Category: Financial Markets Commentary

Monthly financial markets commentary from Sabino Investment Management, LLC

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Next Moves for the Fed and BRICS+

The Federal Reserve’s Open Market Committee (FOMC) meets Tuesday and Wednesday of this week.  The FOMC meets approximately every 6 weeks and releases their policy statement at the end of their two-day meetings.  The consensus expectation is that the FOMC will announce an increase in the fed funds target rate of 75 basis points this week.

When Chairman Jerome Powell gave testimony to Congress on June 23, he noted that inflation remained “well above our longer-run goal of 2 percent” while the “labor market has remained extremely tight.”  Not much has changed during the last four months regarding both inflation and employment.  The rationale for higher interest rates remains in place for now.  Interest rates remain far below the level of inflation as measured by the government.  However, in the future, there are limits to how much the Fed can raise rates.

As of September 30, 2022, the US Treasury has $30.9 trillion of debt outstanding, reflecting a debt/GDP ratio of 123%.  In December 1980, when Fed Chairman Paul Volcker raised the fed funds rate as high as 22%, the US Government had $908 billion in debt, which represented 32% of GDP.  Since the US debt to GDP ratio has nearly quadrupled during the last 42 years, the Fed will eventually have to consider the impact of higher interest rates on the interest expense of the US Government, as well as businesses and households.  Higher interest rates raise the risk of debt defaults.  It remains to be seen where the tipping point of financial pain is due to higher interest rates.

Meanwhile, in the rest of the world, the dynamics of international relations are changing rapidly and the United States is losing its leadership role.  ZeroHedge described the recent protests in Europe:

Tens of thousands of people have marched across metro areas in France, Belgium, the Czech Republic, Hungary, and Germany – many of them are fed up with sanctions on Russia that have sparked economic ruin for many households and businesses – but also very surprising, support for NATO’s involvement in Ukraine is waning.

There has been increasing awareness and dissent among Europeans about their countries’ leaders prioritizing NATO’s ambitions in Ukraine over their own citizens.  The prioritization has been in the form of sanctions against Moscow, sparking energy hyperinflation and supplying weapons to Ukraine, which has made Moscow displeased with any country that does so.  Some Europeans are now demanding NATO negotiate with Moscow to end the war so that economic turmoil can abate.

There is also increased interest by many countries in joining BRICS+ (an economic alliance started by Brazil, Russia, India, China, and South Africa).  The original five BRICS countries seek to expand their influence by establishing principles of “inclusive and equal cooperation” for international trade and financial regulation.  Among the countries being considered for admission to BRICS+ are Argentina, Egypt, Indonesia, Iran, Kazakhstan, Kenya, Mexico, Nigeria, Saudi Arabia, Senegal, Tajikistan, Thailand, Turkey, and United Arab Emirates.

Saudi Arabia’s intention to join BRICS+ is significant.  Mohammed al-Hamed, President of the Saudi Elite Group in Riyadh, told Newsweek: “China’s invitation to the Kingdom of Saudi Arabia to join the BRICS confirms that the Kingdom has a major role in building the new world and became an important and essential player in global trade and economics.  Saudi Arabia’s Vision 2030 is moving forward at a confident and global pace in all fields and sectors.”  Thus, Saudi Arabia’s snubs of President Biden are no surprise as the country realigns its economic and geopolitical interests.

As Saudi Arabia is the largest exporter of oil in the world, there is serious doubt about the longevity of the “petrodollar” (use of the dollar for payment of oil deliveries).  Fed Chairman Jerome Powell acknowledged this in June when he said, “rapid changes are taking place in the global monetary system that may affect the international role of the dollar.”

If you have any questions or comments, please contact me.

Sincerely,
Robert G. Kahl
CFA, CPA, MBA

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Europe’s Pending Energy Crisis

On Wednesday, August 30, Russia halted all natural gas deliveries via the Nord Stream 1 pipeline.  Supposedly, this was a planned maintenance that will last 3 days.  Russia had been operating Nord Stream 1 at 20% of capacity, while waiting for the delivery of a repaired turbine from Canada.

One year ago, the Dutch TTF gas futures contract for October 2022 delivery was priced at 28.80 euros per 1 megawatt day.  On August 26, the contract hit a record high of 346.52 euros.  As of the August 31 close, the price stood at 239.91 euros, a drop of 30.8% in 5 days.  German and French electric futures prices have also hit all-time records.

German economic minister, Robert Habeck, said that companies have worked hard to reduce gas consumption in recent months by switching to alternative fuels like oil, making processes more efficient, and reducing output.  But some companies have “stopped production altogether” with businesses that have a large energy component being the most susceptible.  The Budel zinc smelter in the Netherlands will be placed on care and maintenance from September 1 “until further notice.”  Norsk Hydro also announced plans to shutter an aluminum smelter in Slovakia at the end of September.

The dire situation of European energy is now reflected in consumer confidence surveys.  German consumer confidence is at an all-time low of -36.5, whereas the normal range had been between 0 and 10 prior to 2020.  German producer prices increased 37.2% in July 2022 from a year earlier.  Excluding energy, German producer prices, increased 14.6% from the prior year.

