Note Nov. 24,2023: Risk Amid Neither-Nor Markets. The equity markets such as the S&P 500 as benchmark appear neither able to reach beyond the highs set at year end 2021. After a decade and half of gains from credit crisis lows, nor do equity markets appear to be willing, to sustain a classical correction node to weed out built up excesses. The investment risks encompass much in linkages to long term valuation, short term operational company challenges and not least, monetary, fiscal and geopolitical policies. Credit risk has yet to be fleshed out from higher administered rates (above 5% in many jurisdictions after being minimal) and prolonged monetary tightening. Interregnums are not everlasting.
Over 2023 to date in capital markets, momentum continues to flash and then brusquely diminish. We would divide driving forces in capital markets in 2023 into thirds. In the first third, the trend appeared to incorporate economic growth recovery but also early policy ease via lower administered rates. Earnings expectations were optimistic and valuation parameters stable. In the mid third, as Fed Funds rates exceeded 5% amid global quantitative tightening, credit spreads in fixed income increased bifurcation. Corporate result consensus expectations for companies decreased and greater focus developed on valuation, especially with banking stress in the U.S. and Europe as well as ongoing in China and Japan. Then in the last third to date, momentum strategies have again reared, albeit with artificial intelligence and a different set of Information Technology leaders.
The environment seems one of slow and bifurcated economic growth with central banks espousing an elevated administered rate environment for longer amid extended fiscal realities. Between sovereign credits and within corporate tiers, in momentum lite as compared to equities, we see credit spread adjustments in Fixed Income as being incomplete especially for long maturities. In equities, we assess corporations as having to adjust to operational challenges, a less conducive financial engineering environment. Consensus earnings and especially valuations are likely to become more circumspect. A switch from momentum and financial engineering to value and quality balance appears incomplete, not least in the crucial Financials sector. A slower asset growth and greater quality focus may be needed, despite several AT1 and synthetic risk swap forays.
Equities again appear to espouse an early pause/cut in administered rates and quantitative tightening. Merely beating oft reduced consensus appears being taken as a momentum success. As is classical in global business cycles, the U.S. consumer did provide fortitude but marquee companies have indicated caution about future gains. Systemic risk in finance often surprises. On resurgent and narrow momentum leadership, the 1999/2000 TMT excess apparently was revealed to not being limited to retail investors.
Equity valuation globally is not low. Evergreen consensus appears of 10% earnings growth for the S&P 500 for the nearest out year which oft times is then reduced., Our S&P 500 earnings expectation is for less than 5% growth for 2024. Equities are likely to need readjustment to bifurcated (even if positive overall) economic global growth and to political economy stresses. Such adjustments are likely to limit geographical rotation advantages. Likely to favor quality and diversification are bifurcation of delivery within sectors and central banks focusing on continued policies to tame inflation.
The last third of a year typically contains broad assessments and expectations from a variety of sources globally. Those months of 2023 to November have been no exception. It has included those located in a variety of geographies but with overall mandates with focus on growth, finance and not least leverage risk such as the Washington based IMF/ World Bank, the Manila based ADB, the Paris based OECD, the Basle based BIS and the Geneva based WTO. It has also included many that can be regarded as politically tilted such as those of the G7, the G20, the SCO and APEC. Give or take a few decimal points, global GDP growth of the order of 2 ½-3 ½% annually into 2024 appears indicated. It places Europe closest to recession with Africa and Latin America closest to severe stress.
Take home income and rising costs of living remain major global factors of challenge for consumers. Among the largest economies, the U.S. consumer has classically in a more optimistic turn once more been willing to spend but pandemic savings driven activities are likely to diminish. Second largest, China has had a truly remarkable two decades of expansion driven optimism. Two decades of rising prosperity are nonetheless short enough for harder times to be still imprinted in the minds of many and hence cause stop and go activity. It is likely to be a factor in China and for that matter, within other smaller emerging countries.
Back in March 2021, the blockage of the Suez Canal was accidental but did illustrate the present logistical challenges to global trade. For fruition in economic expansion and judging from prior infrastructure endeavors like the building of the Suez Canal, the Panama Canal and innumerable railroads, transportation driven infrastructure takes time. The China led belt and road initiative now appears to be in a classical refinancing phase. In other global infrastructure initiatives, the U.S. led Indo Pacific/Middle East transport plan appears to be in an earlier aspirational phase. Recent conferences have not alleviated the tensions territorial waters and borders in the Asia Pacific. Outright conflicts include China/India border disputes and the raging Ukraine war on the doorstep of Europe. Existent in the historical tinderbox of the Caucuses and the Middle East is currently, the no bars Israel/Gaza conflict on the doorstep of key global transportation and energy hubs. We see as salient the developments like the accidental Suez Canal blockage and various ongoing sanctions. Regional pacts notwithstanding, in the 2020s, trade stress and politics appear closely linked into bifurcating growth. The political economy risk challenges are likely more than seems being assumed by consensus when it comes to the stronger and sustained revenues needed for current valuations in equities and credit spreads in fixed income to be stable.
