Post July FOMC

NOTE: This post was written using data gathered up till 31st July 2022.

During July FOMC, the Fed raised rates by 75 basis points bringing the funds rate in the range of 225 to 250. This post will explore current market expecatations and implications for investors moving forward.

1. Nominal Rate expectations:

Current market yields:

Implied yield expecations from treasury futures:

This tells us that nominal rate expectations imply that rates still have room to move a little further upwards. However, the short end of the curve (2year) is going to move upwards more than the long end (10 year).

Spreads are basically down to zero and below, implying the market is pricing in a recession.

With such a flat nominal yield curve, we can draw the following rough sketch of yield expecations:

The short end is expected to continue rising a little bit, the long end will remain where it is, possibly even moving downwards slightly due to economic slowdown.

After the June CPI release, the most significant thing to happen in bond markets was that 2 year yields went up, BUT 10 year yields did not move up in tandem by the same amount, which means post June CPI release, markets increasingly pricing in a recession.

2. Inflation Expectations:

Here is where things get really interesting.

Current CPI is at 9.1%, 5 year tips spread is at 2.73% and 10 year tips spread is at 2.53%.

After the FOMC meeting, inflation expectations for 5 and 10 year actually went up! This is because the Fed did not raise rates by 100bps, and the probability of containing inflation went down, resulting in higher inflation expectations.

1 Year inflation expectations also moved up to around 2.5% (according to data from ICE Intercontinental Exchange)

Inflation expectations are by no means unanchored, but have definitely moved slightly higher.

What does this imply for the current real yield curve?

As the year moves along, real rates at the short end will move upwards swiftly as inflation comes down and nominal rates move up.

At the long end of the curve, assuming inflation remains constant, real yields will slowly move and hover around zero percent for 5 year and 10 year.

3. Impact on Gold:

As short rates move up swiftly, it will put downward pressure on the price of Gold.

Before the pandemic happened, when the 10 year real yield was in the range of 0.5 to 0%, which was May – Aug 2019, price of gold was in the 1300 – 1500 range. Which means the current price of Gold at above 1700+ is way too high given the changes in the real yield curve that is to happen. As such, my expectation is for Gold to trade somewhere between 1500 to 1700 moving towards the end of the year, but definitely not above 1700 as inflation comes down, and real yields at the short end move swiftly upwards.

4. US Stocks:

As US economy moves into recession, and short rates move up, cost of debt increases, while corporate profits decrease or grow at a slower rate, stocks will be trading at lower multiples than what is currently priced in. Bearish call on the stock market. Even if PE ratio does not change, assuming a PE ratio of 20, as earnings growth decline, prices decline.

5. Bonds:

This is where things get interesting.

Short term maturity debt is great for excess cash right now given high rates.

In addition, it might be good to load up on some TLT as long rates continue to face downward pressures due to slowing economy. However, I feel that the best time to buy into long rates is when Fed policy becomes more clear, will they hike above 3% or remain at 3%? If they remain at 3%, then load up on TLT. If they hike above 3%, we need to see if long rates move up in tandem, and if so by how much.

6. Commodities:

(Not a commodity expert so leaving section blank for future posts)

7. Currencies:

Most of the significant moves in major currency markets have already happened as yield spreads between the US and EU/JP widen. Unless the EU/JP swiftly change monetary policy, the Euro and Yen will remain devalued against the dollar.

For Yuan, expect deprectiation pressure as global physical trade slows down. Will PBOC step in to maintain the current rate at 6.7 or allow further depreciation to 7 remains to be seen.

8. HK Stock:

With a tightening Fed and QT happening, global liquidity growth goes to zero and even negative, bearish on HK and KR stocks.

9. CN Stocks:
Chinese stocks follow a different cycle to the rest of the world in that their earnings growth component depends largely in part on domestic economic policies (excluding the exporters).

