This article was last updated on June 20, 2022
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Note June 17,2022 – More volatility in stocks – Time and Tide Don’t Wait
Alongside to central bank policy, political economy and valuation are all relevant for investment finance. These facets appeared glossed over until recently by consensus. Unlike the last decade ( or even three for some) now and for the next 12 – 18 months, it is central bank policy that is likely to have to follow, not lead developments. Meanwhile, fragility appears among major and minor authoritarian as well as democratic countries, both individually and globally collectively. The old adage of time and tide don’t wait would apply as investment finance is restructured away from chronically suppressed administered rates. Monetary creation ahead of the ability for efficient activity has often led to inflation, whether in advanced or emerging countries, in the past for instance in the 1970s and in current but now erstwhile massive quantitative ease, both with the shock of higher crude oil prices.
A pivot by the Federal Reserve appears further signaling exit pathways for asset portfolios. In the June 14/15 2022 FOMC, the potential for a prolonged sequence of large administered rate increases was signaled, with the present tranche being 75 basis points. Compared to our then aggressive long out of consensus view of 3.50% as being terminal rate by mid-2023, the data as well as central bank commentary indicate 5% could well be breached for Fed Funds and bring valuation to traditional levels. Flexed likewise appear the Bank of England, Bank of Canada, the Reserve Bank of Australia among the advanced countries and among emergent countries with the highest growth, the Reserve Bank of India. Still, not all central banks appear in this lane, notably the Bank of Japan among advanced and the Bank of Turkey among emergent countries. Policy divergence and currency flux have been part of market breaks, small or large such as in 1987. About trade tensions looming from domestic stresses, noteworthy is weakness against the US Dollar from the Yen, in Europe, for emergent countries and even for resource currencies like Canada and Australia.
In another watchful signal much earlier in 2022, while the Fed released stress tests for systemic banks under its supervision, in Europe lately both in Britain and in continental Europe, stress tests signaling have emerged lately. On risk from leverage stretching to reach for return, non-banking financials that may be outside central bank supervision but appear to us to be of concern for unpleasant surprise from the rapidity of the present movements in capital markets.
With new results imminent, striking has been the number of companies and the sectoral breadth of those discussing operational cost challenges – not just in comparison to this earnings cycle of 2009 onwards but also versus many prior ones, with the arguable exception of that giving rise to the great restructuring of the 1980s. Rather than concept businesses, leverage and share buybacks, we see the current advantages as lying with strong balance sheets and strong operational control. These aspects can already be seen in the hard hit Information Technology sector that peaked out at around 32% of the S&P 500, is currently close to 28% but still above our capped target of 25% to tilt against momentum and about which so-called legacy seasoned companies have held up better.
On risk premiums and fixed income yields, the present twists include those within sovereign bonds on a global basis and within the corporate sector, in spreads within credit tranches. It is a market contrast to penchant to stretch for yield of not so long ago. In mirror opposite to many investment practices from 2008 and into 2021, a reverse reset is likely to lead to volatility. As past, culmination of present bear market stresses are likely to include a spectacular failure which has yet to take place, prior factoring and dark pool financing notwithstanding. Perspective exists in the rise in tribulations of the conglomerates into the 1970s, the resource sectors in the 1980s and the Technology Media Telecom catharsis of the late 1990s. Rather than geographic or sector rotation, advantage may currently lie with financial strength and operational quality of delivery.
Remarkable fragility appears among major and minor authoritarian as well as democratic countries, both individually and globally collectively. Geopolitical tensions appear prolonged. It took years for in the 1980s the observation to be realized of then U.S. President Reagan that defense spending beyond the economic capacity of the then Soviet Union would expose its fragility. Nuclear saber rattling and actual scorched earth tactics notwithstanding, the same may hold today for Russia in its current Ukraine war. Meanwhile, global logistics weaknesses exposed earlier in 2021 pandemic and now basic food grain as well hydrocarbon availability could take considerable time to be overcome, at ongoing cost to even the most basic consumers and companies alike. In the 19th Singapore Security Summit from June 12 2022 on wards, rhetoric has been heated between the United States and China, ostensibly over Taiwan but likely of a broader context in Asia from the south China seas to the broader Indo-Pacific region. The plethora of missile testing by North Korea appears now being matched by South Korea and Japan. Meanwhile, war in the Middle East and a still to be resolved nuclear agreement with Iran remain. In the United States, the November mid term elections are now just over four months away. China has a key CPC Congress in the same time frame. In Europe even as Ukraine war developments affect economic and defense structures, a series of other salient developments appear such as British Brexit revision demands amid many governments with weak mandates, ranged from Britain in by- elections; to Germany with a coalition; and now in France in its parliament elections. At variance to many implicit assumptions in the markets into 2021, the political economy environment appears fragile in several ways which could be investment adverse via accentuating pressures for near term expediency.
