• Angus Crennan

Our end June 2020 Conservative Positioning

In June 2019 I wrote a letter titled ‘Our current conservative positioning’ which explained the asymmetry of investment losses, talked a bit about what global trade rules changing meant and finally provided some analysis that any negative surprises could result in painful losses. If anyone is a sucker for punishment and wants to revisit it, that letter is posted here.

In many ways the world has changed a great deal from June 2019; The Coronavirus, Black Lives Matter, synchronised global recession and further relationship deterioration between democratic countries and China for example. However, one critical element of the investment environment has not changed and that is the price of investments remain extraordinary expensive.

This letter lays out my analysis of the investment environment in the middle of 2020 and why we remain conservatively positioned. We start with some high-level market valuations to give some context, then move into analysis of risks, paying particular attention to the US and global bond markets. We explore some surrogate sources of information (company guidance and bank actions) which reinforce that risks are elevated then finish with some comments on making money in this environment.

It’s a long letter which I have tried to make easily readable. If you would like more detail on anything discussed in this letter please contact me.

Key Points

1. Investment assets are expensive

2. Governments have buffered their economies in the near term

3. Bond markets, banks and ratings agencies are all signaling more economic contraction to come

4. Credit quality is deteriorating

5. China is a risk, not a rescuer this time

6. The US is in disarray

Market Valuations

The easiest and yet surest way to protect our portfolio from risk is to demand a higher margin of safety in the form of attractive valuations. Margins of safety have been a consistent part of Balmoral’s approach from inception and it presently represents our main tool to manage risk.

Bond market expected returns are currently exceptionally low. Given elevated risks we have no exposure to bonds at present. It is instead via part ownership of successful businesses where we currently have the best opportunity to achieve our objective of attractive compound annual growth rates on our capital over time. It is therefore sensible to start with some analysis of share market valuations.

UK shares – now more expensive than pre coronavirus

The UK FTSE 100 Index comprises the largest 100 companies in the UK. That index fell by 18.2% over the first 6 months of 2020. The FTSE 100 Index’s earnings yield was 4.7% at end December 2019 yet that had reduced to 4.5% at end June 2020. This means UK companies were more expensive at end June 2020 than they were pre coronavirus at end of December 2019, despite prices having fallen over 18%.

US shares – more expensive than pre coronavirus

The US S&P 500 Index was down 4.0% over the 6 months to 30 June 2020. Its earnings yield at end December 2019 was 5.1% yet its earnings yield had fallen to 4.5% by end June 2020. Like the UK this means the US market had become more expensive than it was pre-virus.

Australian shares – more expensive than pre coronavirus

The Australian S&P/ASX 200 Index was 11.8% down over the 6 months to end June. End 2019 earnings yield of 4.8% still fell to 4.5% by end June 2020. Australian shares also are more expensive than they were pre-virus despite prices having fallen nearly 12%.

These three equity markets are an indication of our framework for cycle awareness. Corporate earnings have fallen due virus-related disruption – business conditions are tough - and yet part ownership of businesses has become more expensive than pre-virus.

According to Refinitiv on 20 July the US S&P500 for example was trading around 22 times its estimated operating earnings for the next 12 months. That metric means US companies, based on their future expected earnings, are the most expensive they have been since 2001.

As of end July 2020 consensus analysts’ forecast was for the S&P 500 companies aggregate earnings to fall somewhere in the range of 20-25% for the year. As Balmoral’s history demonstrates, even in good times we are careful investing in expensive markets, and we are plainly not in good times.

Market Risk Outlook

The Coronavirus is the key catalyst which continues to shape the investment environment – the virus is driving government and central bank actions as much as its shaping business and household decisions. The rampant growth of infection across the US since mid-June appropriately grabs news headlines however the problem is far deeper and wider than just the US. Countries from Russia to Brazil to the UAE countries have very high infection rates. According to Johns Hopkins University as of mid-July more than 14.7m people had been infected and over 609,000 people had succumbed (although more recently the mortality rate from the virus has declined from what those statistics suggest). This virus is so contagious that our only weapon is various levels of social and economic shutdown – from ‘social distancing’, which is only modestly horrible to business profitability and cash generation, to full lockdown quarantine, which is savage for the entire economy.

