The Perils of Closed Circle Thinking

1880 words – a 4 minute read.

One of the more amazing things about a quite amazing few weeks is the degree to which President Putin, widely considered a master strategist (I confess to thinking he was) has been wrong about virtually everything. From his war planning to his idea that Ukrainians would greet Russians as friends & brothers, to the reaction of Europe, Germany and the US & most visibly to the speed and power of modern communication.

He has unwittingly provided a master class in the perils of closed circle thinking – of being insular with little to no diverse input. As an isolated, single decision maker, speaking only to yes men, he has been revealed as completely out of touch. It shows how rapidly the world is changing and how powerful the combination of speed and instant communication can be on a local/global basis. The Arab Spring gave us a hint but the interplay between Putin and Ukrainian President Zelensky has been like night and day. The contrast between Putin and Pres. Biden’s SOU speech is also quite telling.

Social media has been leading the process, not just recording & distributing it. It is pushing politicians to act, faster and more aggressively than they would have most likely moved otherwise. It has provided further validation to the Age of Speed we have written about at length, the push for diversity in society as well as for the idea of being “woke” enough to have concern for your fellow humans. 

The EU’s reaction serves to validate our core Tri Polar World framework – our thesis that regional deepening and integration in Asia, Europe and the Americas is the way forward. The EU will certainly deepen integration on defense and energy security. Here is EU leader Ursula von der Leyen: “European security and defense has evolved more in the last six days than in the last two decades.”

It is also a reminder for us as investors to keep an open mind and be alert to the perils of our own closed circle thinking, whether it is to do with our circle, our inputs, a position one really likes or a portfolio structure one feel sure to work out. These are tricky, tricky times with the speed of change threatening to upend almost every decision making process. Keep it simple, be like water, trust in the process & be calm.

Speaking of process, here at TPW Advisory we had our monthly model portfolio review session this week. Happy to note both models, our Global Multi Asset (GMA) and TPW 20 thematic model, outperformed their respective BMs by considerable amounts over the latest period. This is with both being fully invested. Recent adds to the GMA (PICK, EWZ, GDX) were all near the top of the best performer list while in the TPW 20, 16 of the 20 ETFs outperformed their BM, suggesting that investor appetite for thematics may be shifting. Curious about what changes we made this month? Reach out to learn more about our Model Portfolio Delivery Service (MPDS).

The diversified nature of both portfolios allows them to ride through even the volatility we are seeing now, with UST vol the highest in years, sustained US equity VIX readings well above 30 and a Commodity sector that has had its best start to the year since 1915 according to BofA and its best three day run in over 15 years. As a result, commodities, especially oil, are widely overbought (GSG’s 14 day RSI in mid 80s, WEAT at 81) and should be approached with caution, especially since an Iran deal would seem to be imminent. Broad Commodities are at their strongest backwardation ever.

So where do we stand? Here is an anecdote that I think speaks volumes: we had our monthly call with my ex MS buddies, all senior, all active in the markets and I was the 4th speaker as we went around the (virtual) table. The 4th speaker but the first to utter the word Covid. 

I remain of the view that markets are focused on the wrong issues – at least for an investor whose time frame extends beyond days. Market attention is focused on Russia, the Fed, inflation – recession fears in that order.

My lineup is Covid ebbing, the Fed, Russia. LPL provided a great post WW2 table of US history showing that markets tend to discount conflicts over the course of a month or two with average drawdowns of 5%. Europe is now down close to 20% from early Feb levels, its banks are down 24% and KRBN, the carbon ETF, is down 28%. The US is down much less and Asia, especially China, is down the least over the past month.

Covid ebbing is THE single most important factor and yet it is getting the absolute least attention. This suggests an opportunity is brewing in risk assets. Markets hate uncertainty and right now uncertainty is very high. Once some resolution in Ukraine becomes apparent that uncertainty will fade. It seems likely, if not probable, that some sort of NT resolution will come within a week or two. The costs to Russia are mounting by the day, from casualties on the ground to rapidly growing economic isolation and pain. With its reserves frozen and energy X dwindling the time frame is short for when ordinary Russians really start to feel the pain. Time is not Russia’s friend; Putin’s clock is ticking.

JPM notes that roughly 65% of Russia’s oil exports are not being bought given sanction, insurance fears, even with Urals crude selling at a 20-25% discount to Brent. A  Russian energy shut off – almost impossible to consider 2 weeks ago - is now a live issue and thus one that is rapidly being priced into global risk assets, suggesting we are quite far along the discounting process. Nuclear related headlines this morning further suggest we are quite far along the discounting process. 