Even as inflation has pushed towards 10% in several measures in advanced countries and much higher into double digits in several emerging countries in the early summer of 2022, organizations like the World Bank, the OECD and private ones suggest global annual GDP growth in 2022 could be close to a recession like 3% after having been closer to 6% in 2021, admittedly from a Covid pandemic depressed base. In the key growth economy of China, its target annual GDP growth rate has been reduced to 4-5%, compared to its global stimulus leading 20 year average rate above 10% and its single year 2007 peak rate of closer to 15% during the pre-Covid and pre- credit duress periods. We see as being relevant for investments to recognize that the growth dynamics are likely changing amid the ongoing pandemic, ongoing war and ongoing elevated inflation environment of today. Previously in recent decades, aspiration consumer spending in advanced and emerging countries alike, the evolution of market based policies from statist economies in emerging countries, just-in-time global logistics by businesses and lastly but not least, massive quantitative ease all had major roles but the mix now is likely to be much more convoluted.
For businesses, just-in-time logistics had been found to be wanting for instance by the Suez Canal shipping accident ahead of and also during the ongoing Covid pandemic and now amid war in Ukraine. Tet another factor would be likely in the long term from climate change. In basic terms, money creation ahead of the ability of efficient activity has led to inflation, whether for instance ongoing in emergent Zimbabwe; or Weimar Germany in the 1920s/early 1930s;or guns and butter U.S. policy in the 1970s and the current but increasingly erstwhile massive quantitative ease – both with the shock of higher crude oil prices. We believe that currently amid higher inflation and slower, fractured economic growth, there has emerged increased recognition of the risk of facets like embedded inflation among several major central banks. As such, a pivot underway now for several months by the Federal Reserve appears further accentuated in signaling exit pathways for asset portfolios. In the June 14/15 2022 FOMC, the potential for a prolonged sequence of large administered rate increases was raised, with the present tranche being 75 basis points. Compared to our then aggressive long out of consensus view of 3.50% as being its terminal rate by mid-2023, the data as well as central bank commentary indicate 5% could well be breached for Fed Funds rates with impact in reducing valuation to traditional levels. The Bank of England, Bank of Canada, the Reserve Bank of Australia among the advanced countries and among emergent countries with the highest growth, the Reserve Bank of India have flexed likewise. Still, not all central banks appear in this lane, notably the Bank of Japan among advanced and the Bank of Turkey among emergent countries.
Policy divergence and currency flux have been part of market breaks, small or large such as in 1987. The Yen has been notable in recent slippage and was in upswing into 1987, underscoring that rapidity and not just the amplitude of change in currency rates can surprise capital markets. In another watchful signal, while the Fed released stress tests for systemic banks under its supervision much earlier in 2022, in Europe lately both in Britain and in continental Europe, stress test signaling has emerged lately. On risk from leverage stretching to reach for return, non-banking financials that may be outside central bank supervision appear to us to be of concern for unpleasant surprise from the rapidity of the present movements in capital markets. Weakness against the US Dollar from the Yen to Europe to emergent countries to even resource currencies like Canada and Australia is noteworthy. As global growth slows and inflation remains elevated, poliy pressures such as trade tensions could well rise further into tariffs and other barriers in response to domestic policy stresses.
For companies, ahead of the next tranche now imminent and in the now releases, discussion of results have been quite at variance from post 2009 prior periods. The number of companies and the sectoral breadth of those discussing operational cost challenges has been striking recently – not just in comparison to this earnings cycle of 2009 onwards but also compared to many prior ones, with the arguable exception of that giving rise to the great restructuring of the 1980s. Rather than concept businesses, leverage and share buybacks, we see the advantages as currently lying with strong balance sheets and strong operational control. These aspects can already be seen in the hard hit Information Technology sector that peaked out at around 32% of the S&P 500, is currently close to 28% but still above our capped target of 25% that we used to signal a tilt against momentum while so-called legacy seasoned companies have held up better. More broadly and unlike prior recent quarters where merely meeting oft reduced consensus was applauded, such momentum fervor has been replaced likely by focus on valuation and operational delivery. On risk premiums versus fixed income yields, the present twists include those within sovereign bonds on a global basis and within the corporate sector, in spreads within credit tranches – a marked contrast to the penchant to stretch for yield of not so long ago.
We see these functionalities away from minimalist suppressed administered rates as still being underway, including that of equity valuation re-adjustment. In role reversal well into the next 12- 18 months, central banks appear likely being forced to follow, not lead political economy and valuation developments for investment finance. In mirror opposite to many investment practices from 2009 and into 2021, a reverse reset is likely to lead to volatility and to favor for quality. As past, culmination of present bear market stresses are likely to include a spectacular failure which has yet to take place, prior factoring and dark pool financing not- withstanding. Perspective arises from the tribulations of the conglomerates into the 1970s, the resource sectors in the 1980s and the Technology Media Telecom catharsis in the late 1990s. Rather than geographic or sector rotation, current advantage is likely to lie with financial strength and operational quality of delivery.