From Dusk to Dawn
For investors, 2022 will be looked back upon as a year goldilock investors were chomped by bears.
In a rare feat, the good ol 60/40 bond/equity balanced “goldilocks” portfolio had one of its worst performances ever. The Australian equity component fared a little better than international counterparts thanks to strength in energy and commodity stocks. It’s hard to vision another year of rapid interest rate hikes like the last, the system won’t take it, which leaves the bond component possibly “safe” in 2023, with markets now factoring rate cuts in second half of the year.
As for equities in 2023, well, we doubt the worst is over.
One thing is for sure, the everything bubble, created by years of lunatic central bank zero interest rate policies, has burst and central bankers will again have to choose to continue to “save” the system in 2023 with ultra-accommodative monetary policy or…not. This time with a serious inflationary backdrop.
Investors now need to assess where to allocate capital as the hissing sound of the leaking bubble grows louder. We aim to share some ideas in this note. At the same time, the imbecilic virtue signalling green energy “transition” policies of the West are about to fan the inflation flames even further.
We’ve written about the West’s doomed energy transition policies before so we’ll just sit back and watch what happens when hydrocarbon production gets choked out by policies designed by children and politicians, an epic combination.
Although energy costs and associated inflationary knock-on effects may be the story of 2023, it’s the knock on effects of the recession/inflation combination (stagflation), in an already unstable financial system that investors will need to be most wary of. We’re not going to rehash our thoughts on systemic risk in this note, you can go through it yourself here: https://aurumecho.com/illiquidity-crisis/
What we are interested in doing is assessing what may be some key investment themes of 2023, themes we do not get from mainstream media. We consider the possibility that the actions of global heads of states may well have as much impact on investment themes in 2023 as central bankers in years gone by.
Despite what your views may be on the origins of the Ukraine fiasco, savvy investors know to look through media hysterics for a better understanding of what may be happening. Such as, the quickening of the pace away from USD hegemony by a large number of countries shocked by the March 2022 decision by the US to “sanction” Russian Sovereign assets. Whether one agrees or disagrees with the unilateral decision to freeze a major Sovereign’s assets we stated at the time this would leave many a nation wondering “who’s next” and whether this would lead to a quickening of many countries move away from the USD petrodollar system.
By weaponizing the dollar, the US Government chose the worst possible timing in the context of a financial war against Russia. By removing all value form Russia’s foreign currency reserves, a signal was sent to all other nations that their foreign reserves might be equally rendered valueless unless they toe the American line. Together with sanctions, the intention was to cripple Russia’s economy. These moves failed completely, a predictable outcome as any informed historian of trade conflicts would have been aware.
Instead, currency sanctions have handed power to Russia, because together with China and through the memberships of the Shanghai Cooperation Organisation, the Eurasian Economic Union, and BRICS, effectively comprising nations aligning themselves against American hegemony, Russia has enormous influence. This was demonstrated last June when Putin spoke at the 2022 St Petersburg International Economic Forum. It was attended by 14,000 people from 130 countries, including heads of state and government. Eighty-one countries sent official delegations.
The introductory text of Putin’s speech is excerpted below, and it is worth reflecting on his words.
For further Geopolitical analysis we turn to Credit Suisse monetary icon, Zoltan Pozsar, whose reputation for accurate analysis grew substantially in 2022. In late December he published, “War and Commodity Encumbrance“, which discusses two main things: i) commodity encumbrance (i.e., rehypothecation) and ii) the missing link of the Bretton Woods III world, the Petroyuan. We’ve done our best to summarize the main points from his lengthy and comprehensive analysis, courtesy of Zerohedge.
Let’s start with China’s President Xi, whose visit with Saudi and GCC (Gulf Cooperation Council) leaders in 2022 marks the birth of the petroyuan and a leap in China’s growing encumbrance of OPEC+’s oil and gas reserves: that’s because with the China-GCC Summit, “China can now claim to have built a “special relationship” not only with the “+” sign in OPEC+ (Russia), but with Iran and all of OPEC+.”
Russia, Iran, and Venezuela account for about 40% of the world’s proven oil reserves, and each of them are currently selling oil to China for renminbi at a steep discount. The GCC countries account for 40% of proven oil reserves as well – Saudi Arabia has a half of that, and the other GCC countries the other half – and are being courted by China to accept renminbi for their oil in exchange for transformative investments – the “new paradigm” we discussed above. To underscore, the U.S. has sanctioned half of OPEC with 40% of the world’s oil reserves and lost them to China, while China is courting the other half of OPEC with an offer that’s hard to refuse…
Consider that since the beginning of this year, 2022, Russia has been selling oil to China for renminbi, and to India for UAE dirhams; India and the UAE are working on settling oil and gas trades in dirhams by 2023; and China is asking the GCC to “fully” utilize Shanghai’s exchanges to settle all oil and gas sales to China in renminbi by 2025.
Zoltan puts it simply, “dusk for the petrodollar… and dawn for the petroyuan.“
China is securing its energy future, the West is destroying it with naïve energy transition policies.
