Note Oct. 27,2023: Q4/2023 – Market Joust Against Momentum.
We expect a capital market joust encompassing a higher risk premium against the momentum tilt that had accompanied the emergence of quantitative ease from 2008 and which still periodically flares. As valuation imbalances are addressed, we expect linkages between FICCs and equities to rise and elevated volatility. Quality and diversification appear called for. It contrasts with the solace from monetary and minimal rate largesse.
Political economy and geopolitical events are far from exogenous to investments. Rather than the assumptions of being all knowing that often characterize momentum peaks, the role of risk premiums is to cushion against the unknowns. In trade and geopolitics, the tensions between the United States and China range from cyber security to proprietary technology to the security of trade channels. Separate but linked appear tensions between China within the Indo Pacific space. The war in Gaza has expanded the foot print of conflict. Tensions flare from the Caucuses to South Asia. The Ukraine war changes defense assumptions in Europe. With the peace dividend hypothesis obsolete, already ratcheting up are defense requirements. Climate change and Health pandemic issues remain salient as well.
Many governments did not use the quantitative ease period to strengthen fiscal balance and instead extended deficits, now worsened for many. The period of September to October often used to address economic and fiscal expectations by the authorities appears in 2023 to envisage slow and bifurcated global GDP annual growth of 2 ½ – 3% into 2024. In the OECD, inflation seems slowing but well above 2%. Further Fed Funds rate increases to 6% seem likely with overflow elsewhere. Unlike 2008 to 2021, looming is potential currency turmoil, among even major economy countries. In an upcoming U.S. election year, trade tensions loom such as in North America on materials with the CAD already down to 1.38/USD and on global manufacturing with the weakening Yen to150/USD and the RMB to 7.2/USD.
With 10 year U.S. Treasury note yields now hovering to 5%, we expect the rationalizing of yield tranches, already underway. In Japan, now being with stretched ring fence of low fixed income yields. In Europe, after the lunge up in German Bund Yields, spreads for Italy government issue have increased to also now above those of U.K. Gilts. In low quality corporate fixed income, after lag arguably due to liquidity, BBB yields now approached 12 month highs. We see this fixed income change as still in evolution. In asset mix, we see favor for shorter duration in fixed income and for precious metals as diversifier.
In equity markets at joust with momentum, valuation globally is not low with the S&P 500 at close to 20x trailing operating earnings. Our earnings expectation for 5% growth in 2024 is below consensus of 10%. In equities redress is likely to encompass markets globally with geographical rotation secondary to bifurcation of delivery within sectors to favoring quality and balance.
For balance within growth, we would cap information technology at 25% to favor Consumer Staples at market and Healthcare at overweight. We forgo Consumer Discretionary within the cyclicals to overweight Industrials on defense and infrastructure imperatives on climate change and logistics imperatives. We overweight Energy on change likely to evolve over decades. Materials we would overweight on strategic food and raw materials alongside precious metals in volatile capital market.
Among interest sensitives, in otherwise underweight Real Estate, we favor for the industrial segment. Conditions of stability of demand and in allowed rates of return seem tentative so we underweight Utilities. Restructuring financial services including stronger capital levels are likely to be a crucial benchmark as well.
Asset Mix
We expect a capital markets joust encompassing a higher risk premium against the momentum tilt that had accompanied the emergence of quantitative ease from 2008 and which still periodically flares. It appeared into early October 2023, even as the central bank environment changed from 2021. Unlike being ascribed of being exogenous, tightened and changed political economy and geopolitical tensions are likely to impact these changes in capital markets . As valuation imbalances are addressed, we expect linkages between FICCs and equities to rise and elevated volatility. Quality and diversification appear called for. It contrasts with the solace from monetary and minimal rate largesse that characterized 2008-2021 and parts of the interface of 2022/mid 2023.
Political economy and geopolitical events are often ascribed as being exogenous to investments, which is a misnomer. Rather than the assumptions of being all knowing that often characterize momentum peaks, the role of risk premiums is not to guard against precisely known events but instead to cushion against the unknowns. At the trade and geopolitical levels, the tensions between the United States and China appear to be long lasting. Tension ranges from cyber security to proprietary technology to the security of trade channels. Separate but linked appear tensions between China within the Indo Pacific space. In the greater Middle East, the war in Gaza has expanded the regional foot print of conflict. Tensions flare from the Caucuses to South Asia. The Ukraine war remains bitterly live, changing defense assumptions in Europe. With the peace dividend hypothesis obsolete, these varied conflicts are already ratcheting defense requirements. Climate change and Health pandemic issues remain salient as well.
