I spilled a lot of ink warning that a large portion of the market was playing a “bigger fool” game – investors were buying overvalued stocks and otherwise worthless cryptocurrencies and NFTs, hoping to unload them on bigger fools (I wrote about it in January). Over the last six months the market started to run out of fools. Higher interest rates and inflation returned some rationality to the market. There is a saying on Wall Street: Bear markets return money to its rightful owners. This is what we’ve been experiencing lately.
Several clients thanked us for the placidity of their portfolios in otherwise turbulent times and told us we should do a celebratory dance. I’d be lying if I told you that seeing our portfolio remain relatively stable while many “greater fools” stocks decline as much as 80% doesn’t bring us a certain satisfaction.
But we are not doing a celebratory dance, for several reasons:
First, we realize that there are real people with shattered hopes and dreams on the losing side of what we call the dotcom 2.0 burst bubble. We sincerely feel bad for them.
Second, the last thing we want to do is to let our relative success go to our head or suggest to us that we have got all of this figured out. I don’t want my teammates at IMA to become less vigilant and lose what one of our IMA clients, who has become a personal friend over the years, calls “Russian Jewish paranoia.” He tells me that he sleeps well at night because his money is run by a “paranoid Russian Jew.” Okay, there is only one “paranoid Russian Jew” on our investment team – yours truly. But this healthy dose of paranoia – looking not just at what is in front of us but thinking about risks lurking around the corner – has deeply embedded itself into IMA’s DNA.
As you’ll see later in the letter, the list of things to be worried (paranoid) about is only growing. In fact, when you are abuzz with feelings of either success or failure is when you want to tighten your process to make sure emotions (and over- or under-confidence) don’t mess with your head and decision making. We are constantly double, triple checking every stock we own to make sure our thesis on each is intact.
And third, the “greater fools” wreckage is likely going to turn a lot of ex-darlings, which investors could not get enough at much higher prices, radioactive. These stocks will have the stink of an uninvestable asset class, at least for a while. Just as people confused great companies with great stocks on the way up, they’ll mistake bombed-out stocks for bad companies.
To be fair, some of the stocks that are crashing to mother earth today are bad businesses, while some are mediocre and some are excellent. A massive change in sentiment usually waters down the distinctions between them and they all are treated equally as radioactive waste. Our job is to carefully go through the wreckage and identify great businesses that are trading at great prices (with a significant margin of safety). This recent pile-up has given us a larger universe of stocks to study – we welcome the opportunity.
Inflation is everywhere
The war in Ukraine will likely pour more gasoline on the already raging inflationary fire, threatening to send the global economy into stagflation. Stagflation is a slowdown of economic activity caused by inflation.
Before we go into the messy entrails of stagflation, let’s review what is going in the US and global economies. I discussed some causes of inflation in previous letters, therefore let’s focus on the new culprits.
First, higher commodity prices. Even before the pandemic, the supply of oil and gas was getting constrained by a decline in investment caused by low oil and natural gas prices and petrocarbons falling out of favor with the ESG cult. The pandemic caused a further falloff of investment in the sector. Russia’s invasion of Ukraine forced the world to excommunicate the third largest producer of petrochemicals from modernity.
The oil market has slightly different dynamics from the natural gas market. Oil is a fungible commodity and is easily transported by tankers, and thus it can be (relatively) easily redirected from one customer to another. For instance, if China used to buy oil from Saudi Arabia and now buys oil from Russia, the oil that China stopped buying from Saudi Arabia can now be bought by Germany. That said, Russia produces heavy crude and the Saudis light crude, so refineries need to be reconfigured, and that takes months.
Sanctions on oil will only have an impact on the Russian economy if everyone stops buying Russian oil. If all countries embrace sanctions, then about 8 million barrels of daily oil exports will be removed from the market. That is a lot of oil, considering that world consumes about 88 million barrels a day.
It is unclear if China and India, the largest and third largest importers of oil, will go on buying significant amounts of oil from Russia, as doing so risks damaging their relationships with the West. Neither country wants to be told what to do by the West. They have their own economic interests to consider, but their trade with US and Europe is significantly greater than it is with Russia.
It seems that both countries have been slowly distancing themselves from Russia. For example, the Chinese credit card network UnionPay has quietly cut off its relationship with Russia. Though Russia has an internal credit card network called Mir, since Russia was cut off from the Visa and Mastercard networks and now from UnionPay, Russians have no easy way to spend money when they travel outside of Russia.