For example:
Looking around the world, Zoltan finds that commodity encumbrance has had its first major casualty in Europe already: BASF’s decision to permanently downsize its operations at its main plant in Ludwigshafen and instead shift its chemical operations to China was motivated by the fact that China is securing energy at discounts, not markups like Europe.
Read the above once more to understand the importance of this move by BASF.
It thus appears to Pozsar that unless the U.S. nationalizes shale oil fields and starts to drill for oil itself to boost production, over the next three to five years, we’re looking at an inelastic supply of oil and gas (sharply higher prices) and of that inelastic supply:
- China will get a bigger share at a discount, invoiced in renminbi.
- China will export more downstream products at a wider margin, and…
- China will lure more firms like BASF with discounted energy bills.
- Iran, with Chinese capital, will do more downstream exports too, and…
- GCC countries, with Chinese capital, ditto, most likely for renminbi.
This “new paradigm”, as Zoltan sees it, comes with a theme of “emancipation”: both sanctioned and non-sanctioned members of OPEC, with Chinese capital, are going to adopt the “farm-to-table” model in which they will not just sell oil but will also refine more of it and process more of it into high value-added petrochemical products. Given supply constraints over “the next three to five years”, this will likely be at the expense of refiners and petrochemical firms in the West, and also growth in the West. All this means much less domestic production and more inflation as steadily price-inflating alternatives are imported from the East.
This is not just about oil and gas.
Earlier last year, Indonesian President Widodo (an OPEC member since 1962) called for an OPEC-style cartel for battery metals for EVs. Yes, resource nationalism is in the air, but markets don’t seem to price it as a potential driver of inflation, even though as we have repeatedly warned, China is stocking up for some cataclysmic event (which won’t be deflationary).
Back in May 2022 JP Morgan had this to say, “while the world is short on commodities, China is not given they have started stockpiling commodities since 2019 and currently hold 80% of global copper inventories, 70% of corn, 51% of wheat, 46% of soybeans, 70% of crude oil, and over 20% of global aluminum inventories.” And now, China is aggressively stockpiling every ounce of physical gold it can get its hands on. Almost as if China is actively preparing for war.
The full must-read report “War and Commodity Encumbrance“, which we strongly urge to be read in conjunction with Pozsar’s penultimate analysis “Oil, Gold,and LCLo(SP)R“,
What this may mean for humble investors like us is:
- There is a strong case for a weakening USD in the near future.
- Inflation to be further fuelled by poor energy policy in the West.
- Central banks to return to accommodative monetary policy in 2023 as the global economy weakens (all thanks to Putin, no doubt).
- The geopolitical backdrop of an increasing war economy mentality of self reliance, minimizing holdings of FX reserves in favour of Gold.
It’s hard to see a better set up for precious metals right now. So, how did gold do in the last Stagflation environment? Below is your answer.
Clearly Central Banks are out to improve the quality of their balance sheets and for those that are not, they should, as should you.
Of course, our exposure to precious metals is a compliment to other core holdings in:
- Real Estate
- High quality income generating industrial stocks, including Healthcare
- Energy Producers, including Uranium producers.
But really, the ultimate risk reward trade if the above analysis proves accurate will be in Gold (and Platinum/Silver) producers. Gold producers remain beaten down and some emerging producers are selling for EV’s of a little over $10 an ounce. An incredible opportunity. And finally, for the more professional investor types, lets turn to one of 2022’s most accurate macro analysts, BoA’s Mike Hartnett
Here are Hartnett’s 10 trades for 2023:
- Long 30-year US Treasury…on recession, unemployment, Fed cuts late’23, history (US Treasury returns have never fallen for 3 consecutive years).
- Yield curve steepeners…as US yield curve always steepens as recession begins and markets anticipate Fed flipping from hikes to cuts.
- Short US$, long EM assets…long EM distressed bonds, Korea won on China reopening, Mexican peso on “nearshoring”.
- Long China stocks…COVID reopening was v bullish for US/EAFE stocks, China has high “excess savings” and China stocks remain v contrarian long trade.
- Long gold & copper…US$ peak, China reopening, metal inventory shortages, energy transition acceleration, need in 2020s for inflation hedges.
- Barbell credit…long credit too consensus in ’23, we barbell long IG tech bonds (>5% yield + strong balance sheets) with distressed HY debt in Asia (17% yield).
- Long global industrials and small cap stocks…secular leadership shift in 2020s from deflation to inflation assets, driven by globalization to localization, monetary to fiscal excess, inequality to inclusion and so on just beginning; capex set to be new macro bull story (see industrials breaking above -1stdev level relative to S&P 500).
- Short US tech…the old leadership, still over-owned, era of QE is no longer, era of globalization no longer, plus peak penetration and regulation risks.
- Short US private equity…the old leadership, redemption risks given shadow banking exposures to housing & credit risks.
- Long EU banks, short Canada/Aussie/NZ/Sweden banks…EU fiscal stimulus to wean Eurozone off Russian energy dependence, Chinese export dependence, US military dependence vs real estate market busts in Canada/Australia/NZ/Sweden.
Peace, it may be hard to come by in 2023. One can always start between the ears.
