Author: Amanda Ahne
Bi-Weekly Geopolitical Report – The Changing Face of War (April 22, 2024)
by Daniel Ortwerth, CFA | PDF
If the United States were at war with another great power, would we know it? How would we know it? These questions might seem absurd but consider that the US has not fought a war against a major world power since 1945. Meanwhile, when the US has engaged in conflicts against weaker and regional powers since World War II, the beginnings and endings of the conflicts have tended to be blurred. Technology has advanced in ways unimaginable to the 1945 mind. This has changed the nature of life, and it has also changed the face of war. In this report, we consider how the contours of that face have changed over time, what it takes to recognize war in the 21st century, and whether the US and its allies might already be at war with China and its allies.
By addressing key elements of technological advancement and geopolitical evolution, we explore how 80 years have changed the face of war. We consider aspects of war that have not and never will change as well as what has changed, and we drive to the bottom line for investors. In our view, that bottom line has remained constant through time as war is expensive, citizens pay the price, and that price largely manifests itself in the form of higher inflation and long-term interest rates. Will the US ever go to war again with another major power in a way that we can recognize? Will we know it when we are there? These questions are harder to answer than ever before, but investors can still prepare.
Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify
Keller Quarterly (April 2024)
Letter to Investors | PDF
“What could go wrong?” When that question is uttered with confidence, wise folks immediately brace themselves for calamity. It is an oddity of the stock market that the more quickly a stock ascends in price, the less often people seem to worry about what could go wrong. Rising stock prices have a way of anesthetizing investors against concern that “something could go wrong.”
There’s nothing wrong with the question, but it matters whether it’s voiced with hubris or humility. In our view, an investor needs to critically inquire as to what can go wrong before ever committing capital to an investment. This is where risk management starts. Most investors, however, tend to begin their work with the question, “How much money can I make?” But we have found that worrying about risk is even more important. That’s because while the price of every security has an expected return built into the price (an earnings yield and rate of growth for a stock and a yield to maturity for a bond), the actual return depends on the probability that return is actually realized.
That probability is the answer to the question, “What can go wrong?” Good investors obsess over that question, whether the subject is an individual stock or the construction of an entire portfolio. We know that if we correctly understand the risks, we will better understand the probability that our return expectations will be realized. We can’t predict the future (no one can), so it’s a matter of doing our best to put the probabilities in our favor. That’s where correct analysis of risk comes in.
Our analysts, strategists, and portfolio management teams spend more time on risk management than on any other pursuit. This activity doesn’t guarantee against downside risk, of course. This is a “batting average” business, and the goal is not to eliminate risk, which is impossible, but to not knowingly accept unreasonable risk relative to the returns we expect. I have always thought that if we manage the downside appropriately, the upside will take care of itself.
Last quarter I referred to a book that over 40 years ago profoundly affected how I thought about investing: Benjamin Graham’s The Intelligent Investor. In 2003, Jason Zweig issued an excellent revision and commentary on that classic which, if possible, made the original even better. In that edition is this insightful observation:
The longer a bull market lasts, the more severely investors will be afflicted with amnesia; after five years or so, many people no longer believe that bear markets are even possible. All those who forget are doomed to be reminded; and, in the stock market, recovered memories are always unpleasant.
Even though the stock market has seen some sharp selloffs in the last five years, it seems to me we are living in such a time as Mr. Zweig describes. While the Fed has the overnight rate at over 5% today, memories of extraordinary monetary support (0% interest rates for most of the last 16 years plus Quantitative Easing or bond-buying) have convinced investors that they won’t be abandoned by the authorities. Then add a new productivity enhancer like Artificial Intelligence (AI) and the market had all it needed to take valuations to new highs. But there’s no such thing as a risk-free market.
This is an environment where a long-term investor needs to consider the probabilities of what can go wrong. Is there a cost to weighing risk carefully? Of course, there is no free lunch. It means not chasing “hopes and dreams” stocks that others are, where the prospects of big gains are paired with big risks. The market today seems to be more excited about future gains than the possibility of loss. The wisest saying in the investment business is to “be cautious when others are bold and bold when others are cautious.” We are a bit cautious these days but are prepared to be bold when the opportunities present themselves.
We appreciate your confidence in us.
Gratefully,
Mark A. Keller, CFA
CEO and Chief Investment Officer
Asset Allocation Bi-Weekly – #117 “The Incremental Uranium Demand for Weapons” (Posted 4/15/24)
Asset Allocation Bi-Weekly – The Incremental Uranium Demand for Weapons (April 15, 2024)
by the Asset Allocation Committee | PDF
In our Asset Allocation Bi-Weekly report from March 4, 2024, we began to explain more fully our recent decision to introduce uranium and uranium miners into our Asset Allocation strategies. Our key thesis was that current and planned investments in new nuclear reactors for electricity generation, especially in China and India, will likely lead to booming demand for uranium in the coming decades, while supplies are likely to be constrained. This theory is increasingly discussed among investors, and we think it’s a key reason for the jump in spot uranium prices since 2022, as shown in the chart below. In this report, we discuss a less-recognized source of incremental uranium demand that could drive prices even higher: China’s ongoing rapid expansion in its arsenal of nuclear weapons and the possibility of a global nuclear arms race in the future.
