Markets Incorporate Review and Reassess

markets

This article was last updated on September 26, 2022

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Even as benchmark S&P 500 levels (3693) breach our 3700 pullback, equity valuation remains extended and consensus earnings need to be in downward revision. Benchmark U.S. 10 year Treasury note yields (3.69%) have still to broach our 5% target. Risk premiums seem likely to expand. In asset mix for a changing milieu, we favor quality for sectors overall and tap short duration for Fixed Income.

The first half of Q3/2022 had vestiges of upside market momentum based on yearnings for cessations in central bank policy changes. By contrast, we expect reassessment and review. It has to do with the complexities in a) the evolution of bifurcated central bank policy choices amid elevated inflation, b) political economy intersections worldwide and c) still extended capital market valuations from equities to low quality fixed income hitherto dependent on massive, unlimited quantitative ease.

Erstwhile markets were obsessed with being able to deliver high steady short term returns in seeming disregard of risk balance. It appeared in a behavioral equivalent which included leverage, low grade junk bonds, light covenant fixed income and their equities equivalent of SPACs (special purpose acquisition companies). The switch from financial engineering and focus instead on operational excellence is likely to engender heightened volatility.

In their early summer 2022 expectation of an imminent revising back of policy change, or “blinking”, markets appear misplaced. Worldwide, inflation remains multiple points above the 2% long telegraphed as ideal for stability. The Federal Reserve has thrice increased Fed Funds by 75 basis points as well as signaling after its FOMC meeting on September 21, 2022 that  U.S. core inflation remains high enough for further rate increases into 2024 before decline could be contemplated for 2025. In our opinion, a Federal Funds rate terminal level of 5% is likely by mid-2024 but also potentially remain there for 12 months or more to contain the imbedding of inflation. Many central banks appear willing through time to raise rates and reduce the size of their balance sheets despite a risk of recession but appear moving at different speeds. Further signals are likely around the October 10, 2022 IMF meeting.

Pressures both domestic as well as external such as energy prices, pandemic and now even food security appear elevated and potentially prolonged. Strategic pressures remain between China with a Communist Party Congress due October 16 and the United States with Congressional elections on November 8, 2022.From the ashes of world war and despite periodic crises. emerged global agreements expanding for around three decades, then came three decades of consolidation of new members and broadening. Now, a more fragile third phase is likely already underway. As growth weakens and currency markets become more clouded, engaging and prolonging tariffs are likely to be politically tempting due to domestic industry pressures.

Compared to the financial engineering of the recent past, company cash flow and operations management are likely now to be at a premium. In sector rotation, the past may not be entirely prologue. Cost increases appear as challenges for both consumer staples often considered defensive and for consumer discretionary areas. Amid a more frugal rather than an aspirational consumer in advanced and in emerging countries like China that in the recent past were sources of much anticipated growth, we are underweight consumer areas. Infrastructure investments appear urgent due to strategic, climate change and logistical challenges as well as to build on 5G technology. Earlier not often considered in tandem, both semiconductors in Information Technology as well as industrial, precious and rare metals are crucial. In growth, we favor Healthcare and see Financials as market critical.

While the first half of Q3/2022 did appear with vestiges of upside momentum fervor in the based on yearnings for cessations in central bank policy changes, now in September, likely well into Q4/2022 and 2023, we expect reassessment and review in capital markets. It has to do with the complexities in a) the evolution of central bank policy choices amid elevated inflation, b) political economy intersections worldwide and c) last but not least, extended capital market valuations from equities to low quality fixed income that appeared geared to massive quantitative ease of unlimited duration. The switch from that financial engineering focus and to focus instead on operational excellence is required for all of the above three reasons. It is likely to engender heightened volatility as it is likely to take time. For multiple quarters, markets have been increasingly obsessed with being able to deliver high steady short term returns with seeming disregard for risk balance, a stance that may instead prove to be ephemeral.

Markets appear to have been misplaced in their early summer 2022 expectation of an imminent revising back of policy change, colloquially called “blinking”. With any ease collectively and individually being at best modest, inflation remains elevated worldwide at several points above 2% espoused as an ideal stable zone. The first stirrings can also be seen in attempts to get inflation relief adjustments in wage demands as well as within government transfer payments. These developments have similarities to the 1970s when such adjustments were also initially seen, then snow balled into so-called cost-of-living adjustment (COLA) clauses and then even into inflation adjustment financial statement accounting. In the These developments of the1970s resulted in well-meaning but misplaced imbedding of inflation expectations even in official practices that then took years to reverse. It is essential to avoid such an outcome repeating itself.

In the evolution of central bank policy choices now amid elevated inflation, among the latest administered interest rate changes have been an increase of 100 basis points in Sweden as well as sequential 75 basis points in September in Canada, Switzerland and Europe, 50 basis points in Norway, Britain twice recently and 25 basis points twice as well in South Korea. After twice increasing Fed Funds by 75 basis points earlier, the Federal Reserve has increased it by another 75 basis  points on September 21, 2022 as well as signaling after its FOMC meeting that  U.S. core inflation remains high enough for rate increases to continue perhaps into 2024 before declines could be contemplated for 2025. In our opinion, a Federal Funds rate terminal level of 5% is likely by mid-2024 but also could potentially remain there for 12 months or more to contain the imbedding of inflation. Central banks appear collectively and individually willing to raise rates and reduce the size of their balance sheets despite a risk of recession but appear moving at different speeds.