With the Federal Reserve in the lead at 5 ½%, a number of major central banks including the ECB, the Bank of England and the Bank of Canada have administered rates at or above 5% – with pauses and not far from our 6% target potentially into 2024 /5 with ease only thereafter. Even Japan seems stirring from the lethargy of decades old minimalist interest rate policy. Amid slow economies that in the case of Europe include recession, central banks have clearly stated that getting inflation lower and sooner remains their goal. When it comes to inflation, the 1980s demonstrated that procrastination is costly. When it comes to equity valuation and fixed income spreads, central bank policy obsessed capital markets seem mesmerized and pinind for the short term gains derivable from early ease. We believe that which is being overlooked by consensus are facets of the quality of delivery and its realistic deliverability by companies and governments alike. Amid slow growth, revenue growth is likely to be bifurcated.
The environment seems to be one of slow and bifurcated growth. Amid extended fiscal realities, requiring consideration is that central banks appear to be espousing an elevated administered rate environment for longer. We see credit spread adjustments in Fixed Income as being incomplete between sovereign credits and within the corporate tiers. Over the next 12-18 months in equities, we assess corporations as being required to adjust to operational challenges as well as a less conducive financial engineering environment. Consensus earnings and especially valuations are likely to become more circumspect than currently existent. A switch from momentum and financial engineering to value and quality balance appears incomplete, not least in the crucial Financials sector. Despite AT1 and synthetic risk swap forays, focus is likely required on slower asset growth and elevating quality.
There has recently appeared a return to momentum lite behavior in the FICCs (Fixed Income, Currencies and Commodities) space, albeit not as salient so as has taken place periodically in equities,. Even while several materials (base, precious and rare) are crucially strategic components for 5G and upcoming 6G utility, their capital market relative performance pales in comparison to that within Information Technology, now on artificial intelligence. In the currency space which so often acts as a harbinger of risk and change, there was an initial weakening of many even large currencies earlier in 2023. When it comes to vigilance between advanced economy currencies, it has given way again to what may at best be described as apathy.
In contrast at othe other extreme, several like most recently Argentina in emerging countries are in their umpteenth financial crisis. Among advanced countries, in a pre-Euro world, for the umpteenth time as a direct result of political and fiscal lethargy, Italy would likely also be in crisis. With Fed Funds as benchmark already at 5 ½% and even if our target of 6% is not reached, remaining latent issues are fiscal stress for countries and balance sheet stress for leveraged companies. It is especially so with central banks focused on inflation containment.
As U.S. 10 year Treasury Note yields breached 5% and 30 Year Treasury Bonds breached 5.3% as benchmarks, other yields globally followed suit, albeit not to those levels. U.S. Treasury Fixed Income yields have since declined in movements that we would ascribe to capital market momentum for an early cut in administered rates. It seems in direct contrast to the stance of several central banks. Currency diversification and not yield spreads or fiscal differences appear playing roles in relative apathy about advanced country sovereign yield spreads. Stretching for yield including the use of leverage appears the case in the corporate markets as well and well into the junk bond space. Were central banks to maintain their posture, not least due to the lessons learned in the 1980/90s, higher long term yields, rising spreads and greater currency volatility appear likely in a readjustment that seems still incomplete.
The yearend 2021 cycle peak was of 4793 for the S&P500 as benchmark in the long duration of this cycle. Equity markets in 2023 to date appear neither able to exceed it nor to be able to engage in a fulsome correction to cleanse excesses that inevitably exist. Compared to the central bank dictum of “higher administered rates for longer”, in the first third of 2023 equity markets appeared to correct as the realities emerged of a series of rate increases taking major central bank rates into the 5 % range and more. As risk premium benchmark, closer links between fixed income yields and equities appeared, with U.S. Treasury 10 year Note yields closing to 5% as well. Still, equities have appeared more recently to be willing to espouse an assumption of an early pause/cut in administered rates and quantitative tightening.
In this market environment once more, merely beating oft reduced consensus appears being taken to be a momentum success. As is classical in global business cycles, the U.S. consumer did provide fortitude by spending pandemic driven savings but lately, several marquee companies have indicated caution about future gains. Systemic risk in finance often surprises.As rates increase, in the crucial Financials sector, bifurcation of net interest margins has appeared alongside loan loss provisioning changes. After the European and U.S. banking stresses earlier in 2023 resulted in more rigorous central bank oversight globally, some financials have chosen to increase AT1 issuance again and others to consider synthetic risk swaps. Rather than financial engineering, it may be more crucial to manage for slower asset growth and focus on enhanced quality.
In another resurgent momentum signal, leadership appears dependent on a slim list of Information Technology equities once more but that this time with artificial intelligence as theme. It is also worth noting that the 1999/2000 TMT momentum excess apparently was revealed not to be solely retail investor driven alone. Equity markets valuation globally is not low. As benchmark amid index gains in Q4/2023 to date, the S&P 500 appears to be at close to 19x a consensus estimate for 2024 and over 20x trailing operating earnings. Evergreen expectations by consensus appear for over 10% earnings growth starting in the nearest out year and which oft times are then cut as that year develops. For 2024, our S&P 500 earnings expectation is for less than 5% growth and well below consensus. Equities are likely to need readjustment to reflect bifurcated even if positive overall economic global growth. Salient appear as well political economy stresses. Both appear likely to increase risk premium requirements. Such adjustments are likely for markets globally, with limited geographical rotation advantages. Favoring quality and diversification are bfurcation of delivery within sectors with central banks focusing on continued policies to tame inflation. E.o.e.