THE UGLY, THE GOOD AND THE BAD

“The good, the bad and the ugly”, Sergio Leone, 1966

Stagflation (THE UGLY)

As we anticipated, recession in the US is already a reality. Consumption data released a few days ago confirm this. US consumer spending fell month-on-month by 0.4% in real terms in May, while April’s figure was revised from +0.7% to +0.3%. A slightly negative June figure is likely. US consumer confidence is at a 16-month low. And that is not a negative. We continue to believe the current recession is only a technical recession, created by the collapse of the housing market, the securities market (stocks and bonds), cryptocurrencies, excess inventories accumulated during supply chain problems, and printing money. Between stocks and crypto in the US alone, the value of investments has fallen by USD 11 trillion, a huge amount (about 10% of Americans’ savings). It is a necessary recession to prevent inflation from becoming structural in the system. But it is transitory and probably limited to two/three quarters. Our view is absolutely very positive and absolutely not shared by the market.

Although every cycle is different, what happens to the stock market when rates are raised? It usually goes up. This is because the underlying economy is clearly strong, which is why rates are raised. A significant rise in rates, however, later leads to an economic slowdown, which, depending on the fundamentals, can lead to a hard or soft landing, i.e. a sharp recession or just a dampening of excesses. And that is why economists predict a recession in 2023, at the end of a series of upturns that would historically lead to a major slowdown. Why, instead, has the market been going down since the Fed’s first hike in March? The market is going down both because there was a massive tech bubble and then because of fears related to the repercussions of the return of the great monetary expansion that lasted a decade.

We believe that after the current technical recession linked to the rise in rates and the market crash, a recession in 2023 is unlikely to happen. Why? 1) The housing market, residential and commercial, is not in a bubble. The imbalance between supply and demand is substantial as a result of years of under-investment linked to the scarcity of bank financing in this sector. The end of the pandemic will lead to a recovery in demand for office space and confirm the home as the place to work. Inflation is also another support for this asset class. 2) Consumption accounts for about ¾ of GDP in the US. Today’s consumption dynamics are negative, as is natural after the market crash and recession fears. However, the labour market is extremely strong and this is the backbone of consumption. The relocation of many manufacturing industries will maintain full employment and, along with this, a positive wage dynamic in real terms. Bonds finally provide attractive yields for savers. The stock market has corrected from the tech bubble and the traditional side is extremely attractive and will gradually appreciate again in the not too distant future. This tells us that consumption will be robust in 2023, recovering from 2022. 3) Corporate profits will nominally benefit from inflation, absorbing any inevitable pressures during a rate adjustment phase. In addition, many industries, such as finance, armaments, fossil fuels, and everything related to infrastructure and energy transition, will grow in the next 12 to 24 months. 4) There has been a shift in the US from an attitude of complacency towards inflation to one of strong fear. So much so that by now there is no longer talk of recession but of stagflation, something not seen for 40 years, in completely different environments (Volcker at the FED and Ronald Reagan in the White House). Today, however, inflation is coming down and gradually in the coming weeks and months we will begin to see it in the numbers. The fall in commodities prices these days and the gradual unwinding of the supply chain will contribute to this. The overstocking created precisely to address these problems in the supply chain will lead to substantial discount campaigns. The rate hike cycle will be powerful but entirely manageable, and we believe that the Fed’s current expectations of 3.8% for 2023 will not be revised upwards but may even be tweaked slightly downwards in the not-too-distant future (3.4% at the end of 2022).

Jamie Dimon, CEO of the world’s largest bank and a keen observer who rarely says a word out of place, said a few weeks ago that he sees a storm coming. He doesn’t know if it will be big or small and the repercussions it will have, but he sees it coming. Where does this prophecy come from? Much of it has to do with the speed with which the Fed has decided to raise rates (from the current 1.75 per cent to 3.4 per cent at the end of 2022 and 3.8 per cent at the end of 2023) and the QT (quantitative tightening, i.e. the failure to reinvest the 9 trillion bonds held by the Fed as they mature) that has just begun in the US. This inevitably takes a lot of liquidity off the table in a short time. So some of the money earmarked for real estate or equity investments will inevitably end up buying bonds at (apparently) attractive yields, breaking the legs of speculation and in the short term depressing the real estate and equity markets. Moreover, the market anticipates the enormous volatility that these events can create. Indeed, the consequences of these manoeuvres are always difficult to define, particularly after the events of 2019, the last time the FED initiated a QT. At that time, bank reserves collapsed and REPO rates skyrocketed. So we think it is normal that there is some apprehension on the part of the banking system. However, today the banking system is better prepared (and Dimon himself states in the same interview that the banks are solid and ready) and the Fed has better control of the situation with adequate set ups to avoid a repeat of past tensions.

Elon Musk says he is super negative on the economy and will reduce the workforce by 10k. What entrepreneur isn’t, after the recent market crash and rate hike? Indeed, the US is in recession. However, let’s remember that Tesla has been hiring like crazy and it is right to take advantage of fears about the economy to lay off less useful workers in less efficient locations. Let’s remember that 10k laid-off workers is equivalent to less than a third of Tesla’s net hiring in 2021.

Meanwhile Warren Buffet has since the beginning of the year bought some USD 60 bln in stocks, including Paramount, Citigroup and Chevron.

In an article in the NYT over the weekend Paul Krugman (Wonking out: taking the flation out of stagflation) anticipates that, following the latest economic data, the Fed may soon revise the rate hike rate downwards.

The Economist seeks to respond to the hysteria of those who see a ‘Volcker moment’ today, i.e. the need to raise rates enormously to prevent inflation from entering people’s minds. The British weekly rightly points out that by the time Volcker intervened harshly on rates, throwing the country into recession, inflation had been rampant in the US for ten years. Today we are a long way from considering inflation or super inflation a companion.

Finally, Lawrence Summer, in an interview over the weekend, revises downwards his expectations on inflation (he was one of the first in 2021 to anticipate an inflationary wave and to oppose the Biden tax plan) and on raising rates, in light of the slowdown of the US economy in the first two quarters of the year.

To be balanced, we also report two interesting, slightly less recent and very negative podcasts by Greg Jensen, Co-CIO of Bridgewater. He expects prolonged stagflation in the US and believes inflation will remain out of control here for a long time. However, the thesis is not properly substantiated in our view. He advises investing in cheap assets that produce cash flow (with which we can only agree) and can benefit from inflation while advising to stay away from technology (still agree). He also advises diversifying away from the US, which they believe is priced for perfection, and investing in the rest of the world (also agree). He’s also negative on Europe where he sees an even heavier recession than he sees in the US (which as mentioned we don’t see but, even if we did, it’s already priced in anyway). Here Bridgewater has shorted 27 stocks in the Eurostoxx50 for around USD 15 bln (including many cheap stocks that produce a lot of cash flow). On the other hand, they have been very positive on China for some time and continue to be so even after the big losses and recent geopolitical events. On the dollar, they are negative and anticipate a long bear market as soon as the Fed approaches the end of its bullish cycle. They remain extremely negative on corporate bonds. In general, our opinion is that they see a delicate phase in the markets, with volatility and radical changes and they are betting on a few crashes, ready as always to cover quickly if they are wrong. In short, they are trying, but let’s remember that they are not the only ones and there is a lot of shorting in the markets today that will have to be covered sooner or later. Here are the links: Bridgewater Co-CIO Jensen on Investing Outlook – YouTube     Bridgewater Co-CIO Jensen on Markets, BOJ Policy, Dollar – YouTube.

In Europe, many of the themes presented for the US market apply. With a few distinctions: 1) The European economy does not benefit but is hurt by the current price of hydrocarbons. 2) The risk premium associated with the Ukrainian conflict is significantly higher in Europe than in the US (and, at the same time, the end of the conflict will benefit stocks in this region much more significantly). 3) Inflationary pressures are lower in Europe as fiscal stimulus has been spread out more thinly than in the US. Future fiscal stimulus will continue to support the economy and the labour market in the second half of 2022 and in 2023. 4) In Europe there is less dependence of consumption on financial markets, which we believe will avoid a technical recession in 2022.

