Note June 21,2023: Q3/2023 –Transitions To Selectivity and Valuation, From Yield Suppression and Momentum. We assess that more volatile currencies as well as more focus on spreads between markets are likely to extend. It would be quite different from the prior environment of quantitative ease and quantum differences notwithstanding, with shades of prior decades of restructuring and large fiscal deficits. Central banks appear focused on continuing to tame inflation. Notably, China has been an exception due to domestic pressures.
The RMB/yuan has in turn weakened against major currencies, not least the U.S. Dollar. With global growth likely to remain slow into 2024, trade tensions should hence not be brushed aside as capital market volatility generators. It is worth recalling that even between likeminded countries like the U.S., Japan and Germany back in the mid 1980s, trade tensions boiled over into currency and then capital market turmoil into 1987.
Even if not overtly stated by many central banks as being benchmark policy to be hewed, U.S. Fed Funds rates from 5 ¼ %, could reach 6% in 2024 and be maintained for 12-24 months. Capital market change is usually abrupt, not easily modelled and hence labelled exogenous.Yield suppression and momentum distortion fostered focus away from absolute considerations. Now, for instance in Europe, is British monetary policy really weaker than Italy with ECB backing but with massive troubled bank loans and political paralysis being chronic. Or in North America with U.S. and Canadian central bank rates closely aligned at 5-5 ¼ %, currency and longer dated instrument spreads appear subject to volatility. In now elevated inflation Japan, slivers of change appear of an intertwining between yield spread change and that of exchange rates. Unlike prior “as long as it takes” protestations as favoring broad low coupons, we see weak growth and inflation targeting as requiring fixed income focus on quality, on tangible coupons alongside short duration and precious metals as hedge.
On geographic equity mix in the first half of 2023, restructuring anticipation helped outperformance in Japan, the U.S. markets benefitted from a handful of Information Technology equities with tangible businesses but now elevated valuation. Despite low valuation being enthused as attractive, Europe lagged. Long term growth anticipation appears not to have led to emerging market general outperformance. A conventional rolling sequence has appeared again as being key of the U.S. consumer and leading economic rotation, followed by a lag from Europe and emerging economies providing sustenance to change once global growth has reached higher levels of close to 3 ½ – 4 % annually.
We expect that alongside diversification, lessened leverage and share buybacks as macro factors, bifurcating of operating delivery will favor quality as a selectivity variable across equity sectors. In growth, we have reverted to a cap in Information Technology to diversify with market weight Consumer Staples and overweight Healthcare. In cyclicals, we see overweight opportunities in Industrials, Materials, Energy and industrial real estate entities over consumer areas. Amid higher interest rates, we see rate of return risk in Utilities and advantages for those Financials most ruthless in restructuring.
Asset Mix
We assess that more volatile currencies as well as more focus on spreads between markets are likely to extend. It would be quite different from the prior environment of quantitative ease and quantum differences notwithstanding, with shades of prior decades of restructuring and large fiscal deficits. Central banks appear focused on continuing to tame inflation.
Excepting India at 6-7% annual growth, global annual GDP growth of around 2- 2 ½% into 2024 further disaggregates into 1 – ½% for each of the United States, Japan and Europe with China around 5% annually also hardly strong. Fractured growth has often been a precursor to tensions, often of the unforeseen type. Between the largest economies of the United States and China, much geopolitical, trade and economic tensions appear alongside a flurry of meetings between high officials of both countries. In an environment of weak global growth, it is to be noted that unlike its prior major global stimulant role, the domestic economy of China and real estate markets are weak even while it had planned for more domestic rather than export stimuli.
Notwithstanding weak economies and fiscal deficits, central banks of the United States and in many other major economies have steadfastly indicated policy focus on data releases, especially leaning against inflation expectations becoming imbedded. In advanced and emerging countries alike, many central bankers probably recall that in the 1970s, rates and policy tightening had to be larger than initially anticipated and that political acquiescence took time to develop for such. Even if not overtly stated by many central banks as being benchmark policy to be hewed, U.S. Fed Funds rates currently at 5 ¼ %, are unlikely to meet erstwhile expectations of a cut in 2023, could reach 6% in 2024 and be maintained at such peak for 12-24 months.
