«The Window Is Closing Fast on the Fed»
The crisis in the banking sector is rattling the world. Marko Papic, Partner and Chief Strategist at Clocktower Group, talks about the consequences for the markets, the dilemma facing the Federal Reserve and attractive investments in uncertain times.
The collapse of Silicon Valley Bank and the crisis surrounding Credit Suisse have abruptly changed the environment for financial markets. Concerns about a recession are coming to the fore. Interest rates are falling sharply, the price of oil is plummeting and safe havens such as gold are in demand.
Marko Papic knows his way around messy situations like today. The chief strategist at California-based investment boutique Clocktower Group is a proven expert on geopolitics as well as macroeconomics. «We’re in a very interesting period of time that resembles the period of 1870 to 1920, a multipolar world where everybody is kind of at each other’s throat», he says, describing the big picture.
In this in-depth interview with The Market/NZZ, which has been lightly edited for length and clarity, Mr. Papic explains what the shocks in the banking sector mean for the markets, why the Federal Reserve is facing a difficult decision, what the biggest risks are from a geopolitical perspective, and where he spots opportunities for investments in this challenging environment.
«It’s very easy to be tough on inflation when the CPI is at 10%, but we’re now headed lower, and it becomes harder and harder for the Fed to hold the line»: Marko Papic.
Mr. Papic, events have been snowballing in recent days. How do you interpret what is happening in the banking sector?
There are several interrelated issues that have conspired to cause this crisis. Yes, the Fed is to blame for its hawkishness. Obviously, raising front end rates caused long dated treasuries to suffer losses. However, it was the Silicon Valley Bank that got into trouble, not the generic «Mom & Pop Bank» of some random tiny town. First, its management did not do portfolio construction wisely. Second, it held roughly 30,000 deposits of tech startups on its books. The bank was therefore the epicenter of one of our highest conviction views, which is that we are in the middle of an epic tech collapse.
What do these tremors imply from a macro perspective?
It is macro relevant because the US economy has proven to be far more resilient than the median investor has thought. As such, now was the time for the Fed to step on the brakes, not ease. But now, not only is the Fed backing off from 50 basis point hikes, it has restarted a stealth-QE program at the first sign of systemic risks.
Given the massive movements in the markets, isn’t it prudent for the Fed to take a somewhat less aggressive course for the time being?
My point is that the window is closing fast on the Fed. Keep in mind that the US election cycle starts in about six-to-eight-months, and the Fed has not raised rates twelve months ahead of an US election ever. So if they don’t use that window for a chance to be tougher, it’s game over. A lot of monetary policy watchers would say that I’m a heretic and that the Fed is independent. That’s true, but one of the reasons they haven’t raised rates ahead of elections is precisely to preserve their independence by not being involved in the political process.
What are the consequences of this situation?
If you look at the polls, Donald Trump is doing extremely well. After the midterm elections a lot of people, me included, thought that he was starting to suffer in popularity, but he’s able to hold 40-50% of the Republican vote. Then, you have all these moderates getting ready to run which is a problem because they will cancel each other out. Hence, we can have a situation in six months from now where the Fed will guarantee a Trump presidency if they cause a recession. None of the American elites - left, right, center - wants that. So the most serious geopolitical issue is actually not even geopolitical, it’s domestic US politics.
So what is the Fed going to do?
They are traveling with events, and you’re already starting to hear criticism. It’s very easy to be tough on inflation when the CPI is at 10%, but we’re now headed lower, and it becomes harder and harder for the Fed to hold the line. If we get closer to 4-5% headline inflation, the number of political constituencies in the US that has a problem with that is very low. Consumers are fine with it because real wages have now turned positive. Corporates don’t care, their input costs have come down and they can still pass on 4-5% price increases. Savers also don’t hate it because when you’re a member of a local credit union, you can now get a CD at 6%.
What does that mean for investments?
Investors may be tempted to go long duration and tech given the Fed backing off. Then again, we still think that the macro context is a headwind for both of those trades. Tactically, both may work, but over the course of the year, we do not think so. Instead, we want to be long gold, commodities, and emerging markets.
Let us now broaden our scope to include international events. A few weeks ago, the drama surrounding the Chinese observation balloon highlighted how tense the situation is between Washington and Beijing. How great is the risk of further escalation?
A lot of the issues that were highly topical last year, like the war in Ukraine and the tensions between the US and China, may not have as much of an impact this year. That doesn’t mean they are not macro relevant, it’s just that the market has digested them. So events such as the balloon incident tell us that we live in a very geopolitically volatile world, but it doesn’t really move the needle because we already know that China and the US don’t like each other.
With the tightening of the U.S. boycott against China’s semiconductor industry, the conflict fully escalated into an economic war last fall. Why is Beijing not taking retaliatory measures?
