Shock and Awe Necessary to Curb Complacency

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This article was last updated on August 22, 2022

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Note August 21,2022 – Shock and Awe Necessary to Curb Complacency – Subodh Kumar

Note August 21,2022 – Shock and Awe Necessary to Curb Complacency:

To borrow from long existent military doctrine, shock and awe are necessary to curb complacency that has much has to do with human psychology rather than modelling. For Finance by the late 1970s, central bank interest rate/monetary policy overshoot were globally required to curb inflation. Once more on shock and awe in Finance but on the opposite side twice in the late 1990s and 2000s, minimalist interest rates and massive quantitative were engineered to curb grating paralysis inactivity. Currently, interest rate/monetary policy overshoot may likely again be globally required. Inflation of 10% annually exists in Britain, is muted for Germany and is so monthly in several emerging economies.

Far from a languid summer of 2022, much has been afoot not least on dichotomy in central bank policy and economic prospects. At one end small to medium to large central banks in Norway, New Zealand, Canada, India, Britain, Europe and the Federal Reserve have increased rates and signalled more well through 2023 to curb inflation from getting imbedded and already 9% overall. In other large countries, Japan left policy unchanged despite improved growth and China cut rates likely on economy and real estate stresses while emerging countries like Turkey appear cutting rates despite weak currencies.

Worldwide, the war in Ukraine and Covid pandemic remain substantive issues alongside the operating and financing cost impact of the rise in U.S. dollar exchange rates that has accompanied Federal Reserve policy change. Admittedly difficult to model and thus relegated as extraneous in consensus, political and economic aspects appear currently as even more interlinked.

Global growth was slowing and exposing logistical weaknesses even before the Covid pandemic and war in Ukraine both exposed tensions including for food and energy supply. Global economic growth seems close 3% annually and likely recessionary on mix. Superpower strategic military and trade tensions appear taut ahead of mid-term Congressional elections in the United States and the National Congress of the Chinese Communist Party both in November 2022. Meanwhile, the just announced U.S. fiscal package including climate change stimulus and the internal growth package announced in China in March 2022 appear aspirational when compared to the immediacy of massive fiscal injections just after the credit crisis of 2008 and earlier in the 2000s, the role of China as crucial locomotive. Europe has both short and long term budget and energy security issues to address. Anticipation of global stable economic recovery is likely only from year end 2023 onwards and inflation curbing needs immediate.

The results released into late summer 2022 and corporate discussions of future prospects has been sobering in the  emergence of bifurcation and in exposing dissonance with modest revisions so far in consensus expectations. Using the S&P 500 as benchmark in the event of an earnings downswing, the order of magnitude has been of the double digit percentage variety before bottoming out takes place, especially during recession. At the credit differentiation level, even CCC corporate yields to close to 13% heralds the risk of an onerous calls on cash flow via a doubling of borrowing costs over 5 years and such rates could ratchet much higher, as seen in extremis in the credit crisis of 2008.

After sharp market drops earlier when changes in central bank policy appeared and judging by a sharp recovery from mid-2022 in aggregate equity index levels and a reduction in fixed income interest rate credit spreads, momentum complacency appears ensconced, akin to the last cycle. With existent dichotomy among the central banks and valuations still not inexpensive, it is also likely to enhance volatility in capital markets. In consumer, information technology and social media which determined the last cycle, the results show bifurcation likely not to be conducive for valuation expansion and market leadership. We see diversification and the quality of delivery being bifurcated as likely to be crucial investment aspects over the next 12 – 18 months.

To borrow a term from military doctrine where it has long existed, shock and awe are necessary to curb complacency. For Finance by the late 1970s, central banks discovered that slow and steady policy change did not work fast enough against imbedded practises. Interest rate/monetary policy overshoot were globally required to curb inflation tendencies. Once more on shock and awe in Finance but on the opposite end, in the late 1990s and 2000s into post the credit crisis of 2008, in one fell swoop, minimalist interest rates and massive quantitative ease were engineered to curb grating paralysis inactivity.

Far from a languid summer of 2022, much has been afoot. It is likely that shock and awe monetary policy will be needed well through 2023 to contain complacency especially about inflation psychology. It is salient that while inflation in the United States and elsewhere may have dropped a notch, it remains at several multiples of its 2% annual target and has in the Britain reached to above 10%, is muted to become so in Germany and is at double digits monthly in several emerging countries. Rather than modelling,  shock and awe has much to do with human psychology that leans to assuming all is fine until forced to change.