After decades of keeping only a “minimal” nuclear deterrent of about 200 warheads, China has recently begun a dramatic expansion of its arsenal. Western analysts believe China’s arsenal has expanded by about 42 warheads annually since 2020, reaching 500 warheads in 2024. Publicly observable and classified evidence suggests Beijing aims to match the United States’s deployed arsenal of 1,770 warheads by 2035 (not including reserves), which would imply adding an average of 115 warheads per year until then. Finally, as we have written elsewhere, we think rising geopolitical tensions around the globe and growing doubts about the US’s commitment to its allies could potentially prompt a dozen or more non-nuclear states to develop nuclear weapons in the coming decade or two. If that results in a global nuclear arms race, the world could end up producing several hundred new nuclear warheads each year.
In every scenario we’ve looked at, China would be the main driver of new nuclear weapons production in the years to come. So, in order to understand the incremental uranium demand for weapons, we will focus on China’s expected needs. Because of China’s long nuclear history and technological prowess, we assume its nukes are similar to the advanced, plutonium-based hydrogen bombs fielded by the US and Russia. According to a 1999 declassification guide from the Department of Energy, such bombs can theoretically be made with just 6 kg of plutonium, similar to the mass of fissile material for a uranium-based bomb. Another DOE report says that the US has used 3.4 metric tons of plutonium in its 1,054 nuclear tests since World War II, implying the use of about 3.25 kg per test. Actual weapons probably use more plutonium than the hypothetical minimum or test levels, so we assume current and future Chinese bombs would use at least 10 kg of plutonium each. Data on weapons-grade uranium and plutonium stocks from the International Panel on Fissile Materials suggests modern hydrogen bombs encompass an average of about 15 kg of plutonium each, which we use in our calculations below.
Of course, very little plutonium occurs naturally on Earth; it is generally made from uranium. Open-source reports indicate that producing 1 kg of plutonium takes about 4,000 kg of uranium. If these reports are accurate, each new Chinese warhead requires about 60 tons of uranium, and China’s current annual production of about 42 warheads probably represents about 2,520 tons of uranium. Unclassified sources don’t clarify what form of uranium is used in the 1:4,000 ratio, but if it is standard uranium mine output (i.e., “yellowcake,” or minimally processed ore consisting of about 85% triuranium octoxide), then China’s current annual nuclear weapons output is using the equivalent of 4.2% of the approximately 60,000 tons of uranium that was produced by mines around the world in 2023. We therefore suspect that China’s current nuclear build-up is probably helping to buoy spot uranium prices even today.
Looking forward, if China increases its bomb output to the expected 115 per year, its nuclear program would require at least 11.5% of 2023’s global mine output and would more obviously put upward pressure on uranium prices. Moreover, we believe our estimates could be quite conservative. For example, it may be that the plutonium/uranium ratio of 1:4,000 refers to pure or enriched uranium, which would imply that even greater quantities of uranium ore are needed. China might also decide to build up an inventory of reserve warheads, further boosting the need for uranium ore. Plutonium and uranium production waste may also boost uranium needs. Finally, if geopolitical tensions do result in a global nuclear arms race, we believe the total uranium demand from China, Russia, the US, all other existing nuclear states, and new nuclear states could easily overwhelm global supplies and send long-term uranium spot prices dramatically higher.
Bi-Weekly Geopolitical Podcast – #45 “Is Japan Back?” (Posted 4/8/24)
Bi-Weekly Geopolitical Report – Is Japan Back? (April 8, 2024)
by Thomas Wash | PDF
In the early 1960s, futurologist Herman Kahn boldly predicted Japan’s economic dominance. He envisioned the nation surpassing the United States in per-capita economic output by 1990 and matching its total economic output a decade later. Kahn’s vision seemed imminent, fueled by Japan’s rise as a major exporter of autos and semiconductors. Japan’s advantages stemmed from its relatively cheap labor force, weak currency, and lower borrowing costs, which gave Japanese companies a significant edge over their American counterparts.
Just as Japan appeared poised to realize Kahn’s vision at the end of the 1980s, a series of setbacks plunged the nation into a prolonged economic slump spanning multiple decades. The yen surged, doubling in value against the dollar from 1985 to 1988, while decreased borrowing costs in the US eroded the competitiveness of Japanese exports. Concurrently, Japan’s aging population exacerbated the existing challenges. Additionally, the country grappled with an insurmountable commercial real estate debt crisis, triggering a protracted period of asset deflation.
