Alright, there is a lot to catch up on, so let’s dig in.
With earnings out of the way, the market is solely focused on macro. Scott “I am the house” Bessent has lost control of the bond market and must have realized by now that no matter how many times the Fed hikes rates, it won’t resolve the physical oil shortage the world is facing.
We’ve come a long way since Scott “I broke the Bank of England and the US is next on my list” Bessent was jiu-jitsu-ing the Iranians and using their own oil against them.
Back in March we wrote about how difficult it would be to reopen the Strait of Hormuz, especially after the Iranian leadership had been wiped off the face of the earth. We are now seeing the consequences.
The last time we saw a sudden spike in long-term yields, we learned that Silicon Valley Bank’s management hadn’t attended a risk management meeting for years, and they considered ALM a nuisance that only lowered returns.
When interest rates spike suddenly, that’s when things break. We don’t know what the next SVB will be. But we want to have some cash in case some opportunities present themselves.
Who knows, maybe the Strait of Hormuz opens. Maybe “bridge and power plant day” will actually happen, and even though Iran has prepared for that for 47 years, it will resolve the situation. Or maybe someone in the Trump administration will have to know how to talk to the Ayatollah, while still finding a way to claim victory at home – a face-saving retreat. Maybe the Chinese can find a way out through diplomacy?
But we won’t remain at full risk until we find out.
When the US market hit new highs, we briefly dipped our toes into what we dubbed ‘the catch-up trade’. China and Japan had lagged the US recovery. We also have EM exposure through our Brazil and Argentina thematic. Let’s just say the bond market is making us nervous, and we don’t want to stick around to find out whether the historic relationship between yields and EM stocks will hold.
For starters, we have sold our Brazilian stocks.
Brazilian stock exchange B3 (BOLSY) and wealth management platform XP (XP) were largely rate plays. With real rates at 10% in Brazil, why would anyone bother with equities? If Bolsonaro Jr. could stop the negative FDI, the Banco Central do Brasil could lower the Selic rate, equity trading would pick up, and stock exchanges and stock brokers would benefit. But higher inflation expectations have thrown those expectations amok.
As an oil exporter, is Brazil a net beneficiary of higher oil prices? Sure. Do the Brazilian consumers whose spending was already largely tapped out care? No.
Fortunately, little Bolso has been climbing in the polls, Brazilian equities have spiked, and we can exit our position at a modest gain without taking the binary risk of the election outcome. We are closing our Brazil thematic and moving it to our watchlist.
Speaking of emerging markets, Europe got a wake-up call in 2022 when Russia showed it that no matter how much it invests in renewable energy, it won’t help much if the fossil fuel tap closes. But even though Europeans have had 4 years to change course and secure their energy supply, they have come to realize that cold showers aren’t so bad. And if the entire continent got accustomed to welfare, why would you care if your industrial base gets destroyed in the process?
If there is one lesson we have learned from the winter of 2022, it is that European politicians are even worse energy traders than they are policy makers. In 2022, TTF natgas prices spiked, especially because politicians were the big, very obvious whale in the market. Are they now building diesel reserves while pushing prices way beyond reasonable levels?
Then there is the story of the midterms. With Donald “Look at all the wars I ended” J Trump making the midterms about himself rather than about the Republican Party, the polls aren’t trending favorably for the Republicans.
Will the Democrats sweep both the House and the Senate? According to Polymarket, the odds have climbed to 63%. We don’t think that will be a negative for the markets. In fact, maybe we will finally see those checks and balances that we were promised.
But it will be a negative for some Republican pet projects.
Remember our writeup on for-profit prisons in January of this year? We argued that under Trump, locking up foreigners was in a bull market. After the initial euphoria around the prison stocks CoreCivic (CXW) and Geo Group (GEO), those 2 stocks gave up all their post-election gains as it took longer than anticipated to reactivate idled prisons, and that reactivation actually subtracted from earnings. We bought the dip.
10 months later, sentiment has made a 180. DHS is no longer looking to convert remote warehouses into prison camps after they realized their budget covered only barbed wire and failed to account for sanitation or in-house court systems. GEO and CXW went from trading like they were about to be disrupted by DHS to companies that can sell their assets to the DHS at replacement cost.
But eventually the discussion will shift to what multiple this trade is at when we don’t have a government in charge who makes it a sport to lock up foreigners on their way to El Salvador.
The trade worked. Unfortunately for the home team, we exited this one too early. We hope our KEDM subs made more money on this trade than we did.
Meanwhile,, Mark “Your privacy is important to us” Zuckerberg is testing the market by launching an agent that doesn’t just solve big math problems, but also looks cute. Yes, we are skeptical about the returns that LLMs will earn over time. But we are not blind to what this could do for AI adoption among non-FinX users. We are re-evaluating every business model that relies on the value of customer relations.
OpenAI and Anthropic are realizing they spent close to a trillion on a business with no moat and an infinite supply of new competition. But what better way to create a moat than to lobby the government for one? What if they convince politicians that robots threaten humanity? Haven’t they seen The Matrix? I, Robot? The Terminator? That should certainly force them to step in!?
There are no signs the government will slow down the AI rollout and the resulting competition. Remember our piece on ‘the coming liquidity drain’, where we argued that the SPCX IPO and Google Private Placement were sucking liquidity out of the market ahead of an Anthropic and OpenAI IPO? You can be assured that those two companies will swiftly deal with any remaining liquidity once the IPO window re-opens.
In short, it’s really hard to stay bullish with the US10YR well north of 5% and making new highs almost daily. We’re just making sure we’ve got some dry powder to deploy on the other side.
You know our book… we are hiding in countercyclical assets: Marex, refiners, chemical distributors, European defense, some high-quality defensive compounders… even the more cyclical aerospace has a place in our portfolio. But we certainly have de-grossed.