Sandwich Update: December 2024 – January 2025

Please do make any financial decisions based on the contents of this blog. My blogs are designed to be thought-provoking and introspective, not financial advice. Please do not act on any document unless it is titled “Statement of Advice.”

Following a spectacular run up to December, our Defensive 50 (“Tuna Salad Wrap”) experienced a small drawdown, as did most financial assets. Santa was very unkind to markets this Christmas.

For our portfolio the biggest detractors were duration government bond ETFs AGVT (the Aussie one) and GGOV (the US one). To understand why, you must first understand that there is an inverse relationship between bond yields and bond valuations. When yields rise, the value falls, and vice versa. Investopedia’s explanation is one of the easier texts to follow: https://www.investopedia.com/ask/answers/why-interest-rates-have-inverse-relationship-bond-prices/

So, we want bond yields to FALL because when they do, our duration bond securities RISE.

In December 2024, bond yields rose (bad), for the following main reasons:

The perception of economic resilience: Stronger-than-expected economic data, questionable as it may be, particularly in employment and consumer spending, have led investors to reassess their expectations for Federal Reserve policy. Job numbers and a slight uptick in consumer confidence suggest that the economy may not require as many interest rate cuts as previously anticipated, prompting a rise in long-term yields.
Federal Reserve policy shifts: Although the Federal Reserve has implemented rate cuts, the bond market had already priced in these moves. As a result, when the cuts occurred, there was limited downward pressure on yields. Additionally, the Fed’s indications of a slower pace of future rate reductions have led to upward adjustments in long-term yields.
Increased government borrowing: The US government’s expanding fiscal deficits have necessitated higher issuance of Treasury securities. This increased supply, coupled with concerns about the long-term sustainability of government debt, has contributed to rising yields as investors demand higher returns to compensate for perceived risks.

I believe these conditions will be short-lived. The following scenarios are all highly likely and would contribute to significant decrease in bond yields (which is good).

Interest rate cuts: A bad GDP print could prompt the Federal Reserve to adopt more aggressive monetary easing, including additional rate cuts or quantitative easing measures, which would typically lower Treasury yields. Further rate cuts are all but guaranteed in US throughout 2025. Trump’s pro-business stance also is conducive to further rate cuts. Rate cuts are realistically expected to start in Australia mid 2025.

Fiscal outlook: A reduction in government borrowing needs, perhaps through decreased deficits or fiscal reforms, could alleviate upward pressure on yields by reducing the supply of new Treasury securities. Team Trump have committed to an immediate slashing of government spending, and in the likely event we have a change of leadership back home, Australia will follow suit.

Inflation expectations: If inflation expectations were to decline, investors might accept lower yields, leading to a decrease in Treasury rates. Ignore the fact that the “real” rise to the cost of living is far higher than the official CPI prints (both in Australia and US), if the data points towards lower inflation, we will see lower yields.

Aside from our duration bonds which make a significant portion of the “Tuna Salad Wrap” (combined 17%) , the remainder of the portfolio is going strong.

I think right now would be a bad time to reduce our exposure to AGVT & GGOV.

I also think it would be a bad time to increase exposure to equities.

The other day I published a list of books I read in 2024. One book that really stood out for me was The Black Swan. This book is a lot to take in, but one of the key takeaways in the context of investments is as follows.

The way global financial markets move is the result of trillions of decisions made by billions of consumers, fund managers, policymakers and algorithms – all driven by the impulses and desires of humans who evidently don’t behave rationally. The system is so complex that even the best investors in the world can sustain returns only slightly above average for the long-term (10+ years), and those who pull freakishly high returns cannot sustain such outperformance for long – often crashing and burning in their delusions of invincibility and permanence.

For hundreds of years academics, economists, social scientists and so-called “experts” have been predicting economic and financial market movements using models and theories that sound impressive to the average punter, yet are almost always spectacularly wrong. These “experts” retain positions of power and authority by sheer ignorance of their followers and voters. Almost no-one predicts the Black Swan events that change everything, and despite their astronomical consequences, economists and policymakers refuse to factor them in. You need a wild imagination to contemplate Black Swans, but when you correctly predict one it can only be a fluke because it is impossible to know the future. Anyone who claims otherwise is someone you absolutely should not trust.

