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Monthly Market Commentary - November 2021

"Running with the devil"

MR. MARKET.

This monthly commentary is a little late. I beg your pardon, but I am sure you have noticed that the end of November and the beginning of December have been hectic days for all of us. The slightly different communication from the Fed, the beginning of tapering, and, more importantly, the resurgence of Covid-19, with old and new variants, caused much higher volatility. Today, it is a sunny Sunday here in the south of Switzerland and I finally got some time to sit down and write few notes. Taking in mind my personal challenging task of not wanting to be repetitive and sounding like a broken record, I was scanning quickly through my last comments. I realized that I never had the chance to write a few words about Eddie Van Halen, the immense guitar hero that sadly passed away last year. Born in the Netherlands but grown up in the US, he has got a place second only to Jimi Hendrix when we talk about innovation in the sound of the electric guitar. Van Halen was not only an iconic rock star from the eighties, an incredible musician and guitar virtuoso; he was also a pioneer in music engineering. This is an aspect of his career that is not much appreciated by the wide public. He spent a lot of time and research on “dialling in” a very peculiar range of distorted frequencies that he labelled “brown sound”. As obscure as it may seem, one of the original tricks he used was to put all the potentiometers of his Marshall amplifier to the max level. In a famous interview he said that he put all the controls to “11” (in reality, the highest level is 10). Now, I do not know if you had ever had the opportunity to stand close to a 100 Watt Marshall amplifier with the controls around 3 or 4. Trust me, it is damn loud. I believe that a prolonged exposure to a maxed-out amplifier of that power can make you deaf. No joking, do not try it at home. I was immersed in such thoughts while listening to “Running with the devil”, a great piece from an early Van Halen album. I realized that, on an aggregate level, this is what we are doing with our portfolios, both private and institutional. Financial markets performance moves in waves, like the music that hits a guitar amplifier. Portfolios react according to the control settings we dialled in to process these waves. These days, I suspect that most of the portfolios have high settings (ours included), too many are maxed out. Frankly speaking, this strategy has paid off handsomely in recent years. The louder, the better. Having said that, who is the “devil” we are running with? In my opinion, it is the market narrative that monetary and fiscal policy will always be at our back, that the rising global level of debt it is not an issue given that fixed income investors will accept rising inflation and negative real rates forever and that, crucially, no valuation is too high when money is abundant and the cost of capital is very close to zero. Remove this narrative and we will have very different numbers on our Bloomberg screens. So, it is in everybody’s interest that this does not happen. Policy makers do not want it, investors do now want it (as long as there is an additional profit we can discount in current equity prices). By definition, the future is uncertain, and we will see if such benign scenario will change for good any time soon. I repeated many times, the most likely endogenous event that would derail current circumstances is a policy mistake by the Fed or other influential central banks and/or governments. I believe developed currency markets (gold included) would signal that there is something wrong. I do not see anything strange right now either in directional movements or “weird” correlations from such indicators. From an “exogenous” point of view, the list of known and unknown unknowns is practically infinite, so the only reasonable approach is to keep our eyes wide open and adapt quickly. Therefore, while we are “running with the devil” with highest risk than normal in our portfolios, the only thing we can do is understanding where we are in the financial market cycle and adjust the “potentiometers” of our portfolios. Thinking on recent months, there are few signs that I find important to highlight. On equities, the market breath has deteriorated. On a global basis, the only outperforming strategy has been an overweight of big US megacap tech stocks. When I say “the only”, I mean it. Outside of a handful of stocks, everything else was left behind, both on a regional and sector level. Importantly, “concept stocks” that were very fashionable turned into a significant drag, ask Cathie Wood. The same can be said for “value” stocks. The outperformance of the first 6 months of 2021 of the cyclical and reopening themes was completely reversed. Additionally, there are clear indications that “retail” participation is high, usually a signal of an extended trend. On fixed income, we had some widening of credit spreads in the developed world (honestly not much) and a change in the shape of the curves. In US, bond investors expect some tightening into next year and then a very “flat” expectations for further increase in rates. This implies a consensus view that some limited intervention from the Fed will be sufficient to calm down inflation and economic growth to still positive but more manageable levels. With all this information in mind, I would conclude that we are transitioning from a “mid cycle” environment to a “mid to late cycle” environment. Do not take me wrong, it is too early to call the end of this cycle. Remember there is a lot of demand that could not be fulfilled this year due to supply chain issues and a reserve of private savings accumulated during the worst months of 2020. These are nice adds on for 2022 growth expectations, especially for the first six half of the year. However, since the pandemic, this last market cycle had extremely quick “phases” and this next one should not be an exception to the rule. Then, my basic advice is, “keep on rocking” but have your hands on the potentiometers; the music might change faster than previously thought.

Peppe Ganci, CFA

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