This war was a horrible infomercial for Russian weapons, and there is a good chance India may decide to switch to Western weapons, which would bring it closer to the West.
In the short term, the supply of oil from Russia to the world market will likely shrink; it is just hard to tell by how much. The demand for Russian oil has clearly declined, as the (Urals) price is down 30% while global oil prices are making new highs.
Long-term, the oil-supply picture from Russia looks even worse. There was a good reason why Western companies participated in Russian oil projects. A great love for the West was not the motivator that drove Russia to share oil revenues with BP and Exxon. Western companies brought much-needed technical expertise to very challenging Russian oil and natural gas fields. With the West leaving Russia, long-term production of oil and gas is likely to decline, even if China and India continue buying Russian oil and gas.
Let’s turn to the natural gas market.
Call me Mr. Obvious, but I will say it anyway: natural gas is a gas and oil is a liquid. Shipping gasses is much trickier than shipping liquids. Natural gas can be transported two ways: by pipelines (the cheapest and most efficient way, but they take years to build) and by LNG ships. LNG stands for liquified natural gas – the gas is cooled to -260F and turned into a liquid. Western Europe, especially Germany, is heavily reliant on Russian gas, which today is transported to Europe through pipelines.
Side note: In the future, when you put your livelihood in the hands of well-meaning politicians (especially if you are a resident of California), just remind yourself that German politicians, in their fervor to go green, abandoned nuclear power, which produces zero CO2, switched to intermittent “green” wind and solar (and fell back on dirty coal) and tied their future to a shirtless Russian dictator. I discussed this topic before – you can read about it here.
Some smaller European countries are already abandoning Russian gas. Germany and Italy, the largest consumers of Russian gas, promise that they can delink themselves from Russia’s gas in less than two years. This trend will continue; it just won’t happen overnight (or in two years). Call me a skeptic, but I think it will take a long time for Europe to completely abandon Russian natural gas, as building LNG terminals takes years, and so does increasing natural gas production.
Oil and natural gas prices will likely stay at elevated levels or even go higher over the next few years, and the US production of natural gas and oil will likely have to go up substantially. This will benefit some of the companies in our portfolio, which I’ll discuss in part two of the letter.
The second new source of inflation is food. It’s a significant concern for us. Russia and Ukraine produce about 15% of the world’s wheat supply. They account for about one third of global wheat exports (or about 7% of global wheat consumption). Russia has slapped a ban on wheat exports. Ukraine’s planting season was likely disrupted by the war. The global wheat supply may decline by as much as 7%. This sounds like a large number, but it is not outside the historical volatility caused by droughts and other natural disasters, which have historically driven up wheat prices by a few percent.
This is not what worries us.
We are concerned about the skyrocketing prices of nitrogen and potassium fertilizers since the beginning of the war. Russia and Belarus are the second and third largest exporters of potash used to make potassium fertilizer (Canada is the largest producer). Nitrogen fertilizer is made from natural gas. Natural gas prices are up a lot. High fertilizer prices will lead to significant increase in prices of all calories, from corn to avocados to meat.
Food inflation impacts poor countries and the poor in wealthy countries disproportionately. US consumers spend 8.6% of their disposable income on food (down from 17% in the 1960s). In poor countries this number is significantly higher. For instance, the average Ukrainian spends 38% of disposable income on food. Food prices have been going up, but we are afraid that we ain’t seen nuthin’ yet.
The third new source of inflation is higher interest rates, which make all financed goods more expensive, from washers and dryers to cars to houses. Over the last decade we got used to cheap, abundant credit. If inflation continues to stay at elevated levels, cheap credit will become a relic of the past. Mortgage rates have almost doubled from the lows of 2021 – 30-year mortgages are pushing 5.1% as of this writing. The median home price is $428,000 (up from about $330,000 before the pandemic). The interest increase from 2.7% to 5.1% will cost the average consumer $7,000 a year, or 12% of the total median income of $61,000. About a third of the country doesn’t own a home but rents. Rents increased 11.3% in 2021 and continue to rise in 2022.
Now, if you add the increase in energy prices (gasoline and heating), food inflation, and the higher cost of anything that has to be financed, you’ll see how the consumer is being squeezed from every direction. Government-massaged inflation numbers show a 7–9% increase in prices. We think these numbers are low, despite their having set multi-decade records. A more realistic number is much higher, as is suggested by import and export inflation numbers, which are not adjusted by the government and are running 12–18%.
