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BFI Infinity
February 6, 2023

Improving market momentum setting the tone for 2023?

In our October 2022 investment update, we anticipated inflation would fall from the extremelevels reached at the time and that with falling inflationary pressures, financial markets would start gaining positive momentum again. We’re not at the end of the bear market yet, but at least we see substantial improvement from the very negative dynamics of 2022.

So far, things have been unfolding pretty much as we had expected back in October. Inflationary pressures, while still too high by historical standards, have indeed started to dissipate and the substantially lower input costs that we mentioned in our last report, have started to put downward pressure on production costs. This is certainly good news and the effect on global financial markets can be felt already. Stock markets were able to recover in Q4 of 2022 and also seem to be off to a good start in 2023.

Also, as expected, falling inflation has already started to put downside pressure on the U.S. Dollar. In 2022, the USD went up by around 20%. Since Q4 of last year, this is now going into the opposite direction and the Dollar Index has already fallen sharply from its high in the fall. Often when the dollar is falling, precious metals prices move inversely and start to rise. The past few weeks have not been an exception. Starting from the low 1600s, gold prices have recently surpassed $1900 and continue to be well supported.

The improving market momentum that we have seen in the last couple of weeks is certainly encouraging, but we want to stress that the bear market is not yet over. We might be close to the end, but a cautious approach is still the way to go. This is also the reason why we decided to add downside protection to our standard strategies by way of put options. We want to be protected against a sudden and severe market drop for reasons that we can’t foresee. As we have stressed many times in the past, in our view, prudent risk management and downside protection in uncertain times are the key to long-term capital preservation and growth.

From a macroeconomic view, the picture seems to be stabilizing or even improving a little bit at the moment. Growth has been weakening in the past 12 months and the sharp increase in interest rates in most major economies has had a dampening effect on these economies. Whether or not we are going to see a recession in developed markets will become clear in the coming weeks or months. However, what is already certain is the fact that growth will be very weak. This is not surprising, considering the destructive effects of spiking inflation since 2022, which has acted like an extra tax on every household by significantly reducing the purchasing power of savings.

Probably the most significant development in the past few weeks has been the end of the Chinese “Zero-Covid” policy. Since the pandemic begun, China has had a very strict, zero tolerance policy with widespread and lasting lockdowns. This made it even more difficult for Chinese businesses to operate and since Chinese companies are often the starting point of global supply chains, the lockdowns have resulted in severe disruptions around the world. It was also very interesting to see that the Chinese government ended its zero-tolerance strategy as a result of rapidly growing frustration among the people. What this shows is that it does indeed matter how people in China react to political decisions from the central administration. For many people in the West, this came as a real surprise.

While China’s reopening is certainly positive for Chinese businesses, the question is whether it is inflationary or deflationary for the global economy. Rather than guessing, it is better to check what the actual effect of the country’s reopening has been so far on prices, especially commodity prices. Iron ore or copper, for example, already moved up by around 10% since the reopening was announced and it seems that prices are still trending higher. The European Central Bank recently commented on this and it expects China’s reopening to be inflationary for western economies. What seems to be clear is that the long-term outlook of major central banks is leaning towards higher inflation rather than deflation, which could be a disaster given the high levels of debt in the government, corporate and private sector.

So, keeping inflation above target but bringing it down to more sustainable levels seems to be the obvious strategy that central banks are following. Therefore, inflation could settle somewhere around 3% going forward. The challenge is that it is much easier for inflation to go higher in today’s situation. Almost the entire developed world is suffering from chronic labor shortages, the market is very tight and this means higher prices in the future. At the same time, these labor market conditions will also limit the potential growth rates of western economies. Growth rates in coming years will probably be significantly below what we saw in the last two or three decades and the contribution from developed markets will likely continue to decrease, while the contribution from markets like India, China and other emerging nations continues to rise.

