Q2 2022 - Market Review

ECONOMIC COMMENTARY

Grappling with the prospects of sharply lower global economic growth coupled with inflation that is becoming more entrenched and at levels not seen in over forty years, world equity markets tumbled during the second quarter. Specifically, the MSCI All Countries World Index and S&P 500 Index fell -13.64% and -16.25%, respectively. The resource-heavy S&P TSX Composite Index, which had largely escaped the rout experienced by other equity indices earlier in the year fell -13.19% in the second quarter. It is the first time since the third quarter of 2015 that global equity markets decline during consecutive quarters. Most equity markets have lost approximately 20% from January to June 2022. The last decline of that magnitude in the first half of a year last occurred in 1970. This is highly unusual but interestingly, uncomfortably elevated levels of inflation and a slowing economy also became problems in 1970[1].

Optimists are quick to remark that equity markets have typically recorded strong positive performance in the twelve months following double-digit declines. While this is true, the majority of the declines and recoveries in the past half century were largely driven by natural business cycle oscillations. Today’s circumstances are different. First, there’s a conflict in eastern Europe which increases supply disruption risks for a number of key industries globally. Second, central banks are attempting to reverse a thirteen-year-old titanic monetary easing experiment for which there is no precedent, and which might lead to multiple unintended consequences. Third, just as we thought the COVID-19 pandemic was over, came BA.4 and BA.5, additional Omicron sub-variants that have learned to evade vaccines and which are causing yet another rise in hospitalizations.

For these reasons, we remain circumspect when it comes to adding risk as we view these more likely to impact earnings lower rather than higher. Yet, earnings expectations for the 2022 calendar year are largely unchanged relative to where they were three months ago. Is it possible that corporations on aggregate deliver earnings that equal or exceed expectations? Yes, it is possible. Is it likely? As the scenario is playing out, we do not think so. Anecdotally, the price of electricity one year forward in countries like Germany and France has gone on a parabolic trajectory. This will surely squeeze the margins of a broad cross-section of corporations and it is not yet reflected in earnings expectations.

Investors looking for reprieve in fixed income were disappointed again in the second quarter. To this point, the ICE Bank of America Merrill Lynch Global Government Bond Index declined 4.38%, bringing year-to-date losses to nearly 9%, the worst showing for government bonds since 1980. Separately, the ICE Bank of America Merrill Lynch Global Corporate Index and the ICE Bank of America Merrill Lynch Global High Yield Index declined 6.57% and 10.09%, respectively. Such declines were expected as corporate bonds tend to underperform government bonds when the economy decelerates due to heightened perceived default risk. We note that the quarterly performance of the Global High Yield Index was the worst since 2008 as capital fled the higher-risk sectors. Incidentally, we believe that none embodies this phenomenon better than the cryptocurrency sector which is turning out to be the contemporary equivalent of the 2008 shadow banking sector albeit on a considerably smaller scale, thankfully. For our part, the successive collapses of the Terra stablecoin, of cryptocurrency lending firms Celsius and Voyager and the bankruptcy of cryptocurrency hedge fund Three Arrows Capital (“3AC”) aren’t isolated events. Instead, we see them as dominos in a long chain of undercollateralized participants that were all counterparties to each other.