The problems of the property market, and a very strict COVID-19 policy imply that China faces significant headwinds moving forwards. The three largest drivers of economic growth in China are Exports, Investment, and Consumer Spending. With a global recession and de-coupling occurring, export growth will slow significantly. Consumer Spending remains depressed due to the lockdowns. What remains is government investment in infrastructure projects. The problem this time is that these projects are no longer financed by land sales, but by issuance of government debt. As such, China’s debt to GDP ratio is going to increase towards the end of the year, possibly even up to 290% of GDP. The catalyst for Chinese economic growth remains to be seen, and we will have to wait until after the October party congress for any significant changes to COVID-19 policy.

As always, China is a long play. If you believe they can overcome the middle income trap (which is exacerbated by de-globalisation) and change into a consumer driven economy, then stay long. But if you believe they cannot make it and will face a period of huge debt deflation, something like Korea during the AFC, then you shouldn’t be long China.

Some might argue that China pulled through in 1991, 1997, and 2008, so they can pull through again. I beg to differ as the debt to gdp ratios at those points in time are drastically different to what we see today. Moving forwards, I think the Chinese economy growth rate will continue to slow, there will not be any significant “boost” as the central government needs to maintain a stable debt-gdp ratio, For those who are long-china, wait until october.

10. Oil Supply:

As long as the US, EU and MEast don’t reach a deal, oil supply remains constrained, with oil prices going to be high. If supply is not fixed, when the Fed eventually lowers rates again, oil prices will soar back up.

The key to watch are movements by Saudi and the Rus/Ukr war.

11. US Credibility and rising rates:

As rates begin to rise, the debt servicing of outstanding treasury debt increases in tandem. As such, the Fed is facing yet another constrain when it comes to raising rates. If the market begins to be worried about the ability of the US government to service it’s debt, this will be the worst outcome for global financial markets. We might see a meltdown and a huge spike in the price of Gold. However, at this point in time, markets are not pricing this in.

To hedge against this possibility, it will be good to average into Gold when it drops below 1700.

China Property Market

If you haven’t heard about it, the latest news to roil chinese capital markets have been groups of home owners choosing to halt mortgage payments on unfinished property developments.

As the property crackdown continues, overly indebted property developers simply lack the cashflow to continue building their projects. As such, homes haves been left unfinished and property buyers left stranded with monthly mortgage payments. As there has been no end in sight to the property crackdown, home owners are worried that they are paying off mortgages on apartments that will never be built. As such, a group in 景德镇 Jing De Zhen, Jiangxi, also known as the porcelain capital of China, chose to halt mortgage payments until they can be assured that their homes will be built. This set off a string of events that quickly impacted the entire country. According to reports, more than two hundred property developments have been affected.

The market response was very swift, with the 4 largest state owned banks having their share prices drop between 5 – 10%. Can you imagine if more than two hundred property developments face mortgage default at the same time? There will be huge stresses in credit markets. As I have a position in one of the state owned banks, it was in my vested interest to find out exactly what was going on, and what the impact will be.

But at the end of the day, I could only accept that we will never know exactly what the bank books look like. As such, if we do not know the exact magnitude of the exposure, how can we manage our risk accordingly?

The best answer is: Stay out.

But since I already have a position, staying out is not an option.

So I thought about it and came to this conclusion:

The CCP is not going to let state owned banks go bust.

The CCP is not going to allow a credit crisis to happen in 2022, just before the 20th party congress.

As such, there will be damage, but it will be controlled, and life will go on. Markets seem to think the same:

The crisis will be resolved, the only question is : what will the cost be?

But to say that this will evolve into a fullblown “Lehman event”, is probably overstating it.