In contrast, China has been cutting administered rates and engaging in quasi quantitative ease measures in response. The RMB/yuan has in turn weakened against major currencies, not least the U.S. Dollar. Global sensitivities remain to be seen to further declines with an RMB rate close to 6/USD a decade ago already down to over 7.25/USD in November of 2022. With global growth likely to remain slow into 2024, trade tensions should hence not be brushed aside as capital market volatility generators. It is worth recalling that even between like minded countries like the U.S., Japan and Germany back in the mid 1980s, trade tensions boiled over into currency and then capital market turmoil into 1987.
Capital market change is usually abrupt, not easily modelled and hence labelled with exogenous risk.It may be symptomatic of yield suppression and momentum distortion that caused excess focus to be taken away from absolute considerations. For instance in Europe, is British monetary policy really weaker than is Italy with ECB backing but with massive troubled bank loans and political paralysis being chronic. Or in North America with both central bank rates closely aligned between the U.S. and that of Canada at 5 – 5 ¼ %, longer dated instrument spreads appear subject to volatility. For several months now of elevated inflation, the first slivers of change appear in Japan of an intertwining between yield spread change and that of exchange rates. Unlike in the midst of “as long as it takes” protestations as favoring perpetual bonds with low coupons, German Bunds being stable at negative rates alongside those of Japan at minimal levels, we see the present environment of weak growth and inflation targeting as requiring focus on quality, on actual coupons alongside short duration and precious metals as hedge.
On geographic equity mix in the first half of 2023, restructuring anticipation helped outperformance in Japan, the U.S. markets did lead with fervor for a handful of Information Technology equities with tangible businesses but elevated valuation. Despite low valuation being enthused as attractive, Europe lagged. Long term growth anticipation appears not to have led to emerging market general outperformance. A rolling conventional sequence has appeared again as being key of the U.S. consumer and leading economic rotation, followed by a lag from Europe and emerging economies providing sustenance to change once global growth has reached higher levels of close to 3 ½ – 4% annually.
With central banks tilting against inflation, we do not regard as being stable a corporate scenario of product/service prices being raised alongside operating expenses such as labor and input costs. We expect that diversification as macro factor alongside lessened leverage and share buybacks, quality of operating delivery will favor quality as a selectivity variable across equity sectors.
In growth, we have reverted to a cap in Information Technology to diversify with market weight Consumer Staples and overweight Healthcare. In cyclicals, we see overweight opportunities in Industrials, Materials, Energy and industrial real estate entities over consumer areas. Amid higher interest rates, we see rate of return risk in Utilities and advantages for those Financials most ruthless in restructuring.
Equity Mix
While steep recession risk appears lessened, expectations are widespread among global institutions of 2- 2 ½ % annual global GDP growth, of closer to 1- 1 ½ % for each of the United States, Europe and Japan and 5- 5 ½ % for China. Into 2024, all bear close watching for slippages. India seems a major emerging country bright spot at 6-7% but without the global stimulus heft of China in prior cycles. Instead of momentum markets that continue to periodically flare, the potential for operating margin compression and hence due focus on selectivity appears salient for equity investments.
With central banks giving widespread signals of their continued focus on inflation containment and hence for further rate increases, equity hazards appear of valuation compression and price volatility until more stable global growth appears, perhaps in 2025. With 5- 5 ¼ % interest rates already reached for Fed Funds, the BOE and Bank of Canada bank rates, 6% is likely into 2024 and maintained therefrom. There exists similar potential for for 10 Year U.S. Treasury Note yields as benchmark. Equity risk premiums have yet to reach full potential. After years of quantitative ease and fixed income yield suppression, we expect equity valuation evolution at the index and security level has still to stabilize.
