Regarding… Vol 3 no 13 – Here We Are Now; Entertain Us

This week, markets have been all over the place, so I want to focus on the prices of key assets to see if we can decipher what they tell us about the future. I’ll also add a valuable lesson from Russia.

The oil price is a leading indicator of economic activity. When economies expand, they use more energy, and oil is – and will continue to be – the most efficient and abundant energy source for a long time.

As such, its price tells us about the type of economy the market expects to unfold in the future. So, here’s what the market sees:

TL;DR: it doesn’t expect good things.

The oil price hit a new low this week, back to 2021 levels, when economies were only starting to emerge from the Covid panic-induced funk.

My take: protectionism and a move away from globalism will reduce growth. That’s what the oil price is telling us. However, the global economy will grow again, and the oil price and related assets will eventually become a buy.

The long-dated bond yield (interest rate) tells you about two things.

• Market interest rates move up or down according to the expected rate of inflation in the future. Higher expected inflation brings about higher bond yields and vice versa.
• Yields also contain a risk premium. When the market is uncertain about the future, it rationally demands a higher risk premium, translating into higher yields or interest rates.

Here’s what has been happening to bond yields in various countries:

The USA:

Japan:

And here at home in South Africa:

Globally, bond markets are experiencing uncertainty and expecting higher inflation. The South African bond market is not the same. It’s volatile but not really trending in any direction.

James Carville, a political advisor to President Bill Clinton, famously said: “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”

My take: Yesterday, Trump proposed a 90-day moratorium on tariffs. He would never admit it, but I think the bond market bullied him.

The yuan is China’s currency. There is also something called the Renminbi. The Renminbi is the official name of China’s currency and translates to “People’s Currency.” It represents the broader monetary system, similar to how “pound sterling” refers to the British currency system. The yuan is the basic unit of the renminbi, akin to how a “pound” is a unit of pound sterling. So, when we talk about the currency in China, the correct term to use is the yuan.

The yuan is a tightly controlled currency:

For three years, the yuan has not been allowed to depreciate above 7.30 to the US$. With trade wars kicking off, it is in danger of doing so now.

The Chinese economy is heavily indebted and massively overcapitalised, a recipe for a deflationary bust. However, the Chinese authorities have managed to control the main aspects of the economy: the capital account via strict exchange controls, interest rates, and the exchange rate. Recently, they have also started buying local ETFs to exert control over share prices.

My take: the market always overcomes centralised control. If I had to guess which price would break free first, it would be the exchange rate, which would pour further fuel on the trade war fire.

In South Africa, the market has been reacting anxiously to potential sanctions and their impact on the local economy. So, let’s examine a bellwether stock in a market subject to significant international sanctions.

The stock is Sberbank, which also happens to be in the MWI Worldwide Flexible Fund (aka the cockroach). Like the other Russian stocks owned by the fund, it has been marked to 0, as it is completely untradeable due to financial sanctions on Russian assets. But it continues to do business and trade on the Russian stock market. Here’s a chart:

Since the start of the war in Ukraine and the subsequent sanctions on Russia – marked by the collapse in the chart above – Sberbank is once again at the same price (in rubles) as it was just before the events of January 2022.

But what about the ruble – surely that has collapsed due to sanctions and war? Let’s have a look:

It collapsed by 50% in early 2022 but has since recovered almost all of those losses, leaving it only marginally weaker against the US$ than before the start of the war. I guess interest rates of over 20% have helped in this regard. In fact, with such high interest rates, you would have been better off holding rubles than US$ over the period!

My take (there are a few points to make here):

• Market collapses present good opportunities to buy assets, even if those assets are in countries facing severe sanctions and prolonged conflicts.
• Macro events always look scary in the here and now, but once you step back and look at things from the perspective of time, they don’t appear so bad.
• I will always bet on human ingenuity to adapt and progress. Share prices reflect human ingenuity. So, the next time people tell you frightening things about South Africa, consider Russia and how terrifying conditions must be there. Also, consider the ride Sberbank shareholders have had over the past three years, and where they ended up.

