Note Sep. 22,2023: Reflective Forbearance Appropriate – In late September 2023, equity behavior has again appeared as if instantaneous gratification could repeat the heyday of quantitative ease. The reality learned by central bankers and others experienced with the 1970s/80s has been that for impact on inflation and behavior, policy has to be tighter and for longer than initially expected. It behooves reflective forbearance of which quality and selectivity in investments are a part. Even with pauses as in the September 20, 2023 FOMC statement, we expect the Fed Funds rate to reach 6% by late 2024 and be maintained there for 12 months. Amid risks of currency volatility, it would catalyze global basis point flowthrough for other central banks,.
Actual actionable liquidity is a likely contributor to mismatch in low quality corporate and emerging country bond yields being closer to 12 month lows while U.S. 10 year Treasury Note yields have risen to 12 month highs. The changed macro environment since 2021 adds to risks already inherent in leveraged bond portfolios. Within fixed income portions of asset mix, capital market evolution is tardy, is occurring but is incomplete. Our favor remains for high quality and short duration.
The impact of higher interest rates is not linearly on capital budgeting alone but can also surprise through costs from suppliers and accentuate bifurcation within operating margins. Even amid low rates, an example was in Japan when under duress, large multinationals were forced during slow growth to demand cost relief from suppliers in order to survive. Myriad challenges appear beyond central bank policy as well. Already fissured, the fall of 2023 is important in pollical economic dialog,. After the comprehensive trade policies of the post war period, emergent now appear more fractured regional trade blocs/agreements. Operating business challenges exist across the spectrum, from concept high technology with its high multiples to the more down-to-earth of basic resources and elsewhere.
Geographical equity rotation seems classical for a period of more tepid global growth. Sectoral rotation seems again based on expecting early central bank ease and on valuation expansion. It appears driven especially by a coterie of massive Information Technology components, arguably incorporating expectations of long term annual earnings growth of 20% or more. As demonstrated many times across geographies, myriad sectors and over the decades in conglomerates, operating challenges are immense for delivery and growth from multiple lines each of great heft.
In equities at late 3Q/2023 levels, we would expect heightened volatility. We would focus on selectivity, diversification and quality of operating management, in contrast to momentum fervor on attributes like concept, low quality and high leverage. Indicating as much have been financial tribulations including those in the Financials. To achieve diversification, we would cap Information Technology weightings to 25%.
Reflective forbearance is needed but has appeared to once again be playing a secondary role to momentum. Concept valuation elevation has spread now to a coterie of strong balance sheet high technology. By way of perspective, even as recently as 2007 when the credit debacle of 2008 was yet exposed in fulsome and 10-year U.S. T Note yields were last in the 4- 4 ½% region, the S&P 500 index level was far lower.
With 2023 not being an exception, annually, summer/Early fall has traditionally been a period when multinational institutions and governments unveil their assessments of prospects, currently seeming fragile. The May, 2023 G7 summit in Hiroshima, the BRICs August Johannesburg summit and the September G-20 summit in Delhi offer up some noteworthy evidence of fissures even as agendas broaden. Continued in 2023 have been several facets including health pandemic being globally still latently potent, war flared in Ukraine on the doorstep of Europe and inflation reared upwards. Spillover from Africa may be extreme but angst seems to be globally broad. Globally widespread earthquakes and floods point to climatological challenges. All require funding over the long term and fiscal deficits are high. The 2023 report from the World Trade Organization points to the emergence of trade blocs that contrast with the painfully negotiated and rules based General Agreements on Tariffs and Trade that favored the post world war into arguably mid- 2000s. In aggregate, the recently released forecasts of institutions such as the IMF and OECD point to the probability of slow 2 ½-3% per year annual global GDP growth into 2024. There appear near term fissures of minimal growth in many advanced countries and in the main, highly pressured emerging economies including that of China.
Operating business challenges exist across the spectrum from concept high technology with its high multiples to the more down-to-earth levels of basic resources and elsewhere. While climate change, oil pricing and transition into cleaner environments remain long term challenges, inflation elevation seems to be an immediate challenge well into the next 12-18 months and beyond. In a salient perspective, in IMF Working Paper No. 2023/190 : One Hundred Inflation Shocks: Seven Stylized Facts dated September 15, 2023, Authors A. Ari, C. Mulas-Granada, V. Mulanas, L. Ratnovski, and W. Zhao document how inflation can take longer to tame than initially assumed. Those with anecdotal memories back into the trials and tribulations of the 1970s/80s would recall those challenges as requiring higher administered interest rates for longer than initially expected. Under duress, it spawned as well subsequent urgencies to address fiscal deficits. It gave rise among politicians, the public at large and not least capital markets a fear of bond markets vigilence and increases in risk premiums that were persistent for longer than many anticipated, including the regulators of the time.