Yields and Gold, Post May FOMC

With the May FOMC meeting past us, the Fed has pretty much set the path forward with regards to monetary policy. 50 bps increase per meeting, bringing us to 3 percent funds rate by the end of the year. In addition, the path forward for reduing balance sheet is also set, with a maximum of 95 billion per month by october this year. By setting the path forward, the Fed is fixing in place market expectations with regards to monetary policy. In this post, I lay out some of the most important questions to think about moving forward:

1. When will a recession in the US occur?

The answer is that the exact timing is unknown, but many people are thinking most likely early 2023. But what is more important is what the Fed thinks. The market could be pricing in a recession, but if the Fed does not think so, the Fed won’t budge. So, what is the Fed looking at to tell whether a recession will happen or not? In his Nabe speech: https://www.youtube.com/watch?v=8-HG8qd5Z8U&t=340s

Powell highlighted that he looks at the shorter end of the yield curve, not the 2s10s, but rather the 3m10y. For the Fed’s model see here:

https://www.newyorkfed.org/research/capital_markets/ycfaq#/

Historically, when the 3m10y spread closes in to around 100 bps, market expectations for rate decreases increase, price of Gold begins to increase.

But the problem this time around is inflation. When the 3m10y spread closes in, and reaches zero or even negative, what will the Fed do when inflation is 4 – 6% End 2022? According to Powell, he will continue to hike. If this happens, the stock market will break. If Powell maintains the funds rate with no further increases, the market might not break, but volatility will increase significantly, and indices might see a slow ride downwards.

As such, we need to monitor the 3m10y spread closely, not because it is right or wrong, but because the Fed monitors it, and it will tell us about what the Fed might do next.

2. What affects 3m 10y spread?

The 3m treasury bill is closely related to the Fed funds rate.

The 10y treasury note, in nominal terms is affected by economic growth and Fed action. As such, the thing to watch out for in 10y nominal yield is the “neutral rate”. Right now, expectations are for 10y “netural rate”to be around 3 – 3.5%. To monitor expectations see:

https://www.cmegroup.com/markets/interest-rates/us-treasury/2-year-us-treasury-note.html

3. Possible scenarios:

a) 3m10y spread closes in to zero, Fed maintains fund rate at around 3% because inflation is still high, at around 4+%. IF at this point in time, the 10y yield is hovering at around 3 – 3.5% in nominal terms, then we can safely say that it will begin a slow descent as economic conditions worsen.

Also, 10y inflation expectations by End 2022 will most likely drop, unless we see another huge oil shock.

Thus, if 3m10y spread closes in to zero, Fed maintains fund rate at 3%, this is a buying point for Gold.

b) 3m10y spread closes in to zero, Fed continues to hike. This will break the stock market and most possibly the economy. If this happens, what will happen to the 10y yield?

c) 3m10y spread closes to zero, Fed reduces rates. Stock markets rally slightly, but Gold will have a huge bull run.

4. Inflation, oil, ukraine war:

Right now, inflation is largely due to high oil prices, which is largely due to the supply shock of the Ukraine war. Can oil prices come down significantly to reduce inflation expectations significantly by end 2022? If this does not materialise, which is a possibility, then the Fed will have to choose one of the three scenarios listed above. All we have to do is consider the outcomes, and plan accordingly.

If the Ukraine war ends, Russian oil will still be sanctioned for a period of time, and there will be lots of talks held around the war. But eventually, Europe will want to lift sanctions in some sort of way with the Russians due to the high energy price. The big question mark right now surrounding the Ukraine war is Putin. After russia has seized control of Donetsk, Luhanks, and Mariupol, will they stop here? Or will they continue westwards towards Odessa? My guess is that Putin will stop, and a “new front” between NATO and Russia will be formed, with “East Ukraine” as the key middleground between both parties.

Once this happens, NATO will begin to have a huge presence in Ukraine, unofficially. It will achieve this by sending weapons and military equipment. Will there be a THAAD placement in Kiev? We shall see. As this happens, the EU will be forced to slowly move away from independence on Russian oil and gas. Who can supply the EU then? The US and the middle east. Russian oil will most likely be sent to the east.

