This article was last updated on June 26, 2023
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Momentum Fosters Misdemeanors; Rangebound Fosters Selectivity
Momentum Fosters Misdemeanors; Rangebound Fosters Selectivity – Past experience at capital market, country and company levels shows that prolonged momentum fosters misdemeanors and not just of the legal kind. During the years of Covid pandemic urgency, ignored by the authorities and investors were defense and fiscal objectives as linked to stability. Not being not easily modelled, geopolitics and even domestic politics are often blithely ascribed as extraneous but do have roles via risk premiums. An historical lesson has been that ignoring inflation and deficits have not been conducive to better sustained growth. Rangebound markets reflect change and when prolonged, foster selectivity.
In currency movements, relative interest rates and inside equities, capital markets appear in between momentum and selectivity preferences. Political tensions seem elevated from the Arctic to the Atlantic to the Indo-Pacific. Amid global obfuscation, currency/trade tensions loom. It contrasts to the momentum peak of December 23, 2021 when the S&P 500 set a high of 4797 amid placing a peak valuation on peak earnings. With global growth slow, fiscal and corporate margin challenges will likely mount. Unlike early 2023 consensus pines for ease, when inflation control was seen as secondary in the 1970s, growth and quality suffered in economies and for corporate earnings.
For major and smaller economies, Federal Reserve and central bank stances appear evolved through many rate increases. In schism, Japan and China have opted for minimal rates or cuts therefrom. Global capital market implications, such as risk premiums, have still to percolate through from U.S. Fed Funds at 5 ¼% now and potentially 6% in 2024. Volatility is likely to be elevated well into 2024 and favors selectivity. Evolving are defense/infrastructure vs consumer interfaces. All have implications for sector allocations. We envision a role for precious metals and short duration Fixed Income in investment portfolios.
Not being not easily modelled, politics are blithely ascribed as extraneous. Such predisposition ignores the role of risk premiums in handling uncertainty. Prior prolonged and excess quantitative ease did obscure the political aspects to risk premiums but this disposition appears being likely to fade. We see geopolitical and country politics to have been and as being likely to remain crucial in developing adequate risk premiums in security valuation.
In geopolitics, not contained and building for several years are tensions for NATO, now exploding in Ukraine into war levels in Europe not seen since 1945. The Balkans continue to simmer. Latent in the Arctic but potent is likely to be rivalry over resources and presences. In the Indo-Pacific appear ramifications that are reflective of a more robust military presence from China as underlined in its key annual meetings of March 2023. Meanwhile, continued punch and counter punch flash between the North and South Korea. These events have even forced an explicit defense posture from Japan, previously pacifist since the end of the Pacific war in 1945. Involving different parties but similar to the 19th century great game like interactions are outright battles that appear from north Africa to central Asia to south Asia. For years to come in fiscal matters, room will likely have to be made for sharply higher defense postures and spending
During the years of Covid pandemic urgency, ignored by the authorities and investors were defense and fiscal objectives in their links to long term stability. Currently, several august institutions envisage global GDP growth to be around 2 ½% annually into 2024 which would be below recession neutrality of 3% annually. In its FOMC papers of June 16, 2023, the Federal Reserve envisaged only 1% GDP annual growth for the United States. Many countries currently have no option but to increase defense spending with room over several years to be made in fiscal budgets.
Likely to be a global precursor for public finance tussles were the June 2023 up-to-the-wire struggles on the U.S. debt ceiling. Additionally there loom many elections to come and not limited to the U.S., the U.K. and India. In this milieu of weak global economic growth, minimal or lowered interest rates accompanied by lower exchange rates from major trading nations like China and Japan risk a resurfacing of sharp global trade tensions.
Clear experiences from the 1970s and currently repeating themselves appear a delayed behavioral response mechanism from consumers when it comes to interest rate policy changes. It appears unfolding in actual economic data and in several central bank data dependent response mechanisms. An historical lesson is that ignoring inflation has not been conducive to better sustained growth. Neither have massive deficits been conducive for growth. After the FOMC of June 16,2023 when the Federal Reserve did not raise rates but again in semi-annual June 21 2023 Congressional testimony signaled that containing inflation was paramount. Fed Funds rates could potentially be at 6% into 2024.
