Portfolio Update – August 2024

We ended last month with markets in a state of panic, risk assets plummeting, and money markets irrationally pricing in an excessive number of rate cuts due to recession fears. If you recall from my previous Portfolio Update, I argued that this growth scare was an overreaction, assets were a buy, and the sharp price drops were simply the result of carry trade deleveraging. Well, I hate to say it, but I was right.

The asset decline ended precisely when the BoJ announced that it likely wouldn’t hike rates any further this year. As the rapid deleveraging subsided, assets rebounded sharply. My portfolio gained nearly 11% this month, proving that, while bold, fading that narrative was the right move.

However, the headline of the month was the report from Hindenburg Research, which exposed SMCI’s accounting fraud to the world. For those unfamiliar with SMCI, it’s a U.S. semiconductor company that skyrocketed nearly 300% in the first quarter of 2024. The surge was so significant that SMCI became America’s largest-ever small-cap, accounting for 2% of the Russell 2000. To make things worse, after the report the company delayed the release of its 10-K, which was read by many as an admission of guilt. This report reignited the voices of those skeptical of the AI hype and Nvidia’s share price movements, with some alleging that Nvidia might also be involved in fraud.

Let’s be honest, I understand where they’re coming from. Back in early 2023, I was short on Nvidia and skeptical about the AI hype myself. In fact, I still question the AI hype, finding it unjustified due to the gap between what was promised and what has been delivered. My short position was based on valuation—I believed the market was overly optimistic, pricing in unsustainable revenue growth. But when Nvidia’s results in April 2023 showed that explosive growth, I had to admit I was wrong. Staying short no longer made sense: while I might still question the hype, the valuation was justified by the financial results.

I’m fairly convinced that those calling Nvidia a fraud now are either frustrated at missing out on the gains, which is understandable, or simply don’t understand how companies are valued. Moreover, the idea that a trillion-dollar company, scrutinized by some of the smartest minds in the world, could get away with widespread accounting fraud for nearly two years is ludicrous. It’s even more absurd to think that a random unemployed Twitter user could uncover something that all these experts, with more money, time, knowledge, and access to information, missed.

It’s okay to be wrong. But it’s not okay to delude yourself into thinking you’re “right but early,” especially when two years of data have proven you wrong.

And now, let’s move to macro.

United States

Let’s start with this: the United States is not in a recession. It baffles me that some people are still sounding alarms about recession risks when GDP growth is at 3% QoQ, but these are strange times, and here we are. The data from the last week of August gives us a clear picture of the economy’s direction: consumption is up, inflation is stable, and jobless claims are down. What more could we ask for? Just as it’s unreasonable to talk about a recession given the current data, it’s equally unrealistic to expect a sudden surge in inflation. If you’re still unconvinced, in the previous Portfolio Update I went a bit deeper on why it makes little sense to expect a recession this year.

For now, nothing in the economic data or corporate earnings is signaling danger. This doesn’t mean things can’t change, of course, but even if they do, the Fed has room to intervene and prevent a prolonged downturn. And the markets are clearly pricing in this expectation. It became evident that the Fed achieved a soft landing between October and November 2023, and if you recall, that’s when equities rebounded and never looked back.

An important event this month was the revision of the BLS numbers, to which the markets barely reacted. There are a few reasons why this event shouldn’t concern us:

  • These figures are not final, but are merely a preliminary estimate of the annual benchmark revision. The final numbers could differ significantly.
  • The unemployment rate is calculated from the household survey, so these revisions do not affect that number; they impact the establishment survey through the QCEW.
  • Even after these significant downward revisions, the labor market still appears strong, which aligns with the continued resilience in consumption.

Federal Reserve

Now for the more interesting part: this month brought us Jackson Hole. If you remember, two years ago, in 2022, Powell said bluntly that the Fed was ready to tolerate economic pain in order to fight inflation: “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain” (you can read the full speech here). Then, in 2023, Jackson Hole was a total non-event. And now this year, 2024, it was once again quite impactful, as Powell signaled a significant shift in how future monetary policy decisions might unfold.