The US knows that this will happen, and in order to bring down oil and gas prices to solve it’s own inflation problem internally, the US will have to work with the Saudis to increase international oil export.

What does this mean? This means that oil and gas projects will most likely be increased, and funded by governments, the energy prices will be fixed with long term contracts to avoid volatility and ensure energy security for both the US and the EU. Once long term contracts have been signed, and projects underway, a new geopolitical order will emerge. The US, EU and MEast with regards to energy security.

Speculations aside, the key to inflation right now is oil prices, and the key to oil prices right now is the Ukraine War and Saudi.

My current framework: Oil comes centre stage

Oil comes centre Stage

Today’s post is about oil, and why it is are the center of markets and the functioning of the world economy. The first few parts will be quite brief as everybody probably already knows the details.

1. How did we get to today?

The current business cycle can be traced back to 2018 when Powell began to talk about rate decrease expectations. As interest rate decreases, it spurs people to borrow more and invest more, causing economic growth to come back up.

And of course, the pandemic simply accelerated the process. In addition to unprecedented monetary policy by central banks, global fiscal policy was also unprecedented during the pandemic.

2. Hot economy and inflation:

All of this monetary stimulus led to a super hot economy in the US with very high demand. Increase in demand drove up inflation. In addition, the pandemic fractured supply chains around the world, further exacerbating the problem. As always, when inflation runs rampant, the Fed is forced to raise interest rates.

3. Inflation and Interest rates:

If we pause here and think for a second, why does the Fed HAVE to raise interest rates whenever inflation runs hot? What is this ‘magical’ force that is pushing the Fed to do so? For the answer we have to go back in time to 1971 when Nixon lifted the dollar off the gold standard. The Bretton Woods system which was instituted after WWII pegged the dollar to gold at a fixed exchange rate. This was the beginning of the USD as a global reserve currency. As long as the US promised the fixed dollar/gold exchange rate, the global monetary system would remain intact. However, as the cold war progressed, and the US became increasingly involved in the Vietnam war, and the increased military spending pushed the US into a budget deficit. Even though this was frequently cited as the reason for abandoning the gold standard, another more important reason was the decline in federal revenue:

This meant that the US would eventually have to print USD not backed by gold due to the deepening budget deficit. And sure enough, in 1971 Nixon announced to the world that the USD would no longer be pegged to physical gold.

This was the end of Bretton Woods 1, and the start of Bretton Woods 2. In order to restore faith in the USD as a world reserve currency, the US did three very crucial things which were done by two very important people who helped to shape the world we live in today:

• Volcker. Raised interest rates to combat inflation. But this was only the demand side of the story.
• Kissinger. Went to Saudi to broker a deal with oil. This helped to solve the supply side of the inflation problem, high oil prices.
• Kissinger. Went to China, paved the way for Beijing to enter the UN in 1971 and for Nixon to visit China in 1972. This was the turning point of the cold war. Which eventually led to China opening up in 1978 and the start of the massive globalization push that we see today.

Once American factories got relocated to China, the inflation problem was solved by millions of cheap labor entering the global workforce. Once the Saudi’s agreed to sell oil at USD in exchange for American military equipment, the oil price stabilized and inflation in the US went down dramatically. Once China agreed to open up and co-operate with the US, the soviet union came under immense pressure geopolitically, as Russia’s long border with China suddenly became unsafe. All these in combination helped to lower inflation in the US, and kickstart a second round of economic growth through globalization.

These factors in combination helped to kickstart Bretton Woods 2, which is the world that we live in today. And underpinning the stability of the USD as a reserve currency, is US economic growth and the promise of the Fed to keep inflation in control and maintain the purchasing power the USD. If the Fed loses control of inflation, and we return back to a 1970s scenario, then the world will once again lose faith in the USD a reserve currency. As such, in order to maintain the credibility of the USD, the Fed HAS to combat inflation. Now that we know why the Fed has to combat inflation, let’s take a look at inflation today.