As in the US, we do not expect a recession in Europe in 2023 even in the event of a Russian gas cut. Talking to large German industrial companies, we do not perceive any particular fears. Clearly, forecasts are made to be proven wrong, and clearly the development of the war in Ukraine is decisive for the region. However, it is important to understand that the market now expects a recession in both Europe and the US in 2023. The large infrastructure investments, the post-covid reopening, the savings accumulated during the pandemic and a strong labour market are incompatible with a recession in our view, unless other new events occur. However, even if there were, it would have to be mild and is now more than priced in by the market, with cyclicals in many cases travelling at the levels of the March 2020 hole. We reiterate that now is the time to buy the much-hyped (and often overpriced) cyclicals in 2021 in view of the infrastructure revolution ahead and they are now trading at extremely low levels. Anticipation and diversification is essential. Below are Berenberg’s GDP growth forecasts for 2023 in May and June, which make it clear how the US rate hike and market downturn have distorted analysts’ perceptions. However, we believe the new forecasts are just as unreliable as the previous ones.

Financial Repression (THE GOOD)

We are living through a historic economic phase. Areas that, for various reasons, have suffered economic stagnation and deflation, such as Europe and Japan, are now about to embark on a journey that should return them to growth. It is an experiment, but there is so much at stake that all actors will make sure it succeeds.

From the post-war period until the late 1970s, much of the Western world reduced its war debt through so-called financial repression, i.e. through a level of interest rates slightly below inflation, achieved by banks buying up the debt themselves. Reducing debt in this way is politically more acceptable than raising taxes or reducing public services. The real rate of US short-term government bonds was negative from 1945 to 1980. Anyone who invested in British bonds between 1945 and 1960 would have lost over 1/3 of their purchasing power.

Actually, financial repression has been present in many areas since the great financial crisis of 2008, but as inflation was close to zero, the effects on debt reduction were insignificant. Now inflation has returned and, thanks to structural trends such as deglobalisation and the energy transition, it will not return completely. Through a constant inflation level, financial repression will bring its results. And it is the answer, the only possible answer for Japan and Europe. In a climate of financial repression, the creditor loses in real terms but the system in which it operates grows and develops, balancing these losses through gains on equity and real estate. In this context it will be appropriate to stay away from government bonds and invest in equities and real estate, and not only in inner-city residential but also in commercial and suburban areas, areas that lack of growth has often reduced to semi-abandoned dormitories. Restoring economic growth implies stimulating the demographic trend by accelerating the immigration process necessary to expand consumption and production.

In an editorial over the weekend Seth Carpenter, global chief economist at Morgan Stanley, says that given the rate forecasts released by the Fed Market Committee there is a willingness to accept higher-than-expected inflation for an extended period of time. The ECB seems even more in that camp. Japan is beyond that, continuing to monetise government debt and keeping rates at zero. When inflation finally kicks in vigorously in Japan as well, we would not be surprised if the debt held by the BOJ (about 35%) is wiped out, setting the stage for the last mighty leg of yen devaluation and the recovery of the Japanese economy.

Here is a link to an interesting podcast by Professor Russell Napier, where he talks about financial repression:  Professor Russell Napier: The equity index fund is a dangerous product – YouTube

War (THE BAD)

Russia has captured the last city of Luhansk, one of the two regions that make up the Donbass, the area of the country that Putin promised to ‘liberate’. This represents a major victory for Putin, who needs to demonstrate his successes in order to balance heavy losses and growing internal discontent. At the same time, the new HIMARS mobile launching stations provided by the US to Ukraine are beginning to take effect, destroying Russian weapons depots and command centres with great precision. More will come in the coming weeks. Apparently, the war cannot end until the whole Donbass is in Russian hands. However, several commentators seem to indicate that Russia, after the last dramatic blow to conquer Luhansk, which brought huge losses to the army, is now finding it difficult to proceed further and, at the same time, keep control of the already conquered territories. Russian missiles fired haphazardly at the rest of Ukraine may indicate this. Anything can still happen. Russia may now have an interest in sitting down to negotiate, keeping part of the Donbass and releasing other territories. Ukraine will surely want to continue the war to retake occupied territories and demand damages. The Western world intends to penalise Russia and the Putin regime but, at the same time and without clearly admitting it, to avoid the risks of Russia using tactical nuclear weapons. So it will provide the necessary weapons to balance the forces on the field, nothing more. Today the consensus is for a very long war. And we believe this is indeed a possibility, already well digested by the market. However, we do not exclude that in the course of the next few weeks things may change. Ukraine’s fear of the launch of tactical nukes on Kiev may soften their stance. Indeed, Russia could use the recent Ukrainian missile attacks on depots on Russian territory to threaten missile repercussions on the capital and possibly the very use of tactical nukes. Against this the West has no weapons, not wanting under any circumstances to risk a nuclear war. As always, in the absence of a clear winner, both sides have a lot to lose in order to reach the negotiating table. We believe we are not far from that point.

Any news of opening negotiations would have a significant positive impact on world markets, especially European markets. It would also lead to lower gas and oil prices, easing inflationary fears.

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R for rabbit…

These days the old adage attributed to Nathan Rothschild, “Buy on the sound of cannons, sell on the sound of trumpets,” comes to mind.

A recession 2/3 years after the pandemic, until a few months ago an entirely remote possibility. Such a possibility was not completely discarded by the market just out of superstition. Like when you fear missing your plane to go to the all-inclusive resort in the Maldives, after dreaming about it for years, even though you know in your heart that you will not miss it.

In just a few weeks, recession has become a certainty.

Trying now to rise above the background noise, let us take a look at the cyclical stocks, those that will have to suffer most, alas, from the recession.

Today residential builders in the U.S. are near -50% from their highs of the past twelve months (D. R. Horton and Lennar -45%, KB Home -51%, Redfin -80%). Banks range from-35%(JPM, Bank of America, Wells Fargo) to over -40% (Citigroup).  Insurance companies from -20% to -40% (Metlife -17%, Prudential -25%, Lincoln -39%). Transportation companies, those most anticipating a recession, from -30% to -40% (Fedex -29%, UPS -27%, DPW -43%), retailers from -30% to -50% (Home Depot -35%, Kohls -38%, Macy’s -47%, Target -48%), cement and building materials from -30% to -60% (Martin Marietta -31%, Vulcan Materials -31%, CRH -34%, Tutor Perini -58%), finally, automotive by more than 50% (GM -53%, Ford -56%). All the sectors mentioned are not comparable with the same sectors in 2007 or even 2020. Today they are much stronger and have better medium-term prospects. In addition, the consumer is less indebted and scared.

In Europe, courtesy of war, we find the same retracements in the cyclical sector, albeit with even lower valuations.

Is recession inevitable? We believe not, and we continue to think, contrary to what the market thinks, that we will see a technical recession in the U.S. this year and no recession next year. But prognostications, as we know, leave time for themselves and what matters is still the risk/return profile. So is recession discounted in cyclical prices? We think so. Instead, we would stay away (for much longer) from bubble-object tech and so-called “quality” stocks whose quality, with slowing and rising rates, will soon be tested. And since they are on valuations between 50 and 100 percent above market valuation, it will be appropriate for them to confirm it. Finally, watch out for pharmaceuticals as well. Although optically not expensive on earnings, they nonetheless have very juicy margins (they all now stand between 3x and 5x sales), just as the Biden administration is trying to reduce the cost of prescription drugs in the U.S., the geographic area from which almost 2/3 of the industry’s profits come on average.

We waste time trolling the companies we are invested in. We read what they publish. We pester them with bold inquiries about how they compile their sustainability reports (they often don’t know) or to understand the numbers on their balance sheets or to investigate how things are going in general. What we observe is that those that do not sell commodities (metals, paper, fuels, etc.) tend to update prices with some delay because old contracts do not consider surges such as we have seen recently. Wages also require some negotiation before they are raised. What we mean is that inflation is like a boat, you know it’s going to turn if you move the tiller, but it has that thing, which in sailing terms is called a draft, that creates a time lag. We believe that galloping inflation, the terror of every central banker, is now under control. The market crash and rate movement have restored order. But it takes time before it shows up in the numbers. The risk is clearly that a restless and pressured central banker will kill the patient with too heavy and unnecessary therapy. These things the central bank knows, and it also knows that it has to show itself to be bad in order to kill what are called the “animal spirits” of the market, that is, the human positivity reflected in the rise of the markets, a rise that is itself inflationary.