Even with weak economic growth reports over June 2023, a number of major central banks such as the ECB, the Bank of Canada and the Reserve Bank of Australia increased rates 25 basis points, with the Bank of England opting for a 50 basis point increase amid clear signaling of more as being required to tame inflation. Global capital market implications have to percolate through into reflect U.S. Fed Funds at 5 ¼% now and from potentially being at 6% in 2024. Such percolation would include lower leverage levels than were concocted in capital finance when quantitative ease was at its peak. It also likely includes increased risk premium base and spread levels, unlike the visible but premature expectations of early central bank ease.
In the Indo-Pacific have come mixed signal. Stronger growth India has also been raising rates and appears following a monetary policy distinct from the long past. However among export economies signaling growth concerns, rate increases remain being eschewed in Japan despite its elevated inflation. Rates have been cut in China ostensibly due to domestic weakness fears that appear to have followed a post pandemic bounce back. Of note for characteristics and not size amid extreme inflation, the current stresses of Turkey provided ample lessons of the risks of cutting rates in an attempt to boost economic growth and which have now had to evolve into administered rate increases.
During weak global economic growth, in mid-2023, a schism has risk in the balance between stimulating growth versus containing inflation. Lack of clarity and cohesion amongst central banks runs the risks of currency volatility and trade tensions. With Japan and China being amongst the largest of export nations, recent weaknesses of the Renminbi and the Yen bear close monitor for global risk. We envision a role as continuing for precious metals in investment portfolios.
Since March 2022, much has emerged from two unrelated developments that have been revving upwards – namely war in Ukraine that is likely to be ongoing and the commencement of substantive Fed Funds rate increases to a level now at 5.25% and potentially ongoing into 2024 according to the latest June 2023 FOMC releases. Reflecting the realities of the weaknesses in robustness and technology exposed by war, upward revisions worldwide can be seen into more modern defense postures.
Fiscal budgetary pressures and choices loom that have still to be fully reflected in sovereign bond yields like those of U.S. Treasuries as benchmark and hence in Fixed Income markets at large. The prolonged period of massive quantitative ease and a resultant momentum tilt in capital markets did give rise to misdemeanors , not all legal in nature but also related to risk management at the company level. In the critical banking and finance sectors, the last several months have seen a plethora of regulatory initiatives. For instance in a leadership role, the U.S. Securities and Exchange Commission has been heavily striking scandal in cryptocurrencies. Also, according to the Bank for International Settlements June 2023 economic report, a new framework is urgent for digital currencies to interface with traditional ones. The collapse of two major regional U.S. banks and a major European SIFI in the spring of 2023 has catalyzed a likely stiffening and broadening in capital requirements as well as of more rigorous oversight for finance. It would likely include those for banks below SIFI designations and for NBFIs. As salient events still unfold, in Fixed Income portions of portfolios, we would emphasize shorter duration and quality.
In the global capital markets, much ado emerged earlier in 2023 about the potential for rate cuts by the Federal Reserve and other central banks. It centered on expectations of an early end to focus on inflation containment and questioned the efficacy of a 2% inflation target which took years of research and discussion before agreement was globally reached on its use as an achievable goal. It is worth noting that when inflation control was seen as secondary in the 1970s, growth and quality suffered in economies and for corporate earnings. As perspective on market behavior therefrom, after reaching a DJIA peak of 1051 on January 11, 1973 on the back of nifty-fifty momentum euphoria, the DJIA dropped precipitously to then take close to a decade to return to 1024 on April 27, 1981 as tackling inflation finally emerged as a key policy base.
Present day equity markets continue with a modicum of momentum euphoria that appears in fits and flashes. Prolonged momentum has from past experience, fostered misdemeanors and not just of the legal kind. Back in December 23, 2021 the S&P 500 set a high of 4797 amid placing a peak valuation on peak earnings. As perspective and using long average P/E of 16x and 7% annual earnings growth as base for the S&P 500, we assess that sustaining a 20x P/E would require 12% per year earnings growth delivery. To be sustained, 25x for the S&P 500 P/E would need 18% earnings growth per year. While global economic growth is slow, input costs and labor demands appear on the rise generally, alongside tighter capital conditions. We expect corporate delivery and bifurcation challenges to appear. In even the major economies, central bank stances still appear evolving with geopolitical and domestic pressures at hand. In contrast to momentum market dominance into 2021, prolonged rangebound markets foster selectivity. We assess volatility to be elevated well into 2024. The interface between defense and infrastructure versus a consumer tilt have still to percolate in budgets and in investment portfolios. All these aspects have salient implications for sector allocations.