Geopolitical risks have also substantially increased during 2020. In the June 2019 letter I wrote about the rise of populism and what implementing populist measures meant to the classical economics concept of maximising a nation’s accumulated capital. Sovereign country relations have degraded substantially since, most notably the evolution of developed democratic countries’ perceptions of China from ‘synergistic trading partner’ towards ‘strategic enemy’. In June 2019 the world was beginning to turn away from a liberalized, global trade promoting agenda and now, a year later, we are progressing towards a bi-polar world akin to the Cold War.

China to the rescue?

We are in a synchronised global recession. In 2008 Australia escaped the last global recession partly as a result of China launching a US$ 586bn stimulus program, worth 13% of its economic output at that time (similar in relative scale to the current US Government’s stimulus program), resulting in strong demand for Australia’s key exports which in turn led to strong mining investment and various other economic multipliers here. Other countries also benefited as China’s spending program demanded inputs ranging from raw materials to specialized services and equipment.

China is currently experiencing its own shares of problems. Office vacancy rates in China have been climbing with both Shenzhen and Shanghai over 20% according to CBRE. Unemployment across all Chinese college graduates was 19.3% in June. The Wall Street Journal reported that residential rents across China fell more than 2% in June from a year earlier, a third consecutive month of declines, representing the worst decline Chinese residential landlords have experienced since 2012.

Yet China seems unlikely to stimulate its economy anything as significantly as it did in 2008, likely feeling constrained due its existing high debt levels. In July the IMF forecast China’s stimulus over 2020 to be 4.6% of its GDP and its economic growth for the year to finish around 1%. While Australia may benefit in the near term from higher iron ore prices (mainly while Brazilian production is constrained by the pandemic) it’s uncertain that Chinese growth at 1%, if delivered, will be enough to buffer economic contractions in Australia and other countries like we saw in 2008.

Geopolitical risk is high and rising

Australia’s main trading partner China has stepped up its assertiveness under President Xi Jinping and as a result is generating a range of backlash from other countries. Here are a few recent events to illustrate how frosty democratic country relations with China have become:

· The US closed China’s consulate in Houston, citing espionage and intellectual property theft, and in retaliation China closed the American Consulate in Chengdu.

· On 23 July the US Secretary of State Mike Pompeo gave a speech titled ‘Communist China and The Free World’s Future’, where he described the Chinese Communist Party’s actions as the ‘primary challenge today in the free world’.

· The US announced it rejects China’s maritime claim to large areas of contested waterways while driving two US aircraft carriers with their accompanying naval fleets through those contested waterways at the same time as China was holding navy exercises.

· President Trump used executive orders limiting Chinese social-media apps TikTok and WeChat in the US on the grounds of national-security threats. TikTok is very popular with around 100m monthly users in the US while WeChat is commonly used by foreigners with business and family interests in China.

· China abandoned of its agreement with the UK on semi-independence for Hong Kong and passing the Hong Kong Security Law. The Security Law has been condemned by a range of countries, the US sanctioned various senior Chinese officials and China retaliated by sanctioning various US Senators.

· Chinese and Indian soldiers had a deadly border clash and India subsequently banned a broad range of Chinese smart phone apps (names like TikTok, Clash of Kings, WeChat and Weibo).

· The UK reversed its decision to allow Chinese telecommunications company Huawei to participate building its 5G telecommunications network.

· The EU has announced its members would take coordinated action against China including export bans of sensitive technology and reconsidering extradition arrangements.

· Japan reported that every day since April China has sent armed coast guard vessels into or near its territorial waters. In Japan’s annual defense report, released in July, it noted that China was “relentlessly trying to change the status quo by coercion.”

The consequences of further breakdowns in these key global relationships stretch from increased cyber-attacks, lost commercial relationships, trade impacts, disruptions in supply chains and production to outright armed conflict.

