This article was last updated on July 18, 2022
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Q3/2022 – Beyond Minutiae To Count Markets
Beyond Minutiae To Count : As market participants and policymakers alike adjust to a reality existent now for six months into mid-2022, we expect heightened volatility and focus on quality to expand over the next 12-18 months. It is likely to supersede even geographical or sector rotation. In asset mix, we see reason to hold precious metals as hedge, above average cash reserves with more favor for shorter duration in fixed income and greater discrimination in favor of quality of tangible business delivery amongst equities.
It often appeared in momentum markets that attaining hyper speed in transactions would trump all else. Now, looking beyond the minutiae has risen in importance in policy, currency, fixed income and equity valuations. In the late 1980s/1990s, key policy issues were how robust monetary policy and how much fiscal control was needed. Over the next 12-18 months and beyond, both are likely to be key beyond the minutiae.
Appearing dormant until lately, change appears in currency markets. Whether for individual countries or as global harbinger of smaller or larger market breaks (such as around the Plaza agreement of 1985), sudden movements of currency exchange rates do portend dislocation risk. Presently, the U.S. Dollar rate has sharply risen against many currencies, not just the Yen and the Euro. Several emergent country currencies appear already in financial crisis. Several assessments suggest global GDP growth in 2022 as being closer to 3% which to us appears just skirting recession. Amid elevated inflation, energy costs, dislocations due to war and pandemic, urgency could become acute for many countries to respond. Domestic pressures not limited to lumber or steel or autos have a long history of seeping into U.S. tariff and currency considerations, with elections in the United due in November 2022.
The heyday was likely from 2009 to most of 2021 for massive quantitative ease. The risks of policy bifurcation have become present. The Federal Reserve has clearly signaled a series of administered rate increases as has a leadership coterie, such as the Bank of Canada with a full 100 basis point increase on July 13,2022. Well into 2022, it appeared being only hesitantly followed by the European Central Bank and the Bank of Japan has yet to do so. Compared to a goal of stability around 2%, inflation is many multiples thereof in many advanced and several deciles thereof in some emerging countries. Irrespective of whether monetarist theories are espoused and with the realities of the 1970s a risk, imbedding inflation expectations needs to be avoided.
From their lows, 10 year U.S. Treasury Notes yields have increased over five-fold with potential for 5% over 12-18 months due to inflation levels and the divestment sequences for Federal Reserve portfolios. In Europe, far from a supposed shortage of German bunds for reserve purposes supporting negative yields, their yields have in fact increased well into positive territory. Quality in lower credits such as Italy appears being questioned, despite new powers for the ECB with respect to Euro bonds. Lower down in credit sequencing, CCC corporate bond yields appear reported as aggregating close to an onerous 15%. Non-Bank Financial Institutions appeared especially engaged in leverage and yield momentum activities to deliver yield with less regard to credit risks. As earnings and especially cash flow challenges mount, lesser credits may find severe the servicing demands of debt acquired in balance leverage strategies. With the Fixed Income markets as being in early stages of re-adjustment, we favor shorter duration and higher quality as being imperative.
As equities in the first half of 2022 have experienced declines not seen in decades and after arguably close to two decades of focus and even fervor for growth replete with crescendo for momentum, value has reasserted itself in stealth. As fixed income yields rise deliberately on policy matters or in response to external events, risk premiums can be expected to rise in capital markets and valuations contract. A newer set of corporate releases is imminent. A chronic weakness within consensus estimations has been an underestimation of earnings turns such as 1990/1992 or 2000/2001 or 2006/2008 quarterly sequences. Company earnings appear peaking out due in part to cost increases squeezing operating margins, due to rising interest expense costs with more challenged revenue streams in many industries, even if recession were avoided or be mild.
We espouse quality of delivery instead of fishing within the momentum fervor elements of the last business cycle. Rather than geographic or sector rotation, advantage may currently lie with financial strength and operational quality of delivery. We see the Financials as being crucial to capital market performance, still led by strong restructuring due not least to weaknesses in other financials. Within growth, creativity as well as financial strength therein seems still underappreciated in Healthcare which we overweight with Information Technology which we continue to cap at 25% weighting for diversification reasons.
In cyclicals, we favor Industrials over Consumer areas at this stage of potentially a frugal rather than aspiration oriented consumer. Meanwhile accelerated long term defense spending plans appear. Amid rising costs resulting from inflation and in response to logistics challenges exposed, the rebuild of modern facilities is likely to be urgent for many companies and hence constructive for Industrials. We are overweight Materials and Energy to complement strategic role recognition changes emerging from the Ukraine war about location and usage of basic materials from food to industrial to rare to precious metals.