Much of the decline has already taken place, just as much of the inflation has already run its course. Excluding technology, which lives a life of its own, anticipating very future growth, and the CD quality stocks, which we have already discussed, the U.S. market is attractive again today. The European one is worth a song and remains tied to energy normalization and the end of the war. The Japanese one is always exceptionally cheap, with a central bank that, no doubt in agreement with the U.S., is powerfully reflating the patient and bringing it back to life after thirty years of deep coma. On the other hand, the U.S. today needs a strong Japan that can guard a sensitive area well. Korea seems to be following the U.S. market and presenting the same buying opportunity it presented in March 2020. Meanwhile, many of the emerging markets are benefiting from the commodities super cycle.

Robert Armstrong, a nice and good journalist at the FT, talks this week about the downward revision of corporate earnings (click here to read the article). After premising that at 15.2x 2023 earnings the S&P cannot be considered expensive, the journalist nevertheless speculates that if instead of a 10 percent rise in 2023, as expected, we were to find ourselves with a 10 percent decline, the S&P would go from 15.2x to 18.5x earnings. In an area certainly not cheap. Well, assuming a 10% rise in earnings for 2023 actually amounts to predicting flat earnings, because of inflation for the period. So a 10 percent decline in S&P earnings in 2023 would be equivalent to a 20 percent decline in real terms and would be something dramatic, similar to what we saw in 2020 (Covid) and only less than what we saw in 2008, during the worst financial crisis since ’29. These P/Es are then still the consequence of the strong presence of tech and “quality” stocks inside the S&P. In our portfolios it is difficult to find stocks above 10x earnings and about half trade below tangible equity. Let’s be clear that we are not talking about a few extreme situations; in fact, we have in the various products about 500 stocks. As mentioned above, the situation is reminiscent of the 1970s, when stocks in the real economy were extremely depressed.

We are all scared of R, but there is never a better opportunity than a recession to make significant gains, with the exception of those accompanied by a financial crisis. The latter are long and very dangerous. Best to stay away from them. Today, however, the financial system is sound, as confirmed by James Dimon himself, respected and influential CEO of JPM, and will hold up well to the shock wave.

An average bear market lasts about nine months with declines around 36 percent. Under this assumption, we would touch lows in October with a further 17 percent decline from current levels in the S&P500 index. Certainly not a modest amount of downward space. But let us remember that we are talking about statistics that incorporate bear markets such as the very long one of 2000-2003, the one of the great financial crisis and the huge crash of March 2020. Moreover, from the beginning of the bear market to the end, an inflationary wave, as mentioned, will have protected the downside of the index, which, as we know, expresses nominal and not real magnitudes. In the last twelve months the U.S. CPI has risen 10 percent and in the next twelve months it is reasonable for it to rise 6 percent. So in real terms we are already close to the 36% mentioned. Moreover, in view of the financially sound system and good prospects on the investment front (infrastructure, energy transition, deglobalization) it is plausible that, even in the event of a recession, the downturn should be milder than the average of previous ones.

Therefore, the summer months present an opportunity to invest and position carefully, judiciously, and diversified. Before the market, like a jackrabbit, quickly changes direction, right at the peak of negativity, starting to paw, cheerfully and for no apparent reason, toward an uptrend. The next upswing will be based less on speculation and more on the real economy and will have real repercussions on the latter.

R for rabbit…

ATOS

In the last week, Atos, a stock in which we have significant positions, at least for us who consider diversification vital, lost 50 percent. After it had lost in the previous 12 months already 60%. One might think that this is a stock subject to the Nasdaq bubble. Nothing could be further from that. The stock is one of the titans of IT consulting, with over 110k professionals on the payroll and 11 billion euros in annual revenue. The stock before the collapse of the last 5 days was trading at about 0.4x EV/SALES versus a market trading between 2x (CapGemini or Reply) and 3x (Accenture). Here the problem was governance and management after the departure of Thierry Breton two years ago, who left to become EU Commissioner. A dirigiste chairman of the board, Bertrand Meunier, and a CEO probably without the necessary experience, Elie Girard, produced a series of major mistakes. Earlier in the year the hiring of Rodolphe Belmer, an experienced manager responsible for the successful turnaround of Canal Plus, as the new CEO gave hope to the market. These painfully cleaned up balance sheet (kitchen sinking) and brought the company back to growth in the first quarter. Since his arrival the company has also hired about 10k new professionals (net of departures). Certainly an encouraging sign.

The surprise. A few days ago Belmer was fired, and the company unveiled a strategic plan (click here to access the presentation) that may make sense on paper but lacks the CEO’s support. The plan is based on splitting the infrastructure division from the digital and cybersecurity (BDS) divisions. Split to be done within two years. Belmer, on the other hand, wanted to sell the BDS division, which accounts for 12 percent of sales for which he had received an offer from Thales for 2.7 billion euros (the company before the collapse was worth 4.8 billion considering debt of 2 billion). Airbus also seemed interested in taking it over for more than 3 billion. Selling BDS would have left the restructuring infrastructure division to be managed in the future as a cash cow and the digital division whose growth could be revived.

Faced with management’s show of disagreement and the final decision to pursue a strategy that the recently hired CEO did not believe in, hedge funds jumped in to sell short. Other investors (including us) dismayed tried to make sense of it all. Meanwhile, to make the HFs’ job easier, the French government was issuing a statement specifying how the company could not be subject to takeover.

ATOS vs CAPGEMINI 3Y Total Return

Source:  Thompson Reuters

Unfortunately, these things happen. The time to return on capital gets longer but potentially the return increases. Despite the understandable disappointment, there is no reason for the stock to trade at these prices, regardless of strategy. The right management will eventually be found. The company has unique divisions of the highest quality. We believe that the crisis in the infrastructure sector at 12 months will have receded due to the reduction in supply and the trend of industry consolidation. The support of the French state, the company’s first customer, is unconditional. Pessimism and shorting on the stock are extreme. There is no risk of false accounting or bankruptcy. The BDS division can at any time be liquidated at a valuation now equal to the value of the entire company, including debt.

We are therefore buying back the stock, always within the framework of proper diversification and risk control.

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“S’ha da aspettà, Ama’. Ha da passà ‘a nuttata”

In these last few days, the desire to stay invested in equities is understandably being put to the test.

As we know, there are many problems, but let us try to put them in perspective together with the opportunities that tend to be forgotten at these junctures.

• Rates go up. Rising rates take liquidity off the table and therefore less leverage and less investment. However, more ‘normal’ rates help the profitability of the financial system, reduce corporate and public pension deficits and increase savers’ returns. In addition, rate normalisation reduces speculation, the enemy of long-term real growth. As for mortgages and the real estate market, let us remember that a family buys a house when it is confident about the future of its job, and a 2 per cent higher interest payment is only decisive for the highly leveraged real estate company.

• Inflation is very high, not far from 10%, in both the US and Europe. However, 1/3 of that in the US and 2/3 of that in Europe derive from the volatile components related to food and oil, now under pressure as a result of the war. Once the war is over, the rate should gradually fall to levels close to, but above, 2%. However, this inflation wave is important to stimulate the economy in areas like Japan and Europe, which have been locked in a deflationary grip for years. While it is true that inflation initially weighs on the consumer, it is also true that it then reactivates the wage dynamic, stimulates the real estate market, particularly in secondary areas, and makes listed companies linked to the real economy, with plants and assets, even more attractive, those that are now on the value side. While it is true that some sectors may initially suffer in terms of profits, it is also true that in the medium term almost all companies post higher profits in an inflationary environment, at least nominally. Finally, inflation reduces public and private debts.