Finally, as a side note, the MWI Worldwide Flexible fund owns 4 Russian stocks, all marked down to 0. Consider it a free call option on sanctions being lifted in future.

Howard Marks writes an irregular “Memo to Investors,” which is among the best things you can read about the market and how to rationally handle its emotional ups and downs.

His most recent memo, Gimme Credit, deals with the hottest of hot assets: private credit.

In the memo, he provides a highly readable exposition of private credit, what differentiates it from public credit, and why it is so popular. Unsurprisingly, given that his firm, Oaktree Capital, specialises in high-yield (and private) credit, his recommendation is to be long.

One should, of course, always carefully weigh the answer you get when asking the barber if you need a haircut. However, Marks’s reasoning makes a lot of sense. It essentially boils down to the fact that the interest rate on high-yield bonds (i.e. loans to the riskiest type of lenders) structurally overcompensates lenders for the risk of default.

The provisos (and there are always provisos!) are that you need a diversified portfolio of such bonds to benefit from the structural mispricing, preferably managed by someone experienced in these matters. You also need the fortitude to sit through some interim negative mark-to-market events, such as what is happening in the high-yield market at present.

The high-yield spread is the additional interest a risky borrower must pay above that of high-quality borrowers. Here’s a chart of the spread between high-yield bonds and the highest-quality bond issued by the U.S. government.

A widening spread, as we are experiencing now, means that interest rates for risky borrowers are increasing. This typically occurs during periods when markets are unsettled and uncertain. If you hold such bonds now, you will see price markdowns. (In bond mathematics, interest rates are inversely related to price.) However, as Marks points out, in the fullness of time, you will receive the yield at which you purchased the bonds, and in his opinion, that is high enough to provide a good return.

I agree with Marks, as long as you can sit tight and not be scared out of the market by newspaper articles, like this one. If they scare you, you probably have too much exposure, especially if you bought it due to criminally misleading promotion, as pointed out by Cliff Asness in a post on X.

The key difference between private and public credit, similar to private and public equity, is that the public type has transparent pricing because it is listed, while the private type is not consistently marked to market. In all other respects, they are essentially the same.

My take: Just because “the lights are out” and you can’t see the pricing doesn’t mean it’s less dangerous!

One of the best things I read this week was the piece by Ben Hunt (of Epsilon Theory fame) on the effect of trade wars.

He uses game theory to contrast the current system, “Pax Americana, “a cooperative game, with the world we are moving towards, which will be more of a competitive game.

The outcome is that everyone will be worse off. The current system isn’t perfect, but according to Hunt, it is a good deal better than the one we seem to be moving toward.

You can read his piece here.

My take: Many misconceptions exist about Ricardian “comparative advantage” and the benefits of global trade. Many of these misconceptions have taken root in the White House, and we will discover just how suboptimal the outcome will be from shifting to “home bias” and away from globalised trade.

And what better music to listen to in these times than Nirvana? Here’s Nirvana in three ways:

• The first ever live performance of “Smells like Teen Spirit” – a breakthrough song released in 1991 which changed the face of popular music. The quality of the recording is not great, but its visceral intensity comes through strongly. Those were the days!
• Tori Amos covering the same song. It is much more elegant and restrained – but no less challenging. Possibly even more so in her own inimitable way. An interesting coincidence is that both Ms Amos and Nirvana released their breakthrough albums in 1991. Different styles, but equally cutting.
• A jazz band improvises a Nirvana song – Heart Shaped Box – on the fly. After listening to the original recording once and not even knowing who the band is, they do a wonderful job of covering it. If you ever doubted the musicianship of jazz artists, doubt no more! This video was a joy to watch and a good way to end the letter in a tumultuous market week.

Remember, as this week’s volatile market action probably reminded you, please be careful out there!

Piet Viljoen
RECM