4. Inflation and Oil:

 As we can see from this data series, there is a broad correlation between oil prices and inflation. As such, if inflation is to come down, oil prices definitely have to come down. Which brings us to the current relationship diagram below:

Let’s walk through the one by one.

1. Energy security and the Ukraine War:

The Ukraine war was a major catalyst driving oil prices up all the way to ~$120 a barrel:

However, do note that even before the war started, oil was trading above $90 a barrel, which is already very high. The Ukraine War and the disruption it had on commodity markets raised a very important question to the entire world: Energy Security. If I am dependent on another country for my energy and raw materials, they can then use it as leverage against me geopolitically. The only way to solve this is to either increase domestic production for countries that can, and to diversify supply sources around the world. However, the problem with diversification is that there are only a few major oil players around the world: US, OPEC/Saudi, Russia, Iran. This was also the reason they the US has historically maintained a strong presence in the middle east, to secure oil supplies. However, things have changed with the advent of shale oil, and the US is now mostly energy self-sufficient. Regardless, the Ukraine war has opened up a can of worms and countries are now forced to rethink energy self sufficiency. Other than oil, perhaps natural gas, coal, or nuclear energy. All of these are difficult long term decisions which will not impact the price of oil in the short term.

• Geopolitics: Iran and Saudi

If the Iranians can once again sell oil on the international market, then global oil prices for sure will come down, helping the US to alleviate inflation pressure. This is also why the US has been working very hard for a Iran Deal 2.0 in recent months.

Saudi: If the Saudi’s agree to dramatically increase oil output, then global oil prices will fall as well. But at this point in time, the Biden administration does not seem to be able or willing to meet the demands of MBS.

• Climate Change and ESG:

The climate change push and ESG investing mindsets have dramatically reduced the investment in fossil fuels by major banks and energy companies. In addition, if we look at the ROI on oil, it is pretty abysmal.

If we take the average 10 year return, it’s pretty much close to zero. As such, if banks are unwilling to finance long term energy projects due to ESG and low returns, and if countries have been underinvesting in fossil fuels since the paris accord, then it is no wonder why oil prices are high right now because supply is not keeping pace.

In short, the world and the US needs an increase in oil right now to bring down inflation and CPI, and stabilize the economy. The Fed can only bring down demand, but if supply continues to remain tight, prices and CPI can continue to remain elevated for longer than desired. In the short term, what factors can bring down oil prices:

• End of Ukraine war: Unlikely. Because even if the war is over, Russia sanctions will not go away
• Iran Deal: Maybe? 50% probability.
• Saudi hiking oil output: Maybe? 50% probability as well.

As such, oil will definitely stay high in the short term. The best we can hope for is that it steadies around $100/barrel.

In mid to long term:

• Increased oil production by the US
• Increased oil production by Canada

• The big question for markets right now:

The big question for markets right now is, when will oil price come down significantly, and when will inflation as measured by the CPI start to go lower below 4%? If the economy slows down, and inflation and oil prices remain elevated, will the Fed be able to lower interest rates to stimulate economic growth? If it lowers interest rates when inflation is high, this will affect the credibility of the USD as a reserve currency. If it does not lower interest rates when inflation is high and growth is slow, the US economy will most likely be tipped into a recession. Either way, the Fed is boxed in.

As such, the key thing to look out for that will affect short term oil is Saudi and Iran. Can the US get them to increase oil output in the short term?

5. How to invest:

Well, this is the million dollar question isn’t it? The key question to answer is that, what will the Fed do when economy slows down but inflation remains high?

Scenario 1: Iran + Saudi oil come online

Oil prices drop back down, inflation expectations drop back down, real rates rise up, Gold decreases, equities most likely rally a little bit.

Scenario 2: No increased oil production

Oil prices remain elevated, inflation expectations remain elevated, gold slowly decreases over time as inflation slowly subsides, but remains relatively high at around 4%. Equities volatile, unlikely to have a strong rally.

