Don’t Get Complacent, Considerable Risks Remain

Growth stocks have been in a brutal selloff, with smaller growth stocks peaking in February/March last year and diving 50%-70% in many cases. Many of these little stocks are clearly crushed too much and sentiment is shifting, some of these have started to bounce considerably (and we have been nibbling for our marketplace portfolio).

We think this can continue, but severe macro risks, some of which are of our own making, remain.

The shift towards a more positive sentiment is not difficult to explain, as a recession has replaced inflation as the main macro worry for the markets. The Fed now seems to have risen and be equal to the inflation risk. In fact, some worry that they risk overdoing it, hence the increasing worries about a recession.

Demand destruction is doing the rest with wages not keeping up with inflation, consumer confidence collapsing and fiscal policy turning contractionary. All this is on top of the negative wealth effect and confidence-sapping decline in stock values.

The positive jobs surprise last Friday might even have eased the recession fears itself as there is still a huge momentum in the jobs market. Another positive development is that supply chain problems seem to be easing at least some, as measured in supplier delivery times and container rates, for instance. In any case, much of it is temporary and caused by the bullwhip effect.

Risks remain

However, we don’t take this improving picture for growth stocks for granted as severe macro risks remain. Standing out is energy supply, most notably Russian oil and gas supply.

This week, the Nord Stream 1 pipeline, the main avenue through which Russian gas reaches Europe, will go into maintenance, supposedly for a week.

But many fear that supplies will not come back fully, or even at all, frustrating the summer buildup of gas storage that is required to get many European countries through the winter.

This would hurt Russia, but it would hurt many European countries much more, which is why we think it is a realistic, in fact, a likely prospect. It will open the prospect of gas shortages and rationing in the winter, producing economic mayhem.

As with Covid before it struck in 2020 governments don’t seem to want to create a panic and take expensive measures before they seem necessary.

With Covid, early and decisive intervention mattered, and every day of inaction made a dramatic difference down the line as Covid grows exponentially. We know that countries that intervened before Covid got off the ground fared orders of magnitude better in 2020.

The time to prepare for this is now, but there is a worrying lack of sense of urgency. More than half of French nuclear reactors are closed for maintenance. German nuclear reactors have closed and the remaining ones are still scheduled to close by the end of the year.

We do realize that there are all sorts of problems attached to keeping these reactors open, but should it not at least be considered, and every effort exerted to make it possible?

In the Netherlands, the government argues that they can only fill the main gas storage facility (and one of the largest in Europe) by 60% as Gazprom, the Russian energy giant, owns rights to the remaining 40% storage.

One might think that in the face of a possible severe crisis and dealing with an adversary who has no qualms throwing cluster bombs on urban areas and has itself broken legal obligations, they could dispense with the legal subtleties here, but apparently not. At least in Austria, facing a similar situation, they have the sense to do so.

Perhaps the Dutch government doesn’t want to drive up the price too much by announcing their strife for full capacity of the facility, but the facility remains curiously underutilized at just one-third of capacity filled.

China

We understand the reasoning behind plans to prohibit exports to China of chipmaking equipment. On the other hand, a chip equipment embargo of China isn’t necessarily more successful either, especially in the long run (Bloomberg):

China’s chip industry is growing faster than anywhere else in the world, after US sanctions on local champions from Huawei Technologies Co. to Hikvision spurred appetite for home-grown components. Nineteen of the world’s 20 fastest-growing chip industry firms over the past four quarters, on average, hail from the world’s No. 2 economy, according to data compiled by Bloomberg. That compared with just 8 at the same point last year.

But is now the time to raise this issue when at the same time the US foreign secretary is calling on China to stand up to Russia? Would such a move decrease or increase the risk that China will go after Taiwan and its foundry giant TSMC?

There are reasons to think that even if China successfully incorporated Taiwan and TSMC, that isn’t a guarantee for success (Friedman):

Over the years, TSMC has built an amazing ecosystem of trusted partners that share their intellectual property with TSMC to build their proprietary chips. At the same time, leading tool companies — like America’s Applied Materials and the Netherlands’ ASML — are happy to sell their best chip-making tools to TSMC… And if China thinks it can get around that by seizing Taiwan just to get hold of TSMC, that would be a fool’s errand. Many of the key machines and chemicals TSMC uses to make chips are from America and the European Union, and that flow would immediately be shut down.

But even if it isn’t, the world economy isn’t well adapt to deal with yet another disruption at this critical juncture, and some see $360 a barrel oil prices as a result, which includes a Chinese move for Taiwan as one of the triggers.

Now, that might be quite an exaggerated scenario but given the very precarious macro background there are no reasons to make it any more likely either, the potential for things to go seriously wrong in the world economy is large.

And we don’t need dramatic escalations like an invasion of Taiwan to send oil prices higher, Goldman Sachs sees oil reaching $140, enough to put a wrench in the neat trade-off between inflation and recession risk and spook the markets once more.

Conclusion

With a Fed shooting into action, plunging consumer confidence, demand destruction and easing of some supply chain constraints, the risks have clearly shifted from inflation to growth with many believing we’ll face a recession.

This scenario limits the rise of long rates and has already led to a renewed interest in much plagued growth stocks. We’ve hinted at this multiple times for our members and started nibbling some plagued names in this space already.

However, risks remain elevated, most notably from the energy front and the war in Ukraine. We’re not at all convinced Europe has their energy need covered for the winter and gas rationing is a realistic prospect.

We believe that without the war in Ukraine we would be well and truly out of the woods already with growth stocks, but the bleak prospects for the winter in Europe and the possibility of any further substantial oil price rises still put a wrench in the rally.