Apparently, Russia and Ukraine were prepared to negotiate a peaceful settlement in April.  Prime Minister of the United Kingdom, Boris Johnson, went to Kiev that month.  According to Ukrainska Pravda, Johnson had two messages for President Zelensky:

    • Putin is a war criminal and should be pressured, not negotiated with, and
    • Even if Ukraine is ready to sign some agreements with Putin, the UK and US are not.

And so, the war in Ukraine continues.

China has increased its imports of Russian natural gas substantially this year.  During the first six months of 2022, China increased liquified natural gas (LNG) volumes by 28.7% compared to the prior year.  China also imports natural gas from Russia via the Power of Siberia pipeline and the volumes imported via the pipeline increased 63.4% during the first half of the year.  There are several reports of Chinese (formerly Russian) LNG cargoes being sold to Europe.  So, Europe is willing to buy Russian natural gas from China, transporting it on ships with LNG capabilities.  This is an expensive alternative to Nord Stream pipeline deliveries, but it does get around the economic sanctions imposed on Russia.

The profits from acting as an intermediary natural gas deliveries are very attractive.  News sources indicate that Sinopec has sold 45 cargoes of LNG to Europe year-to-date.  Profit estimates from reselling Russian LNG to Europe using China as an intermediary range from tens of millions of US$ to over $100 million for a single LNG cargo shipment.  ZeroHedge writes that the embargo on Russian energy has failed spectacularly, and: “Worse, while Europe could buy Russian LNG for price X, it instead has to pay 2X, 3X or more, just to virtue signal to the world that it won’t fund Putin’s regime, when in reality it is paying extra to both Xi and to Putin, who is collecting a premium price thanks to the overall market scarcity.”

Unless there is a break in the geopolitical situation, this coming winter in Europe will experience inadequate heat and food for its residents, as well as a dramatic decline in economic production.  There are likely to be many European business failures and bank insolvencies as well.  The repercussions are likely to be global in nature.

If you have any questions or comments, please contact me.

Sincerely,
Robert G. Kahl
CFA, CPA, MBA

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What’s Next?

US real (after inflation) GDP declined by 1.6% in the first quarter of 2022.  According to the Atlanta Federal Reserve Bank’s GDPNow model as of July 1, second quarter real GDP is forecast to decline a further 2.1%.  The Blue Chip Economic Indicators consensus forecast of economists for real GDP was a full 5% higher at the end of May than the latest forecast of the Atlanta Fed’s model.  There are likely to be substantial reassessments by economists and securities analysts during the next few months.

The current P/E ratio of the S&P 500 Index is at 19.3 based upon the last 12 months of reported earnings.  The P/E ratio of equities held in client portfolios is lower than the S&P 500 due to my value orientation.  The P/E ratios of some stocks are substantially lower than the rest of the stock market.  For example, US Steel (X) sells at 1.0X trailing 12 months earnings, or 1.5X forecast earnings.

Year-to-date, the total return of the S&P 500 is -19.1%.  Since the Fed is expected to raise interest rates further and there is a high probability that we are in a recession that will impact corporate profits, the S&P 500 Index is likely to decline further during coming months.

The potential catalyst(s) for a turnaround in the economy are difficult to identify.  Here are some current economic indicators:

    • The consumer price index (CPI) is currently 8.6% higher than a year ago, and it is expected to remain at an elevated level for the near future.
    • The University of Michigan’s consumer sentiment index hit a record low, as the high inflation rate is hurting household finances.
    • Real (after inflation) wage growth on a year-over-year basis is lower at -3.9%.
    • The market capitalization of US equity markets has declined by $13.6 trillion since its peak at the beginning of this year.
    • The interest rate on a 30-year fixed rate mortgage is now at 5.81%.
    • Corporate profit margins are at record high levels but are likely to be under pressure from higher wage and material costs and a recessionary environment.

Meanwhile in Europe, the antagonism between NATO countries and Russia may soon get worse.  Russia has already reduced Nord Stream 1 gas flows by 40% while citing technical issues.  Gazprom then announced that they have scheduled an “annual maintenance” for a period of ten days from July 11 to July 21, that will shut down gas deliveries.  This should serve as a painful reminder to the NATO/European Union countries that they rely on Russian energy exports.  Germany and Italy together account for almost half of the European Union’s gas imports from Russia.  France, Hungary, the Czech Republic, Poland, and Austria are also large natural gas importers.

Some European companies have already hit their breaking point.  Germany’s largest gas importer and power utility, Uniper, is now seeking a 9 billion euro bailout package from the German government.  Uniper’s share price has declined by about 75% since the beginning of the year.

For now, the European energy supply problems have benefited American companies that are able to liquify natural gas (LNG) and export it to Europe at higher prices.  However, the LNG infrastructure has limited capacity.  If Russia takes the next step and eliminates energy supplies to Europe, an economic depression for the European economy is inevitable and will have consequences for the American economy and financial system.

What’s the good news?  The market declines of 2008-2009 and 2020 created some great buying opportunities.  We may see a similar opportunity before the year is over.  In the meantime, we have a low allocation to equities, debt with high credit ratings and shorter maturities.  We have a large allocation to precious metals, which did well until mid-April.  I expect more investors to recognize the importance of including precious metals in their investment portfolios in the future.

If you have any questions or comments, please contact me.

Sincerely,
Robert G. Kahl
CFA, CPA, MBA