In the US, the recent statements from China’s National People’s Congress are interpreted as very aggressive. But I don’t think they’re aggressive at all. Basically, Chinese policy makers are saying «You’re containing us, you’re pursuing economic warfare, and there is no clear end goal other than to make sure that we don’t grow.» American policy makers are not taking this very seriously. When they craft China policy, domestic politics play 70% of the role, and geopolitical strategies only 30%. In this regard, it’s telling that the US has not articulated any clear demands from China other than big picture things like compliance with international rules and human rights. So the Biden administration is being tough on China just for the sake of being tough on China.
How will this conflict develop further?
There will be constant escalations. America is being very aggressive against China because it’s trying to get China to retaliate, and then Washington will have very solid evidence to present to Europe and the rest of the world that China should be contained. I don’t think this will become market relevant over the next twelve to eighteen months because the Chinese are not stupid. They understand that they are being trapped. But I don’t have confidence that that’s the case over the next decade, because it’s clear where this is headed. So if you’re a long-term allocator of capital who wants to invest in China, you have to bet that Chinese policy makers will continue to keep their cool against extreme pressure from the US.
Where do you currently spot the greatest geopolitical risk?
One of the most important things is the tensions between Iran and Israel. This is not in the market, it’s not on the frontpage of the newspapers. But I worry that the highly complicated domestic political situation in Israel and Iran’s intransigence, their willingness to push the envelope, are creating a dynamic that increases the probability of Israel using unilateral military action against Iran. That’s my number one concern. I’m not saying it’s going to happen, but if the probability of Israel using military action was 5% before, it’s probably 20% now.
It has now been more than a year since Russia launched the war against Ukraine. How do you assess the situation in this conflict?
There is a possibility of a geopolitically induced market upside next year with some sort of a conclusion to the Ukraine conflict. But both, Ukrainian and Russian military are looking to do more offensives. That makes it hard to tell the probability of this conflict magically ending. One thing is clear: In Donbas, the Russians now completely control Luhansk and they want to conquer the remaining territories in Donetsk, since Moscow considers the borders of Donbas a new territory of Russia. So if the Russians win the battle of Bakhmut, which remains the hot spot in the war, and then sweep through the rest of Donetsk, there is a possibility that Putin just declares victory. This would be extremely positive for European assets, but I have a very low conviction view that it’s going to happen.
So what will the energy situation be like in Europe next winter?
I’m a little bit worried. Last year, I had a high conviction view that Europe was fine. One of the reasons was that the Russians were utterly stupid, for the lack of a better word. They supplied Europe with natural gas throughout the first two quarters of the year, and then they were surprised that Europe managed to fill its storage. This year, it’s a little bit different. From my back of the envelope calculation, Europe needs about 30 billion cubic meters of gas from Russia. That means at some point, Russia has to be engaged again with Europe. So if Moscow feels comfortable that it has conquered what it needs and Putin has some sort of «mission accomplished» moment, I think Russia will be open to sending natural gas again to Europe.
Europe consumes almost 400 billion cubic meters of gas per year. Are supplies from Russia still conceivable at all in view of the horrific events in Ukraine?
Of course, Europe has a political problem. It can’t accept that gas easily. But if the conflict in the Ukraine goes from page one to page six in the newspapers and electricity prices start rising again in Germany, France, and everywhere else, I think everybody will be fine to take the gas. And even if they’re not, 30 bcm is not a lot, and there are ways for Russia to send that gas to Europe quietly.
How is that supposed to work?
I don’t know if you have noticed, but Azerbaijan and Russia have a new natural gas deal for about 10-12 bcm. So Azerbaijan is going to buy Russian gas which is ridiculous since they don’t need it. What they are going to do is to take the Russian gas and export more to Europe. There will be a lot of shuffling from one pocket to another, and I think Europeans will find a way to buy that gas in a politically acceptable way domestically.
In order to no longer be dependent on Russia, Europe is counting on imports of liquefied gas by LNG tankers. Won’t that be extremely expensive?
In the short-term, Europe will continue to pay higher prices for LNG, but supply is coming online and by 2025 this will not be an issue anymore. So the dumbest thing I’ve ever heard is illustrious media organizations like «The Wall Street Journal» and «The Economist» saying that Europe will deindustrialize. Fair, if you’re running a fertilizer business or a chemical business where natural gas is an input, you probably want to move your factory to the US. But let’s talk about all the other industries: As a CEO, are you really going to invest in factories in the US which will take years to build when in two to three years LNG prices are going to collapse globally because there is a tsunami of LNG coming? When that happens, Europe will be fine.
What are investment opportunities in this regard?
