The GeoVest Approach
We have been highlighting the changing nature of the US economy over the past year and it’s why we were relatively successful in the equity markets in 2022. Now that this adjustment period has become clearer to investors, we believe that stock picking will become even more successful in relation passive strategies such as index funds.
Last quarter, we discussed the move from inflation expectations to fears over deflation expectations. Such a shift has been proven in the markets with the 10 year US Treasury yield falling from 4.25% to its present 3.55%. We believe long term interest rates have further to fall in 2023. As such, we expect that whatever weakness occurred in our bond portfolios in 2022 were only temporary and that 2023 remains promising for our clients.
Our primary risk focus for 2023 will be the value of the US dollar in global currency markets because if the dollar breaks higher again, we risk a financial contagion around the world. Yes, everyone else is worried about the dollar or claim they are worried about the dollar moving lower but such a move would be positive for the global economy. The real stress in the world today is based on decisions made between 10 and 20 years ago that sought to profit from the demise of the dollar.
In conclusion, 2023 may prove volatile like 2022 but that volatility may bring us some exciting profit opportunities that we will do our best to capture. Thank you and it’s our continued pleasure to serve you.
Philip M. Byrne, CFA