As a long term benchmark, the earnings parameters of the S&P 500 have been of 7% annual earnings growth and a P/E of 16x on trailing earnings as long term averages, give or take a bit. While earnings currently for the S&P 500 may have slowed to 195-200 operating and 170-175 reported levels, that decline has scarcely been one of even a garden variety fear of recession. Downside expectation risk appears with consensus expectations of over 20% growth for both for the two years ended 2024. At present P/E levels, markets appear to be incorporating an evergreen consensus of 12% for long term annual earnings expansion that has yet to be achieved. As well, along with visible earnings that are not distorted by recession for instance, at well over 30x earnings for some growth segments and individual companies within Information Technology but also Healthcare and Consumer Staples, 20 – 25% or more annual long term sustainable growth appears incorporated in consensus. Momentum fervor has clearly not abated. Volatility remains on the horizon.
In our sector mix, growth sectors have elevated valuation so, we have reverted to a 25% cap for Information Technology and an underweight in Communications Services in order to build diversification via raising Consumer Staples to a market weight on restructuring potential and overweight Healthcare sector on prospects in treatments, services and devices unleashed by technologies like those from mNRA applications. In the consumer versus industrial cyclical spaces, we see changes in defense imperatives, response to the exposure of global logistical weakness and trade tensions as favoring the Energy, Materials and Industrials spaces over areas more focused on the consumer which will likely be under pressures for a variety of reasons from consumer disposable income allocations to rising cost of goods for companies. Consumers globally may now be more inclined for basic rather than for the aspirational activities of the past. As interest rates evolve alongside net interest margins and capital market volatility into a new phase and even after two decades of change, we see the beneficiaries as being those Financials most ruthless in restructuring but rate of return risk in Utilities.
Communication Services: We have Communications Services at underweight as both the telecommunications and the social media segments face business challenges. More intense platform competition has built up replete with country centric champions in social media. For social media, regulatory pressures were initially most acute in Europe and Asia, had elsewhere been building and expanding on issues such as payment for news products and the proliferation of fake news alongside allegations of election interference. Inserted now with a vengeance has been the issue of misuse of artificial intelligence (AI) into social science elements. It includes areas like plagiarism that appears extended from middle school to even senior academic circles. It seems akin to the outcry about experimentation on cloning which was followed by widespread implementation of controls and limitations. In markets that was part of momentum fervor, the concept euphoria about social media has now come up against reality.
Intense business pressures are also to be found in telecommunications which were initial beneficiaries of the bursting of the TMT bubble in the early 2000s and which for current markets have the attributes of dividend visibility but have now been finding that large 5G capital investments are required upfront but the revenue benefits still evolving from consumers and businesses alike. Their media and entertainment segments seem also subject to restructuring. Alternately, restructuring but selectively so, tangible product focused entertainment is likely to be more interesting. We expect evolution rather than solace from Communications Services.
Consumer Discretionary: In an environment prone to expecting instant gratification, often omitted is that consumer predispositions do not turn on a dime. One of the most salient reality checks of such took place in the 1970s about which central banks admitted to surprise that the consumer response to tighter conditions was initially tepid. To achieve the desired effect of inflation dampening, it necessitated higher interest rates than initially expected. These behavioral reasons equally apply currently in that the consumer effect of policy change may initially be counterintuitively for activity even in large outlay items like housing. These aspects may be at play in OECD countries. The U.S. consumer has shown post pandemic resilience. In the world’s second largest economy, China has also had a burst of post pandemic spending. However also at work in China is a combination of harder times being within the memory span of consumers and their families as well as the government tapping down on ostentatious displays of wealth. The global repurposing of retail space also appears to be in the early/mid stages. A consumer focus on basics is likely a global facet. We have underweight Consumer Discretionary.
Consumer Staples: During a long delayed restructuring phase and now with input cost inflation, recent reporting so selectively shows several Consumer Staples companies as possessing the management skills to improve results from operations. We would not consider improved operational delivery to be universal in Consumer Staples and for which we have raised the sector to market weight. Brand proliferation seems an ongoing challenge. Private label brands appear to also be in expansion. Increased scrutiny is likely from authorities about marketing strategies such as maintaining printed prices on packaging but for lesser content volumes. As consumers husband funds with the basics such as food exhibiting biting costs, even pharmacies have reportedly not been immune to revenue delivery issues. We expect big box consumer staples companies to be aggressive on both product positioning including for their private brands, and on pricing demands of their suppliers from soft drinks to clothing and beyond into entertainment products. We prefer Healthcare but raised Consumer Staples to market weight to avail of restructuring business leaders.