Scenario 3: Iran + Saudi oil say no.

Oil prices move upwards, possibly going past $120 a barrel. Inflation expectations go higher, real rates depressed, gold moves higher, equities very volatile and bearish.

Scenario 2 and 3 will continue to be the main market expectations until long term oil production in the US comes online. And if these scenarios come true, the second question is: What will the Fed do when the economy slows down, but inflation remains high? When will long term US oil production come online? This is the second biggest unknown right now.

Scenario 4: Fed accepts higher inflation rate at 3 – 4%.

In this scenario, gold and equities will rally in a big way.

I think that Scenario 4 is the most likely out of all the different outcomes. But for it to materialize takes time, because at the moment, the Fed is only beginning to raise interest rates and runoff the balance sheet. It has yet to say, “we will accept slightly higher inflation”.

In scenario 4, stagflation is most likely and Ray Dalio did a great talk with Summers on this:

The more I think about scenario 4, and what Dalio said, the more I think that this will materialize. Why? Because as the US continues to re-shore supply chains, this sort of structural change is in itself inflationary. By bringing back manufacturing, inflation will undoubtedly rise up due to rise in wages and rise in cost prices of goods. However, this is not what the market is pricing in at this point in time.

6. What I am doing now:

Thinking deeply about scenario 4, and when is the “buy” opportunity to stock up on gold. From now until May FOMC, it is safe to say one can sit back and enjoy the ride.

产业生命周期的初期: VC Investing

Venture Capital Investing is characterised by: High Risk, High Volatility, High Return. In this type of environment, it would be foolish to put all your eggs in one basket. As such, if you had a million dollars, you would invest in 10 companies, $100k in each. You will know that 9 companies are going to go bust, but you are hoping that the one company that makes it becomes the next google or amazon or facebook. However, there is a time early during an industrial revolution where you can make big money being a VC.

When we look at the rough history of the third industrial revolution, it really began in the late 1980s and early 1990s with the launch of windows and apple OS. That was the beginning of the PC revolution, and more importantly the birth of the internet. Perhaps the most important book you had to read in 1990 is ‘The Third Wave’ by Alvin Toffler.

Key characteristics of a new industry beginning are young companies with brand new ideas that do not make much money. Recent examples are uber, air bnb, wework. In fact uber is still losing money last time I checked, but everybody knows that the technology is going to change the world, and it has. I can’t remember the last time I actually hailed a cab waving my hands, we all do it on our smart devices now.

Early on when a new industry is coming of age, it starts with venture capital. People who are willing to invest in companies with futuristic technology. It’s like investing in Uber in 2010. You could most probably lose all your money, or make 100X on the initial investment. Once the companies have matured from the VC phase, they then get listed on the secondary market, the stock market. And the secondary market also begins to slowly buy into the new technology. The internet is going to change the world. A PC on everbody’s desk in 5 years. We will hear slogans and cries of amazing discovery and technological revolution that have YET to happen. BUT because future expectations are so high, these future expectations begin to drive up stock prices significantly.

Above is a picture of the SNP 500 from 1990 to year 2000 just before the dotcom bust. During this 10 years, the internet was the most exciting and sexy technology of the time. Everybody knew it was going to change the future economy in a big way, but it had YET to happen. And because stock prices are driven by future expectations, the increasingly euphoric mindset behind the internet companies drove stock prices higher and higher and higher.

As such, during the beginning of the birth of new technology, before the burst of the bubble, we can expect very good returns investing in companies with low cash flow but a very rosy future. A good recent example are the companies that ARKK invests in. Are these companies going to change or shape the future? Maybe, maybe not, but the industries and ideas that they are thinking about definitely will. There might be another company that does what Roblox does, and becomes the successful one, Roblox might not make it in the end. But at this stage of the game, it dosen’t matter. What matters is that stories are being told of the future, and people are buying into those stories, driving up stock prices.