• High oil, gas and agricultural commodities represent a tax on the consumer. However, they also represent a huge incentive to invest heavily in energy and food, sectors that are crucial not only from an environmental and social point of view, but also because they are highly capital intensive. Agriculture means fertilisers, seed, farm machinery and land that gains value. Energy means renewables, grids, pipelines, hydrogen, as well as stimulating the growth of gas supply through more upstream investments. We are talking about hundreds of billions of dollars of increased investment over the next three to five years as a result of the anomalies that emerged with the war. This creates a powerful flywheel that feeds aggregate demand.

• War is a dramatic event. Not a day goes by without our thoughts going to the families devastated by the conflict. However, wars end. And this one will be no exception. The longer the war lasts, the more volatile the markets will be, but the greater the likelihood that Putin’s regime will end. A long war will be difficult to explain even for a totalitarian regime. Once it is over there will be hundreds of billions of euros to spend on rebuilding Ukraine. Europe will finance a large part of the reconstruction and benefit proportionally.

• So much we complain about supply chain bottlenecks, but little is said about the fact that these are an integral part of the deglobalisation process that will bring so many important manufacturing processes back in-house, supporting the already strong labour market.

• The announced global fiscal stimulus has yet to be released to a large extent and will support the above trends, particularly in Europe, Japan and Korea.

• The ECB has disappointed to some extent. True. Having already prepared an instrument against another eurozone crisis (‘fragmentation’) would have been wise. It probably takes some tension in the markets for it to be prepared, otherwise there is a lack of political support in the Netherlands or Germany. Today, however, another eurozone crisis is highly unlikely as it is known that in that case the ECB would certainly intervene clearly and quickly, with instruments that are already known and effective.

• Even in the event of a technical recession, it is better not to bet on sharply downwardly revised profits. The dynamics described, in addition to the desire to restart after the pandemic, and the over-savings accumulated during it by households, will act as an impulse for consumption.

• Valuations on the traditional side are very low, particularly outside the US.

Against a backdrop of war, inflation, the end of QE, tech bubble deflation and with a likely tech recession in the US coming, it may seem easy to bet against the market and follow the trend these days. We wouldn’t. If these themes keep the market capped for now, the above arguments create important support for it. It will continue sideways and this will give the most flexible people a chance to buy on weakness (not tech) and release on strength. We should probably wait for the technical recession in the US with the inevitable inflationary slowdown to lift the stops and enjoy a significant market rerating, starting with Europe and Japan. Since the downside of the market today is limited (traditional/value side) we believe it is better to stay there and take advantage of these stressful phases to accumulate financially sound stocks with a good franchise and low or very low valuations. And you are spoilt for choice….

Panta rei

A couple of weeks ago Bank of America published a report by Peter Harnet in which a very interesting graph appeared. It illustrates the breakdown of global GDP by geographical area in different historical periods. So you can see that 2000 years ago China, India, Greece, Egypt and Turkey accounted for 84% of global GDP. In the mid-1800s Russia and China accounted for about 40%. Communism reduced them greatly. In particular, Russia went from 30% in 1800 to its current irrelevance, probably made even more extreme by the recent conflict. While China returned to growth with the advent of Deng Xiaoping’s ‘market socialism’, rising from 5% in the 1970s to 25% today. The growth following its inclusion in the WTO in 2001, which marked the beginning of the extreme phase of globalisation, was dramatic and coincided with the reduction in weight of Western countries. Japan grew from nothing to 5% with the economic expansion of the Meji era (1868-1912) that ended the shogunate and samurai rule. The Second World War heavily downsized Japan, which then, however, from 1960 to 1990, rode two phases of exceptional growth that brought it up to 14% of global GDP. Almost 30 years of deflation and bear market then brought it back to 6%, and now there are signs of stabilisation. Britain experienced its heyday in the Victorian period and has always declined from there, although less than Europe. The next few years will see the results of Brexit on the country. Europe managed to stay relevant for 2000 years, with relays between the Romans the French and the Germans. The peak was reached in the 1960s and 1970s with the creation of what would become the European Union. Unfortunately, there was then a gradual decline that accelerated dramatically with China’s entry into the WTO. After that phase, Europe lost about 10% of global GDP. India has also remained relevant over time. After the glories of 2,000 years ago, when its GDP was larger than China’s and touched almost 40% of the global GDP, there was a gradual decline in importance that became more pronounced with the departure of the British and the partition of the country. A country with great resources but a confusing democracy, India remained at around 5% of global GDP throughout the 20th century and is now showing signs of revival, unfortunately, as is often the case, with a democracy with autocratic overtones. Finally, the United States. They are those among the Western countries that have been best able to manage globalisation, limiting their loss of weight, which nevertheless amounts to 5% since 2001.

Everyone can draw their own conclusions. We limit ourselves to a few reflections.

An autocratic government that does the right things can often accelerate the country’s growth, but if it does not, it can easily be the cause of the country’s demise. So for investment, a democracy, however imperfect, is always preferable.

While recognising the merits of globalisation, it was badly set up and led to an adjustment too fast. The results are there for all to see, with a West dependent on a powerful, autocratic, belligerent China with completely different values from the West.

Russia seems ready to hit rock bottom and we would not be surprised if this mad war represented the final stage of its dramatic decline.

Europe could probably find in a true union the solution to get out of the decadence in which it finds itself. While it is still difficult to be optimistic on this front, we can say that we are more so than we were three years ago.

Global GDP breakdown by geographical region over the past 2000 years

Yayoi Kusama

The bursting of a bubble is a dramatic and fascinating event. With profound repercussions. It is nothing new. However, the tendency to forget it or, for younger people, not to analyse what happened in the past, is strong.

1) The first consequence of a stock market bubble bursting is a drastic reduction in the investor’s appetite for risk. This applies indiscriminately to all asset classes, even those not affected by the bubble and, in the initial part, even to those that will gain from the burst. It is therefore important to be cool and calm, trying to anticipate the return to normality by buying securities that have been unfairly penalised.

2)The second consequence of the bursting of the bubble is the enormous loss of wealth it causes. This is evidently followed by a marked reduction in the propensity to consume and invest. It therefore acts as a severe restrictive manoeuvre. The bursting of the bubble we are witnessing will put a nice cap on market rates (and the strength of the dollar), which is extremely positive in a context of inflationary hysteria. It could also bring the US into, or very close to, a technical recession. However, a sound financial system and the high level of household savings will prevent chain reactions and the economic recovery will then be relatively quick.

Yayoi Kusama, Infinity Mirrored Room – The Souls of Millions of Light Years Away, 2013. Wood, metal, glass mirrors, plastic, acrylic panel, rubber, LED lighting system, acrylic balls, and water, 287.7 × 415.3 × 415.3 cm. Courtesy of David Zwirner

3) The third consequence is that bubble assets may be untouchable for a long time. In this context, one can observe different behaviour related to different types of investors. a) Fanatical growth investors. These are driven by the same fervours that drove the crusaders in the Middle Ages. They are loyal to bubble themes. Reading Cathie Wood’s biography can help one understand these people. There are no valuation considerations, because what they buy does not, for them, have a fair price. They are the ones who ride the bubble to the most imaginative peaks and accompany it back to hard reality.

b) Opportunistic growth investors. These present themselves as growth investors but actually follow momentum, flair and common sense. They are smart, quick to get out and also quick to get back in. They sell to clients, colleagues, friends, family and even themselves, the amazing qualities of stocks and the endless future opportunities they hold, but in reality, they remain aloof and ready to dump them when needed. After ten years of continuous stock market growth and three years of an imaginative bubble, however, they tend to be bolder and less fast. Every time they have gone out, they have come back higher. This leads them to lose enough before adjusting to the new reality.