Energy: Practically from the moment of global espousing by several money managers about exiting energy investments, the weighting of Energy has doubled to 4% on the S&P 500. Apparently glossed over has been the reality that each epoch of energy involves decades to complete switchover, from muscle power to wind power to coal to paraffin to liquid hydrocarbons to nuclear centricity. More sedate have been politicians such as the German Chancellor who literally travelled the world with German industrialists to secure energy supply for the near term such as including LNG terminal build and secure the longer term of hydrogen supply for greener energy. Others like the Netherlands accelerated wind power while China and India have espoused decentralized solar power. We maintain that as benchmark, crude oil pricing around $60-70 /Bbl. wti. offers both incentives for current supply as well as for the development of alternates such as wind, solar, hydro, nuclear and leading edge hydrogen and longer term, those bio based. Energy has long been a politically fraught business. The current OPEC plus production schedules and Russian sanctions evasion machination are no exception. Further and risk astute, the larger energy institutions are likely to participate howsoever energy develops and for which we are overweight.
Financials: The criticality of liquidity in funding schedules and of balance sheet strength was underscored among the Financials by the failure of major regional banks in the United States and of a SIFI bank in Europe along with the continued obscurity of loan portfolio qualities in Italy, Japan and China to name but a few. These Financial sharp edges have appeared in even far from onerous conditions, albeit now in transition from extreme quantitative ease. Global economic growth appears to an a slowed to 2- 2 ½ % annually which marks an interface bordering on recession if 3% annual global annual GDP growth were seen as a minimal non-recessionary benchmark. Major central banks like the Federal Reserve, the ECB and others have made clear that higher administered rates could occur to tame inflation. All these aspects as well as the individual managerial weaknesses ongoing in being exposed will likely have impact on leverage fragility, nonperforming loans and on net interest margins in the Financials. Meanwhile, depositors have been dealt lessons about the different tranches of safety tha previouslyt received less attention when quantitative ease was effusive. Instead of Utilities, we have an overweight in Financials but believe the advantages still accrue to those most ruthless in restructuring.
Healthcare: When market attention turned to momentum fervor as has recently again as recently as in the first half of 2023, participants apparently have had no qualms about placing extreme skew and high multiples that even the best managed Information Technology companies might have troubling in sustaining delivery over the long term. For these and for fiduciary reasons, we have diversified with overweight a lagging Healthcare segment. We see the covid pandemic as having added impetus not only to mRNA build as new healthcare technology for biotechnology and pharmaceutical companies alike but also for facility and device managers. Meanwhile among the ostensible defensive growth areas, we see restructuring Consumer Staples as less attractive and at market weight with Healthcare as more attractive for overweighting.
Industrials: In the balance between financial engineering and industrial engineering, we assess the present business environment as moving inexorably to the latter. The real cost of finance appears not just rising as central banks focus on cutting inflation expectations but also potentially being rationed more closely during lesser quantitative ease and scandal. In operations, costs appear rising from labor to facilities to other inputs, including those of raw materials. Meanwhile and augmented by war, trade tensions and the covid pandemic, weaknesses in logistic chains globally require urgent attention. The epochs of war expose weaknesses that often cause a leap of change in technology usages. Just a few examples would be the introduction of gunpowder into many uses, of steam/metal warships and of tanks and aircraft. The wars in Ukraine, west and central Asia have once more underscored this reality amid a likely transition to drone warfare. Indo Pacific rivalries are being augmented as well. We see all these aspects as favoring an Industrials overweight of suppliers from advanced technology like aircraft, defense and very prosaic but essential productivity enhancers like industrial machinery and industrial design facilitators.
