AI's Effects on Investing, Get Ready for the New Market Coming

The era of low interest rates is over. Time for a new approach

Jason Taylor - Ronin Trading Partners

The Great Wave of Kanagawa pictured above, by the Japanese artist Hosukai, is one of the most reproduced works of art in the world. First in his series 36 Views of Mt Fuji, this wood block print was made in 1831 just as his country was opening up to the west. Renowned for its use of european inks and one point visual perspective while still adhering to the traditional Japanese aesthetic. Made for mass consumption, its visual symbolization of the chaotic change a country faces as it opens up to a wider world is just as applicable today. We may live in 2022 but the circumstances seem similar. Netflix, our purveyor of mass consumption entertainment, is showing ever more international content to viewers (Squid Game, Money Heist, RRR) because it's successful. Pop music increasingly crosses international borders. Politically, countries around the world are wrestling with questions of cultural change, with liberals seeking a global outlook and conservatives turning inward, more focused nationally. The fact that this is happening across the globe, no matter the region or political orientation shows this problem’s grown to tsunami proportions.

Hosukai saw it, artists have a way with that. The established order that centuries earlier fought bloody wars to quell regional fiefdoms into a nation state and established an extended period of peace was ending. The outside world was encroaching, coming at them like a great wave and the country’s economy and political order would never be the same, except by figurehead (more on that later). Today smart money managers and corporate chieftains see too. They are all repositioning if you watch closely. They’re repositioning to survive and prosper for the next investing era. The pros can recognize the death of a market when they see it. It’s in the increased volatility, the large swings up and down without any fundamental change. It's the cacophony of financial pundits screaming the Fed is wrong, not wanting the party to end. The smart money is gearing up for the next bull market because they know the current one’s run its course. You need to as well.

Changing Sentiment

True changing market sentiment is a rare thing. In over 25 years investing & trading financial markets I think I’ve seen maybe 2. Off the top of my head I’m thinking of Federal Reserve chairman Alan Greenspan telling folks he was stepping on the gas in the wake of the 9/11 attacks. At the time we were dealing with the Dot Com bubble and the prevailing sentiment was higher rates were needed to put the brakes on all the “internet stuff”. Greenspan in his ever cryptic manner, announced a pivot, and was going to start lowering rates. Little did we know it would start a trend lasting over 20 years. The other one was Bernake in the height of the 08-09 Financial Crisis telling anyone who’d listen, the Fed was buying up anyone’s debt (that’s a corporate anyone, by the way) and replacing it with crisp clean Treasuries. They even marketed a name for it “Modern Monetary Theory or MMT for short. It was Bernanke’s new iteration of the game that gave us the bull markets of Obama and Trump. The chattering class in the financial media, always looking backwards, complained all the way up, Obama would ruin the dollar, Trump would shatter our trade relations. Capitalism kept on chugging, giving us the biggest bull market in generations.

Higher Interest Rates

Six months ago we had another one. Current Fed chair Jerome “Jay” Powell stated he’d start hiking rates and reversing the Fed’s balance sheet, effectively reversing the policies of both Greenspan & Bernanke. The markets, ever forward looking, sniffed it out three months earlier, peaking in January of this year and have been falling ever since. Again the chattering class can be heard complaining, ‘Powell will cause a recession’, ‘He should only hike a few times and stop, the economy is too precarious then insert the current economic boogeyman there. Meanwhile, we’re five rate hikes in and Jay shows no signs of stopping.

One of the underappreciated effects of higher interest rates is its ability to deter economic ventures because they’re just not profitable enough. Why spend time analyzing a business, taking on risk, if the risk free rate (investing in a Treasury) is higher? With every rate hike, the profitability hurdle gets that much higher. Startups will face a much harsher economic climate and established corporations will be reluctant to take on new projects with risks. I think we’ll hear a lot more CEOs talking about “getting back to fundamentals”.

Rising rates also hamper a corporation’s ability to goose earnings through financial tricks. Gone are the days when a Fortune 500 CEO could punt his debt to the Fed, get back Treasuries, (that’s the MMT working) then use those treasuries as collateral to take out loans to buy back the company stock. That nifty trick has helped countless companies boost their stock price. The game has gotten harder and only the real players will succeed. You’re gonna have to pick your spots, find specific names in an industry if you hope to profit. Buying the index, and waiting; habits that were successful in the previous bull run, won't work in this next market. There’s no tide to lift all boats, in the form of falling interest rates. Quite the contrary, the tide is going out, a prelude to most tsunamis.

The Fed’s permissive monetary policy of low interest rates for homebuyers got them into the house of their dreams. The policies for corporate America were even more generous, allowing anyone with a Fortune 500 corporate charter to turn in their debt in exchange for pristine newly issued Treasuries, sadly those days are over. Folks can no longer count on the Fed backstop their debt allowing them to borrow out of their mistakes. It’s a new day, new Fed. But it’s just not the Fed, it’s the European Central Bank calling for a minimum global corporate tax. It’s the Chinese Central government, reining in tech giants. Worldwide folks are seeing their balloons popped.

