Weekly Edition #56
Updated: Mar 11
In this edition:
We’ve written before that in the last 100 or so years there had been several cases of markets going to zero, Russia in 1917, China in 1949, and now Russia in 2022 (probably only market within 100 years or so to do it twice). The sanctions unleashed on Russia have been unprecedented. We wrote last week about the different sanctions that have been implemented on the Russian economy. It seems like every day new sanctions are being announced, the US recently banned importing oil from Russia. Even if the war ended today, things are not going back to the way they were a couple of weeks ago.
Some thoughts on what will change:
The sanctions placed on the Russian Central Bank (RCB) essentially wiped out almost half of their reserves. Basically, any deposit the RCB held at a Western financial institution is untouchable by the RCB. Therefore, even though they have ~$600 billion of reserves, half of them are not able to be used. This sanction is unprecedented, this will probably force other Central Banks to rethink their reserves policy. For example, China holds roughly $1 trillion of their reserves in US Treasuries. If they were to invade Taiwan, the US could freeze these assets. Maybe they won’t change their reserve mix (US markets are the most liquid which is why central banks hold reserves in USD), but at least they are thinking about what they could do to mitigate it.
Germany realized that shutting down their nuclear power plants and depending on Russia for their natural gas was probably not a good idea. Therefore, the EU has a goal to reduce their dependence on Russian gas by about 80%. We don’t know how exactly they’ll do this but it’s probably a mix of importing liquified natural gas from other places, more renewable power (although the adoption here has been slow) and restarting their nuclear program (which is green energy!). What isn’t going back to normal is the flow of gas from Russia to Europe.
Germany also realized that they should probably beef up their military and not rely on others for their security. Therefore, they have increased their military spending to 2% of GDP, a roughly 30% increase.
A growing list of companies have stopped selling their products in and to Russia. This, along with sanctions, has had the effect of crippling the Russian economy which is expected to contract 35% in the second quarter of 2022. Entire industries, such as aviation, will be decimated as suppliers have stopped sending parts. This will probably drive a trend away from globalization. We think after Covid there was already a movement of shortening supply chains and onshoring production of certain goods. This war between Russia and Ukraine will only further that effort, especially for things made in China.
Will the level of sanctions make China think twice about invading Taiwan? An invasion of Taiwan would be much more serious since the US has entered into the Taiwan Relations Act, which states that the US will supply defense articles and services necessary for Taiwan to maintain “sufficient self-defense capabilities”. No one know exactly what this means, since the US has been vary vague about it, on purpose. However, it is much more than what the US had with Ukraine (nothing). Taiwan is also the main (only?) supplier of the most advanced microchips in existence, a key input into many products we use today.
We may be wrong on all points above about how things play out. However, what we’re fairly confident of is that the world isn’t going back to the same old ways of just a couple of months ago. The events over these last several weeks have changed the world and government policies, and we’re not going back. Faced with this uncertainty, it makes sense to adjust portfolios accordingly. We think volatility is here to stay.
Russian stocks have become essentially worthless. Russian GDRs (global depositary receipts, essentially a certificate which represents ownership in another stock), have fallen around 97% in London. It’s easier to picture this catastrophic loss with a picture.
Yes, that’s what a 97% loss looks like, from $75.7 to $2.59. Russian stocks are un-investable right now. Even if you could buy Russian stocks, which is hard because of sanctions, who would want to buy now? The war isn’t over, it seems like everyday new sanctions are being placed, and even if they were removed today, the world isn’t going back to how it was.
Because of everything that has happened, index providers have decided to kick Russian stocks from their indexes. MSCI (a large index provided) has decided it will essentially mark down the value of these positions to zero and kick them out. The rise of ETFs and index investing in general has given index providers a lot of power. In the case of Russia their actions probably don’t matter much, as in investors would probably not invest irrespective of what the index providers said. However, in other cases (like in Peru in 2015), decisions by index providers can have real impacts in economies.
As is often the case with war and international sanctions, the people who are least to blame are the ones who get hurt the most. Russia invaded Ukraine, civilians in Ukraine, who had nothing to do with anything, are having their homes destroyed, having to flee the country, and many have already lost their lives. They are innocent bystanders in a conflict that has upended and may have ruined their lives. Russian citizens will also be hurt but in a very different way. Their lives will also change but in an economic sense.