Information Technology: In terms of fiduciary issues related to portfolio diversification, several risk issues arise in lopsided weightings. We have reverted to a weighting cap stance for Information Technology, at a benchmark of 25% compared to its weighting close to 28% inthe S&P 500 at end of Q2/2023 and having once more shot up. Information Technology valuations appear to have expanded dramatically. While the small coterie of companies have led and do have tangible business delivery, the future challenge posed by high valuation would be the ability of companies to actually deliver sustained annual 20-25% earnings growth over the long term. In business terms, the political and logistical brouhaha about semiconductor production appears resulting in a proliferation of multiple new greenfield facility announcements even as demand slippage appears being recorded in both actual semiconductor chips and materials. Competition up the Information Technology chain appears intense. Even some of the largest software and hardware companies have been announcing layoffs in an industry known for growth but also for cyclicality – aspects glossed over in the recent resurgence of concept fervor.
Materials: Only 2 ½ % of the S&P 500 and often forgotten until crises erupt, nonetheless we have Materials as overweight. In an ancillary but crucial development in food supply from grain to fertilizers, the war in Ukraine and sanctions have brought to the fore global supply chain tensions and chokepoints such as Black Sea ports. Recent record atmospheric temperatures in 2023 and floods have also brought to the fore crop destruction in rich and poorer regions alike. Trade tensions over security as well as technology misappropriation allegations have focused attention on the availability of rare metals that are so crucial for instance for new technology like 5G to fully flourish. High stakes positioning up to the Arctic has ensued about mineral access in the oceans and underscores the criticality of materials. Base metals like copper and nickel have been volatile in pricing and conventionally so during slow economic growth. However, base metals are also crucial well beyond their historical cyclical moniker.
Real Estate: Dissecting Real Estate into consumer, commercial and industrial segments, we see pressures as being most acute in the first two segments, favor industrial exposure but are underweight overall. After recovery driven by low cost easy money within massive global quantitative ease, pricing in many residential portions appears now driven to levels with affordability pressures. As well exists a salient and ongoing shift by significant central banks towards sustainedly raising administered rates that may have further to go. It is a joust against inflation expectations not seen since the 1970/80s. Meanwhile in areas like China and India, overbuilding also appears to be an issue. In the commercial space, redeployment is in its early stages of retail malls repurposed into whole use venues including residential, entertainment and retail selections. The redeployment appears in early phases as well of office space from being singularly for work and into similar multiuse functions. By contrast, as a result of global supply change logistic weaknesses, inter trade tensions and not least efficiency parameters driven by risen costs and technology all seem likely to favor green field industrial real estate activity.
Utilities: Water utilities in the United Kingdom that were among the earliest to be privatized in the hope for efficiency have been only the latest Utilities segment with revenue and operating business disconnects between freer market pricing needs versus the political pressures that emerge from consumer ability to pay for basic needs. Similarly but for different reasons, electrical utilities in several other parts of Europe and Asia have previously also felt the effects of political caps on pricing. Meanwhile, as administered rates rise, cost of capital elevation is likely to press against build requirements in a shift from coal to cleaner energy including for massive LNG and Hydrogen based alternates. We would underweight Utilities and prefer the equipment and engineering service providers of overweight Industrials as well as the stronger Financials among the interest rate sensitives.
Asset Mix
Global U.S.
Equities-cash 49 % 54 %
-priv. 6 6
Fixed Income 25 20
Cash 15 15
Other 5 5
Total-% 100 100
Geographic Mix
Currency/ Equities Fixed Cash
Real Income
Americas 61% 65% 67% 55%
Europe 22 20 26 37
Asia 9 13 6 3
Other 8 2 1 5
Total -% 100 100 100 100
Global U.S. Stance
Comm. Serv. 1.6 % 8.4 % Under-weight myriad challenges
Cons. Disc. 10.2 10.7 Under-weight favor frugal basics
Cons. Stap. 10.5 6.7 Market-weight for brand pruning
Energy 4.7 4.1 Over-weight favor strong cos..
Financials 16.9 12.4 Over-weight, restructuring
Healthcare 11.2 13.4 Over-weight across segments
Industrials 12.2 8.5 Over-weight, capex suppliers
Info. Tech. 24.6 28.2 Capped for diversification
Materials 3.82.5 Over-weight diverse and prec.
Real Est 1.6 2.5Under-weight, favor ind. ppty
Utilities 2.7 2.6 Under-weight -rate risk.
Total-% 100.0 100.0 E.o.e.