This is especially true given that Europe is entering this environment in a reasonably strong economic position – record low unemployment, solid PMIs (Feb Composite @ 55), Covid reopening, strong fiscal spending etc. GS suggests that an EU growth reduction of more than 0.5% has already been priced into risk assets and notes that EU equities trade at under 13x earnings, a significant discount to historical levels and a large discount to the US. It expects moderate returns over the next 12 months. 

Widening our view, Russia’s invasion has taken an aggressive Fed off the table as we wrote in Tag Team. Chair Powell’s testimony this week and market pricing have served as confirmation. Covid’s ebb and the resultant global reopening coupled with a priced in Fed is an attractive combination for risk assets that we shouldn’t lose sight of amongst the war headlines. Global growth remains unhindered by Russia’s actions as evidenced by Dr. Copper breaking out to new ATHs and the A$/Yen cross pushing towards new 52 week highs. 

Growth is solid around the globe – whether the US, Europe or Asia. HIS Markit notes that: “manufacturing conditions in ASEAN improved strongly in February with Manuf PMIs among the highest on record.” China’s February PMIS were BTE across the board. JPM believes that should oil average $150 for a sustained period of time that it would reduce global GDP by roughly 1.5% - note that is 30% above current elevated levels. In the case of the US, Moody’s Mark Zandi has shaved his 2022 GPD estimate from 3.7% to 3.5%, still well above pre Covid trend levels.

We continue to expect and are starting to see LTE inflation data and BTE growth data. Here’s Pantheon on the US reopening: “The recovery in the near real time indicators of US economic activity in the past couple of weeks has been startingly rapid”. Today’s US jobs report provides just the latest example with BTE jobs # coupled with upward revisions to past months so solid for growth and lower than expected AHE, coming in at 5% y/y vs a 5.5% forecast, so LTE inflation data reminding all that the much feared wage price spiral may not be automatic. ULC in Q4 came in at a 2.75% annualized rate – further support for lower than expected inflation data. Note that 2 year forward inflation breakeven for the US sits at 2.5%, beyond that the rate falls to 2.1%... markets as opposed to headline writers are quite sanguine about medium term inflation.

At TPW Advisory, the focus is on the Ukraine endgame bc we think it could come quickly, perhaps in the coming weeks. Putin doubling down seems to be where most are at with a corollary that sanctions won’t influence his thinking. Having been wrong on the invasion I hesitate to voice an opinion but of course I have to have one and mine is that both those views will prove wrong. The longer this lasts the greater the risk Russia ends up as a Chinese vassal state. Alternatively, China sets up talks, Putin employs his total internal media control to spin de escalation as a W and the US – EU provide an off ramp for some sanction relief as Russian troops pull out. Key point though is the reduction in uncertainty – almost any outcome will lead to a risk asset bounce.

Beyond the immediate near term, Covid’s ebb is the most important issue – bullish for growth, low inflation and risk assets. The Fed is priced in and the sell off over the past weeks – European equity is down all but one week ytd, is throwing up bargains on any decent time frame – some that come to mind are JETS, EUFN (JPM sees broad sector exposure to Russia/Ukraine at <1% BV), KRBN etc. 

Sentiment is horrible (read bullish), Bespoke notes that SPY forward PE has now fallen below its 5 yr. average for the 1st time since April 2020, buybacks are huge, positioning is much cleaner given weeks of selling and huge short positions in Tech (biggest since 2018) and in thematics like ARKK (record short). JPM notes that thru the Q4 2021’s US earnings season, 2022’s forecast EPS #s have risen slightly while given the recent pullback the S&P now sells for roughly 17x 2023 EPS estimates of $248. A Spring risk asset rally remains quite feasible with March – April the two best months of the year for US Value.

Don’t go to sleep on China; it’s Two Sessions meeting is this weekend – look for more support for the domestic economy. Post the “Two Sessions” China could have a role intermediating talks between Russia and Ukraine as an acceptable 3rd party to both. Putin doesn’t have time for siege warfare, besides doing to Kyiv what was done to Aleppo or Grozny will ensure Russia’s elites & their families will be global pariahs & seems unlikely in todays’ global communication at speed age. I agree with Sir Lawrence Freedman, one of the world’s leading authorities on war and international politics: “Putin doesn’t have inordinate time to sort this out; the economic hardship is just starting to be felt; he can’t let this drag on for weeks and months which is how long sieges can go on… so time’s a real problem for him”.

Stay focused my friends.