The Almighty Macro
September 2022 Newsletter
The Almighty Macro
2022 has been an interesting year. From War, to surging commodity prices, an ever strengthening U.S. dollar, and monetary policy tightening around much of the globe, this has seemed like a year that is all too perfect for macroeconomic driven investors and strategies. Since we are bottom-up investors, we wanted to take this investment letter to talk about how we think about macro factors in this type of environment, especially foreign exchange rates.
For much of the time since the financial crisis in 2008, the capital markets action has mostly been in the U.S. equity markets. For any type of volatility, and material price action, the S&P was the only thing close to must see action. The bond market was slowly and assuredly put to sleep with the assistance of monetary policy. Commodity prices have had bouts of serious volatility, especially around the peak of COVID -19, but profitable trades were far from frequent. And foreign exchange was the ultimate snooze fest.
CBOE Crude Oil ETF Volatility Index
What of course changed was the one-two punch of red hot inflation data combined with an invasion by resource rich Russia of agriculture rich Ukraine. The latter move precipitated unprecedented sanctions from the West, effectively closing Russia out of the much of the global economy. Dovish central bankers have since turned into hawks, excluding Japan of course. According to Professor Edward McQuarrie, professor of business at University of Santa Clara, we are on track to have a worse year in bonds than any other year in American history except for 1842 (source: Wall Street Journal, 5/6/22). Interest rates are interesting again. And volatile. The MOVE index measures bond market volatility. See the chart below.
The Merrill Lynch Option Volatility Estimate (MOVE) index
Crude prices of course became interesting because the War and sanctions involve one of the largest oil producers in the world. Alas, everyone that has ever driven a car is now an oil expert again! While this has to be frustrating for those that read every note from the International Energy Agency, the “true experts” get to appear on the financial news stations after a seven year hiatus.
And then there is foreign exchange. Economic conditions are very strange the world over. Uncertainty and worry are around every corner. Within that, the United States, and by extension, the U.S. dollar, look to be the least bad of a very bad lot. The U.S. economy is strong, and looks like it may be able to withstand a strong rate rising cycle.
Deutsche Bank FX Volatility Index
SOURCE: V-Lab, NYU Stern School of Business.
At Ballina Capital, we are bottom-up investors. One may envision a bottom-up investor facing down this kind of stormy macro environment by burying the head in the closest sand until the storm passes. However, this isn’t the case. It also might help to review why investors choose to implement a bottom-up process. After all, if the markets are nearly 100% interested in top down, doesn’t that, at least for a period, render the bottom-up approach obsolete? The reason equity investors choose a bottom-up approach is that macro forecasting is always very difficult. We all enjoy hearing and reading the views of macro forecasters, but they’re pretty much never accurate. At best, they are somewhat accurate directionally. When you take a bottom-up approach, you’re sticking closer to where you believe you can be effective, analyzing companies and their securities. Bottom-up investors can run scenario analysis on macro forecasts. The idea with the scenario analysis is not to identify companies that are completely invulnerable to macro factors, but to best understand how specific company’s fortunes can twist and turn with the macro factors. With the benefit of this analysis, we understand the company better. Understanding the company better doesn’t mean that we then plan to own it forever, but for a given share price you can start to better appreciate what macro forecasts are being embedded.
Now back to the rapidly moving macro environment. Crude oil embarked on a strong run in Q1, and given the War, this looked well supported for some time. Energy equities moved up quickly and dramatically while most everything else was falling (at least in Q1). For many funds, they raced out to buy energy equities. In our case, we went into the War with little in the way of traditional oil and gas exposure. This had to do with the discipline we have involving our front end idea generation screens. When it comes to our developed International markets, our screens capture the fact that quality energy related companies are in short supply outside of the U.S. Aside from Scotland and Norway, the major developed markets of Europe and Japan have very few oil and gas resources, or engineers for that matter. It naturally follows that these major International markets have relatively few oil and gas related companies. That scarcity leads the few listed companies to be relatively expensive compared to, for example, the U.S. or Canada where there is a much larger supply of energy engineers and companies. Emerging markets have relatively more energy companies, but many of these are quasi arms of the state, and it may be hard for us to see much upside when we build our price targets. For some more top down investors, once the fundamentals seem to have shifted, they could very likely have taken the view that the Energy equities were a better buy at the now higher prices. For us, where we would err towards embedding more of a market consensus on these macro factors such as the oil price, we would be unlikely to make that calculation. We do like free cash flow, and it is impossible to deny that there will be more free cash flow for energy companies in the next few years. But with the relatively small number of International energy equities chased by an increasing number of investors, it is more likely that the greater free cash flow to energy companies will be outweighed in portfolio construction built upon by our ranking system by the equities that went down while the energy prices went up. We did come into Q1 of 2022 with energy exposure to small “off the radar” coal companies. We have held onto these for as long as we could, but as Thermal coal prices have continued to rise in 2022, these companies have jumped onto the radar of larger investors, moved down our ranking system, and we have trimmed or exited.
