Client Memo: Geopolitics
Below is a copy of a recent letter to clients addressing market volatility and geopolitical events. As a reminder, this blog is an outlet for our thoughts, primarily on the macroeconomic environment, which contextualize our investments. Please subscribe to receive future post notifications.
Dear Clients & Friends,
We wanted to share a mid-quarter update given the heightened volatility in markets.
It's our belief this period is among the most compelling opportunities to deploy capital in the universe we follow since the initial Covid crash of March 2020. As equity investors focused on individual companies and their growth profiles, we are extremely compelled by valuations in our innovation-centric sphere. In many cases, shares of companies whose technologies were major Covid beneficiaries are trading at or near pre-Covid levels despite achieving two years of unprecedented growth and scale.
Asset markets have been in decline since the Federal Reserve had no choice but to change its tune on monetary policy. Washington is looking at the Fed to “fix” high inflation running at 7.5%[1], which does not sit well with the American consumer and subsequently politicians’ popularity. Despite the pressure to act, the Fed has only talked about doing so, as they would like any changes to policy to be telegraphed to the market well in advance. While announcing a decline and proposed end of their asset purchases (Quantitative Easing), the very fact it is still continuing tells us all we need to know. The Fed is trapped, their usual tool kit is not capable of addressing the structural causes of today’s inflation, which are primarily supply-side constraints due to Covid disruptions/backlogs, energy, and commodity shortages due to years of underinvestment (plus ESG restrictions). These factors were exacerbated since the onset of the pandemic by significant increases in demand for goods thanks to a combination of Covid restrictions forcibly shifting demand from services to goods, government stimulus, and the positive tailwinds of the “wealth effect” (asset prices rising) on consumer demand. Make no mistake, the Fed had everything to do with the latter.
Government stimulus (both fiscal and monetary) was achieved by deepening our debt burden, which currently stands at 122% of GDP[2]. What’s at risk if the Fed over-tightens financial conditions? A recession. This deflationary outcome would increase the debt burden in real terms and require more debt to grow out of – this scenario must be avoided at all costs. Thus, from the government’s perspective, inflation is not only the lesser evil but a necessity. Below is an excerpt from our August 2021 blog post, titled Financial Repression:
- There are several ways for a country to reduce its debt burden: 1) grow its way out in real terms (GDP growth > nominal debt service cost) 2) exercise fiscal austerity (increase taxes, decrease spending) 3) default and restructure (everyone takes a haircut) 4) inflate away the debt. Through low rates, the Federal Reserve tried to promote option 1 over the last decade to little effect. Option 2 will not happen in this administration and is unrealistic given the size of the debt load. Option 3, default and restructure may happen in emerging markets, such as Argentina, but is not realistic for the world reserve currency. This leaves option 4.
The Russia/Ukraine conflict is yet another iron in the fire. In a world short of oil, Putin finds himself holding pocket aces. Russia is the largest exporter of oil and gas to the rest of the world, and the second-largest net exporter to the U.S[3]. Western reliance on Russian resources is highlighted by the $700 Million worth of oil and commodities bought in the 24 hours after Putin declared recognition of Ukraine’s separatist states[4]. Sanctions on Russia will only increase energy costs and further fuel inflation. Putin is taking his opportunity to achieve the independence of Donetsk and Luhansk, something he’s been targeting since 2014.
What’s Next?
We can only hypothesize. Our view is the administration will use the geopolitical crisis as a scapegoat for inflation. In fact, media headlines are already driving the narrative there – “How the Ukraine crisis is already hitting American’s wallets?”. If so, recognition of supply-side constraints driving inflation will lift political pressure off the Fed to tighten policy. In some sense, the Fed’s hawkish tone (all bark, so far, no bite) aggravated by the Russia/Ukraine conflict, has already done their job for them. The S&P 500 is down nearly 13% from its highs and the Nasdaq 19%[1]. Just a few weeks ago some banks were predicting the Fed would hike rates 12 times to 3%[5]. This level of tightening into a slowing economy and geopolitical mess is unrealistic and risks the aforementioned deflationary situation. We think the Fed will be less hawkish than what the market has been pricing.
We will leave you with the below chart. Cathy Wood’s ARK invest, widely regarded as a pure “innovation” proxy ETF, has nearly round-tripped. Meanwhile, the median company in her ETF has grown revenue by 106% since the onset of the pandemic compared to the Dow Jones median of 7%[1]. The median company in ARKK is projected to grow revenue nearly 30% annually over the next 3 years versus just 5% for the Dow Jones[1]. Investor psychology drives extremes in either direction. Just last year sentiment was at all-time highs and there wasn’t a price the market wouldn’t pay for the next blockchain, genomics, or electric vehicle company. Today, any company associated with these innovative technologies, and many more like them, are being sold indiscriminately, hence the opportunity. Not all are created equal, and we are highly focused on finding “diamonds in the rough”.
Total Return of ARKK (blue) vs. Dow Jones Industrial Average (purple) since January 31, 2020
For Illustrative Purposes Only
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Sources:
[1] Source: Refinitiv Data. Lane Generational Research.
[2] Federal Reserve Economic Data. Total Public Debt as Percent of Gross Domestic Product
[3] U.S. Energy Information Association & BP Statistical Review of World Energy 2020
[4] Bloomberg. Commodities Aren't Being Weaponized in Confrontation Over Ukraine, For Now
[5] Reuters. Bank of America says it sees seven Fed rate hikes this year