Now, what we need to be careful about is, when does the bubble burst?

Bubble always burst when the cost of money increases. It is impossible to keep investing in companies that do not make money at no cost. There is always a cost of initial capital. And when the cost of capital remains the same, or decreases, see 1996 to 1998, everyone is having a good time. But when money becomes expensive, then the rate of increase of investments in these companies is going to decrease and decrease and decrease, and eventually hit a inflection point that bursts the bubble.

As such, in the 1990s period, if we were to invest in the SNP500, we should be aware we are earning money that is eventually leading to a bubble, because stock market is being led by early stage companies with no significant increase in profitability. The best time to do this is during the period of rate decreases, meaning 1995 to post 1998. And IF we look at the SNP500 chart, that is exactly the time when the SNP500 had the steepest increase in its value.

However, close to end of 1998 and 1999 the Fed began to hike interest rates. One year later, the dotcom bubble happened.

What does this tell us? This tells us that, at some point during the bubble, monetary policy will change course due to normal economic factors. And at that point in time, you should exit the market. Yes, you’re going to look really stupid if you sold in 1999, but once the dotcom bubble burst, you’ll be the one laughing in your chair. And once the dotcom bubble does indeed burst, then you can re-enter the market and just stay long through an ETF, because the next wave when companies mature is going to yield very good returns as well.

The forces that shape 2022

The forces that will shape financial markets in 2022 are pretty simple when you break it down, they are just terribly difficult to predit.

1: Economic Growth:

Will we see a large global economic recovery as the virus goes away? Or will new variants hamper growth.

2: Inflation:

Nuff said about this.

3. Commodity Prices:

4. US Fiscal revenue: Can Biden get some tax bill through congress before mid term?

5. US Mid terms. If republicans take over, Biden’s foreign policy is greatly weakened.

6. China. How far will the CCP go to stabilise growth? What impact will this have on commodity markets, especially for Australia/Brazil etc.?

NASDAQ VS SNP

The past 10 years saw the Nasdaq 100 overtake the SNP in terms of returns. The reason is pretty simple, that the most proft making companies of the past 10 years are the FANG stocks. And if we break down their weightage on the indices as of today:

So it’s pretty simple, the FANG stocks hold a higher weightage on the Nasdaq 100 index, up to 40%. This sort of concentration helped to supercharge returns on the index.

And if we make the reasonable assumption that for the forseeable future, the companies which are going to be able to continue making money are the internet companies, then it makes sense to hold the Nasdaq 100 vs the SNP 500.

Sometimes, it dosen’t feel good to be right

Above is the timepoint, Wed 16 March when I chose to add a little bit into my QQQ position. At that point in time, oil had fallen to below $100 USD, and markets pretty much priced in a ‘goldilocks’ scenario where the ukraine war would be over swiftly and iran deal goes through together at the same time. To be honest, I was quite skeptical at that point in time, but as always there is that little bit of FOMO. And looking out 3 – 5 years ahead, 16 March was definitely in the region of market low for the year, and it made sense to add on more QQQ for long term holdings.

However, the base case scenario for this year is: Hawkish Fed + High Inflation + Slowing Economy, most like recession. As such, the macro ‘buy’ signal for the index should be when the Fed has announced the QT program schedule, inflation expectations as evidenced by the 10 YR and 5YR tips begin to drop, and Gold beings its drop as real rates rise and normalise. Once the market has priced all of this in, then it’s back to low volatility, and reflecting company return average over the long run.

I hoped I was wrong, and a goldilocks scenario would emerge. But alas, it does not feel good to be right. Nasdaq was down 1.4% last night, and the VIX increased 2.75% and gold is up ~1.5%, reflecting fears of an inflationary crisis further down the road as oil once again heads back up above $110 USD.

