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Higher inflation = Higher risks

Video Transcript

Hello everyone and welcome to beat the market. In the next ten minutes or so I'm going to talk about our investment strategy for the week, with my views on the sectors, and the stocks that will be in our systematic global large cap portfolio.

Last week bonds sold off while equities were basically unchanged.

This is in between our growth optimism and liquidity tightening regimes, which is where we probably ought to be after a period of growth optimism.

Using ACWI to measure global equities, we just squeak into the growth optimism regime, which is consistent with copper rallying strongly. That makes it 4 out of 5 weeks in growth optimism on a weekly basis.

On a daily basis though we vacillated between liquidity easing and liquidity tightening last week. Indeed if we look at my liquidity pricing indicator, we see that stocks were basically just trading off rates.

High inflation prints on Tuesday and Friday were largely responsible for tightening, while weak retail sales and some soothing comments from Fed officials resulted in easing on the other days.

The reason we ended up in growth optimism was international equities, led by China.

This is presumably why copper had a strong week too.

Looking at the holdings of the China ETF FXI, it was consumer stocks which led the way higher. Most notable was that the best performing stock was 1880. 1880 is the ticker for China Tourism Group Duty Free Corporation Limited.

This must be telling us that the important New Year travel week in China was a busy one. Indeed official data showed that rail trips increased by about 60% compared to the same week in 2023. A cynic might say that the Chinese are all stuck

driving EVs that are useless for long trips so they have to take a train. However hotel reservations also increased by about 60%, so it looks like the increase in travel is real. There appears to have been corresponding increases of purchases of gifts, but box office receipts are not strong, so there are still some signs of frugality among Chinese consumers.

On balance though, I think we have to take the data on strong travel seriously. Chinese messaging recently has been trying to instill confidence, and this is some evidence that their efforts are having an effect domestically. I think the banks are still in trouble from being asked to help fix the property sector, but consumer stocks could do well, given the amount of pessimism priced in.

Perhaps the biggest problem for the Chinese banks is that the prospect of Fed cuts became more distant this week. The basic point is that the Chinese would like to be able to ease monetary policy aggressively, but if they do so before the Fed starts cutting rates then their currency will plummet. This will shake whatever nascent consumer confidence there is.

The question then is whether the higher than expected CPI print from January is a blip or something more lasting. Well firstly it doesn't appear to have anything to do with the disruption to shipping in the Red Sea. The main reason why inflation was so high was the high cost of rent, with secondary reasons of higher car insurance and air fares.

High rent inflation is a result of the unusual housing situation where new mortgages are unaffordable, but house prices remain high because there is no supply. This situation is not going to change soon, so I think that landlords will continue to have pricing power for now.

Higher car insurance and air fares could both be attributed to the premature growth of EV sales. Insurance is highdue to a lack of servicing infrastructure while demand for air travel could be high in part due to a lack of charging infrastructure. The growth in EV sales appears to have slowed, but they are still going to become a larger part of the fleet so these factors too will remain.

Energy costs were relatively contained in January, but if Chinese demand for travel is increasing, this might well start to put upward pressure on inflation too.

So I wouldn't bet on the Fed cutting any time soon.

Does this mean it is time to get short stocks?

Well this week was actually quite unusual in that US equities sold off, international equities rallied and the Dollar also rallied. This combination has only happened in 10 weeks since 2015. It is more typical of a period where interest rates are low everywhere and currencies are the primary mechanism to transmit monetary policy.

In recent years this hasn't been a signal of impending doom for the equity market. I think that all we're looking at is some reallocation of capital away from US and into international equities. Asset managers have been selling EUR and JPY in

futures, which could be a result of hedging positions in European and Japanese stocks.

A neutral stance on equities may therefore be appropriate.

Last week in the sectors I was looking for staples to outperform and sold materials against this to take a bearish view on China.

This obviously worked quite poorly, with retail sales coming in weak, and Chinese related assets rallying.

I already told you last week which sector I would be selling this week, and it is financials. As a reminder, financial stocks tend to sell off this week after bonus grants have been made.

Against this I'll buy 50% technology and 50% materials. The idea here is that if we continue to get a China led rally in international equities then materials will continue, but otherwise a rally in stocks will probably be a result of the dip in

technology being bought. An alternative would just be to buy SPY, although that is more heavily weighted to technology.

At the industry level last week I thought the dip in URA would be bought, and wanted to sell gold.

URA was again among the laggards, although it hasn't broken trend line support yet so I still think a resumption higher is likely. Gold did test lower after CPI, but didn't get any follow through so it looks like it is going nowhere.

The biggest laggard this week was the cloud ETF SKYY. This is a topic that I touched on on the forum on Tuesday. The main point is that in the current capex cycle, companies are buying hardware, and moving away from cloud providers. If you want your own custom chips, then obviously you're going to want to have your own computers rather than someone else's.

I think the cloud will continue to lag behind hardware manufacturers as a result.

Also at the industry level, I think banks are going lower this week on inflation risks.

The VIX moved higher last week, on what looks like demand for puts.

It remains relatively low, but is distinctly trending higher at this point. We're clearly getting closer to the point where we have a more significant correction. I think that for now VIX is still low enough that traders will buy puts rather than sell next time the market wobbles. The time after that though, they could well sell.

Okay next let's talk about our systematic global large cap portfolio.

Last week our portfolio was up 25bps compared to the benchmark being down 2bps. We're now up 8.4% on the year compared to 5.9% for the benchmark, which is the MSCI World Large Cap index.

It was our new positions in MELI, PLTR and ALGN which gave us the positive return while TEAM and CCL offset this.

TEAM seems to be a cloud problem, while cruise lines may be getting hurt by demand for air travel. As I talked about last week, I think ALGN is in a great place and is a good long term prospect.

This week we are moving to neutral, which means exiting our high beta stock portfolio and replacing it with the index ETF ACWI.

I must say I'm glad that this is the signal that the model came up with. NVDA reports earnings this week, and after the run it has been on in 2024 there should be a fair bit of volatility. No-one seemed to be interested in selling NVDA last week, so it could just as well jump up as down. However any volatility could potential trigger a momentum reversal, and so I think it is better to be out of our momentum stocks, while still staying invested the market.

WMT also reports this week, which should tell us more about the health of the consumer.

Finally, this week there appears to have been a big buyer of PFE calls at 26 for next week. This looks like someone trying to buy in size without moving the market too much, which tells us something about demand for PFE at these levels.

Okay so to summarize, we're neutral this week and will sell our stocks in favour of the index ETF ACWI.

In the sectors I like selling financials against materials and technology. I think banks are going lower this week, and that cloud stocks will underperform hardware.

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