Yayoi Kusama, Infinity Mirror Room – Phalli’s Field (Floor Show), 1965/2016 (detail).
Installation view, Yayoi Kusama : Infinity Mirrors, Hirshhorn Museum and Sculpture Garden

c)Opportunistic value investors. These have stayed away from bubble stocks for much of the time. This has created a certain liver ache for them. People with no art and no part produced considerable returns, much higher than theirs, just by following the herd or passively placing themselves on indices dripping with growth. For years they also had to listen to the speeches about the great opportunities this new theme will bring. Impervious as they may be, some of this narrative has permeated into them as well. Once the theme disintegrates and seemingly reaches more comprehensible valuations, this investor first rejoices at the loss of the injustice suffered, but then invests. And he is normally wrong. In fact, the apparently attractive valuations he sees are completely fictitious. A bubble undermines the very functioning of the market. Much of the growth in turnover is the work of the bubble itself. It is precisely this exceptional growth that leads to a continuous rerating of securities, which, by attracting more money and investment, produces further false growth and rerating. It is a house of cards where it is difficult to tell how much is fake and how much is real. This process of self-magnification is reminiscent of the work of Yayoi Kusama and her beautiful mirror constructions (above). A few elements and many mirrors create realities as infinite as they are illusory.

In addition to the above, there is, as has been said many times, regulation. We well remember how the first warnings about antitrust and regulation of the digital sector in 2017/2018 led to fears and takeaways. The current news on this front is truly alarming, but the market seems anaesthetised. Fat and indolent, accustomed to fideistic gain, it does not listen. It will soon taste the consequences.

Bubble stocks that do not fail historically go into oblivion for a long time. The sequence of bad news that the bursting of a bubble releases is incredibly long. Holding on to them risks jeopardising a fortune or a career. It is better to neglect them for a while and perhaps go and rediscover some sectors that have been the subject of previous bubbles and so far irretrievably neglected, such as telephones, financials, utilities, ADAS, lithium cell manufacturers, IT infrastructure (local and hybrid, as opposed to pure cloud), newspapers, broadcasters, retailers, etc. Not forgetting the even more remote geographical bubbles, such as the Japanese, Korean and Indonesian bubbles of the 1990s, areas that after more than two decades of purgatory now present very nice and healthy investment opportunities. Alternatively, for hard-core growth investors, it is better to wait until the Nasdaq continues to cleanse itself of the stocks that were the subject of the recent bubble and its ecstatic investors, in order to repopulate itself with new companies and new trends, as well as more pragmatic and cynical investors. A process that we believe requires a great deal of patience. In the meantime, there is money to be made for dynamic and capable traders during the powerful rebounds.

The Blue Hole

‘The Blue Hole’ is a famous, yet fascinating, marine depression about 70 km off the coast of Belize. Besides being fascinating and famous, this depression is definitely dangerous, and almost 200 people have died there in the last 15 years. Indeed, strong currents, deceptive reflections, deep caves and treacherous sea creatures present great risks to even the most experienced divers.

The Blue Hole reminds us so much of corporate pension deficits. These endless financial holes have the ability to slowly strangle companies. And that is what has happened over the last ten years. The ‘defined benefit’ system used in the past tends to increase and decrease companies’ pension surplus or deficit depending on the change in related assets and liabilities. However, liabilities, i.e. future pensions to be paid, tend to be particularly sensitive to interest rates, which are used to discount the cash flows going to employees. While much hullabaloo is made to alert investors to these pension risks, little emphasis is given when, thanks to rates, these liabilities improve. In the US, for example, the corporate pension deficit has shrunk by almost 200 billion in the last year and coverage has reached 98%, a level not seen since 2007.

In old Europe, we have British Telecom, the company with the largest pension fund in the UK, which at the beginning of 2021 showed a pension deficit of around £7 billion, which a year later, at the end of March 2022, had fallen to £1 billion. Accustomed to the figures of the new economy on the Nasdaq, where companies that do not make a peak are still worth many tens of billions of dollars, all this seems like little. However, for BT, a company with about 100k employees and ownership of the UK fixed-line telephone network, this £6bn represents about 1/3 of its market cap. For E.ON, 70k employees, the pension fund savings over the past 18 months represent 25% of market cap. For Atos, 111k employees, this difference represents over 35% of market cap. For Volkswagen, 670k employees, 20%. That’s a lot, by golly!

If you then consider this significant reduction in debt, together with retained earnings (or realised losses) and about 10% inflation over the last 18 months (we are talking about companies with real assets), BT compared to January 2021 is down 20% (vs. +20% from list). E. ON is down 30% (vs. +10% list price). ATOS was down more than 80% versus -66% from list. Volkswagen was down almost 40% against a 5% drop from list. And one could go on… In short, adjusted for pension funds, retained earnings and inflation over the past 18 months, many old economy companies have an exceptionally strong value profile and are much closer than they appear to be to the March 2020 hole, albeit with much better prospects than then.

Farewell to the ‘Neglected Luxury’ Niche

The Niche was present at the launch of the Asian Niches fund in February 2019 and has always had a weighting within the fund of between 3 and 5%, with a maximum allocation set at 5%. Together with the Internet Victims Niche, it represents the least Asian of the Niches in the Asian Niches fund.

The Niche has been particularly volatile and has performed only decently since inception, returning 14%.

The Niche was composed of five sub-niches at the start:

1) Luxury Travel

2) Beauty and Personal care

3) Fashion&Watches

4) Luxury cars

5) Champagne and fine wines

Luxury Travel had a very mixed performance due to Covid and the war. The small position in the Carnival cruise line unfortunately lost money. However, the most heavily weighted stock here, the Mandarin Oriental Group, a name that spoilt readers will be familiar with, did well thanks to its brand and property assets.

Beauty&Personal care consisted of one stock, Nu Skin, a dynamic multi-level company with a very high and innovative product. We believe the company can still do well but took a modest profit, made a little less modest by the strength of the dollar.

In Fashion&Watches we made some money buying on Hugo Boss weakness and holding and adding to Swatch Group.

Luxury Cars, although very volatile, contributed much of the upside in the Niche. Companies such as Daimler, Volkswagen, Harley Davidson and BMW performed very well. We have taken profits here and maintain a small exposure to these companies through the Electric Mobility Niches fund. These stocks, although now out of momentum, remain extremely valuable. They also indirectly serve as a reminder that the growth bubble is still far from

over.

We would like to digress from this theme. In fact, the annual figures for China’s electric mobility darling, NIO (but we could say Xpeng or Lucid or others), coincided with those of BMW. The two stocks are trading at 70% and 20% respectively from their highs, reached for NIO in early 2021 and for BMW in early 2022. At the highs, NIO was worth around USD 100 bln and BMW USD 67 bln. Today the two companies are worth USD 35 bln and USD 54 bln respectively. For those who like to buy underperforming stocks Nio would seem to be the player to bet on… And indeed we find analyst studies with headlines like “NIO down 66% with supercharged growth, time to buy”. Wow!

Let’s look at the results of the two companies.

• Nio sold 92k vehicles (clearly all electric) in 2021, a 109% increase over 2020. BMW sold 328k electrified vehicles in 2021 (BEV+PHEV, of which BEV 108k), a 70% increase over 2020. Nio grows more, but BMW sells about 3x the number of electrified vehicles of NIO, and 1x pure electric ones. I’d say one point for BMW.
• BMW also sells non-electrified vehicles. It won’t last forever, but in the meantime it sells them and makes money from them. Including these, BMW sold over 2.5 million vehicles (+200k bikes) in 2021. Another point for BMW.
• Nio has sales of USD 5.2 bln in 2021, up 118.5% year-on-year. BMW’s growth is much lower, 12.4%, but with sales about 24 times higher (about 120 bln USD). Another point for BMW.
• Nio realised pre-tax losses for 2021 of about 630 mln USD, and for ordinary shareholders the loss was even 1.6 bln USD. BMW made a pre-tax profit of around USD 18 bln. Another point for BMW.
• Nio has net cash (industrial) at the end of 2021 of about USD 3 bln. BMW has net industrial cash of about 28 bln USD (almost 50% of market cap). I still think BMW is better.
• Nio invests a lot in R&D and by 2021 has invested 720 mln USD. BMW also invests a lot, and for 2021 has invested 8.5 bln USD, 11x what NIO has invested. Another point.
• Nio FCF 2021 should be negative 1 BLN USD, while BMW’s FCF should be positive 8 BLN USD (and in 2022 could exceed 10 BLN USD). One more point

If we value Nio as BMW’s EV division, despite it selling far fewer cars, and assume that BMW’s EV division does not make as much profit as Nio, it follows that the rest of BMW would be valued at 19 BLN USD, or a P/E of less than 1.5x. Either Nio is overvalued or you have to sell your house and pension fund to buy BMW shares!!!