The pattern here seems to be that Jackson Hole is worth following only during even-numbered years. So, by this logic, next year will be a total non-event, and in 2026, we should brace ourselves for some bad news.

At Jackson Hole, Powell said “the direction of travel is clear” on future policy, but that “the timing and pace of rate cuts will depend on incoming data, the evolving outlook and the balance of risks”. Powell also clearly articulated the reaction function for once, saying that the upside risk for inflation have diminished while the downside risks to employment have increased, as I tweeted out back in April: “…there’s no reason to expect a second wave of inflation, and the direction probabilities for the labor market are skewed to future weakness.” (tweet). The most significant sentence, in my opinion, was the following: “We do not seek or welcome further cooling in labor market conditions”.

To me, the most interesting take from his speech is not that the Fed pivoted, but rather that the Fed is now ready to cut rates, even aggressively if necessary, to prevent additional economic weakness or further worsening in the job market. This, in turn, means that the best course of action for investors is to be long risk assets, as the Fed is effectively selling a put on them at a higher strike than before. For FX, this means the expected returns on the dollar are skewed to the downside, even though the current positioning is so stretched that a tactical long makes a lot of sense.

Regarding the next meeting, there’s little doubt the Fed will choose to cut rates, but the size remains in question. While some advocate for a 50bps reduction, I believe that would be a mistake: if the cuts aren’t gradual, they signal panic, and that’s the last thing the Fed wants. This is also why the Risksbank recently opted for a more measured 25bps cut, rather than a larger 50bps move.

Aside from economic and monetary considerations, from a personal perspective, Powell’s dovish pivot makes sense. At 71, he is quite wealthy and unlikely to seek another job, making this role the pinnacle of his career and legacy. If he didn’t want to be the Fed chair who allowed inflation to damage the economy, why would he want to be the one who triggers a recession? Although he may have been fortunate with the 2022 recession, with his legacy nearing its end, it’s understandable that he might be willing to tolerate some inflation risk to safeguard the economy. Of course, his role requires him to act in the nation’s best interest, but at the same time it’s clear that some personal considerations are also at play.

Europe

In August, European consumer prices rose at their slowest pace since mid-2021, increasing by 2.2% YoY, down from 2.6% last month and nearing the ECB’s target. Additionally, key indicators of long-term inflation expectations in Europe have dropped to their lowest levels in almost two years, reflecting investor optimism about the future outlook and confidence in the ECB’s ability to manage inflation. Notably, the 5y5y forward inflation swap, a measure of market expectations for price growth over the second half of the next decade, dipped below 2.1% for the first time since October 2022.

However, while the decline in inflation is welcome news, the headline figure masks underlying challenges for policymakers. Much of this decline is attributed to lower energy prices, with core inflation—which excludes energy—edging down only slightly to 2.8% from 2.9% in July. Economists and commodity traders generally expect energy prices to rise again, potentially leading to a modest rebound in inflation later this year. This suggests that inflation is more likely to hover between 2% and 3% rather than staying at current levels.

This situation complicates policy decisions for the ECB, which now faces the “Central Banker’s Dilemma” I anticipated in December. The ECB must navigate two significant risks:

  • Cutting rates too quickly could cause services prices to continue rising rapidly, leading workers to demand higher wages in 2025 after securing substantial raises this year.
  • Cutting rates too slowly could mean missing the opportunity to achieve a soft landing for the eurozone economy.

These challenges are exacerbated by the fact that Germany, the eurozone’s largest economy, contracted in Q2, manufacturing across Europe is under sustained pressure, momentum is slowing according to survey data, and any economic boost from the Paris Olympics is likely to fade as summer ends.

Nevertheless, despite the mixed outlook on inflation, the substantial progress made toward the target, combined with the weaker economic outlook, provides enough justification for the ECB to consider rate cuts.

European Central Bank

Near the end of last month, I noticed that ECB Vice-President Luis de Guindos, in an interview with Europa Press, hinted at a possible rate cut in September. Given that the ECB typically hints at their decisions 2-3 months in advance and gradually builds consensus, this suggested that a cut in September was likely. While we don’t yet know for sure whether a cut will occur, the odds are leaning significantly towards a dovish outcome, and it’s clear that the consensus is moving in that direction.