I’m not overly concerned with predicting the Black Swan event. I have some very specific theories ranging from a deliberate and controlled demolition from the major fund managers to discredit the Republicans (and get out at the top), to a cyber attack that will disable critical metropolitan infrastructure.

My point is, we don’t know what will happen and we don’t need to know. Anticipating catastrophes you have no control over (and probably will not happen) is anxiety-provoking and unproductive. Instead, the best way to prepare is to accept that a Black Swan event of some kind probably will occur. If you survive today it means one of two things: you are immortal or you are one day closer to death.

It’s not the Black Swan event you should be concerned about

Equity markets are overpriced, and this is the result of a series of bad fiscal decisions over the past 5+ years that have conferred enormous amounts of printed money into the system with very little production to show for it. Once you understand that money does not equal production, you’ll begin to understand how fragile the financial markets really are. The Black Swan will not in of itself be the thing that causes financial chaos. The damage has already been done. Rather, the Black Swan will shine a light on the mistakes that were made.

The strange part about this is, none of it is controversial. Even the most bullish of investors right now are acknowledging how insanely overpriced everything is, but they are still pushing forward in the hope that they won’t be the one to pin the flag on the summit. They’re delaying the hangover by drinking even more – this strategy works for a while, but doesn’t end well.

I’ll finish on an interesting chat I had with a family friend in Sydney on Christmas Day. He is a very clever guy with many qualifications in finance and works as a CFO (or something like that) for a major corporation (can’t say which one). He was “mansplaining” to me that if major sell-offs occur, the money has to go somewhere, so if for instance money goes from Equity A to Equity B, B will theoretically rise in value by the same amount that A will fall in value, thus implying that if the overall market capitalisation remains the same, diversified portfolios of aggressive equity strategies will hold their value.

How cute!

Money over matter and market makers (unintended alliteration!)

The theory that matter can neither be created nor destroyed does not apply to money. Money gets created when Central Banks (The Fed, RBA, ECB etc) type it into a computer and buy bonds and create reserves for private banks to pile new debt upon… and voila, you have new money! (100 trillion dollars worth!)

The way this money gets destroyed is something very few people stop to consider. When these bonds mature (get paid back), and the Central Bank decides not to reinvest them, then the money effectively disappears from circulation. This is what the finance bros call “quantitative tightening (QT).” How and when households, corporations and even governments decide to reduce debt rather than borrow more is very complex so I won’t get into it here. The key thing to understand is when interest savings (guaranteed) outweigh the expectation of interest earnings (not guaranteed), there is a higher appetite to repay debts.

The other flaw in my friend’s argument is that value (not necessarily money) can very rapidly “disappear” from share markets by virtue of the market maker. Say you’re a big fund manager and you think Apple shares will fall to zero next week and you want to sell $50 billion worth of your Apple shares. You can’t just click your fingers and dispose of your Apple shares and receive $50 billion cash in hand. There’s not enough cash (“liquidity”) for that. So you put in a sell order and then the market maker gets back to you with a price that is based on a number of highly complicated rules, regulations and, most important, market conditions. If sentiment is good and investors really want the stock, you’ll get a favourable price, albiet much lower than the current price (any sane investor would question why such a large sell order?). But if sentiment is dire, you’ll get a much lower offer. By the time the news gets out, people will be wondering why the hell you are selling? What do you know about Apple that we don’t? Quick math suggests that in today’s market, a $50 billion sell order would result in a ~10% overnight drop in Apple’s share price before any shares or money change hands.

And that, my friend, is how money “disappears.”

My retort was quietly acknowledged and he didn’t seem to have anything further to offer in this conversation. We cracked another beer and enjoyed a lovely Christmas afternoon trading stories and memories.