Geopolitical shifts are making the situation even worse, as we are moving to an increasingly multi-polar world with increasing tensions (or even wars!) between the various blocks, which is also inflationary rather than defla- tionary. In the short to medium term, let’s say the next 12 to 18 months, it seems very likely that growth will initially weaken and then stabilize at lower levels. A subsequent recovery will be slow and the long-term potential growth rate will be relatively low for a long time to come, unless there are any significant improvements in terms of efficiency gains, which we don’t see as very probable. For many developed nations, excessive levels of debt have become a serious problem, which is set to create more and more headwinds for economic growth. As part of the “solution”, we expect a continued effort to try to reinflate these economies in order to indirectly devalue the debt. In fact, we are not only seeing this as just the most likely scenario, but as the only realistic way to move forward.

While this remedy is known to work not only in theory but also practice, it will have a sharply negative effect on the valuation of currencies. This will become a big problem, especially for the U.S. and the USD, while other currencies will benefit and rise in relative terms. For example, the level debt/GDP in Switzerland is below 30%, while the U.S. is already at 123% and rapidly catching up to nations like Italy. Investors need to take this into consideration when making long-term investment decisions. We believe this creates an even stronger case for constructing a global portfolio.

Investors have to realize that we are not simply “going back normal”, to the world as we knew it before the pandemic. This is an entirely new chapter, something we have already written extensively about in previous years. Our special report (On the Brink of a New Era – are you prepared?) that we wrote more than two years ago offers a great summary of what we are seeing now and what we can expect to see next. The sharp spike of inflation in 2022 has left consumers with less buying power and the full effect of that will only be seen in 2023. The chart above shows that the U.S. consumer is far worse off than before the pandemic as savings rates plummeted. This is not a good signal for consumption going forward.

As we are moving in to this “New Era”, we must bear in mind that it will become more challenging to invest. Simply buying and holding a basket of growth stocks is not going to be enough. Over the last 10 years, technology shares and the FAANG stocks have outperformed everything else by a huge margin and investors have increasingly pumped money into a relatively small basket of tech mega cap stocks. This was also the main reason why the U.S. stock market has outperformed just about any other market globally. This is most likely now coming to an end and the relative outperformance of international stocks over U.S. stocks in recent weeks and months might already be a con- firmation that this paradigm shift is now underway.

These changes are also influencing our own investment approach, as we are now focusing on sectors and companies that not only have strong current fundamentals but also a strong business model for the coming years. Valuation is another important criterion, which has not been that important in the past, as investors were willing to buy growth stocks at huge premiums. Now, however, stocks like Facebook/Meta, Google, Amazon, tc. have already tumbled by more than 50% from their peaks, highlighting the need for investors to be much more selective going forward. This is the reason why we are screening globally for attractive investment themes and trends and why we don’t want to limit ourselves to just the U.S. and/or Europe. We believe that the future will require a global investment approach and that indexing the market will not work.

We think that 2023 will offer investors very attrac- tive buying opportunities, but despite the improving momentum, there are still risks in the coming weeks that should not be ignored. Investors are expecting central banks to eventually stop their interest hikes when they see inflation move lower. We share this view, however, the timing remains uncertain. With economic momentum slowing, there comes the realization that very weak growth or even a mild recession is now becoming a very real possibility. This could, at least in the short term, cause additional downside pressure for markets, which would in turn bring the reversal of central bank policies even closer. This will eventually be the time when a strong and more sustainable recovery can start. We think this is now getting closer, but we are not quite there yet.

We hope that you all had a good start to 2023 and that you’re ready for another interesting year. We live in a highly dynamic world and this can sometimes create concerns, but we are also living in a time of fascinating transformations. The last three years have brought changes for all of us that would have been unimaginable a few years ago, especially the pandemic and the way it affected all of us. Last year, the outbreak of the Ukraine war reminded us that freedom has its price and that we should always be proactive and protect the freedom that we have. But the biggest risk to our freedom might not come from the outside, but from the inside.