We don’t want to push BMW (which is a very nice company), but we do want to focus on the valuation of NIO, Xpeng, Lucid etc, which are still short. For those who would like to go long, perhaps on the consideration that these stocks have lost 70% from their highs, we recommend that you leave it alone and rather think about investing in a product like champagne, yes champagne, both through shares of the major players and through the product itself. The ETF on champagne does not yet exist, however, a few hours drive away there are plenty of wineries… And it can be a much more joyful way to enjoy this spring which has already started badly, rather than hoping for improbable recoveries of Nio and company.

Moving from chicory to risotto, Tesla remains a beautiful carmaker and its products drive us crazy. The company will see its market share grow a lot more and the Model Y is a great car and will be a super success. There is no risk of bankruptcy here, but the risk of the stock derating is huge. In our view, the company would be expensive even if it were worth just 30% of its current valuation. We also recommend that Tesla shareholders consider spending at least part of their capital gains on champagne. But as is always the case, those who have been so good as to hold them so far hardly look at the fundamentals, and will not take profits except in a panic.

Fundamental analysis can do nothing against momentum and euphoria. These act like a spell that protects the fortress against seemingly insurmountable forces, such as common sense. However, when the spell dissolves, nothing more can be done to defend the fortress. At that point, reality relentlessly exacts its merciless revenge. Far beyond what can be imagined. There is no shelter. There will be no survivors. Goodbye Gamestop, goodbye meme stock, goodbye anything that doesn’t have a real underlying. The alarm clock has gone off. Time to get up, wash up, get dressed and get back to the real world. Fascinating though, especially if there is champagne on hand….

And so we come to the sub-niche that negatively weighed most heavily on the performance of the Neglected Luxury niche, namely Champagne. Let’s not hide the fact that this is the sub-niche we are most fond of. In this sub-niche, Masi performed well, which we hold as an exponent of prestige wines, particularly the cherry-coloured Amarone. In contrast, the three listed companies that are heavily exposed to champagne performed poorly (the biggest player is LVMH, but the company is almost entirely dependent on the “elegant” Louis Vuitton bags, while the champagne part is marginal). Remaining extremely positive on the subject, we now create the Champagne Niche, a Niche purely focused on these champagne companies, dedicating 2.5% of the fund to them. The remaining 2.5% freed up by the closure of the Neglected Luxury Niche will be added to the Japanese Orphan Companies Niche, the Japanese micro-corporations that have not been covered by analysts, have been listed for decades, are flush with cash and have profits and dividends worth a song. Waiting for the world to remember them. We already have about a hundred of them in the Asian Niches fund and we plan to increase the number. They are all companies with which we engage directly with management and for which we produce an ESG and SDG analysis.

Champagne, the elegant lithium

There is no doubt that champagne is elegant, sparkling and sometimes fruity. However, in recent years, it is not these qualities for which it is remembered by its poor investors, but rather the dry and acidic feeling it has left at the back of their palates, and in their wallets.

Champagne companies, as some of our readers know, have a peculiar balance sheet. Among their assets they have two fat items. The first is tangible assets, in particular land and vineyards. But also the equipment to process the grapes into wine and the huge (and ancient) cellars to age it. The second is the inventory, i.e. the bottles that are fermenting (semi-finished products) and those being aged. On the other side, among the liabilities, we have the debt, normally huge, which covers the stock.

The debt is a bank debt, with long-term financing at fixed and variable rates. This will only gradually be affected by rising rates. The stock inevitably benefits from inflation, as this was produced well before inflation emerged. Land, vineyards and buildings are real assets, a natural refuge against inflation.

20 years+ chart of Vranken Pommery

As we had the opportunity to explain, champagne has been paying for a diabolical alignment for 15 years now, which occurred in 2007. In that year, the economy was flying and champagne was flowing. However, the number of bottles that could be produced was then, as now, limited by two factors: the land on which the product (Champagne) is named and the yield per hectare. Both of these factors are determined by regulation and cannot be exceeded. In 2007, Champagne consumption seemed destined to rise astronomically and this consumption, meeting a finite number of producible bottles, dramatically inflated prices, risking depriving some transalpine people of the precious drink (the French consume about 50% of Champagne). This was without even taking into account the Asian markets that were gradually opening up to the product, which until then had been opposed because of its dryness (the Chinese love sweetish spirits). So the regulations were changed, the yield per hectare was raised and the designation area was enlarged. From a maximum of 300 million bottles, 340 million bottles of champagne could now be produced per year. Then came the crisis, champagne no longer flowed onto tables, but piled up in cellars. Champagne prices plummeted along with those of the producers’ stocks, and it was dark….

…until 2020.

In 2020 the collapse of champagne consumption was remarkable because of Covid. This led the government to protect the industry from Covid-related losses. The industry was therefore less stimulated to produce in 2021, and this was compounded by the very unfavourable weather in the 2019/2020 season and Covid-related restrictions on staffing. However, in 2021 demand rebounded to 322 million bottles, surpassing 2019 levels, but with a low level of production and the need to build up stocks. Despite the war in Ukraine, the recovery in tourism is now expected to add demand. Meanwhile, the process of champagne’s slow penetration in Asia continues, driven by investments in marketing by major maisons such as those held by LVMH (Moet&Chandon, Veuve Clicquot, Dom Perignon, Ruinart, Krug, Mercier).

To be highlighted as:

– Champagne has a staggering operating leverage. A 10% increase in price can triple profits, given that we are starting from a low margin. As we are not far from the maximum number of bottles that can be produced, we believe that there may be room for a significant price increase. The first step could be the elimination of the discount sales campaigns we are used to.

– Champagne companies trade at or below tangible net worth. However, if we adjust this equity for the selling price of the finished goods in the huge warehouses the price/tangible equity ratio is well below par.

– If we then consider that the value of land, vineyards and buildings after depreciation is equal to or greater than the tangible net worth, securities are a clear anti-inflationary asset.

Today it is possible to buy hard assets like champagne, at 10x earnings, with growing profits, and P/TBV below 0.5x, in times of inflation…

With a little patience, lithium, the asset of the moment, can be found in abundance. Champagne is limited, beyond a certain amount you can’t go. Moreover, unlike lithium, champagne is good, and the companies that produce it today are cheap.

The upside here is substantial. We accept that for many of our readers we have lost credibility since we have been waiting for champagne to recover for years. But we repeat that it is precisely because we have been following it for years that we can now better perceive that we are close to the inflection point. Wishful thinking? Maybe yes, I will see..

En attendant, sante’!

Scent of light

There are many tasty dishes that are simple to prepare. However, the ingredients are extremely important, as is the correct combination of them. The same applies to the stock markets. Below are the ingredients for a tasty and healthy dish. With few calories and potentially some capital gains.

1/4 of dramatic geopolitical event whose peak has passed

1/4 of nice strong inflation, from transient factors

1/4 clap of solid consumer savings and a pipeline of strong infrastructure investment

1/4 interest rates normalising and a robust financial system

Supportive governments, as much as required.

Mix everything well, no rush. Dramatically increase lower wages before baking.

Take care to burst any “growth” bubbles that arise during baking.

Serve with depressed traditional market valuations, on a bed of fresh recession and stagflation fears.

It should be doused with something sparkling and young, like post-pandemic, vintage 2020 or 2021 spending appetite.

Taste possibly after Macron’s victory and before the dividend wave coming in May.

Enjoy.

CardYes, CardNo

An experienced friend of mine has expressed his perplexity about Nexi’s performance. After reaching €18 per share, the stock has halved in a few months, with constant and worrying weakness. Anyone who knows the market well, knows that prolonged phases of weakness can hide serious problems, and so he wondered if there might be something rotten in the stock.

Intrigued, we took a look at the company. An in-depth analysis would require more time, particularly on a sector that is extremely popular with the market and as such, ignored by us.