Although it does not seem as important a risk catalyst it is worth noting that Russia has been suffering economically as energy prices have collapsed and concurrently the coronavirus infection rate in Russia is exceedingly high. Russian GDP has tumbled as has confidence in Vladimir Putin. Distractions which stir national sentiment, such as the annexation of part of the Ukraine, have been used in the past to focus and unite the Russian people’s attention in times of difficulty. India, Brazil and Mexico are similarly heavily affected by the virus which understandably has a large number of people frustrated and upset.

In a world struggling with the pandemic crisis, the US turning inwards and preparing for its Presidential election, these sorts of geopolitical risks can emerge into serious problems for global commerce and so are worth monitoring.

Global unemployment has rapidly risen to high levels

The punishing trifecta of lock downs, diminished global production and trade and reduced consumer and business investment driven demand has resulted in rapid increases in unemployment around the world. Fiscal policy, which means government spending relative to tax revenue, has become very supportive to help economies absorb that shock.

In some countries, most notably the US, households have been supported by direct government crisis payments. However, despite those payments supporting consumption and preventing bankruptcy and eviction, unemployed workers are still unemployed. We know that workers become increasingly discouraged as their skills, confidence and relationships diminish the longer they stay out of work. Amongst other consequences discouraged workers take longer to reabsorb back into the economy.

In other countries the true level of unemployment is being temporarily masked by government measures which, instead of focusing on payments direct to households, target preserving the link between workers and their employers. The Australian Treasurer Josh Frydenberg recently noted Australian unemployment is around 13.3% when taking the number of people on government support into account. This system potentially gets around workers becoming discouraged while the program is running. However, it prevents the economy adapting if those jobs being sustained by the government are no longer needed.

The University of Chicago researchers estimate that 32% - 42% of American job losses during the pandemic will be permanent, which suggests even a V shaped recovery in the US would still result in higher than usual unemployment. It also means that at least some of the jobs currently being protected by government programs like Australia’s Jobkeeper will cease to exist once government support is removed.

While record government spending programs has cushioned the impact of the crisis, those programs cannot be maintained indefinitely. Bank of America analysis has calculated global government debt jumped to over 110% of global GDP at end March 2020, up from around 80% at end of 2008. Australia’s experience of the pandemic has been mild relative to other countries yet our Federal Government has already committed more than $300bn in support measures resulting in a budget deficit set to exceed $200bn this last financial year, our first 10% deficit since the Second World War. While Australia entered 2020 with reasonable amounts of sovereign debt relative to its economy, other countries were already burdened with substantially more debt going into this crisis. A second sovereign debt crisis is a possibility if we have multiple waves of infections.

Without explicit government guarantees of payments coming for at least a period into the future households and businesses with debt to service will progressively look to the end of emergency support measures and consider their need to generate income in a changed economy to meet their liabilities. When that happens consumer and business activity would diminish.

The United States of America is in turmoil and that is highly concerning

The US is home to many of the world’s best businesses, is the cornerstone of the global financial system and contains the deepest and most influential capital markets. Depending on the index you choose US shares and bonds generally represent somewhere in the range 40% and 65% of a ‘global’ investment asset allocation, which means US investor sentiment is critically important to all investor sentiment. The old saying that ‘when the US sneezes the world catches cold’ captures this relevance.

Since the end of the Second World War the deep pockets of the US consumer have been the target of many successful businesses and US household consumption remains easily the largest part of US aggregate demand. After an unprecedented collapse earlier in 2020 US retail sales have recovered yet at the time of writing remained 10% below pre-crisis levels which, if sustained, would alone suggest a very severe US recession. Given the enormous shock to US labour markets – peak US unemployment during the GFC was 10.0% yet US unemployment was 11.1% in July down from 14.7% in April 2020 – the rapid rebound we have seen in US retail sales can only be accounted for by large government crisis payments. At the end of July around 30m Americans still relied on unemployment benefits to pay their bills. Deutsche Bank estimates that it will take at least 2 years for the US consumer to get back to pre-pandemic levels of spending. US consumer confidence rebounded from March 2020 lows back to pre-pandemic levels over May and June (which aligns with those rapid retail sales rebounds) yet then started to deteriorate again in July as virus infection rates again skyrocketed.