Indeed, with price growth slowing and economic momentum stuttering, ECB officials have signaled another cut on September 12th. And while what happens beyond September is even less certain, policymakers are already setting up the stage for more cuts. Quoting Muller: “If the actual developments continue to be in line with the projections and we see some further deceleration in inflation, also when it comes to the core numbers and services inflation, then I also believe that it’s possible to ease further beyond September, […] but to what extent, I think it’s too early to say.

The markets are already pricing in this outcome, so there is little room for speculation. Nonetheless, if both the Fed and the ECB are set to cut rates at roughly the same pace, the rate differentials remain stable, and the currency plays begin to rely entirely on positioning and narratives. In other words, FX markets are set to return boring.

Looking at the other news, this month the account of July meeting was released: however, if the meeting itself was something of a non-event, its minutes were even more so, as they contained little to no new information for the markets to digest. Indeed, it was noted that inflation is expected to fluctuate around the current levels for the rest of 2024, while the signals for core inflation remain mixed. On growth, it was said that the short-term outlook had deteriorated, and risks to the economic growth were tilted to the downside. Finally, in terms of monetary policy transmission, it was generally observed that it was unfolding according to expectations and that September was a good moment to reconsider the level of monetary policy restriction.

United Kingdom

In August, the GBP reached its highest level against the dollar since March 2022, peaking at $1.3246 after central bankers outlined differing outlooks for interest rates in the US and UK. Although the GBP has since retraced slightly, it remains on track for its best monthly performance against the dollar since November.

Several factors contributed to this outcome. Firstly, stronger-than-expected economic data in recent months provided support: the UK private sector grew faster than anticipated, reaching its highest pace in four months, and overall growth of 0.6% exceeded expectations. Additionally, there is optimism surrounding the new government, which is expected to usher in a period of political stability and growth-enhancing reforms. While I don’t follow politics closely enough to assess the validity of this optimism, it is certainly a factor influencing market sentiment.

However, the most significant factor driving GBP strength is probably the divergence in monetary policy outlooks between the UK and the US. For example, at Jackson Hole, Powell indicated that “the time has come” for rate cuts in the US, while Bailey warned that it was “too early to declare victory over inflation” in the UK. And to be fair, this cautious stance from the BoE makes sense. While headline inflation is nearing the target, which is a positive sign, services inflation remains stubbornly above 5%. Moreover, UK salary increases, although slowing, are still growing at 5.4% YoY, indicating no immediate need for easing. Additionally, unemployment has also fallen, signaling continued resilience in the labor market.

Given this uncertainty, it’s likely that the BoE will hold off on further rate cuts for now. In practical terms, this means we shouldn’t expect another cut in September, but if the data permits, a cut in November could be on the table.

Japan

As anticipated earlier, the BoJ walked back its talk of potential further rate hikes after initially unsettling global markets. Indeed, just a week after the bank’s meeting, Deputy Governor Uchida, in a speech to business leaders in northern Japan, clarified that Japan is not in the same position as the United States and Europe were a few years ago when surging inflation forced rapid rate hikes. He emphasized that “the bank will not raise its policy interest rate when financial and capital markets are unstable.”

Uchida also underscored the dovish stance of the BoJ’s current policy, noting that the policy rate of 0.25% is particularly low in real terms after adjusting for inflation. This reassured the markets, halted the deleveraging, and led to a strong rebound in most assets, delivering impressive returns for dip buyers.

However, while this helped global markets shift their focus elsewhere, it didn’t prevent the yen from appreciating. Fundamentally, traders understand that the BoJ will likely hike rates again; the difference lies in the risk implications between traders assuming an outcome and the central bank confirming it.

The expectation of further hikes is justified by recent data: Tokyo’s Core CPI increased by 2.4% YoY in August, up from 2.2% in July, partly due to the phasing out of energy subsidies. This is significant because Tokyo’s CPI is often seen as a leading indicator for nationwide inflation. Additionally, industrial output recovered sharply in July, and retail sales rose by 2.6% YoY in July, following a 3.8% increase in June. While some may argue that industrial production is too volatile to provide a clear signal, the overall narrative remains consistent.