​Most risk assets have had a decent fall this year. Long overdue and somewhat predictable perhaps but, as ever, it’s the most popular stocks and styles that have been hit hardest.

Along with the Ukraine invasion and continued Covid-induced lock downs in Asia, the rise in the US 10 year note yield has been responsible for this reappraisal of risk.

The US 10 year note yield is fast approaching 3% and the whole curve has occasionally inverted which to some ‘scribblers’ portends a recession. To put this rise in perspective, the US 10 year note yield was 0.5% in July 2020 and started this year at about 1.6%. That’s quite a loss of capital given the long duration at such low yields. Over that same 21-month period, US equities are up about +30%!
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Too late, the ‘inflation is transitory’ narrative has been removed, and we now perhaps have a more aggressive tightening to endure than we would have had if action had been taken sooner? “A stitch in time saves nine” is a useful refrain to remember.

Archive: A fictitious memo to Jay Powell from a ‘staffer’ at the Fed?

​We have been told that ‘tightening’ is an imminent rise of 50 basis points in the Fed Funds rate (the short end) but also need to bear in mind that the size of the Fed balance sheet is going to be reduced. This represents an additional source of tighter monetary policy and so the effective tightening of policy is greater and quicker than most realise. This has consequences for the kinds of risk factors one should favour; put another way, a different kind of stock will do better in the next five years than in the last ten. The 30% rise of US equities compared with a 15+% fall in the value of ‘safe’ government fixed income is unlikely to continue.

We call it investing in stocks that meet needs rather than wants.

Archive: Equities As an Inflation Hedge? Choose Wisely Though

To repeat, in our view, new emerging investable themes will be: –

A) Defence, food and energy security are all now clearly priorities and are not wants but needs. The green transition couldn’t have been handled worse, as we detailed in our recent presentations (“All revolutions eat their young”). Nuclear power should be on the agenda. All this is investable.

Archive: 1 Stock for the Energy Infrastructure Overhaul

B) De-globalisation or National Industrial Policy is on the rise as we suspected it would be. This means both a need for an increase in domestic capital investment and the involvement of government in ‘helping’ revitalise and protect strategic industries. The semiconductor industry in the USA is one such example.

C) Buy backs have to give way to capital investment incentives. This increase in capital expenditure in the name of National Industrial Policy is much needed. This inflation is different from that of the 1970s when the labour force was very powerful and not very productive (at least in the West). Then wage increases were way above inflation and fed the beast with expectations of price increases driving the next round of higher wage demands. This time it’s a dearth of supply side competition that is causing the price pressures and misguided legislation against oil companies, pipeline companies, lobbying to prevent break ups of monopolies, the shedding of defined benefit obligations, the introduction of zero hour work contracts have placed capital firmly with its throat on labour. Capital investment has been disincentivised and buy backs rewarded. This has to shift back.

D) In an era of inflation and rising mortgage rates, the consumer will become more discerning about where they spend their money since inflation has been eroding income for a long time and personal debt is high already. This again means the extrapolation of subscriber growth and price increases is naïve. Anyone for Netflix?

To us, this means one should favour basic materials, energy (pipelines are probably a better position than ‘evil’ oil?), industrials, defence, infrastructure and, increasingly, banks, especially US regional banks.

One area needs a mea culpa, one which has hurt our returns and surprised us, Japan. Japan and especially the Yen are getting sold harder than Europe and the Euro. We have been roughly benchmark weight the US and USD while being overweight Japan and the Yen and underweight Europe and the Euro. We understand that the Bank of Japan, the central bank, has signalled it won’t tighten policy and thus makes the rising yield on the USD attractive relative to the Yen, but Japan remains a massive net creditor nation and has not (yet?) displayed any excessive inflation. Meanwhile the ECB cannot raise rates for fear of sparking a new crisis in the Euro still held together by smoke and mirrors. Inflation, even in Germany, is getting serious and, at over 7% p.a. as of March 2021, is the highest since 1981.
We’ll continue with our positioning.

There is still plenty of risk and lots can go wrong with the attempt to create a soft landing. It’s not our expectation but, it’s worth bearing in mind, we can see a whole lot more intervention and confiscation.

Archive: Future Tense or Past Imperfect

​So, be aware of risk and portfolio construction even if you wish to focus on only a few markets and sectors.

A portfolio should comprise of more than a few favourite stocks. Ten companies isn’t a diversified portfolio, nor is twenty. Probably not even thirty. Combine strategies that do different things and invest in different kinds of stocks with perhaps different holding periods; i.e. time diversification. Prepare to be content with 8% p.a. and there is still time to position away from the ‘growth at any price’ style!