Policy dichotomy appears as an issue of concern and in contrast to bouts of capital market complacency.At one end of dichotomy on the central bank policy execution, the small but well regarded Reserve Bank of New Zealand on August 17 and the Bank of Norway on August 18, 2022 raised administered rates by 50 basis points after a 50 basis point hike earlier in August by both the Bank of England and the ECB. The Bank of Canada raised rates by 100 basis points in mid-July. Then was recorded the Federal Reserve raising Fed Funds by 75 basis points to 2.25-2.50%. Among major emerging economies, the Reserve Bank of India also raised its rates by 50 basis points in early August 2022. Despite pressures underscored by falling currency exchange rates among smaller economies from Latin America to Africa to Asia, some like Turkey have again cut its rates. Earlier and despite growth improving, the Bank of Japan pointedly left its longest standing quantitative ease policy unchanged. The People’s Bank of China cut its rate by 25 basis points to 2.75% on August 15, 2022  reflecting likely both economic and real estate pressures.

Admittedly difficult to model and hence sometimes relegated as being extraneous in consensus considerations, political and economic aspects appear currently as even more interlinked. Global growth was slowing and exposing logistical weaknesses even before the emergence of Covid pandemic in 2019 and war in Ukraine in 2022, both appearing to result in long lasting tensions not least even for such basic needs as food and energy supply. Global economic growth appears to us as hovering close to 3% annually that would come close to recessionary due to the mix of countries concerned.

Superpower tensions appear taut ahead of mid-term Congressional elections in the United States and the National Congress of the Chinese Communist Party, both in November 2022. Both countries appear testing not just military spheres of influence but also strategic economic interests from raw materials to semiconductors as well as in effect linking these to key trade policy. In comparison to the immediacy of fiscal (and monetary) largesse of 2009 and again in 2020, the just announced trillion dollar U.S. Inflation Reduction Act that included climate policy stimulus and the substantive domestic oriented plan announced in China in March appear at least in part to be aspirational for the long term. In Europe and in addition to budget tensions in its south, the war in Ukraine has unleashed needs for energy security, once more with likely lesser immediate stimulus and more of long term import. The latest observations from China appear to indicate its 4% GDP growth for 2022 should be regarded as aspirational. Such growth in China would be a quarter of the levels of the earlier 2000s when China acted as a key global economic locomotive. Crude oil prices remain high at close to $90/Bbl. WTI after having been even higher. The war in Ukraine and Covid pandemic remain substantive issues. The same likely holds for the operating and financing cost impact of the rise in U.S. dollar exchange rates that has accompanied the Federal Reserve focus on containing inflation expectations from becoming imbedded. Anticipation of global stable economic recovery is likely only from year end 2023 onwards.

The corporate results released into late summer 2022 and corporate discussions of future prospects has been sobering in exposing bifurcation and dissonance when compared to only modest revisions so far in consensus expectations. In contrast and using the S&P 500 as benchmark in the event of an earnings downswing, the order of magnitude has been of the double digit percentage variety before bottoming out takes place, especially during recession.

During the release torrent, Energy companies have been clear beneficiaries from high crude oil prices. Alternate energy and equipment suppliers are likely to also benefit. In overall market consensus, the reduction of expectations by a few single digit percentage points seems to us to hardly indicate confidence about robustness but misplaced in not indicating concern about revenues or margins. In the key areas during the last cycle of consumer related companies, of information technology companies as well as in social media, the results have indicated industry bifurcation and seem likely not to be conducive l for valuation expansion and market leadership.

In a seeming reversion to earlier practises when quantitative largesse was expanding, momentum activity has appeared to reward consensus being exceeded even with the same being reduced, including via seemingly ongoing guidance. Central bank induced liquidity seems ratcheting lower and the ability for near term fiscal largesse seems limited. Valuation multiples around 17x for the S&P 500 as benchmark on anticipated 12 month earnings can hardly be regarded as inexpensive  nor as stable were earnings were just to wobble lower. On fixed income yield based risk premiums, the ratcheting up of administered rates has valuation contraction risk as well. At the credit differentiation level, CCC corporate yields to close to 13% herald the risk of an onerous call on cash flow via a doubling of borrowing costs over 5 years and such rates could ratchet much higher.

After sharp market drops earlier in 2022 when changes in central bank policy appeared and judging by a sharp recovery from mid-2022 in aggregate equity index levels and in the reduction in fixed income interest rate credit spreads, momentum complacency appears still ensconced and akin to the last cycle. With existent dichotomy among the central banks and valuations still not inexpensive, it is also likely to enhance volatility in capital markets. We see diversification and the quality of delivery being bifurcated as likely to be crucial aspects in investments over the next 12 – 18 months. StrategeInvest’s independent consultancy operates as Subodh Kumar & Associates. The views represented are those of the analyst at the date noted. They do not represent investment advice for which the reader should consult their investment and/or tax advisers. Any hyperlinks are for information only and not represented as accurate. E.o.e.

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