There are more nuanced ways to gain exposure to an Energy up cycle. We own shares in Yangzijiang Shipbuilding (“YZJ”). This is a Chinese shipbuilder that is listed in Singapore. Shipbuilding is a pretty awful business for equity investors. But as happens often for us at Ballina, when you’re willing to do the research in an area that is neglected, you may find something surprisingly good. YZJ has used low cost and good operations to generate strong historical Returns on Equity in their financial statements (Net Income/Shareholder’s Equity). Some of the vessels that YZJ builds are Liquefied Natural Gas (“LNG”) vessels, as well as oil product tankers. When we think about the volatile macro factors this year, we view YZJ through a lens that you can see below. Tighter financial conditions and a stronger U.S. dollar are negative for the underlying business of YZJ. The FX impact is a bit more complex than you’d expect. A stronger U.S. dollar, all other things being equal, should help earnings at YZJ in the short run. It is the increased risk temperature and the impact on global trade from the very pronounced U.S. dollar run that takes a toll on the fundamentals of YZJ, i.e. expect fewer ship orders. When you have an Energy supply shock, as we have had, energy will be required to travel further in terms of miles on the water to get to market, i.e. the incremental energy is further away. This is effectively an increase in energy shipping demand. This is a positive for YZJ.
Source: Ballina Capital
Upward moves in the interest rate curve would normally be expected to help Financial institutions, especially banks with large loan books of healthy borrowers that can easily withstand higher rates. But the volatility in interest rates in 2022 has been in both directions. Interest rate volatility of the kind that we have been experiencing feels more like uncertainty. The drivers are not a normal economic cycle, but a serious bout of cost push inflation. Investors worry that more leveraged borrowers will not be able to handle the new environment, even without considering higher rates. Recession and credit losses look more likely. For Ballina, we attempt to view our financials through the economic mosaic. Some banks, for example, look like they may experience more net interest income, but receive fewer fees and commissions. Some are more exposed to provisions for credit losses than others. What do we expect in the form of dividends? Is it reasonable to expect more? Is it reasonable to expect a higher multiple than where the stock currently trades? We have less exposure to financials than we did this time a year ago, but this is not from a top down view of the macro. Many of our Financials moved up too far and too fast in our view in 2020 and 2021. For a small number of companies, macro concerns for their specific market did matter. Risks have increased, and financials always wear risk right out on their metaphorical sleeves. We own shares in Swedbank, one of the largest Swedish banks. See below. Swedbank has a relatively large position in the Baltic states (Latvia, Lithuania and Estonia). The volatile macro environment of 2022 has been unkind to the Swedbank share price. In this example, we’re actually a bit more confident. While the Baltics may drive earnings lower for a while, we’re quite confident that their economies will bounce back in time. As far as the Swedish housing market, which is always a concern for Swedbank investors, we believe the interest rate increases may have come just in time to cool a housing market that looked a bit too hot. House prices have fallen by a few % points since March. A strong market position means that Swedbank could be more selective of their borrowers. Higher rates are already positively impacting the income statement of Swedbank. Capital ratios look quite solid. We believe that Swedbank will, in time, be able to pay higher dividends. But in the meantime, the dividend yield is more than 6%. We believe, altogether, it is quite a compelling picture, just one available at a lower price due to macro volatility.
Source: Ballina Capital
The U.S. dollar has been the champion this year, and it’s not even close. See the JPY/USD pair below. This is not just true of basket case currencies such as the Turkish Lira or Argentine peso. And what makes this even more interesting is that monetary policymakers, in a shift of course versus the last thirty years, actually want their currency to be stronger because the stronger home currency could aid in the battle against inflation.