Deglobalization

The new market that's washing over us is more than just one of higher interest rates, we’ve dealt with that before. This market is also unwinding the two other deflationary forces we’ve come to rely on, globalization and low energy costs. The behaviors learned during quarantine, less traveling, emphasis on video conferencing, relocating supply chains closer to home, may all be preludes to come in a world of higher energy inputs and deglobalized supply chains. When America then later Europe opened up for business in the spring and summer of 2021, China remained shut to the outside world, deciding to focus inward. Their international ports remained closed, international flights scarce, major cities still remain in lockdown as of writing. The global supply chain took notice, China didn’t want to play anymore. They’re taking their ball (factories) and going home. Global Capitalism took notice, Apple and Google announced manufacturing pivots to India, Malaysia and Vietnam. And I think Xi Jinping is just fine with it.

This current trend of deglobalization has been a long time coming, starting with Obama’s pivot to Asia in November of 2011. A ‘pivot’ as in a change of focus from the Middle East and its energy extraction to Asia and its technology creation. China, while not happy with Obama’s actions, were mollified by his diplomatic words. Trump, not so much. His imposition of tariffs on steel, solar panels and washing machines were decried by both the left and right as a blunt tactic and ineffective but quietly most have been kept in place by the Biden administration. Biden even announced new restrictions on semiconductor technology. Seems like the only difference is of style not substance.

For the last 25 years the industries of finance and technology have unleashed powerful globalizing forces that have “Flattened” the world to borrow from Thomas Friedman. Today, nobody is surprised at the notion of a person in Africa buying tech goods from Asia, consuming entertainment from the US, paying for it with a bank from Europe and having it shipped to him from a tanker based in the Caribbean. And while our commerce and technology have gone global, our society has not. People aren't as fungible, can’t move around as fast as money or data can. Societies lag.

Instinctively national politicians pick up on this. Playing to the crowd they propose solutions that harken “back to the old days”. Brexit, Trump’s election, Covid response even the war in Ukraine. The left calls it Nationalism the right calls it Populism but the impulses are essentially the same, greater suspicion to globalized approaches, a greater reluctance to “assimilating” into a new global culture. the latest Italian election. That's what will be discussed in China’s upcoming Communist Party Congress next week. Its leader, Xi Jinping is faced with two choices, look for global growth or focus domestically, improving Chinese business and fostering control locally. I’m betting he chooses the latter.

Higher Energy Costs

Here at Ronin we focus on viewing the markets dispassionately, free of any preconceived notions or sentimentalities. I’m not swayed by energy corporation PR attempts to capitalize on the growing popularity of renewable energy. I see it in purely economic terms. Fossil fuels are running out and fast. Management consultant McKinsey sees global demand for oil peaking next year with supplies running out in 30 years, natural gas 40 years. Conversely, in 30 years they see renewables accounting for 80% to 90% of power generation. Energy giant British Petroleum, BP confirms as much, stating in February it was growing its transition growth businesses (bio-fuels, electric vehicle charging, hydrogen and other renewables) to 40% capital expenditures next year. They can see the brick wall of depletion, when the cost of the energy put in is greater than the energy taken out, staring them in the face. In pretty clear terms the CEO outlined how the company would look to rely on high oil prices to fund the transition to renewables and energy generation. Like Hokusai he can see the world changing and he’s looking for firm ground.

Global events will also keep prices high. Just as the pandemic changed how we view our retail supply chains, the war in Ukraine has shocked us into changing how we view our energy supply chains. Europe and Germany in particular will be living out this social experiment this winter, results tbd. But even under the best circumstances I think Germany will rethink its oil consumption deals from Russia. That reworking of energy inputs will be expensive and those costs will bubble up throughout the European economy.

Ok, ok, I hear you, what’s the solution to this new investing environment we’re living in? What should you do? First off, let me say what these words aren’t. They aren’t to be construed as individual investing advice. As the legal disclaimer says below, your circumstances are too individual for me to give effective individual investment advice here. For that contact us below. But what this does serve is an informational template for you to make your investment decisions. A way to make sense of the financial news coming at you from every angle.

Unlearn Bad Habits

The one thing I hope investors take away from this is to unlearn the habits that served you well in a climate of falling rates. In an era of low interest rates if a corporation makes a mistake they can always refinance the loss away later, as long as it meets accounting standards. Those days are over. The end of low interest rates also signals the End of Index Supremacy. Buying the index only works in low interest rate markets where all companies, no matter the sector, are pulled along. For investors to be successful in today’s market they've got to know how to pick their spots. And that requires work.

To give you a general framework, in rising rate environments stocks do better than bonds. With industry sectors like energy, financials, healthcare and info technology tending to outperform the others. Finally at the individual level, look for companies that manage their debt and data well.

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