September Commentary

Through August our year-to-date net weighted average return was +4.99%. Our net average return by strategy:

Conservative: +4.26%

Balanced: +4.92%

Growth: +5.72%

Since 2015, we have generated a net weighted average return of +62.09%.

Market Update

It has been said that bull markets end in one of two ways: They climb the wall of worry until there is no more worry and the markets run out of steam as widespread investor euphoria exhausts the availability of the next marginal buyer. Alternatively, a negative shock with the power to destroy global GDP in the magnitude of trillions of dollars comes out of nowhere and surprises everyone, leading to a mad rush for the exits.

In March 2020, the world experienced the second of these two alternatives, which thanks to swift action by policymakers meant the swift crash in financial markets was stopped quickly and markets have been on an upward trajectory ever since. So where are we now? Here is a quote from the top article that I pulled up on the Bloomberg Terminal this morning:

“As investors brace for the Federal Reserve to wind down its stimulus, fears are mounting about slowing economic growth, elevated inflation, supply-chain bottlenecks, a global energy crunch and regulatory risks emanating from China. A near –record technical streak for the U.S. equity benchmark has some bulls worried that a sharp pullback is overdue.”

Joanna Ossinger & Cormac Mullen, Bloomberg News

Objectively, that does not sound great.

I think we can agree that investor sentiment is not overly optimistic about where we are today. So do any of these factors have the potential to create a massive negative shock to the global economy and cause markets to crash? The short answer is probably not, but it is worth exploring the situation and looking beyond the headlines and hyperbole.

Rather than comment on the all of these fears, I want to focus two in particular that have been grabbing attention over the past few weeks: regulatory risks from China and the global energy crunch.

A lack of imagination – Evergrande and China’s “Lehman Moment”

I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail.

Abraham Maslow

On Monday of last week, the story of the potential bankruptcy of China’s largest property developer, China Evergrande Group, became the center of attention and caused a significant shift in sentiment and increased selling.

Burdened with over $300 billion in liabilities, it was not long before experts were warning that Evergrande could cause a credit contagion that threatens the global financial system. China was experiencing its Lehman moment.

There are more than a few problems with these claims. For one, the lack of imagination is disappointing:

We have heard this somewhere before…

On the one hand, it makes sense to draw parallels to a possible insolvency event in China’s real estate sector to the 2008 bankruptcy of Lehman Brothers because of the collapse of the subprime mortgage market. It is simple and gets the point across: real estate, insolvency, knock-on economic effects.

But language has meaning. And drawing parallels to the biggest financial crisis of our lifetime, one that was defined by the opaque credit default swap market that by the end of 2007 exceeded $62 trillion in outstanding liabilities, is lazy and irresponsible.

Yes, this is a potentially serious issue, given the size and importance China’s real estate sector and Evergrande’s prominence. Its default is going to cause short-term pain for the financial system and economy. And it does not help that growth in China was already slowing due to tightening policies.

But the Evergrande crisis is not due to market-induced stress or euphoria running out in China’s real estate sector. It is the result of government action meant to control financial risk and speculation in housing markets by imposing strict leverage limits on property developers. If managed properly, its negative impact can be limited.

Are we going to freeze this winter?

If you haven’t heard, energy has gotten a little expensive.

The spot price of natural gas is up 400% since the start of the year. Electricity prices in turn have jumped 250%. Brent crude oil touched $80 earlier this week for the first time in almost three years. Blackouts and shortages in China have forced companies to restrict energy usage.

One things that the pandemic has revealed is how much we take for granted in how the economy functions, and nowhere is that more apparent than in the energy sector. While we turn our lights on and off at the flip of a switch, things happen much more slowly the further up the energy chain you go. Even small adjustments to production or supply to one region over another can have a massive impact on the marginal price of energy.

Last winter, Europe, Russia and Asia experience a colder weather than the average over the past 40 years, leading to a severe drawdown of natural gas reserves. A confluence of factors has prevented those reserves from being refilled: faster than expected economic recovery drawing demand, delayed maintenance due to the pandemic restricting production in Europe, an unexpected drop in wind power during the summer that necessitated burning gas, lower than expected imports from Russia (which is also refilling its own reserves), just to name a few.

So as winter gets closer with prices at record highs, the cacophony of calls for an energy crisis grow ever louder.

Yes, all of these factors are keeping prices up and pulling gas away from Europe, but that does not mean that we risk running out and freezing this winter. Storage is still filling at a steady rate that should make sure that even in a cold winter the situation will not spiral out of control.

Higher gas prices will force disruptions to industrial users and force power to switch away from gas or shut down for a period, as we have already witnessed with fertilizer producers in the UK. There are real economic consequences for the situation we find ourselves in, but they are relatively manageable.

Governments will continue to show surprise and shock in the face of these price spikes and look for people to blame, while market participants will diligently watch what is going on, waiting for the next shoe to drop.

In all likelihood though, the current gas prices already reflect much of the fear that we are in for another long cold winter. That does not mean prices cannot go higher from here, but certainly not enough to bring Europe to a halt.

Global financial markets will continue to face new uncertainties or experience negative shocks that, at the time seem likely to bring things crashing down. Most of the time, these crises will pass without any serious repercussions.

As for us, we will continue to work diligently to try to determine what the true risks are and where the biggest rewards lie.

On behalf of our client portfolio management team, thank you for your continued trust and support.