The US initial response to the pandemic was primarily financial. In April 2020 a staggering US$ 2 trillion stimulus package was approved. According to Goldman Sachs by early July discretionary fiscal support by the US Government had totaled over 12% of GDP, a global standout and very substantially larger than comparable fiscal support of Goldman Sachs estimate of around 6% of GDP in China and Japan and 4% in Europe at that time.

The enormous additional borrowing by the US Government to fund these crisis payments has increased US sovereign debt to 101% of US GDP (and the US Government’s own projections are for its level of debt to grow to 108% by end of 2021). Although we cannot know if this will cause a problem for America, what we can say is at similarly high levels of indebtedness both Japan and Italy struggled to grow in subsequent years. Japan got to 100% debt to GDP in early 1990s and Italy in the GFC so these are substantial periods of time to struggle working through high debt loads without much success. As importantly fiscal stimulus, especially in the sums we have seen over 2020, is borrowing substantially from the future and many politicians can be expected to be uncomfortable with that which means support for future fiscal stimulus packages may be lacking, especially for already deeply indebted countries. A recent RBA paper addressed exactly this point:

The central bank, unlike any other institution, is able to create money and the resource cost of creating that money is negligible. So the argument goes, if the government needs money to stimulate the economy, the central bank should simply create it in the public interest. The reality, though, is there is no free lunch. The tab always has to be paid and it is paid out of taxes and government revenues in one form or another.’

Philip Lowe, Governor, Reserve Bank of Australia, July 2020

After that big bang early fiscal approach the US’ response to the pandemic became disjointed and largely delegated to the State Governors who took varied approaches. Those varied approaches created different outcomes and we saw the rate of coronavirus infection increase quickly from mid-June 2020 in particular across the US’ southern and western states.

Those direct government payments to families represents an enormous amount of cash being made available in a very short space of time. Government policy makers and investors would variously hope for, and expect, spillover impacts from that much cash gushing into the pockets of families with a high propensity to use that money. Academic research informs us of the ‘House Money Effect’ which refers to lack of rigor handling money that has been given or easily obtained. In the US some households received more cash in the second quarter of 2020 than they would have earned had they still been employed, so we would reasonably expect at least some of that cash to be treated with a lack of rigor.

Speculative activity in US share markets exploded in the second quarter of 2020. The number of US retail investor positions in the S&P 500 via the popular Robinhood broking platform for example nearly tripled from ~5m in February 2020 to over 14m in July 2020. According to Bank of America analysis ‘technology funds’ had been consistently receiving record inflows from investors over July. Because of those speculative bets, regardless of the contractions caused by the coronavirus, the US S&P 500 as a whole finished the second quarter of 2020 up 20%. Tech companies in particular have been the stand out recipient of sudden investor euphoria and its worth listing a few points what that looks like:

· According to Goldman Sachs towards the end of July 2020 the S&P 500 was trading on 18 times forecast 2021 earnings. That is expensive. Yet Facebook, Amazon, Apple, Microsoft and Google were collectively trading on 31 times their forecast 2021 earnings.

· The US Nasdaq 100 index, which is dominated by the largest US tech names, is now trading at the most expensive valuations we have seen for 15 years.

· Facebook, Amazon, Apple, Microsoft and Alphabet now represent over 20% of the S&P500, which is more than double their concentration in that index 5 years ago.

· In July 2020 the US tech sector accounted for 37% of the total value of the US S&P 500, yet tech revenues only represented 10% of the S&P500’s revenues. That ratio has only been matched once before and that was during the peak of the tech bubble.

· Apple’s single stock concentration in the S&P 500 index is now the all-time record.

