The Market is a Voting Machine…
At the end of last week, a large panic ensued over fears of a new COVID variant. This caused a sharp rise in healthcare stocks and companies which benefit from working from home, and a substantial drop in energy and consumer retail stocks. Brent crude was down as much as 12% on Friday, however, this was in contrast to many oil stocks down only 5-6%. It seems that this exaggerated drop in the oil spot price was therefore due to institutional hedges on the oil price being triggered (buying put options to hedge long positions in oil). Oil continued to drop this week, as OPEC+ decided to continue with its planned 400,000 barrel per day increase in oil supply, but the cartel stated that if there were to be a substantial hit to demand due to the new Omicron variant, then it would be prepared to cut supply in order to stabilise the oil price.
Also in the oil market, the US has attempted to tackle rising inflation by taking 50mn barrels from its’ Special Petroleum Reserve (a reserve built for use during times of energy crises). 50mn barrels sounds like a lot, but the country uses 18-20mn barrels per day. This oil release will therefore last 2.5 days and will have no effect on oil prices. It is also laughable that, when questioned on the amount of oil the US uses daily, its very own Energy Minister didn’t know. Whether the Biden administration is simply incompetent or just wants to be seen to be trying to combat inflation, I am not sure.
In my first article for The Spark, I commented on the over-fearful reaction of markets to the Delta variant of COVID-19, where I was proven correct as governments continued to reopen economies, and cyclical stocks continued to march higher. We have witnessed a continued sell-off across the market this week, and although I do not yet have an opinion on the market impact of the Omicron variant (as I want to see how it develops), I thought I would share two charts with you.
The Omicron Variant seems to be a lot more contagious than other variants, Source: Financial Times
Total cases in South Africa - all time, Source: Google
There have been several eye-catching headlines about the new variant. Looking at the first chart (produced by the FT), we can see that the Omicron variant seems to be a lot more contagious than other variants. However, looking at the second chart, the country of origin (South Africa), still is yet to register a substantial rise in cases, relative to previous peaks. Also, the benefit of an mRNA vaccine is that the various companies which have produced vaccines can restructure the RNA to fit the new variants code, and issue booster shots to the vulnerable. We will not find out whether this strain is vaccine-resistant or not for another week or so, but I do not think it is time to panic just yet (at least regarding COVID).
Looking back at the oil market, the fact that new variants are continually arriving means OPEC+ and oil companies around the world will continue to limit their supply and capital expenditure, as they know any increase could tank the oil price. It is comical that the Biden administration is trying to blame the oil companies and Saudi Arabia for profiteering off a high oil price by restraining supply. The US is completely energy-independent. If the Biden administration would give assurances to US Shale oil companies rather than pushing unrealistic ESG mandates, the energy crisis would be solved. Sentiment and fear were the reasons for the latest move in the oil market. The biggest risk I see to the oil price and companies within the sector is a global slowdown. This is becoming increasingly likely, with the Federal Reserve (Fed) and other central banks around the world being stuck between a rock and a hard place. If they raise interest rates, bankruptcies will be rife and the governments debt repayments will become unsustainably high. If they don’t raise interest rates in the hope of a further improvement in the labour market and supply-chains, inflation could become a long-term problem.
The Fed Chair Jerome Powell has said the word ‘transitory’ should be removed from his vocabulary, and that the current tapering program of $15bn may speed up next year. This was further confirmed on Friday by a number of other Fed Board members. Goldman Sachs has predicted tapering will increase to $30bn a month from January 2022, meaning tapering would finish in March 2022 rather than June. On top of this, the Federal Funds Rate (interest rate) is now expected to rise twice in 2022.
On this news, the long bond’s yield dropped, and the US Dollar rallied, two very significant moves. First, the long bond falling is a worrying sign. As a wrote about previously, the bond market is smarter than the stock market. Bonds with longer maturities (longer times until repayment, e.g. 20 or 30 years) are more sensitive to changes in interest rates. Generally speaking, if interest rates are expected to rise, this is an indication that the economic outlook is improving. This means yields should rise (interest rates and yields have a positive correlation), and the long bond’s yield will rise faster than bonds of shorter maturity, creating a nice, upward-sloping curve (see below).
The Yield Curve, Source: Google
However, when the bond market believes that the central bank is raising interest rates too fast, and therefore could cause a slow down in the economy, the long bond (30yr) yield falls, as was the case this week. One of many complexities in investing! The Fed is worried that high inflation is embedded into the US economy and will be hard to reduce, and the market is worried that the Fed is accelerating its tapering program too soon, since we still haven’t got past COVID.
The US Dollar strengthened because tapering and interest rate rises increases the value of the currency, especially when other regions are timid about raising rates (the European Central Bank for example). This rise in the US Dollar and interest rates will affect global markets. It will make emerging markets’ debt repayments more expensive, as they are priced in US Dollars. This may exacerbate the issues in the Chinese property market. This could lead to contagion selling around the world.
Furthermore, the spread between the 10yr bond and 2yr bond continues to fall, showing that bank’s willingness to lend is continuing to fall. This slowdown in lending comes alongside higher inflation, rapid tapering, and lower yields.
This environment will benefit precious metals, which The Spark currently has 16% exposure to. Healthcare stocks should continue to hold up and we have seen Vertex Pharmaceuticals (VRTX) shares spike higher as its kidney disease treatment scored in a Phase 2 study. The company is diversifying revenue, has a number of different medical drugs in its pipeline, and has an attractive valuation.
Micron Technology (MU) and Airtel Africa (AAF) continued to hold strong during the market rout this week, as did Pennon Group (PNN) and the iShares Japan ETF (SJPA), the primary reason they are held in The Spark’s Portfolio.
As I suspected Cameco (CCO) sold off due to the rising US Dollar and risk-off sentiment. Because commodities are priced in US Dollars, a rise in the US Dollar means a fall in commodities prices, exacerbating moves down in Uranium, and indeed across the commodities market. I took a small position in Cameco due to this risk, but I plan to add to this position if the move downward, in my view, becomes too irrational.
The reason I repeatedly stress about knowing what you own is for times such as these. When you know what you own, a fall in the share price should not affect your emotions toward the stock (and could in fact be an opportunity to add to such positions). I understand what The Spark holds in the portfolio, and the recent move downwards has not changed my fundamental thesis for holding any stocks in the portfolio as of yet. My exposure to oil may be reduced in the coming weeks should a global slowdown seem increasingly likely. In this event, I will likely half my exposure to SPOG. But right now, I am not panicking.
Recent market movements are the reason why I have been conservative with my stock selections and weightings over the past several weeks, and why I will continue to be cautious over the coming weeks. This is also the reason I aim to hold a high weighting of total AUM in cash (or dry powder), to exploit pricing anomalies when the market overshoots to the downside.
“Rule number 1: Never lose money. Rule number 2: Don’t forget rule number 1.”
Until 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.