I think many of us fail to grasp the severity of these sanctions and what they will mean for the Russian economy. As time goes on and the Russian economy continues to be shut off, things will gradually get worse. Many companies have already stopped selling their products, so Russians that want a new iPhone won’t be able to get one. But eventually industries will start to collapse. For example, Boeing has suspended parts, maintenance, and support for Russian airlines. In the short run the impact might not be that severe. But eventually planes break down, and need repairs, if they cannot get them then the planes stop working or become dangerous to fly. This will eventually happen with many industries as the economy keeps on getting more and more isolated from the rest of the world. The best thing all of us can hope for, including the average Russian citizen, is for this conflict to end and end soon.
One of the main theorems of finance is that markets are efficient, or at least relatively efficient. This means that there shouldn’t be any clear, easy, and cheap to exploit arbitrage opportunities. For example, two funds which hold the same securities should trade at similar prices. To instruments which have the same payoffs should have the same price (a key tenet in derivatives pricing). However, there are a couple of examples in which this has broken down and the market has been clearly inefficient. For example Palm and 3Com in 2000, in which the implied price of 3Com was -$63, yes negative sixty three dollars (you can read the details here).
It seems we’re living in one of those moments right now. The Trump SPAC, DWAC, is not trading in line with its warrants (a warrant is much like an option in which it gives the right to buy a stock at a certain price in the future). A warrant has two sources of value, intrinsic value and time value. Basically, how much it would be worth if it expired today (intrinsic value), which is the difference between the current stock price and the exercise price of the warrant. The other source of value is that stuff can happen between today and expiration, so there’s value in that time (time value). In this case the time value of the DWAC warrants is roughly -$45.36 (yes, negative again). Why does this happen? Probably a combination of things, limits to arbitrage and high retail participation in DWAC would be our guess. In order to correct this mispricing, you need to short the stock and buy the warrants. The problem is that to short the stock you first need to borrow it, and in order to borrow it you need to find shares to short. Once you have found those shares, you need to pay whoever lent them to you, and last we checked the fee was going at around 100% annualized. Therefore, if you wanted to short the stock and buy the warrants (assuming you found stock available to borrow), you would need roughly 100% per year. So for this trade to work out the distance between the stock and the warrant would have to close out pretty quickly otherwise it would be too expensive to trade.
We’ve written several times before that things can change in an instant. The Russian invasion of Ukraine is one of these instances. The crippling of the Russian economy is another. Probably no one knew the West would impose such harsh sanctions and in record time. This is why we always say that we need to diversify instead of making concentrated bets. Out of a subset of emerging market funds, only 8% did not have any exposure to Russia. This wasn’t because they saw the crisis coming and decided to sell out before the collapse. But rather because their investment process led them to not invest in Russia.
When things can change in an instant, and when the consequences of getting things wrong can mean millions or billions of dollars in losses, it’s best to diversify and not bet everything on a couple of positions. Like we’ve said before, no one knows what will happen. And if someone says they do then ask them why they are sharing that information with you instead of trading on it and retiring on a beach somewhere!
Thanks for reading!
To receive this information weekly subscribe your e-mail clicking here:
Past performance is not a guarantee of future performance. Future returns are not guaranteed, and loss of capital may occur. This material is not to be reproduced or distributed to any other persons and is intended solely for the use of the persons to whom it has been delivered by or on behalf of K Squared Capital. This material is not for distribution to the public. The sole purpose of this material is to inform, and it is in no way intended to be an offer or solicitation to purchase or sell any security, other investment or service, or to attract any funds or deposits. The information provided herein does not constitute tax, accounting or legal advice. Investing in financial markets involves risk, including the risk of principal loss. Information in this document is in no way intended as personalized investment advice and should not be interpreted as such. Past performance is no guarantee of future results. K Squared Capital disclaims responsibility for updating information. In addition, K Squared Capital disclaims responsibility for third-party content, including information accessed through hyperlinks. Certain assumptions have been made regarding historical performance information included herein, and such performance information is presented by way of example only. No representation or warranty is made that the performance presented will be achieved as a result of implementing an investment strategy substantially identical or similar to that described herein or that every assumption made in achieving, calculating, or presenting the historical performance information has been considered or stated. Any changes to assumptions could have a material impact on the investment returns that are presented by way of example. Returns for any period may be attributable to certain market conditions, fund size, and timing of transactions, which may not be repeated. Diversification does not assure a profit or protect against loss in a declining market. Past performance is no guarantee of future results. Actual results may vary.