To The Moon

The big difference in 2022 was made by the Russian invasion of Ukraine. The year started positively, following on from the excellent stock market year 2021. Despite rising inflation that year, interest rates remained historically low. As a result, we started 2022 with extremely negative real interest rates, and something like that always does wonders for financial markets. It even briefly reminded us of the times of the dot-com bubble when money was also free. Only this time, the excesses outside the stock market were much bigger than in the stock market. The valuation was high, but not as extreme as a valuation belonging to a bubble. Then the stock market could still easily rise by 30 to 50 per cent. It was not to be.

There was barely a week between the official end of restrictive measures following the corona pandemic and the Russian invasion. In response to that raid, prices fell, but it initially paid off to buy on the dip. Consequently, immediately after the raid, stock markets recovered. Only in late March 2022, the Federal Reserve decided to change course. The central bank definitively abandoned the narrative that inflation was transitory. Henceforth, inflation was again the great enemy to be fought. The late Paul Volcker was even called in to signal that the Fed meant business this time. What followed were many months of consistently higher-than-expected inflation, followed by multiple 0.75 per cent interest rate hikes. The stock market followed interest rates one-on-one from March onwards. The Fed's policy rate rose from 0.25 per cent to 4.5 per cent in a year to wreak havoc on the bond market. Such losses were unprecedented. With bonds still acting as a buffer in previous corrections this century when there was a fall in the stock market, the correction in the stock market hit mixed portfolios unprecedentedly hard.

Now that extremely low-interest rate was no surprise. Nor that low-interest rates had actually given bonds a much higher risk profile than what risk managers were counting on. Bonds had become an asset class with only risk and no return. It is striking how strongly even in the institutional world the rule that government bonds were the ultimate risk-free investment was adhered to. Even when interest rates there were negative, they stubbornly stuck to it. Apparently, we all drive a blinded car and have to determine direction while looking through the rear-view mirrors. This also shows once again how dangerous it is when things are harmonised in finance. Everyone has the same forecast yields, the same risk profiles, and the same ALM rules. If there is then a mistake in these, there is immediately a systemic risk. Last year, such a risk revealed itself in the UK pension market. Apparently, it was not wise after all to try to hedge future liabilities with four times leverage so that there would also be room for inflation compensation. Dutch pension funds are also having probably the biggest loss year ever. Besides the hundreds of billions in losses, much of it on bonds with negative interest rates, there are of course also the purchasing power losses due to high inflation. In such a bad year where the pension pot quickly shrinks by 25 per cent in real terms, it is, therefore, inappropriate to start rejoicing over the increased funding ratio.

In the summer of 2022, there was a real bear-market rally. The narrative was that although the Fed was going to raise interest rates, it would cut them again in early 2023. Historically, this is not surprising. Often, a round of rate hikes ended quite quickly in a first-rate cut again. Especially if the rate hikes caused a "too big to fail" institution to collapse, central banks would be the first to cut interest rates again. But given the inflation trend and the strong economy, this was mostly wishful thinking. The bear-market rally was therefore completely reversed. Only after the meeting at Jackson Hole, there was clearly some panic among central bankers. The moment central bankers panic, the market may stop panicking. However, that did not happen, sentiment remained extremely negative. Never before have I experienced so many parties having a negative view of investing. In other words, an excellent entry moment.

Indeed, secretly, the Fed is not wrong that much of inflation is transitory. Inflation is caused primarily by too much money, and the nearly 30 per cent growth in the money supply at the start of the pandemic was unprecedented. Moreover, while governments were on the brakes during the Great Financial Crisis, they were now participating fully. And where the money disappeared into the holes of the financial system after the GFC, much of it now went directly into the real economy. Meanwhile, that money growth is negative, the moment when financial accidents can happen. But also the moment when inflation is suppressed. In the last five months, US annualised inflation was just over 2 per cent. If that continues, we will be at 2 per cent by summer next year. Moreover, there are many signs that inflation is falling sharply. This is not permanent, but a reaction to the sharp rise in prices and, in that respect, again transitory.

Inflation could easily hit 2 per cent in 2023, but the main question then is what central banks will do. What they should do in the US is push on until a hard recession follows, so that inflation is under control. But what they are likely to do is crow victory and prepare the market for interest rate cuts. This does mean that we are not out of higher inflation levels for now. Not the extremes we saw last year, but the risk looms that something between 3 and 5 per cent will settle between our ears. Just try getting the toothpaste back in the tube. Arguments abound and that is mainly in the supply-demand imbalance. First of all, global demand is rising sharply due to emerging consumers in Asia. In the western world, we continue to consume but stop producing. This is due to an ageing population. This is the first generation in history to have worked one-and-a-half days a week during their working lives to save that for retirement. Now, all that past production is being converted into consumption and, as a result, prices can only go one way and that is up. Furthermore, the two major components that have kept inflation low since the 1980s are being mulled over: globalisation and the IT revolution. Now it is regionalisation and tech companies are monopolies that constantly raise prices. Incidentally, the picture here is much more grey than black and white. IT does enable people to work from home and those people who work from home can be replaced by a much cheaper employee in India or by a smart algorithm. Furthermore, the margins in Big Tech are so high that the wait is for disruption. Web 3.0 is ready for it.

A bear market lasts 19 months on average, so this one is not over yet. We have probably already seen the bottom, but unlike a bull-market correction, we will not go up in a straight line then. Again, confidence comes on foot. It does become clear during the bear market who the winners will be for the next bull market. In this respect, commodity stocks are good candidates. Firstly, because they are extremely cheap. Furthermore, they benefit from the energy transition and climate change. Commodities are still extremely cheap, especially if all negative externalities are also internalised. The remarkable thing is that there is completely insufficient investment for future demand. Of course, this is also linked to the high level of uncertainty that characterises times of high inflation. Yet with commodities, there is more going on. The energy transition is creating additional uncertainty. Nobody seems to want to invest in fossil fuels anymore, while a multitude of investments in alternative energy is needed to move forward at all. Left (fossil) or right (alternative) should be able to benefit from this.

Finally, 2022 was the year of the strong dollar. Is it because the US economy is strong (the cleanest dirty shirt) or is it because the world is unsettled, and the dollar is benefiting? That may start to change as US growth softens and calm returns. That also coincides with the Fed pausing. Moreover, the Western alliance seems to be doing all it can to make its currencies less attractive. Understandable when it comes to the Russians, but Arabs, Chinese, and other nations less favourable to the US probably also want to be less dependent on the dollar, euro, etc. The Chinese have an attractive alternative in the form of the digital renminbi. Finally, a digital currency has held up better than other cryptocurrencies over the past year.