What emerges from our initial analysis is that:

1) The weakness of the stock seems to reflect the weakness of the sector. Below is the chart showing Nexi, Worldline, Adyen and Paypal at one year. Adyen and Paypal belong to a different league in terms of quality, but we see that they too have been subject to strong derating.

2) At the beginning of the year, the company was showing a considerable premium to its direct peers as seen below. Today the premium has partially reduced.

3) Nexi has a number of expiring lock-ups ahead of it which could create a substantial sales flow over the next 12 months. Below is a mirror showing that 136m shares in lock-up have already been released since January.

4) The company’s guidance released in conjunction with its Q4 results indicates that it is struggling to meet its targets, which in turn perhaps indicates an increase in competitiveness in the sector.  Below are the changes in EPS estimates for 2022 and 2023 in recent months. Couple this with valuations that at the start of the year reflected a lot of positivity about growth and substantial, though to date unceremonious, debt, and you can understand why some have reduced exposure

Today the company is worth around 10x 2023 EBITDA (EV/EBITDA) in line with its direct peers (companies like Adyen and PayPal have different characteristics and deserve premium valuations over Nexi). The valuation of the stock and the sector cannot be considered expensive today and its rerating or derating will be linked to whether or not earnings growth is confirmed. Given the assumption that digital transactions increase earnings growth will depend in the short term on competitive pressures in the sector and, a little further down the line, on any risks from technological change. As in all bubbles, first comes the massive and seemingly incomprehensible derating and then, gradually, the problems emerge. We believe that stocks related to bubble issues should be treated with great caution because the adjustment process usually takes years, not months. The same optimism that creates bubbles then leads to a glut of players, acquisitions made at optimistic prices, regulatory attention and stimulus for technological change. And it often goes from being shamefully expensive to shamefully cheap.

CardYes, CardNo(2)

We country managers find the digital payments sector quite complex. There are so many players and roles. Issuer, acquirer, gateway, processor… Only apparently there are large unassailable players. In reality, excluding issuers (VISA and etc) the other roles are vulnerable. An example comes from the small Adyen that in a few years has become a colossus, a cut above the rest, thanks to a faster and more efficient software and an intelligent strategy.

Then there is another problem. And this also concerns issuers. The future of payments is not necessarily tied to the debit/credit card circuit. Merchants do not like interconnection costs and technology is improving. ACH (automated clearing house) and BNPL (Buy Now Pay Later) models are interesting alternatives with some shortcomings. Blockchain circuits such as cryptocurrencies could also be an alternative, although they also present some problems, of cost and speed. However, things could change quickly.

In conclusion, we are not sure that securities such as VISA or Adyen itself, leaders in their respective markets, deserve extremely generous valuations as they do today, given the many risks in the sector.

Goodbye plush toys?

We grew up with the idea that the democratic world was well organised. Entrusted to capable and responsible men and institutions. Balanced and fair. That governance was fair and well defined. But this is not the case. The level of incompetence, ignorance, inefficiency and dishonesty is staggering. Many of the international institutions that claim so much credibility are in fact inept and useless hulks, at the mercy of economic and political interests. In such a context, it is not surprising that organised greed in the form of corporations/businesses prevails, controlling the ganglia of power and the very lives of billions of people.

The only glimmer of light for today’s democracy is to analyse its alternative: autocracy. This renders the current defects of democracies meaningless, however imperfect, is the only adequate organisational form. It must be improved to make it sustainable. A democracy that does not represent the demands of the majority of citizens, inevitably leads to nationalistic regurgitation. We have seen this recently in the USA, as well as in Europe and elsewhere. Economists such as Stiglitz, Krugman and Korten, who saw risks to democracy in an excessively savage capitalism, have often been sidelined. Today they are being re-read and reappraised.

It cannot be denied that globalisation has had positive effects. Thanks to it, much of the poverty in emerging countries has been eradicated (see graph above) and the average age of life has risen considerably. However, its exaggeration has had a cost for the West that is now proving excessive, particularly for the weakest and most numerous, as can be seen in the two graphs above. This cost has risked plunging the West into the darkness of autocracy. To open a long period of stalemate in the path of progress, like the Middle Ages. However, Covid and the Ukrainian invasion have opened a new phase. A necessary and inevitable phase of deglobalisation. It will bring manufacturing, investment and jobs back to the West. The losers will be the autocracies in the emerging countries, the large Western corporations that sell (and produce) in the emerging countries, and the large and small traders who profit greatly from the fat margins associated with imports from the emerging countries. Europe, like the US, has allocated large funds to help emerging countries, for their economic and democratic development. The opportunities for Western corporations will have to go hand in hand with the democratic development of the countries where they invest.

In November 2019, the book “Meeting Globalization’s Challenges”, a collection of pieces by distinguished economists on the topic of globalization, was published. The introduction was left to Christine Lagarde, then General Director of the IMF, one of the most influential and most criticised international institutions. It is precisely her introduction that is a sweetened re-presentation of the narrative offered in the 1990s and early 2000s about the goodness of globalisation. There are several references to papers of dubious quality and transparency showing that globalisation does not lead to job losses in the West. More transparent, however, but highly questionable, is the description of how re-training and social safety nets would protect the weakest in the West from globalisation. While admitting several errors, Lagarde, inevitably, still in 2019 defended the IMF position, written by the US years under the dictation of big corporations, the primary beneficiaries of globalisation. We know that propaganda does not only exist in Russia.

One of the pieces in the book belongs to Nobel laureate Paul Krugman, one of the exponents of sustainable capitalism. Here the economist acknowledges his mistake when, in the 1990s, he supported the process of globalisation, defending it against the accusations of those who said it would increase social inequality and impoverish the West. In fact, globalisation soon turned into what some economists dubbed ‘hyperglobalisation‘, responsible between 1998 and 2005 for the loss of 10% of the manufacturing workforce in the West, over 10 million people. This number has continued to rise until today, with damage to the social fabric of the West and its supply chain.

Political Europe today is finally united. The atrocities in Ukraine and, before that, China’s lack of transparency linked to Covid, have shaken public opinion and politics. Corporations are also realising that the pursuit of short-term profits can create major problems in the long run. Today there is total alignment. Hyperglobalisation is over and we are moving towards a path of substantial domestic investment, which will create jobs and support wage developments and purchasing power. Some corporations will suffer, but then they will regain in the West some of the growth they have lost in emerging countries. Countries like China, India and the Middle East, which have implicitly approved of the massacres and violation of sovereign territory in Ukraine, will be affected by this shift in perspective.

Today, Europe has a trade deficit with China of over USD 300 billion.  These are not just useless teddy bears or acrylic blouses, but much of it is advanced machinery (see graph on the right). Much of this will have to be produced in the West in future.

The lights of the Renaissance now seem to prevail over the shadows of the Middle Ages. If this is the case, we can look forward to years of good growth in Europe, the reabsorption of debt accumulated during the Covid era, fiscal and political union. On the other hand, we should say goodbye to disposable T-shirts and plush toys. With significant benefits for the environment.

Optical illusions

A lot works sinusoidally. We would say everything, when there are human beings involved. The market teaches us this on a daily basis. Last weekend the hope for a ceasefire in Ukraine seemed to grow. This weekend it seems to be shrinking. Fears, albeit remote, of Russian use of tactical nuclear warheads or chemical weapons are re-emerging in the newspapers. The success of the Ukrainian army is being questioned. Putin’s determination to continue the war, as he himself stated during the recent pro-war demonstration in Moscow, seems certain. The willingness of the Chinese to support the Russians, veiled by Xi in his video call with Biden on Friday, seems dangerous.

In reality this is not the case.