The last couple of years have shown that western societies tend to create their own problems and that government interventionism and control is on the rise. Freedom is based on true tolerance, individual responsibility and respect for others, and a strong market economy. Capitalism, the free market and our western democracies are certainly not perfect, but they work better than anything else we’ve tried. Instead of pushing for more laws and rules, the world needs a renewed sense of optimism and a strong belief in a better future. Instead of drowning in pessimism and problems, we need to focus on solutions and opportunities.

With these words, we would like to wish you all a great 2023!

Are chips the new oil?

Semiconductors have been regularly in the news over the last few years and significant developments intheir supply and demand dynamics have often had a huge impact on other industries, from the automotive sector to big tech. However, the shift that is presently underway has the potential to reshape the semiconductor market and it can offer very interesting investment opportunities to those who pay close attention.

The story so far

Semiconductors, also referred to as chips (even though technically “chip” is a blanket term for semiconductor component products), are found in countless modern electronics, such as computers and smartphones, medical equipment, or household appliances. Their distinguishing characteristic, as the name implies, is that unlike insulators or pure conductors, they can conduct electricity under certain conditions but not others, depending on how they’re designed and the purpose they’re meant serve. There are different types of chips, destined for different uses, but broadly, the four main categories: memory chips, microprocessors, commodity integrated circuits and ”systems on a chip.”

The chip industry is an extremely competitive and fast moving one, as companies constantly try to come up with smaller, faster, more efficient, more reliable products, employing new technologies to bring down the per-chip production cost. Also, unlike in the infancy of the industry where companies would undertake the entire chip production process, today the supply side is much more fragmented and there is a much higher degree of specialization and outsourcing.

For instance, there are foundry companies, whose sole focus is manufacturing, there are extremely specialized design companies, and there are separate testing and packaging businesses too. Many semiconductor companies today, known as “fabless” (short for fabrication-less) only handle design and marketing and they outsource all or part of their manufacturing.

Although semiconductors were invented in the US, East Asia eventually became a manufacturing hub, with Taiwan emerging as the biggest producer of the world’s most advanced chips and with the Taiwan Semiconductor Manufacturing Company (TSMC) as the world’s top chipmaker. Other leading nations include Japan, South Korea, the US, and China. China in particular, thanks to extensive state investments and the massive import of crucial talent and tech, has been catching up fast over the last years.

As far as the other side of the equation goes, namely demand, while in the past semiconductor growth was linked to personal computer and mobile phone growth, today chips are essential in the production of virtually all modern electronic devices, appliances and vehicles. As a report by Accenture aptly points out, there are about 170 semiconductors in the average smartphone and anywhere from 1,000 to 3,500 in a modern car. That’s to say nothing of electric vehicles, which, according to the International Energy Agency, require almost twice as many chips as equivalent conventional cars.

Chips are what make our modern world go ‘round and a harsh reminder of that came last year, when global semiconductor shortages caused widespread disruptions in multiple industries that depend on them. The “great chip shortage” was triggered by the lockdowns and the forced business closures that were enforced during the pandemic and hit Asia particularly hard. The lockdowns also had an impact on demand, as remote work meant that the need for more laptops and smartphones skyrocketed, creating a perfect storm.

Apart from this “covid shock”, however, there were also multiple other factors and various structural issues that rendered the sector relatively fragile and vulnerable to such a scenario. As S&P Global highlights, “Over the last decade, the market has seen many businesses moving toward just-in-time inventory strategies. This is cost-effective and efficient when the supply chain is without shortages, because a just-in-time system saves businesses on inventory storage space and costs as they reduce their supply chain inventory. Consequently, businesses depend on factory capabilities to accurately increase and decrease production based on their forecasted orders and inventory pipeline.”