Bifurcation appears to have been large and building among central banks. Administered interest rates are still low compared to inflation. Central banks do need to lean against its imbedding and are likely to be pressed to do so with further series of administered rate increases as well as via their much telegraphed expectation of reducing the size of monetary ease balance sheets. While some central banks such as the Federal Reserve among advanced countries and such as the Reserve Bank of India among emerging economies appear to be without overt currency level positioning, the positioning of several others appears more nuanced. Some current outliers on interest increases to reflect inflation pressures notably have been in Japan among advanced nations. Several emerging countries like Turkiye that seeming willing to accept currency crisis therefrom.

Pressures appear elevated and potentially could be so for a prolonged period in facets both domestic as well as external such as energy prices, pandemic and now even food security. Subsequent to a prolonged period of focus on quantitative ease as savior and especially as economic growth slows globally, for reasons of political developments and of differential speed mechanisms in monetary policy changes among central banks, currency volatility appears already and potentially in expansion.

Coming at a crucial time are the September 13-27 UN General Assembly meetings in New York to be followed by the IMF/World Bank meetings in Washington over October 10-16 2022. War in Ukraine with an ensuing food crisis among the poorest, energy availability uncertainty in Europe as well as cost elsewhere, pandemic still ongoing and climate change all require investment worldwide. Meanwhile as the U.S. Dollar strengthens alongside Federal Reserve rate increases, we see currency pressures as being likely to build in advanced countries with the weakness being most salient in almost completely reversing the Yen strength of many decades and which has elicited overt intervention in Japan as arguably highlighting concern. A rising U.S. dollar exchange rate has also to be seen elsewhere from the Euro to the Renminbi amongst the largest trading zones. Currency competitiveness issues seem likely to build within the OECD countries. Meanwhile several emerging countries appear already in severe financial duress, to mention but a few from Argentina in Latin America to Lebanon in Africa to Turkiye in Europe to Sri Lanka in Asia. From the ashes of world war and despite periodic crises. new global agreements emerged such as the IMF/World Bank, GATT, ECSC,NAFTA and others for around three decades into the 1980s. Subsequently came three decades of consolidation of new members and broadening such as GATT becoming a wider WTO and ECSC becoming the EU as well as in Asia, several initiatives, most notably the TPP.

Now underway is a third political phase that appears already more fragile. As growth weakens and currency markets become more clouded, engaging and prolonging tariffs risks becoming more politically tempting due to domestic industry pressures. Further, strategic tensions appear not limited to Europe having to restructure due to Russian trade pressures. In China, the 20th National Communist Party congress is to be held from October 16, 2022. In the United States, in November 8, 2022 the mid-term Congressional elections are to occur, be tightly fought and potentially fraught over control of the political agenda. Between the very largest trading nations, strategic tussles exist from semiconductors to rare earth have emerged, replete with control mechanisms such as tariffs continuing. Food and energy trade as strategic weapons have emerged from the ongoing Ukraine war. Currency volatility have often exacerbated tensions. Countries and companies have had to recognize vulnerabilities in both global trade logistics and product/services availabilities. The capital markets are likely to be subject to buffeting from political winds and hence attenuate expansion on an unfolding of review and reassessment.

As far back as in early 2022, the Federal Reserve muted policy change away from stress on quantitative ease. In a behavioral equivalent of overlooking risk from unknown unknowns, the stretch for return in capital markets had included leverage, low grade junk bonds, light covenant fixed income and their equities equivalent of SPACs (special purpose acquisition companies). As subsequent change, capital market palpitations appeared initially in the U.S. Treasury markets arguably due to its depth and liquidity. Now in Fixed Income markets at the end of Q3/2022, readjustments have expanded more broadly into global sovereign and corporate areas as well as across credit tranches. We expect such Fixed Income readjustments to flow into equities. In the financial markets, we see a Fed Funds rate of 5% as potentially likely and being possibly prolonged – above the FOMC dot plots presented on September 16, 2022.

Fixed income and indeed equity valuation does not appear to have fully reflected such a benchmark and hence appear not yet inexpensive. Especially at turning points, consensus earnings downward expectations adjustments appear to lag and presently is likely to be the case. On corporate earnings releases at the tail end of the deluge in Q3/2022 and of revenue warnings in transportation such as air freight, in consumer areas such as automobiles and consumer retail such as apparel, we see the switch from financial engineering focus and instead to focus on operational excellence as still as being very much a work in progress, including the potential for crises in cash flow for some.

Compared to the financial engineering fervor of the recent past, company cash flow and operations management are likely to be at an upcoming premium. In sector rotation at present, the past may not be entirely prologue. Cost increases appear to be challenges for both consumer staples (often considered defensive) and for consumer discretionary oriented sectors and often assigned as cyclical. We are underweight consumer areas, reflecting a more frugal rather than an aspirational consumer both in advanced countries as well as in emerging countries like China that in the past cycle were sources of much anticipated growth. For several reasons like political strategic imperatives of security of supply, climate change and business logistical challenges as well as new 5G technology, infrastructure investments appear urgent. Not often earlier considered in tandem, both semiconductors in Information Technology as well as industrial , precious and rare metals are crucial. In growth, we favor Healthcare and see Financials as market critical.

Even as benchmark S&P 500 levels (3693) breach our 3700 pullback, equity valuation remains extended and consensus earnings need to be in downward revision. Benchmark U.S. 10 year Treasury note yields (3.69%) have still to broach our 5% target. Risk premiums seem likely to expand. In asset mix for a changing milieu, we favor quality for sectors overall and tap short duration for Fixed Income.

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