At Ballina, we invest around the world, and where possible, we buy the local shares, even if this in a foreign currency. Yet, we do not forecast foreign exchange, and do not have a view on these currencies. We believe that the current spot rate is the best forecast, similar to the line of thinking on most macro indicators. We would rarely be correct on our FX forecasts. What we aim to understand, is for these foreign equities, how are they sensitive to the changes in foreign exchange? For example, we own shares in Honda Motor, the Japanese auto manufacturer. Honda makes a lot of profit in the United States, and in FYE 3/22, they derived 56% of profits from North America (source: Honda financials). While Honda has lowered the Japanese costs in their overseas operations over time, the JPY costs are greater than 0%. Even with 85% of Honda vehicles produced overseas (source: Honda disclosures), JPY component costs of overseas production are greater than 0%. What we end up with is leverage to the USD/JPY rate. In the FYE 3/22, Honda generated growth in Operating Profits of ¥168.9bn due to the yoy changes in FX rates, primarily the USD/JPY pair (source: Honda Financials). This alone was worth a 25% increase in Operating Profits. What is going on within the figures is that Honda experiences a translation as well as a transactional effect on earnings from FX swings. Translation is easy to follow, and there isn’t much a company can do about it. If you earn money in a foreign market in a foreign currency, repatriating the earnings back into the home currency will bring some fluctuations. It could make profits appear to be down, when in local terms, they were up. Transactional issues with FX are potentially more serious. This captures the extent to which a company produces good or services in one currency, only to sell in another currency. If the FX of your cost base appreciates too much, it could be that the competitiveness, i.e. margin, of the underlying business will suffer.
As the JPY has weakened over the past year (as we write this, the JPY is trading at 143 per USD, versus 110 one year ago), we have become more bullish on Honda Motor, but again this is with a view towards the overall mosaic for Honda. See below. Higher interest rates make it harder for consumers to afford a new vehicle. The harshest news for a vehicle manufacturer is that volumes will be very light. If our positive assessment of Honda proves to be sound, it may have more to do with Honda’s ability to cut costs in a downturn, and or Honda’s ability to sell vehicles and motorcycles to consumers in a period of high energy prices.
Source: Ballina Capital
We invest in many different companies with varying fundamentals. We would not pretend that they all line up nicely with the direction of macroeconomic factors. For example, with the current weakness of currencies such as the British Pound and Japanese Yen, one could question the logic to owning domestic UK or Japanese companies. Yet, we own several domestically oriented companies in these markets. We weigh the forward dynamics for these companies, including macroeconomic factors, against the valuation of the shares. We do place more value on resilient franchises. Macroeconomic volatility eventually settles down. Until it does, we will remain cautious long-term investors that frequently revisit our company specific models.
International All Cap Value returned -9.86% on a gross basis, and -9.94% on a net basis, in September 2022 versus -9.91% for the benchmark. Year to date performance was -21.23% on a gross basis, and -21.82% on a net basis, versus -26.65% for the benchmark.
Global Small Cap Value returned -9.6% on a gross basis, and -9.68% on a net basis, in September 2022 versus -10.23% for the benchmark. Year to date performance was -19.94% on a gross basis, and -20.54% on a net basis, versus -27.74% for the benchmark.
Top Contributors and Detractors
International All Cap Value’s top contributor in September was Swedbank. Some analysts that cover the Swedish Bank’s stock have moved to a more positive recommendation. The strategy’s top detractor was Australian Utility AGL Energy. One of AGL’s largest coal fired power plants has remained offline due to supply chain issues.
Global Small Cap Value’s top contributor in September was Chinese Logistics/Property group, Xiamen C&D. This was a recovery after weak share price performance in July and August. The strategy’s top detractor was the Russian Property company, LSR Group. Russia has been faring badly in their war in Urkraine, and this has led to increased uncertainty regarding the next steps to be taken by political leadership in Moscow.
The opinions expressed herein are those of Ballina and are subject to change without notice. Past performance is not a guarantee or indicator of future results. Returns are presented gross and net of fees and include the reinvestment of income. The benchmarks being shown for comparison purposes are: a) for International All Cap Value - the Vanguard Total International Stock ETF (VXUS), and b) for Global Small Cap Value – a 50/50 weight on each of the iShares Russell 2000 ETF (IWM) and the Vanguard FTSE All-World ex-US Small-Cap ETF (VSS). The information contained herein is not investment advice. You should not consider the information and commentary published herein as a recommendation to buy or sell any particular security. You should not assume that any of the securities discussed in the commentary published herein are or will be purchased for your account, or are or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the securities listed in commentary. Consider the investment objectives, risks, and expenses before investing.
For the Top and Bottom Contributors: Contribution reflects the impact of performance and the portfolio weight to total portfolio return. Data show is from a representative account of the International All Cap Value and Global Small Cap Composites. All returns are Gross of Fees. Timing differences of purchases and sales may have a modest impact on the actual contribution numbers presented. The calculation methodology along with detail on all holding’s contribution to the overall accounts performance during the measurement period are available upon request.