We were largely good investors this year, remembering always and everywhere one of the cardinal rules of investing – “Don’t fight the Fed” either when it is easing or most especially when it’s tightening. We stuck with Energy and basic materials stocks. Ironically, we made more money on our longs than we did our shorts in a bear market. This was largely due to the lack of discipline and violating another investment bromide – never let a profit turn into a loss. After all these years, we are still learning.
As always, we tried, sometimes unsuccessfully, to remain intellectually flexible and to focus on arbitraging time horizons. We are well aware that the holiday season is largely about the children, but the following items might help the parents who subsidize your munificence to make ends meet when those credit card bills show up in January.
Your consideration is greatly appreciated.
AN INVESTOR'S WISH LIST FOR 2023
A Central Bank Commitment to Price Stability & Keeping at it
A Balanced View of Fossil Fuels’ Place in the Global Economy
A Consistent Regulatory Framework for Private & Public Equity Investments
Real Rewards for Active Management
Clear Rules on Crypto Currencies
Accelerated Federal Permitting for Energy Projects
1. A Central Bank Commitment to Price Stability & Keeping at it
When it comes to inflation, hope is rarely a good strategy – the longer it persists, the more difficult it is to control. Although market-based measures of inflationary expectations are still contained, survey data from the New York Fed and recent wage settlements at companies like Delta Airlines suggest that there is a risk that those expectations will become unanchored. There will be two significant union negotiations in the U.S. next year – the Big Three automakers with the United Auto Workers (UAW), and UPS with the Teamsters. While a far smaller portion of the American workforce is unionized today than it was in the 1970s, such headline settlements could be important signals for labor at large. Add in the fact that the 60% of the federal budget is indexed to inflation and it is not hard to imagine that the Fed will need to, in Paul Volcker’s parlance “keep at it” to make sure that inflationary pressures continue to ebb. (For reference, the cost-of-living adjustment for Social Security this year is +8.7%.) Declaring victory too early risks the “stop-and-go” monetary policy of the 1970s that led to peaks of inflation of 6% in 1970, 12.3% in 1974, and 14.8% in 1980. By the time the great bull market in stocks started in 1982, the multiple on the S&P 500 was a mere 6x. The political pressure on the Fed to stay the course is likely to be intense – restrictive monetary policies are never so unwelcome as when they occur in the midst of layoffs.
2. A Balanced View of Fossil Fuels’ Place in the Global Economy & the Energy Sector’s Role in Equity Portfolios
No less than Larry Fink, high priest of ESG investing, admitted that fossil fuel use was likely to remain at the core of global energy production for the next 70 years. Adopting an air of moral superiority when it comes to fossil fuels is easy when they are plentiful and cheap, it is quite another when they are scarce and expensive. Simply not owning the Energy sector was a source of alpha in equity portfolios over a 1-year, 3-year, 5-year, and 10-year period by the end of 2020. Sadly, in some quarters, environmentalism has become a secular religion in which any deviation from the prevailing orthodoxy leads to excommunication from polite society. Left unsaid is that there are no reasonably inexpensive or reliable alternatives to fossil fuels for energy production today. Few would dare to say that the widespread use of oil and gas has been the basis for one of the greatest improvements in the standard of living in human history. Unfortunately, it required a war in Ukraine to teach all of us how much we took this blessing for granted. Renewable energy sources and new technologies will undoubtedly lead to a reduction in carbon emissions in time. A sober, less-hysterical approach to balancing our needs to be good stewards of the environment while meeting the day-to-day economic needs of ordinary people might lead to more sustainable peace and prosperity. Given these realities, it would not surprise us to see policymakers expand their use and definition of “green” energy initiatives to include nuclear and natural gas projects.