It’s really difficult to trade this market, but perhaps for long positions there are bargains to be made. The rest of my short positions are totally in cash right now.

A case for cash?

High inflation is the story of the year, and moving forward the Fed will definitely maintain it’s hawkish stance. The unknown right now is how fast and how quick the balance sheet runoff is going to be. Regardless, this environment does not bode well for equities and bonds in general.

Gold will probably see a drop back down below 1700 as short term inflation slowly dies off, and nominal rates increase, resulting in real interest rates increasing back up.

The only options left that I see are real estate and cash. Real estate can be easily accessed via REIT’s. However, I am not choosing to deploy into REIT’s at this point in time because to get return from the REIT, you need to hold until the dividend payout date. However, I would like the flexibility to deploy my cash anytime I want. As such, the best option for me right now is to hold cash and cash-like liquid instruments. The option of choice for me, based in Singapore, is the Singapore Savings Bond. This is a highly liquid instrument, redeemable anytime you want, and principal guaranteed! Right now, I’m sitting on 40+% cash, and it will go into purchases of SSB’s at the end of april as I need time to convert currency to SGD and consolidate all my spare cash.

The first hike: March FOMC

You can read the meeting minutes here: https://www.federalreserve.gov/newsevents/pressreleases/monetary20220316b.htm

Things to note are:

1. Don’t trust the Fed projections:

The Fed projections are not meant as a guide for what will actually happen to the real economy. If we want to see what is most likely going to happen to the real economy, listen to economists and watch the bond market. What the bond market is pricing in, is basically a recession heading into End 2022. Historically, when oil shoots above $100, a recession soon quickly follows because the Fed has to raise interest rates.

2. Inflation:

The inflation target by the Fed tells us they are sticking to their long term inflation goal of around 2%. In my opinion, they can live with 2.5 – 3%, if we look at inflation data for the past 10 years. Nevertheless, the Fed has yet to budge on this number, YET.

Also, can we trust the Fed’s inflation target numbers? Some forecasters expect 6 – 9% based on M2 growth.

In addition, the longer the ukraine war drags on, the likelihood of persistent inflation due to commodity prices being high, and the likelihood of a food crisis increases.

3. What FOMC tells us?

It does not tell us about what will most likely happen with the economy and inflation. What will most likely happen is: Recession + High inflation. We may end the year at 4+% like the Fed forecasted, or closer to 9% according to estimates by others. Answer is: Who knows?

Bottomline: Recession + High inflation seems to be likely this year.

Whether inflation remains persistently high moving into 2023 will depend on a number of factors. Wage growth, energy prices, commodity prices, money supply, etc.

What FOMC tells us is that, the Fed’s number 1 target right now is inflation. To combat inflation, to bring it down no matter what. And the problem as we all know is that, next year once economic numbers come in, and the Fed is forced to face the fact of higher unemployment, lower gdp growth, and probably higher than expected inflation, what is the Fed going to do? I really have no idea.

4. Time will tell:

This is probably the trickiest market to navigate in decades because the unknowns are just too many. Which is why we see a flight to quality, to own stocks/companies that have solid cash flows and pricing power. To own commodities in an inflationary environment. To own real assets such as real estate and gold.

5. Long term, next 3 – 5 years:

IMO, the long term trends of the world economy have not changed, and the structure of the world economy in large part has not changed. When inflation does come down eventually, the Fed’s going to open the flood gates again. Simple as that. So just hold and wait and be patient if you don’t know how to navigate the short term.

Long term trends: 5G, AI, Electric Vehicles, Renewable Energy, Healthcare, Technology, Metaverse. These are not going away. Holding power is key.

6. What to do now:

The best thing to do now is to do nothing. At least wait until the war is over and see how things go. If you really want to buy into something, average out and do small amounts monthly. If a global recession + food crisis occurs, the market is going to tank again. If it dosen’t, the market rallies slightly. The risk-reward is not worth it at this moment in time.