The performance of commodity markets diverged from that of other asset classes during the quarter. In effect, the S&P GSCI Commodities Index posted a return of 2.01%. Interestingly, the space had traded significantly higher in early June but proceeded to decline late in the quarter as there is evidence that higher prices were contributing to demand reduction, especially in the industrial metals space. On a somewhat related note, there was not much positive news to feed on during the quarter but one that caught our attention was the recapture of Snake Island (or Zmiinyi Island in Ukrainian) by the Ukrainian army on the last day of the quarter. Russia had been occupying Snake Island since the last days of February. While the Kremlin propaganda suggests that Russian troops had left Snake Island as a generous gesture of goodwill, the reality is that they were forced to leave after being successfully bombarded by Ukraine’s artillery. Why does this matter? Good question, since Snake Island is after all a tiny rock of a dimension of less than 0,2 square kilometer (by comparison, Nun’s Island is over 20 times that size). Well, Snake Island may be small but it has great strategic importance. It is located approximately 45 kilometers off the Danube river delta and once Ukraine forces retake control and install an unsinkable (land-based) launch site for NATO newly gifted Harpoon[2] missiles, this will force the Russian navy to withdraw a further 150 nautical miles into the Black Sea. This may prove sufficient to enable Ukraine to safely clear a shipping lane to the Bosphorous (Turkey) and the Mediterranean Sea through the sea mines that block the route to Odessa and protect food ships from Russian interference. If ships that have been stranded for a few months can suddenly pass through with a wide range of agricultural and soft commodities cargo, this may alleviate inflationary pressures on a relatively large scale.

 WINNING AT TIC-TAC-TOE[3]

Unless you are the proud parent of a toddler or work in a kindergarten, you probably haven’t played tic-tac-toe recently because it is relatively tedious as most games end in draws. To be specific, it is a game you cannot lose if you do not make a mistake and you cannot win if your opponent does not make a mistake. In other words, tic-tac-toe is not about winning. It is about avoiding to lose and to do that, you must learn to avoid making fatal moves. If you play a large number of tic-tac-toe games with a focus on not making mistakes, unless your opponent plays in the same programmatic way that you are playing, the odds are that your opponent will eventually make mistakes and that you will win the series.

Our view is that long-term investing, as an activity, is very much like a long series of tic-tac-toe games in that it is more about avoiding mistakes than trying to be more clever than our opponent or finding better ideas. This premise may seem counterintuitive given the general design of the investment management industry[4] but it is nothing new. In fact, Charles D. Ellis has exposed this idea in his seminal 1975 paper titled “The Loser’s Game”   [5]. Therefore, our due diligence process is not focused on identifying what we think are superior investment strategies or funds but rather on identifying excessive risks for which investors are not compensated for. The idea is not to try to convince ourselves that a particular manager is better or smarter but rather that he or she has implemented processes that minimize the risks that he or she does silly things, like veering off mandate, becoming overly excited by shiny new things (like alternative protein, cannabis, electric vehicles or cryptocurrencies), getting too leveraged or too tempted by non-liquid assets. Those are the fatal mistakes to avoid in this game. It does not mean that our managers will not ever lose, but rather that we think we can win over the long-run just like we can playing tic-tac-toe; by avoiding big mistakes that others make.

At Patrimonica, we take pride in being obsessed about risk analysis. We spend a considerable amount of time to identify and measure the risks present in the investment strategies that we recommend. This is an exercise that we consider crucial. Why? Because risk is a finite resource that must be spent wisely and we believe that this can only be achieved by figuring out the sensitivities (including hidden sensitivities) of various strategies to a broad range of risk factors in addition to the potential value add. Getting back to our tic-tac-toe analogy, we believe proper risk analysis is what allows us to avoid mistakes which often consist in deploying too much capital (or risk) where we are not rewarded accordingly. This is how we avoid losing at this game.

[1] From a United States perspective, inflation had many causes, including but not limited to, demand shock created by the Vietnam War and the plateauing of US oil production which caused shortages of heating oil among other things.

[2] Long range, all-weather, over-the-horizon, anti-ship missile developed and manufactured by McDonnell Douglas (now part of Boeing)

[3] Known as Noughts & Crosses in certain parts of the commonwealth.

[4] We believe the investment management industry still strongly emphasizes security analysis over portfolio construction, risk control and cross-asset thinking, judging simply from the number of resources employed in each area.

[5] Charles D. Ellis, “The Loser’s Game”, The Financial Analysts Journal, Vol 31, No. 4, July/Aug 1975, 19-26. New York: Financial Analysts Federation