Some technology companies are absolutely benefiting from increased economic activity conducted online, although that increase is incremental. Bank of America Merrill Lynch Global Research for example forecasts online sales as a percentage of total retail sales to be around 20% in 2020, up from their pre-coronavirus forecast around 16%, and 2021 online retail sales to be around 23% up from their 18% pre coronavirus forecast. Companies like Amazon will benefit from that step change, yet its valuation change has been enormous. Other areas of the tech sector are not as well placed as Amazon; the Wall Street Journal reported that over the three months to end June some 70,000 tech start up employees lost their jobs as part of the economic fallout from the pandemic and recently LinkedIn also announced it had to let 6% of its workforce go.

This euphoria for US tech stocks has led to some extremes of valuations. I want to recognize that if we could time the euphoria, and get out before the inevitable correction occurs, then we could make a lot of money. However, surfing tsunamis is not what we are about, and the sustainability of current elevated market valuations over any reasonable time horizon needs to be challenged.

To argue for share market sustainability at these valuation levels we would need at least one of the following to occur:

1. A clear path for the economy to quickly and sustainably recover and so re-absorb all the unemployed, or

2. Governments’ crisis payments to be maintained at elevate levels for ‘as long as it takes’ until the economy recovers, or

3. Corporate earnings in aggregate increase rapidly and so justify elevated valuations.

My view is none of these three are realistic. At a minimum it is prudent for us to wait to see what happens to these very expensive share prices once record government stimulus payments get wound back and bank repayment holidays cease.

Let’s look into the big US tech names and their extraordinary valuations one step deeper. Two of the big tech names, Facebook and Alphabet, generate very substantial revenues from advertising. Can advertising spend hold up, or grow, in contrast to previous recessions where it reduced? At the end of July 2020 Google announced a US$ 2.6bn drop in advertising revenue over the second quarter of 2020. Hundreds of businesses, including Disney, recently announcing a boycott on Facebook advertising over how that business was handling hate speech and divisive content – will that advertising spend never eventuate or only divert elsewhere?

The global scale of the major tech businesses sustaining strong returns on equity also needs to be questioned; Australia for example has recently introduced fees for the traditional media content major tech platforms previously shared freely and Europe is similarly changing its rules for global tech platforms. Competition regulators recently ensured Amazon understood it can no longer preference high margin sellers on its platforms. The recent cyber hack on Twitter, which saw accounts of very prominent people controlled for hours to broadcast a cryptocurrency scam, reveals the ongoing necessity of deep capital investment and world leading cybersecurity these platforms require.

The big US tech names are no longer fast-moving capital-lite businesses able to exploit a global audience and generate scaled profits on small levels of capital investment; their future is looking more regulated, taxed and capital heavy. If that is the case do those businesses, in that changed incarnation, deserve enormous valuation premiums? If the largest and most successful global tech businesses cannot remain as nimble and responsive as they have been in the past then is it increasingly possible for specialist and focused competitors to successfully challenge their dominance in valuable niches or in specific regions?

US valuations are not just stretched in the tech sector. The amount of cash that has been invested into the US share market in a short space of time, and the rigor of those investments, has resulted in some pretty wild distortions. Some broad market valuation examples are already provided above, let me give you three more specific examples:

1. At the end of June, the combined value of General Motors, Ford, Fiat Chrysler, Honda, Daimler and Ferrari were pretty similar to the value of Tesla, despite Tesla only generating around 3.5% of the revenue of those established global businesses;

2. Herman Miller is a well-run 120-year-old business we know well as we were part owners until last year. It generates a lovely and (in normal times) consistent stream of cash per year from producing and selling globally sought-after furniture like the Eames Chair. Contrast that with a competing furniture business called Wayfair.com which has somehow become valued at 13 times more than Herman Miller, despite it losing money and only selling standard furniture (albeit via a more sophisticated technology platform);

3. In one wild month Eastman Kodak Co.’s share price exploded from US$2 to US$60 thanks to a public announcement they would receive US$765m in loans from the government to make drug ingredients – when that news was corrected, resulting in the US Securities and Exchange Commission launching an investigation, the share price quickly plummeted.