Pere Borrell del Caso – Escaping Criticism, 1874. Oil on canvas. Collection Banco de España, Madrid

What we see today is a tug-of-war in view of an agreement that is just a few lines away from being signed. Putin needs to save face. Russia demands the neutrality of Ukraine (a huge step backwards from the “denazification and demilitarisation of the country”), the recognition of Crimea as part of Russia and the recognition of the two regions of Luhansk and Donetsk as independent states. Ukraine accepts neutrality, but does not recognise the expropriation of Crimea or the independence of the two republics. Moreover, expropriation by force can never be accepted as a matter of international principle. Moreover, thousands of lives would have been sacrificed for nothing. So an agreement on the independence of the Crimea (which its population would approve in a referendum, as has happened in many countries in the past) and a form of boosted autonomy for the two republics is likely. Finally, war damage. Here the tug-of-war is tight, but they will be granted against a relaxation of sanctions. We believe that Russia cannot politically afford to continue the war to the bitter end. That is why it is important to make it look like it can, to have more strength in the negotiations. Moreover, the conquest of Mariupol and thus of access to the sea from Crimea to Russia is crucial. Its return can be bargaining material at the agreement table. As for China, it does not want to weaken Putin’s position now that he is negotiating. But it certainly exerts pressure for a cessation of hostilities. China absolutely must avoid being cut off from the West, a West that already seems inclined to do so (see previous article). The confirmed news that China has denied spare parts for aircraft to Russia goes in this direction. The market relief offered on Thursday by the Chinese government expresses strong unease and growing concern.

We cannot say how long it will take but we believe a ceasefire is close. And the last days before the ceasefire will be the days when Russian forces launch their last and fiercest attack. This phase has already begun.

Putin will save face. He will probably sell the war damage to be paid as aid for the friendly country devastated by Nato pressure. However, gradually the truth will come out. In the meantime the Russian population will be dramatically affected, even though many of the sanctions will be lifted in the coming months. This could lead within a couple of years to Putin’s departure, not unlike the departure in 1999 of Boris Yeltsin. A departure apparently voluntary, but in reality obligatory. This should mark the beginning of recovery for this huge country and its unfortunate population, which has not benefited from global growth for the past 25 years. The graph opposite shows the GDP growth of China and Russia over this period.

As for the recession that many expect, we believe it is very unlikely. If you watch TV you can see the damage to the economy in European countries. The media creates a lot of anxiety. This damages aggregate demand. However, we can’t help but notice how the removal of covid restrictions leads people to go out and spend. Spring has started and this trend will increase. Temperatures are rising and the price of natural gas will fall. Oil supply remains plentiful, its price reflecting speculation. Finally, in the wake of this anxiety, which also grips institutions as always, new fiscal policies will be implemented and will manifest their benefits well after the end of the war. The only (apparently) positive thing circulating is that ECB rates will not rise. Here too we disagree. Rates will go up soon, fortunately.

Ultimately, we believe that any downturn in the market can be a good opportunity to increase exposure to equity, particularly the value component, which is the most affected in this phase as it is generally more linked to economic growth. This is always within the framework of a balanced allocation, which takes due account of the risk profile of the product/investor and respects diversification, which must always be significant.

Dear Mr Cheicheiar,

Dear Mr Cheicheiar,

I’m a 10-year-old boy. When I was born, my grandfather gave me some of his Telecom Italia shares. Savings shares which, my grandfather told me, always give a dividend that could help me pay for my studies one day. But I would like to buy a PlayStation.

Grandpa bought them almost 20 years ago for his old age, but when he told me about it he made a strange expression.

I don’t know much about stocks, but I like them. Dad is crazy about them and spends his Sundays reading the financial papers. Mother doesn’t seem happy. She’d rather go to Ikea or Zara.

Dad told me that the shares Grandpa gave me are no good. He says Grandpa is old and doesn’t understand much about stocks. Dad says that Grandpa’s shares have gone down so much and that I’d better sell them and buy apple. This made me very sad. Also because it seems that what I have left is not enough to buy a PlayStation.

Grandpa says the company makes us talk on the phone. With Mum, Auntie Ginetta, and Auntie Assuntina. And it also lets us watch Disneyplus, which I really like. All this, Grandpa says, for the monthly cost of a lunch at the deli down the street. I really like the stuffed peppers they make there.

I think that’s good. Talking to the aunts and watching Disneyplus all you want for the monthly cost of stuffed peppers, ice cream and a barley water drink sounds good to me. Dad replies that Tim doesn’t make money at these prices though, but they can’t raise them because of Mr. Regulator. I didn’t quite understand who he is, but I think he’s a bad guy, because he punishes good companies.

Dad says that the only ones who make money are the bosses at Tim. They stay for a short time and make millions. I wish daddy was the boss of Tim.

Daddy then says that you, Mr Cheicheiar, want to buy Tim by paying much more than it’s worth now. So much so that I’d get the money for the PlayStation. I’m not sure why you’re doing this, but I’m glad. It’s good.

At the same time, the current boss of Tim, Mr Alessio, and his friends who run the board with him, say that the company is worth almost five times what it is now and almost three times what you offered, Mr Cheicheiar. But if it’s worth so much, why is it that if I sell it I can’t even buy a PlayStation for it? I don’t really understand the difference between price and value. For the PlayStation, the two values seem to coincide.

I asked Dad why anyone would say the bid is low even if it’s twice the price I can sell the stock for today. He didn’t answer me.

Grandpa then told me yesterday that the boss of Tim decided not to pay a dividend to my savings shares otherwise he would pay tax on them. Apart from the fact that Grandpa says that paying taxes is the right thing to do in order to keep hospitals and the police functioning, I wonder if the head of Tim is lowering his salary in order not to pay taxes. Of course this gentleman is strange. Even stranger than Mr. Regulator.

I, Mr Cheicheiar, would be very happy if you bought Tim and made a lot of money. I’d still be talking to my aunts who I love. And I would buy a PlayStation.

Sincerely

Ukraine and China

Edvard Munch “Anxiety” (1894)

As the bombings tear apart Ukrainian cities, the media tammy continues, creating anxiety and volatility. We believe the market is now afraid of two events. The first is an extension of the conflict to NATO. The second is that sanctions will be extended to China, which is guilty of helping Russia. In the first case, talking about asset allocation does not make much sense, whereas it would make sense to start making arrangements to move to the mountains or the cellar. In the second case, recession would be certain. As we have already said, although mistakes are always possible, we believe the first scenario to be very unlikely because of the consequences it would bring. We also believe the second scenario, which would see a China with negative economic growth that would in turn bring risks to the stability of the Chinese regime, is unlikely. In China, citizens give up democracy in exchange for the journey to prosperity. Today, however, wealth is concentrated on a minority and it is Xi Jinping’s goal to redistribute it. A recession would weigh on the weakest (who are also the most numerous and the most angry).

If the likelihood of the two events recedes over time, we believe the market can slowly return to normal. Oil and gas will gradually fall and so will commodities. And equities, particularly value stocks, would recover. Even if the conflict were to become chronic.

If there is a credible ceasefire in the near future, the readjustment would be rapid. But we realise that a certain amount of optimism is required to assume this, an element that we do not lack today…

Cybersecurity and paranoia

Our IT has decided that a Russian-originated cyber attack is imminent and that we must further strengthen our security. This is the slightly paranoid air that now circulates in the environment and we, although hesitant, comply. The damage, though remote, would be too great otherwise. We would not be surprised if tobacconists and perfume shops started installing cybersecurity programmes and processes.

Atos, an IT consultancy that we have mentioned several times and which is going through a difficult transition phase (it recently came out with yet another profit warning), has a division called BDS. The acronym stands for big data and cybersecurity. This division is considered one of the leaders in cybersecurity and is clearly the first choice of the thousands of customers of Atos’s other divisions. The BDS division has sales of around 1.5bn EUR and has been valued at 3 to 4bn EUR. It recently received an initial bid from Thales of 2.7bn EUR, which was rejected.

We value the BDS division on the basis of what THALES offered. If we also value the Atos infrastructure division at 50% of where the market is (i.e. only 0.1x sales), the digitalisation division at a 40% discount to where the market is (i.e. 1x sales) and subtract the modest debt, the stock would be worth around €60 per share. With cautious assumptions. Today it is worth only 25. If you want to invest in the growing fear of cyber war, poor, scrappy Atos seems to be the quality value player with one of the most attractive risk/benefit profiles on a global basis.

Europe, now or never

A different world