3. A Consistent Regulatory Framework for Private & Public Equity Investments
It is an article of faith that in inflationary periods central banks tighten until “something breaks” – a euphemism for a financial crisis. We constructed a long list of potential candidates for such an unfortunate event in the past year. Crypto “failed” but does not appear to have been large enough to be systemic. As luck would have it, Liability Driven Investing in the United Kingdom was not on our list and came within a cat’s whisker of torching the financial system. Given the widespread use of cheap debt in both the public and the private sector during an era of financial repression and the fact that the world’s central banks are still tightening, it seems likely that there will be other close calls. It might be too obvious but good candidates for the next financial crisis may be in parts of the financial ecosystem that are highly levered and largely unregulated. It would be difficult to find another industry that has benefitted more from the long-term use of quantitative easing than private equity. The asset class has become a silver bullet for fiduciaries wishing to meet lofty actuarial assumptions. But while such a strategy worked well during a period of secularly low inflation, it is unlikely to be as successful during a period of higher and more variable interest rates. The size of the private equity industry and the differences in the regulatory oversight of the private and public equity investments may put a wide variety of less-sophisticated investors like pensioners at risk. This is to say little about the fees associated with these vehicles.
4. Real Rewards for Active Management
I fear that, among the variety of unintended consequences of financial repression and quantitative easing over the past 13 years, there is a more rigid belief in the efficient frontier when it comes to asset allocation. Such a strategy will work beautifully when interest rates are low and stable but may be more challenged when they are not. It would be difficult for many of us to remember a time when cash was considered a viable asset class. While this may have something to do with the fact that it is difficult to earn fees on cash, it probably has a lot more to do with near-constant negative real rates since 2008. The emergence of persistent inflation, however, has resulted in a broken play for money managers that will make it difficult for them to stand in the pocket. Scrambling, rather than simple allocation, is likely to be a more important skill for those entrusted with managing the money and the wealth of others. Such a development should lead those managing large pools of assets to value more properly active over passive management. As it stands today, the five largest stocks in the S&P 500 still represent an astounding 19.6% of the broader Index. This characteristic of the Index is wholly inconsistent with the concept of risk mitigation.
5. Clear Rules on Crypto Currencies
In what must go down as one of the greatest examples of understatement in the past year, Sam Bankman-Fried’s “I’ve had a bad month” at The New York Times Dealbook conference last week must take the prize. As we say in Italian “non ci resta che piangere.” To be candid, I still don’t know whether blockchain is a world-altering technology or an overhyped attempt to improve processes that don’t need much improving. I do feel strongly that its practical applications as a currency are suspect if only because central bankers and other financial policymakers will, in the end, so jealously guard the state’s control of seigniorage and, by extension, their own influence and power. It should be remembered that gold was forbidden from being used for monetary purposes in the 1930s. If I had to guess, what will remain in 10-years’ time will be central bank issued cryptocurrencies that will carry with them real questions of privacy and social control. In the meantime, the virtues of a speculative vehicle that promises wealth without work will not be immediately obvious for society, economic policymaking, or “Wall Street.” If the entirety of the financial damage from the decline in the value of cryptocurrencies has already been seen, we should all be thankful that it did not lead to a far more serious and systemic problem.
6. Accelerated Federal Permitting for Energy Projects
While the price of oil and gas have come off the boil, few consumers or policymakers feel confident that the energy markets are in balance, creating economic and geopolitical vulnerabilities among freedom-loving peoples. The intransigence of Western policymakers to pursue a greater supply-side response to the current energy crisis may ultimately be seen as one of the most predictable, precarious, and pointless policy errors of all time. Whether one is wholly wedded to fossil fuels or renewables sources of energy, an ability to streamline the process of receiving federal permits for energy projects in the U.S. could ease global economic and geopolitical concerns at a critical time in history. As it stands today, a wide array of federal agencies conduct environmental impact studies on fossil fuel and renewable energy projects alike. It is not unheard of for these reviews to take as long as a decade. Sometimes you must eat before you can dream. Senator Manchin’s proposal for permitting reform was left out of the National Defense Authorization Act released this week. Progressives were opposed to its inclusion while Republicans didn’t think the reforms went far enough. There is a chance permitting reform gets attached to an omnibus spending bill in the lame duck session of Congress, but our Washington team believes the vote will be pushed into next year.
Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments. Data provided by Refinitiv
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