January Junkyard Dogs
January looked like a great start to 2023, after the losses of 2022. The S&P/ASX200 index was up 6.2% for the month, similar to the 6.3% rise in the US S&P500 index. Share markets in Europe, China and Latin America were even stronger.
But appearances can be deceptive. The January rally was built on hope, not facts. Investors were betting that the Fed would stop raising interest rates and the battered tech sector would recover. For example, Tesla gained 40%, Bitcoin jumped 38%, and even the joke Dogecoin rose 32%.
What investors were doing is called bottom fishing: that is, they were buying the assets which had fallen the furthest in 2022, on the grounds that they must be cheap after such big price falls. For example, Meta Platforms (the disaster formerly known as Facebook) fell by 76.7% from peak to trough in 2022. In January 2023 it rebounded by 109.8%: simple arithmetic tells you that it is still down 51.2%, i.e. Meta shareholders have still lost half their money. Is Meta cheap? History suggests it isn't.
The investors who are buying beaten-down tech stocks in this cycle are usually too young to remember the aftermath of the 2000 dotcom boom. As PT Barnum said, "There's one born every minute." Older readers will recall that the tech stocks began to slip in April 2000, and kept sliding for the next four years. They did enjoy rebounds every few months, but these were all false dawns as the bear market persisted. The best of the tech stocks - think Amazon, Google, Microsoft - lost about 75% of their value from peak to trough. The rest of the tech stocks just disappeared altogether. In fact, if dividends are excluded, the whole US share market was no higher in 2007 than it had been in March 2000.
The January 2023 rally ended in early February as the Fed (and other central banks, including our own Reserve Bank) put an end to investors' fantasies by making it very obvious that interest rates were going higher and staying up for longer. Early reporting from US companies for the December 2022 quarter showed that in many cases profitability was falling short of expectations.
Arminius continues to believe that, even though we are now in the Year of the Rabbit, several of the tigers from 2022 are still hanging around, such as oil prices and the Ukraine crisis, and they have been joined by the problem of Congressional gridlock in the US. The biggest of these tigers is inflation, which is not going back to the sub-2% levels which was obtained in the peaceful decade before Covid.
At best, US inflation will abate from 7% to around 4%, but then it will get stuck. The tight US labour market is pushing up wages in key sectors, and companies are pushing through price increases in order to pass on increases in wages and input costs. Persistent inflation means that the Fed will not cut interest rates as quickly as the bond market is hoping.
At worst, US inflation will fall slightly then begin to rise again, e.g. because of external factors such as higher oil prices or higher commodity prices. Under these circumstances, the Fed may have to raise interest rates again ala the Ghost of Arthur Burns past.
The outlook for Australia is better than the outlook for the US, and we expect the Australian share market to outperform the US over the next three years. This has nothing to do with domestic Australian policies; if anything, it's in spite of. The main drivers of this positive outlook are China and the resources boom. The Chinese economy is not recovering as fast as the bulls might hope, but it will be back to pre-Covid levels by late 2023. In addition, the Chinese government is quietly stepping back from its unofficial bans on Australian exports from coal to lobsters.
Global de-carbonization is fueling a resources boom which will focus on the minerals used in batteries and clean energy generation, "critical minerals" such as copper, nickel, cobalt, graphite and lithium. This latest resources boom means that Australian investors will enjoy a rising A$ against most major currencies, which will also help to curb domestic inflation. US investors, by contrast, will see the US$ continue to weaken, which tends to mean importing inflation.
The single most important thing for investors to remember in 2023 is that the world has changed. We are not going back to the world of ultra-low interest rates because inflation is not going away, and the forty-year bull market in bonds ended abruptly and painfully in 2022. This paradigm shift means that investors need to question the habits which they have built up since the GFC, and adjust their investment strategies to a world of higher volatility, where real assets will outperform financial assets.
Australian equities will perform better than most of the world over the next three years, but the new paradigm of higher volatility means that the old strategy of buy-and-hold won't work very well in a world where commodities and resource companies lead share market performance. To cope with the coming turbulence, investors will need exposure to commodities and to long/short strategies - i.e. the ability to short shares as well as buying them.
The Arminius Capital "ALPS" strategy returned +21.67% in 2022, compared to negative -19% for the US S&P500 and negative 1.1% for Australia's S&P/ASX200. The 2022 return puts ALPS among the top 3 out of 39 alternative funds. The key factors behind the ALPS annual return of +21.6% were to invest in commodities and to invest long/short.
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