Supply Chain Problems
Another culprit responsible for higher inflation is supply chain issues. China is going through another partial shutdown of its economy. Putin made us forget about the coronavirus, but the coronavirus did not forget about us. China – the initial source of Covid-19 – has suffered among the lowest per capita numbers of infections and deaths from Covid. The downside of this is that China has very low herd immunity. And though China has locally-made vaccines, they are not very effective, and China refuses to import Western vaccines.
Chairman Xi banked his reputation on a “zero Covid” policy. Today this policy is being sorely tested. China is shutting down cities that are the size of a largish European countries to keep the virus from spreading. Since China makes a lot of the stuff we consume, they’ll make less of it. “Transitory” supply issues from China will persist and add to inflation.
Finally, the War in Ukraine has accelerated deglobalization. Globalization was a great deflationary tsunami. The pandemic exposed the fragility of our vaunted just-in-time inventory and global supply system. The war in Ukraine reminded the West that the global trade system is built on the assumption that we don’t go to war with our trading partners. The war in Ukraine broke that assumption and accelerated the pace of selective deglobalization, which will lead to higher prices of everything in the long run.
This brings us to stagflation.
Stagflation may be our next stop, but that is not what I am worried about.
If rising costs (inflation) were predictable, then wages would match this increase and the impact on the consumption of goods would be benign. This has been anything but the case lately. Though wages have risen 3–4%, they significantly lag official inflation numbers and are left in the dust by actual inflation. And this is before high interest rates and high fertilizer prices caused by the war in Ukraine hit food production, food prices, and consumer wallets.
As inflation outpaces the growth in wages, consumers find themselves poorer and thus their ability to buy discretionary goods declines. This is how inflation turns into a headwind for economic growth, and it’s called stagflation. The impact of inflation on the economy will depend on the differential between the inflation rate and wage growth. The higher the difference between these two numbers, the more inflation slows down the economy, causing stagflation.
We are not worried about a recession.
Recessions are natural cleansing mechanisms for the economy. Over the course of economic expansions, companies start to drip with fat. Their processes loosen, they hire too many people, they accumulate too much inventory. Recessions are nature’s diet plan for companies that need to shed some fat. Recessions are not fun (especially for those who lose their jobs), but historically they have been short-term interruptions between economic expansions.
To see what the economy and stocks will do during a high-inflation environment, you can look at what they did in the 70s and 80s. Or you can just look at the last 20 years and invert.
Over the last twenty years we had declining interest rates and low inflation, which in turn caused never-ending (with only short-term interruptions) appreciation of housing prices. This put extra money into consumers’ pockets and drove prices of all assets up (especially stocks), which in turn boosted consumer confidence, as people felt wealthier and were encouraged to spend.
Credit flowed like beer at a Saturday night fraternity party. Stock market multiples expanded. Despite government debt tripling, the interest payments on our debt as a percentage of the Federal budget are near an all-time low. Low interest rates and government spending are stimulative. Now, invert all of that and you get anemic long-term economic growth and contracting stock market multiples. The tailwinds of the past turn into the headwinds of the future.
Over the last 20-plus years, every time the economy stumbled, Uncle Fed bailed it out – he lowered interest rates, injected the market with liquidity, and the economy and market were back to the races. The pain from which we were spared did not go away; it was being bottled up in the pain jar. This jar has nearly run out of room and is now leaking. Today, to prevent inflation turning into hyperinflation, the Fed will have to do the opposite of what it is used to doing in the 21st Century – it will be raising rates.
I have been doing this long enough to know that the economy is a complex, self-adjusting mechanism, and thus the grim picture I have painted in this and previous articles may or may not play out. One should never underestimate human ingenuity.
However, our job is to prepare for the worst, and hope for the best. Since hope is not strategic, we are focusing all our energy on the preparing part. Considering that the dotcom 2.0 bubble still has plenty of room to deflate (we rifled through the wreckage and did not find anything we liked), high overall stock market valuations, and grim global economic picture, we are continuing to position our portfolio very conservatively.
We have intentionally positioned the portfolio for a low-growth environment. The majority of our companies don’t march to an economic drummer. In other words, their profitability should not change much if the economy goes through a protracted contraction or low (real) growth. Yes, the market is expensive and the economy is rife with uncertainty; but we don’t own the market, we own carefully selected high-quality, (still-) undervalued companies.