The best trade since the Ukraine war started is tankers, LNG tankers as well as regular tankers. Put differently, the best way to play this is to buy and hold capex goods companies. It’s like in the semiconductor space where you don’t necessarily want to own semiconductor companies, but rather companies that build the fabs. The same applies in the energy space: You don’t want to necessarily own producers because you don’t know who’s going to win. You want to own the companies that allow those producers to put their product on the market. That’s why I consider tankers and shipbuilders as attractive capex plays in the energy sector.
Another important aspect of capital investment are structural trends such as near-shoring. Who benefits most here?
Opportunities vary depending on the country. For instance, I don’t see India capturing market share in terms of global exports, but other countries like Vietnam, Indonesia, Mexico and even Saudi Arabia are. Here’s what’s really interesting: Everybody thinks this movement is led by Western firms trying to get out of China. But that’s not the case. It’s led by Chinese firms trying to get out of China so they can continue to trade with the US. This is anecdotal, but people who do a lot of business in Mexico say that the Chinese are coming in droves. Everybody thinks friendshoring is going to be about the West hermetically sealing themselves in one sphere, and China in the other. But it’s not like that at all.
What is the best approach for investments against that background?
You want to invest in geopolitically promiscuous countries. In the 1960s and 1970s, you had the non-aligned movement which was led by my homeland of Yugoslavia, India, Egypt and other countries. They got together because they didn’t want to be formally aligned with or against any major power bloc, they wanted to work with everybody. The problem was that these countries were extremely poor, so it wasn’t relevant. But today’s emergence of what I call geopolitically promiscuous countries is different. Indonesia is a great example. In terms of FDI, both the US and China are showering the country with money. The same goes for Vietnam and many Latin American countries. So this emergence of a new 21th century non-aligned movement is where you will definitely find some alpha opportunities with the caveat that you still want to worry about governance.
And this movement includes Saudi Arabia?
Like in a good stew, several positive ingredients come together in the investment case for Saudi Arabia. It's like a goulash of bullishness. Commodities are an important part. That means you definitely have to have a positive view on commodities and oil. But to me, it’s really a nation building story. Most people aren’t aware of it, but I think what we’re witnessing is something like Japan’s Meiji Restoration when Japan became the first Asian state to modernize based on the Western model and accelerated its industrialization process enormously. Saudi Arabia is 100% focused on this today.
However, basic human rights are not respected in Saudi Arabia, which repeatedly gives rise to controversy.
You have to go there and see it for yourself. What I’m most impressed with is the social cultural changes. Everybody criticizes Saudi Arabia for human rights violations, and that’s fair. But they just doubled the female labor force participation rate in the country to 40% in five years. So if you are running a large pool of capital and you decide not to invest in Saudi Arabia because of the Khashoggi murder, then you’re basically punishing them, even though they probably made a bigger difference in terms of their female population over the last five years than any other country in the world. And it’s not stopping.
What steps are being taken to make the economy less dependent on the energy sector?
They are doing a lot of interesting things. The most impressive example is the Neom project in northwestern Saudi Arabia. The site is north of the Red Sea, east of Egypt across the Gulf of Aqaba, and south of Jordan. Essentially, they’re building a whole new province which is geographically located where the altitude and the weather is really conducive. So it’s also a hedge against risks that climate change may bring to other parts of the country. They are building a Saudi car which is very smart because it’s going to create a whole industrial ecosystem. The car might not be great, but that’s fine. The Malaysian Proton is not a good car, you're probably not going to want to own it, but it did a lot for Malaysia in terms of creating an industrial infrastructure.
How can one invest in Saudi Arabia? For example, is a fund such as the iShares MSCI Saudi Arabia ETF an appropriate choice?
For a regular investor this remains on oil play. Unfortunately, if oil prices go down 30%, you will still lose money, even though I’m super bullish on where Saudi Arabia is headed as a country. A little bit more sophisticated way is to invest in Egypt. Egypt is a clear market for Saudi Arabia, it’s a country that will extend Saudi foreign policy and geopolitical reach. Another way is trying to get exposure to private equity plays in Saudi Arabia that have to do with demographics. Obviously, that’s difficult for regular investors, but there will be a lot of innovation in Saudi Arabia. You’re already seeing that in fintech and communication technologies.
What do you generally recommend when it comes to investments with a geopolitical background?
We’re in a very interesting period of time that resembles the period of 1870 to 1920, a multipolar world where everybody is kind of at each other’s throat. I’m not bearish about this as an investor. I think innovation is going to skyrocket as the government re-enters the innovation marketplace. This means we’re in a world with slightly higher inflation, where the ten-year bond yield is going to be higher, money has a value, and hard-tech innovation is needed. So the obsession with SaaS businesses is going to collapse. Europe missed the software boat absolutely, but this decade is a decade of industrials, of energy and materials, and Europe is actually pretty good at that.
Marko Papic