Among others, the Bank of International Settlements in its September 18, 2023 quarterly report continues to warn about the risks. Included are those from accentuated leverage as interest rates elevate to levels not seen for many years, even decades. At the other extreme, China faces wilting real estate and deflation risks. Over 2023, several central banks have increased rates again, with Japan being an exception but with markets overriding its yield control measures. In balancing containing inflation versus slow economic growth, many central banks including the Bank of Canada, the ECB and Bank of England as well as emerging countries like India, Türkiye and others appear step wise in increasing rates and pausing. All seem emphasizing unfavorable inflation even as it is more extreme for some than or others. The Federal Reserve in its FOMC of September 20 2023 likewise highlighted elevated inflation still almost twice 2% targets for stability. The Federal Reserve continued a rate assessment of potential future increases, even with the pause contained in its September 2023 statement.
With these macro level assessments and periodic pauses notwithstanding, Fed Funds rates are likely to reach 6% by late 2024 and equally important, be maintained therefrom for 12-18 months. It would be consistent with the policy lessons learned from the 1970s/80s and with present day global related events. These evolutions have capital market import that points to volatility. Most advanced central banks have rates that are likely to be pressed to follow U.S. rate increases in basis point form if not actual levels or else potentially be saddled with currency volatility even amid economies that are tepid. Political economy trade tensions could rise acutely. Emergent economies and their central banks already and sharply face such risks.
In the fixed income markets over the last 12 months, while U.S. 10 year Treasury Note yields have been approaching our 5% target, those of junk corporate bonds have appeared mired at the lower end of their ranges as appear emerging country 10 year fixed income yields. We believe actionable tangible liquidity is a likely contributor to such mismatch in behavior. Amid the changed macro environment since 2021, it adds to risk that is already inherent in accentuated leveraged bond portfolios positioned to reach for yield. Within fixed income portions of asset mix, capital market evolution is tardy, is occurring but is incomplete and our favor remains for high quality and short duration.
Some forbearance seems in order for equities as it relates to the risk premiums implicit in late Q3/2023 index levels. Using the S&P 500 as benchmark, equity index levels peaked at the end of 2021. It seemed in response to a significant change in Federal Reserve and others in deemphasizing quantitative largesse and embarking on policies of significant and prolonged administered rate increases. These central bank policies have again been reemphasized for reasons discussed previously. Yet, in late Q3/2023 a return has emerged to momentum behavior in equities. The impact of higher interest rates is not linearly on capital budgeting alone but can also surprise through costs from suppliers and hence can accentuate bifurcation within operating margins. An example even amid low rates was in Japan when under duress, large multinationals were forced during slow growth to then demand cost relief from suppliers in order just to survive.Geographical equity rotation does seem classical for a period of more tepid global growth. Developed markets have in particular been led by those of the United States and special factors like Japan reflecting restructuring and regulatory/governance reform, but with Europe reflecting recession fears and emerging markets also lagging pending better global economic growth.
However, equity sectoral rotation paints a tableau once again seemingly based on expectations in consensus of early central bank relief and on valuation expansion driven especially by a coterie of massive Information Technology components. On valuation, if the S&P 500 were used with a historical valuation benchmark of 16x earnings and 7% annual earnings growth, a 35x plus earnings multiple for some of these equities would imply expected sustained long term earnings annual growth of 25%. Even if ambient consensus of 21x earnings and 10% annual earnings growth for the S&P 500 were used as benchmark, a 35x plus earnings multiple for some of these equities would still imply expected sustained long term earnings annual growth of 20%.
In terms of practical considerations with some reflection, an unseasoned company with a unique product/service in a buoyant new issue market could well emerge initially at high multiples. Still and as demonstrated many times across geographies, myriad sectors and over the decades in areas like conglomerates, the challenges become very different for business delivery and growth from multiple lines that each are of great heft. At the macro capital market level, equity risk premiums appear not to have adjusted to ambient fixed income yields, such as those of 10 year U.S. Treasury Notes now closing in on our 5% yield targets. At the operating levels, management selectivity can be expected to have to respond to margin pressures as already seen in Information Technology, notwithstanding euphoria about artificial intelligence.
In equities compared to late 3Q/2023 levels, we would expect heightened volatility and expect focus to be required on selectivity, diversification and quality of operating management. It contrast wiyh the momentum era market fervor that included attributes like concept, low quality and high leverage. Already indicating as much have been financial tribulations including those in the Financials. To achieve diversification, we would cap Information Technology weightings to 25%. E.o.e.