End of Q3 Review
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Since my last article, markets have gone wild. Last week, the Federal Reserve (Fed) Chair, Jerome Powell, confirmed another 75bps (0.75%) interest rate hike, and reiterated his tough stance on the inflation battle. Assets moved as expected, with stocks down and the US Dollar up. Fast forward to this week and we witnessed the latest US Consumer Price Inflation (CPI) print come in under expectations at 7.7%. US Dollar down and stocks RIPPING higher – NASDAQ 100 up 6% on the day!
With the violent swings in asset prices recently, I believe now is a good time for a macroeconomic and portfolio update.
In this week’s article, I will discuss;
- The potential future paths for the economy and global stock markets
- How The Spark’s Portfolio performed during Q3
- How I am positioning The Spark’s Portfolio
At a Crossroads
This year I have found it difficult to keep a cool head and remain objective while managing The Spark’s Portfolio. I believe I have done reasonably well so far but I have made mistakes. It was easier to foresee the future path for markets in late 2021 with stock valuations highs, inflation rising, and central banks tightening. This only pointed to downward pressure for both stocks and bonds, especially in the highly valued US market. However, we are now at a crossroads.
I am finding it increasingly difficult to forecast the future path of the economy. It seems we are coming to the end of the rate-hiking path for many central banks, and that’s a sign of relief for stocks. Inflation also seems to be plateauing. Markets have been pricing in a recession for the last six months, so any ‘less bad’ news is now great news. Valuations have also come down substantially from the ridiculous levels of 2020-21.
In my mind, I see three potential scenarios for the global economy:
1. Inflation rolls over quickly, so the central banks can loosen policy - We enter a new bull market
2. Inflation rolls over, but not quickly enough for us to avoid a recession. However, the central banks can cut rates quickly enough to stimulate the economy - We avoid a deep recession
3. Central banks find it difficult to bring inflation back to the 2% target, and continue to tighten for too long- We are driven into a deep recession.
I urge you to make your own mind up on the future path you believe is most likely. For me, Scenario 1 is out of the question.
Scenario 2 is possible but unlikely in my view for two reasons. One of the components of CPI is Rent and Shelter. This is calculated with a 6-month lag, i.e., the October 2022 CPI print of +0.8% was taken from April 2022. Furthermore, there is typically a 9 - 12month lag between an interest rate rise and that rate being reflected in the housing market. This means that the steep rise in interest rates we have been experiencing this year won’t be fully reflected in housing or the CPI until Q2 2023. In addition, the reopening of China is likely to result in a spike in consumption and another acceleration in inflation.
Scenario 3 has been my base case for some time now. However, I have been repeatedly asking myself, “What if you’re wrong?” and I have recently recognised a potential problem with my current positioning.
Markets are looking for any indication of a slowdown in rate hikes, and they found it with the recent fall in CPI. I currently hold 50% of the Spark Portfolio’s AUM in US Dollar assets, which has benefitted me until now. However, a major decline in the US Dollar will significantly hurt The Spark’s Portfolio performance. Markets are forward-looking, and the rate of change of interest rates is just as important as the nominal value. The steep rises in rates we have seen this year are not likely to continue and the market is starting to recognise that, so I believe now is a good time to reduce some exposure to US Dollar assets through the sale of iShares 0-5yr TIPS.
On a side note, if this does prove to be the top for the US Dollar, we will see significant outperformance in commodities and especially precious metals.
A Quick Word on Q3 performance
For the third quarter of the year (to the 30th of September), The Spark’s portfolio was down -0.7%. Most assets moved as expected, with risky stocks down and defensive assets up. Digital Turbine rose 80% this week following its earnings. Unfortunately this has only recuperated some of my losses, but it does convey the opportunities currently in the market if you are in the right companies.
Aside from general performance, I would like to make one point regarding diversification. One age-old phrase used by many commentators is that ‘Diversification is the only free lunch in Finance’. However, there are many nuances in the investment world, and diversification is no different. Below you will see the performance of each of The Spark’s holdings on Friday (a positive day for markets).
The Spark Portfolios holdings % Returns on Friday 11th November, after an 8% rally in the S&P 500 Index., Source: TradingView
Why am I showing you this? Ignoring the actual performance, observe what has risen (green) and what has fallen (red). Defensive securities – Lockheed Martin (LMT), Bristol Myers (BMY), the US Dollar (TIP5), Gold (PHGP) and Silver (PHSP) were all down. On the other hand, risky stocks such as Digital Turbine (APPS), Paypal (PYPL), Transocean (RIG), and Overstock (OSTK) were up.
This is a great depiction of how assets move in a bull market and conveys the downfall of diversification (when implemented the wrong way). When the market is rising, as it has over the last few days, returns are diversified. Different sectors rise and fall at different times. However, in a bear market, the correlation between different sectors (and asset classes) tends towards 1 – i.e. all assets fall together. This gives novice investors a false sense of security. In bull markets, many investors think their portfolio is well diversified, as the assets move in different directions during pullbacks and rallies.
This is a fallacy that comes to light in a bear market, as we have seen this year. The left tail (large losses) is something that is very hard to diversify away, as we have seen this year with indiscriminate selling across asset classes.
Left Tail Column - In sell offs, most assets become highly correlated and diversification becomes a fallacy
Overall I am happy with my performance for the quarter and am excited to deploy the excessive cash I currently hold. I may begin to drip-feed this into the market over the coming weeks if the US Dollar really has topped out. Major currencies are starting to turn higher against the US Dollar (see below) which suggests the tide is finally turning.
Momentum turning for major currencies (Euro - Orange, Swiss Franc - Yellow, Sterling - Blue, Renminbi - Turquoise, Yen - Purple), Source: TradingView
“In the business world, the rear-view mirror is always clearer than the windshield”
Selling 100% of iShares 0-5yr TIPS UCITS ETF at $5.08 for a 2% gain (£3.57)
Portfolio Return Year-to-date: 0.2% vs S&P500: -17%
Total Return since inception (20/09/2021): 6.2% vs S&P500: -8%
Let me know your thoughts by emailing me at thesparknewsletter@gmail.com
See you next time,
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.