Decades later, Kahn’s unfulfilled prophecies seem like a distant memory. Nevertheless, signs point to a genuine turnaround, with the Nikkei 225 recently reaching a new record high for the first time in 34 years — just the tip of the iceberg. The return of inflation, rising wages, and a modernizing corporate culture all suggest a more sustainable recovery. Japan’s apparent reemergence is perfectly timed as investors seek alternatives to an increasingly insulated China and growing desires from the West to strengthen allies in the Indo-Pacific.
To assess the longevity of Japan’s recent stock market swell, this report delves into its historical performance, including past periods of economic stagnation. We then examine recent changes within the country, particularly the initiatives designed to bolster corporate profitability and stock valuations. The report explores how the intensifying rivalry between the US and China has contributed to Japan’s increased attractiveness to investors. Finally, we conclude by analyzing the potential market ramifications of this resurgence.
Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify | Google
Asset Allocation Bi-Weekly – Gold, Gold Miners, and Central Banks (April 1, 2024)
by the Asset Allocation Committee | PDF
One challenge for investors seeking to benefit from rising gold prices has been that trading and holding the yellow metal is often more expensive than trading or holding stocks or other financial assets. Buying physical gold can involve fat commissions and large costs for storage and insurance. Buying gold futures requires a margin account that may not be available for some investors. Many investors therefore buy gold miner stocks instead, assuming that rising gold prices will buoy miner profits and cause their stocks to appreciate in line with gold. Our analysis suggests that was a reasonable strategy until about 2003, when the Securities and Exchange Commission first allowed exchange-traded products (ETPs) that invest in gold. Up until 2003, the NYSE Arca Gold Miner Price Index (GDM) was highly correlated with gold prices. Since then, however, the relationship has swung wildly across periods. Now, there appears to be no lasting, consistent relationship between the GDM and gold prices. In the post-2003 era, it appears private investors seeking gold exposure should just buy gold or gold ETPs.
But what is the correlation between gold and gold ETPs? Until recently, spot gold prices have tended to move in tandem with the amount of the yellow metal held by ETPs, suggesting financial investors have become the market’s key drivers. As investors buy gold ETPs, the funds purchase physical gold and buoy prices. Our analysis suggests investor demand for physical gold and gold ETPs is often driven by concern about the value of the dollar and can increase when investors worry about issues like the rising federal budget deficit or inflation.
More recently, however, we have noted a breakdown in the relationship between spot gold prices and ETP gold holdings. As shown in the chart below, gold prices and ETP holdings had moved largely in tandem for more than a decade and a half, but they began to move in opposite directions toward the end of 2021. Since then, gold prices have soared and recently reached a new all-time record of $2,212 per ounce, but ETP gold holdings have been declining. How can gold prices be rising in the face of an apparent drop-off in investor demand for gold?
We think the answer is increased gold-buying by central banks. The chart below shows that the world’s central banks now hold nearly 36,000 metric tons of gold, a new record high. Importantly, central banks don’t necessarily act like private investors. For central banks, gold is part of their foreign reserves, which can be seen as a sort of “rainy day fund” for their country. Since the gold held in these reserves is for their own country’s economic security, central banks are likely to be relatively price insensitive when they go out into the gold market. Another distinguishing aspect of central bank gold-buying is that the institutions are much more oriented toward the security of holding physical gold rather than ETPs. Putting it all together, it appears that major central banks have been actively buying up physical gold despite today’s record-high prices, while gold-holding ETPs have apparently been selling to them.
We suspect much of today’s central bank gold-buying is being driven by institutions outside the US geopolitical and economic bloc or the central banks of other countries at odds with the US. After seeing US and Western moves to seize foreign currency reserves belonging to Afghanistan and Russia in recent years, we think many governments that aren’t on good terms with the US or might fall afoul of US policies have directed their central banks to shift their reserves more toward physical gold and other assets that the US or other Western governments wouldn’t be able to seize in times of souring relations. Given today’s ongoing spiral of tensions between the US bloc and the China/Russia bloc, which seems set to continue for years, we think central bank gold purchases will remain strong and give a continued boost to gold prices, at least in the near term.
Note: there will not be an accompanying podcast for this report.
Business Cycle Report (March 28, 2024)
by Thomas Wash | PDF
The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities. The intention of this report is to keep our readers apprised of the potential for recession, updated on a monthly basis. Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.
The Confluence Diffusion Index was flat from the previous month, suggesting that the economy may be losing momentum. The February report showed that six out of 11 benchmarks are in contraction territory. Last month, the diffusion index was unchanged at -0.0909, slightly above the recovery signal of -0.1000.
- Financial conditions are weakening as markets fear higher-for-longer interest rates.
- Consumer confidence is holding steady but lacks momentum.
- The latest household survey points to a possible cooling in the job market.
The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is in recovery. The diffusion index currently provides about six months of lead time for a contraction and five months of lead time for recovery. Continue reading for an in-depth understanding of how the indicators are performing. At the end of the report, the Glossary of Charts describes each chart and its measures. In addition, a chart title listed in red indicates that the index is signaling recession.