The big shift

While the worst is over, for now, in the chip shortage crisis, there are other important developments that investors need to pay attention to. Beyond the vulnerabilities that the shortage exposed and the clear realization that as technology advances, the need for more and more chips will be inevitable, more recent geopolitical events served as fresh reminders of how essential it is for a nation to be “chip-independent”. It became clear that it’s not just securing the chips that is important, but one must also be strategic about who supplies them. Much like“energy-independence”, semiconductors took on a wider role, and the control over and access to them eventually came to be seen a national security concern by a growing number of countries.

The war in Ukraine and China’s “special relationship” with Russia, as well as the ever-intensifying frictions between China and Taiwan, gave rise to serious fears over future chip supply and motivated the US political leadership to take action to prepare for worst-case scenarios. The CHIPS (Creating Helpful Incentives to Produce Semiconductors) and Science act, passed last summer, is meant to boost American semiconductor producers and it provides $280 billion in new funding over the next ten years in various subsidies to domestic chipmakers. This represents one of the biggest steps so far to onshore and reshore chip manufacturing and the US isn’t alone. The EU is also trying to support its own chip industry, with the proposed European Chips Act, Taiwan recently offered tax credits to its chipmakers in order to maintain its technology leadership, while Japan and South Korea also provided their own incentives.

Apart from direct support to domestic manufacturers, however, countries are also trying to band together to reduce their reliance on China. The “Chip 4 alliance”, comprised of the US, Taiwan, S.Korea, and Japan, is a proposed semiconductor supply chain alliance. In- troduced last year, it represents an effort by the US to unite forces with its East Asian allies to counter the regional superpower and cut off its access to the tech needed to produce advanced chips. Further- more,aftertheUSalreadybannedtheexportofchips, chip-making equipment, and software containing US tech to China, it also secured deal in late January with the Netherlands and Japan to restrict exports ofadvancedchipmanufacturingmachinerytotheir common adversary.

Investment implications

The bullish case for semiconductors in general is rather clear cut, with a number of mega trends aligning in its favor. Demand for chips is set to keep growing, as technical innovations in the indus- tries that need them move apace. The global push for the mass adoption of EVs, as part of the fight against climate change, might or might not be suc- cessful, but for the foreseeable future, EV makers will continue to gobble up twice as many chips as their internal combustion engine (ICE) peers do.

Other “green” initiatives and renewable energy producers are also set to play a growing role in pushing up demand, as both solar panel systems and wind turbines are highly dependent on semiconductor technology. AI applications, most recently capturing public attention due to the impressive ChatGPT, are another clear and imminent epicenter of demand, as are the perpetually advancing industrial robots and other automated equipment. According to a recent report by McKinsey, “the global semiconductor industry is poised for a decade of growth and is pro- jected to become a trillion-dollar industry by 2030”.

The most straightforward way for investors to take advantage of the semiconductor industry’s expected growth is the “pure play” approach of investing directly in chipmakers. Another interesting investment approach is to focus on chip-making equipment, instead of the end product itself. Overall, Asia might still be leading the semiconductor race at present, but solid, resilient companies can be found in the West as well, and given the recent moves by the US and Europe, that could be increasingly true going forward.

Legal Disclaimer

This report was prepared and published by BFI Infinity Inc., a Swiss wealth management company registered under the U.S. Investment Advisors Act of 1940 with the U.S. Securities and Exchange Commission (SEC) as an investment advisor.

This publication may not be reproduced or circulated without the prior written consent by BFI Infinity Inc., who expressly prohibits the distribution and transfer of this document to third parties for any reason. BFI Infinity Inc. shall not be liable for claims or lawsuits from any third parties arising from the use or distribution of this document. This publication is for distribution only under such circumstances as may be permitted by applicable law. This publication was prepared for information purposes only and should not be construed as an offer, a solicitation or a recommendation to buy, sell or engage in any venture, investment or financial product. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis. Although every care has been taken in the preparation of the information included, BFI Infinity Inc. does not guarantee and cannot be held responsible for the accuracy of any statistic, statement or representation made. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results.

All information and opinions indicated are subject to change without notice.

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