These distortions suggest there is a lot more emotion than rigorous analysis in some recent share purchase decisions, which is consistent with the House Money Effect. This flood of capital effectively betting on ‘sexy stocks’ means the efficiency of the market in allocating capital has degraded, which should really alarm index investors in particular, although exchange traded funds continue to receive record inflows. As we have seen time and time again throughout history emotion goes both ways and without a good reason to buy there is no good reason to stay invested. This means in the future we will see bigger swings in share prices, which in turn creates the anxiety that eats investor risk appetite. More volatility in share prices fits the classic description of risk.

The best information about how a business is doing is known within the company itself. Management has all the inside information on sales trends, new product pipelines, corporate actions, expenses and so forth. Management’s inside information is so good, and represents such an unfair advantage buying and selling shares, that it’s illegal to buy and sell shares in a company which you have inside information about. The Wall Street Journal recently reported that more than 40% of the S&P 500 companies have now removed their earnings guidance. If management cannot even provide broad guidance what they expect then really no-one can accurately predict what businesses will be earning in this environment. Understandably equity analysts’ forecasts are now the most dispersed they have been since before GFC.

Given surging levels of infection US health experts have been stepping up pressure for the re-imposition of lock downs across various parts of America. Second lockdowns are really damaging; reopening from a first lockdown requires restocking inventory, hiring (or rehiring) staff, deep cleaning and implementing a covid safe environment, which all costs money and time. In addition to the obvious risks to business solvency of spending money after it has already lost money for months, then having to close back down, the impact on smaller business owner-manager psychology is significant. What I mean by psychology is a realisation that this pandemic is not going to go away, which in turn catalyses evaluating if it’s even worth planning to re-re-open. We have seen a resurgence in coronavirus community transmission infection rates and hospital admissions in Hong Kong after just a few weeks of relaxed quarantine rules. Closer to home the rapid escalation in infections we saw in Victoria was equally alarming. For businesses that make rational long-term forecasts, basing big decisions on those forecasts is understandably gut wrenchingly difficult during a global pandemic and in many cases will be deferred or cancelled. That means business investment (a second critical source of demand from household consumption), can reasonably be expected to be weak for some time.

Aside from the inside knowledge of management, banks have the next best view of how businesses are performing. In addition to their close corporate relationships banks also have firsthand data on sales revenue, outgoing expenses, the stable level of net cash generation and a good understanding of what funding is available at what cost because they bank those businesses. US banks reported their second quarter of 2020 earnings in July which gave them a good chance to share with us what they were seeing in their data, and they pleasingly obliged. The US banks were unanimously unequivocal that the US recession will continue, there is no ‘V’ shaped recovery, and in aggregate US banks doubled the amount of provisions they set aside for bad loans to corporate customers right across the economy (US banks had already substantially increased their provisions for consumer loans in the first quarter of 2020).

With debt payment holidays still in force around the world we as investors don’t have accurate knowledge where the bad debts are, or how severe the situation is. Our proxy for that deterioration in credit quality is the actions of banks, who do have a good insight, so these warnings are important to listen to:

“In the first quarter, when we were really looking at a deep but short-lived downturn, we were really very much focused on the most impacted sectors. Now that we’re looking at a more protracted downturn, we’re reserved for a much more broad-based impact across sectors.”

Jennifer Piepszak, Chief Financial Officer, JP Morgan.

By July 2020 US bankruptcies had increased to over 30 per month, eclipsing the GFC, and that is despite bank payment holidays and huge government crisis payments. The US economy is in disarray, and in some sectors in severe distress. While ‘the economy’ and ‘share prices’ are not the same thing ultimately the capital markets, which the economy sustains, always ultimately return to reflecting earnings and cash generation prospects over time.

Debt Capital Markets

We have no current investments in bonds because valuations do not reflect risks. With yields so low we would also risk losing purchasing power to inflation and virtually any defaults would immediately wipe out coupon returns. Such investments would not contribute to compounding our capital over time.

Never the less global debt markets will always be an excellent source of information and so it’s important to pay close attention. Global bond markets are pricing in serious difficulties ahead:

1. The Bloomberg Barclays Global Aggregate Index, which blends global investment grade debt from 24 countries, yielded 0.947% at end June 2020, down from 1.22% at end March 2020 and 1.45% at the end of 2019.

2. US Treasury Bonds, regarded as the safest asset in the world, are indicating the same story. 2-year US Treasuries yielded 0.149% at the end of June 2020, down from 0.246% at the end of March 2020 and drastically down from 1.57% at end 2019.

There has been a lot of central bank intervention in bond markets however in the US the intervention peaked in mid-June so US Treasuries would have normalised to a certain degree if it was only central bank activity driving yields down. As at 31 July 2020 the 2-year US Treasury yield had reduced further to 0.11%.

The dominant global ratings agency Standard & Poor’s recently estimated the default rate for speculative grade US companies will reach 12.5% in the year to March 2021, which exceeds the worst rate of default experienced during the GFC. This pool of issuers owe around US$3 trillion so defaults at that level would cause some serious problems, and that is just the sub-investment grade public issuance in the US; consider what this means if we saw similar impacts across other geographies as well as across the structured and private debt obligations outstanding, many of which were issued in euphoric bond market conditions in 2018 and 2019 with limited investor protections.

A second big global ratings agency Moody’s has similarly published an unprecedented range of credit bond downgrades for the second quarter of 2020, easily dwarfing its bond downgrades from the GFC.

The importance of these developments cannot be stressed enough. In an environment where the World Bank has declared over 90% of countries in recession simultaneously, and the IMF expects the US, Germany and Japan to each contract more than 5% over 2020, global debt was more than US 258 trillion at the end of March 2020 which is around 333% of global GDP.

More importantly over the medium increasing the perception of increased probability of defaults progressively changes the behaviour of lenders. That outcome is a major concern for policy makers because it means a potential turning point in the global credit cycle. That concern drove the US Federal Reserve for example to invest directly into public credit during 2020. I wrote about what a credit cycle rolling-over looks like back in the December 2019 investor letter and it’s not pretty. The summary is less access to more expensive credit and lower asset prices.

We have appropriately focused mostly on the US because of its importance to global capital markets and its high coronavirus infection rate. However, disruption is everywhere. Shipping companies, which handle about 80% of trade globally, are facing what the World Trade Organization is predicting will be the industry’s worst year since the Great Depression. Even agriculture is not immune; trade limitations have increased wastage and recent United Nations data suggests that current global per person consumption of meat has reduced by 3% to the lowest level since 2011.

Can we make money in this environment?

Yes, we can, provided the analysis and resulting decisions are correct. The Balmoral Fund has the full suite of tools available to it which means it can make money in all market conditions. I used some of those tools in March 2020 resulting in our fund increasing in value while global markets fell heavily for example.

The decision to remain conservatively invested during the speculative increase in share prices we have witnessed in recent months does incur short term opportunity costs – no one likes to collect very little of rising market gains. However, thinking that we can time a bear market rally would be approaching this job only focused on return, whereas a cornerstone of Balmoral’s positive return focus in that we always want to be compensated for risk.

There is nothing riskier than paying an insane valuation on an asset because making a profit selling that asset would require someone to pay an even crazier price, something we will never set ourselves up to rely on happening. In a risk saturated environment like we have at present it is critical to remain patient and ignore overconfident sellers asking high prices to sell their business interests. We will buy what we want when it suits our investment objective.

In the interim remaining conservatively positioned means we effectively manage the systemic risk speculative excess represents. Investment losses are something we want to avoid and losses are what results when excesses unwind.

As a final point, assuming the correlation of the Australian Dollar to investor risk appetite remains, when markets do give up some of their excesses then I expect exchange rates will reverse some of the large changes we saw in the second quarter of this year. Our foreign currency exposures increasing in value in Australian dollar terms would unwind some or all of the currency headwind we experienced this last quarter.

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