It is noteworthy that two separate analyses namely, J. van Binsbergen, W. Diamond, and P.Van Tassel, in “Options for Calculating Risk-Free Rates,” Federal Reserve Bank of New York Liberty Street Economics, FRBNY October 2, 2023 ( https://libertystreeteconomics.newyorkfed.org/2023/10/options-for-calculating-risk-free-rates) and A.T S.K,, Karamfil Todorov BIS 09 October 2023 in “ The cumulant risk premium” address issues related to risk premiums. Salient is the reality that many governments did not use the quantitative ease period to strengthen fiscal balance and instead extended deficits, now worsened for many. The period of September to October is often used to address economic and fiscal expectations. In 2023 from institutions like the ADB/ BIS/IMF/OECD and World Bank, it appears to be one of bifurcated and slow global economic growth into 2024 of 2 ½-3% annually with elevated inflation. In the OECD, inflation seems slowing but well above 2%. Further Fed Funds rate increases to 6% seem likely as are other major central bank rate increases from differentially lower levels. Across for emerging countries appear high inflation and currency stress. Unlike 2008 to 2021, looming is potential currency turmoil, among even major economy countries. In an upcoming U.S. election year, trade tensions loom such as in North America on materials with the CAD already down to 1.38/USD and in global manufacturing with the weakening Yen to 150/USD and the RMB to 7.2/USD
In Fixed Income, with 10 year U.S. Treasury note yields now hovering to 5%, the pressures are likely to rise on rationalizing yield tranches, including between the currencies of fixed income denomination. After prolonged response lags especially during the heyday of quantitative ease, several yield developments underscore change now. In Japan, now with the lowest rates among major economies, the authorities have been stretched to ring fence fixed income yields. In Europe, after the lunge up from negative yields to notably positive German Bund Yields, spreads for Italy government issue have increased and are also now above those of U.K. Gilts. In low quality corporate fixed income and again after a prolonged lag, arguably due to liquidity, BBB yields have also now approached 12 month highs. We see this fixed income change as still in evolution. In asset mix, we see favor for shorter duration in fixed income and for precious metals as diversifier.
In equity markets at joust against momentum, valuation globally is not low with the S&P 500 as benchmark at some 17x a fulsome consensus estimate for 2024 and close to 20x trailing operating earnings. Our earnings expectation for 5% growth in 2024 is below consensus of 10%. In equities in readjustment to a change of reduced even if positive overall economic global growth, we expect such redress to encompass markets globally and hence for geographical rotation to be secondary. In primary effect, we expect bifurcation of delivery within sectors to favor quality as well as favoring diversification balance.
For instance for balance within growth, from such momentum favorites as media and information technology at cap at 25%, we would favor Consumer Staples at market and Healthcare at overweight. We forgo Consumer Discretionary within the cyclicals, overweight Industrials for increase in defense spending and increase in infrastructure on climate change and logistics imperatives. We overweight Energy on change likely to evolve over decades.
Materials we would be overweight on the tense realities of strategic food, raw materials (including for 5G evolution) considerations alongside precious metals in volatile capital market. In underweight Real Estate, we have favor for the industrial segment but are underweight in the consumer and commercial segments. Conditions of stability of demand and in allowed rates of return seem tentative so we underweight Utilities
Restructuring financial services including stronger capital levels are likely to be a crucial benchmark as well.
Equity Mix
In the first third of Q4/2023, equity behavior initially appeared as if ease were imminent and could repeat the heyday of quantitative ease. The reality learned from the 1970s/80s has been that for impact on inflation and behavior, policy has to be tighter and for longer than initially expected. We expect U,S, 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 into interest rate policy for other central banks. Quality and diversification are called for in portfolios.
Earnings sequential and corporate outlook discussions continue to be globally noteworthy in being more circumspect than equity market valuations would indicate. In much hyped Information Technology, bifurcation and consolidation appear in semiconductors, including for leaders like South Korea and Taiwan. Real estate and leverage appear to be globally singeing, not least in China despite its ease stance. In S&P 500 earnings as benchmark, the cycle earnings low rate appeared to be set in Q2/2022 during pandemic at quarterly earnings annualized at 188, compared to our risk estimate of 175. It is not unusual for P/E multiples to expand at earnings low points as markets anticipate recovery. However and unusual since the Q2/2022 earnings low has been that as earnings recovered, multiples then also expanded substantially.
Slow economies notwithstanding, equity consensus appears once more to be reverting to expecting earnings growth of 10% annually on top of recovery levels. We expect that for 2023/24 the earnings growth rate could be 5% or so on the S&P 500 as benchmark. Amid the recent most flows globally of corporate earnings and operating discussions, more sedate and volatile behavior has been alternatingly emerging, even within the same sector. 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. Unlike the market behavior during its momentum phase, it appears ripe to be more selective than merely applauding the beating of much reduced consensus.
For a period of more tepid global growth, geographical equity rotation has appeared classical (albeit with Japan in benefit of restructuring anticipation), with lag versus the United States, from Europe and emerging markets. Still, sectoral rotation seems to have been based on expecting early central bank ease and on valuation expansion especially for a significant coterie of massive Information Technology companies. It likely even if implicitly so, that incorporated have become expectations of long term annual earnings growth of 20% or more. Many times in many jurisdictions, sectors and over the decades in conglomerates, the operating challenges in delivering sustained relative hyper growth were discovered to be immense when managing multiple business each of great heft. Presently, volatility could ensue.
For equity markets in a joust against momentum, valuation globally is not low. Midpoint in the earnings results reporting season of late 2023 and with central bankers individually and collectively espousing the requirements of patience in order to contain inflation, we believe there will be more capital market focus on adjusting valuation and earnings expectations. As benchmark, U.S. 10 Year Treasury Note yields appear at close to 5%. We expect such a fixed income rate to have worldwide risk premium impact. The S&P 500 as benchmark is some 17x a fulsome consensus estimate for 2024 and close to 20x trailing operating earnings. Consensus appears tardy and trailing in readjustment to a more challenged period for businesses. In the first two quarters of 2023 corporate results, margins appear declined to more sedate levels with companies becoming circumspect on prospects and also cutting costs. Financing costs appear rising with the high point is likely past of low cost borrowing . For the globally crucial Financial Services sector, capital strengthening controls appear as likely to expand due to inadequate risk control exposed earlier in 2023 in segments of U.S regional banks and European SIFIs.
The equity markets appear in a joust against momentum amid political economy variables of war, slower growth and geopolitical trade tensions. Now that 10 Year U.S. Treasury Note have steadily moved yields close to our long held target of 5% with inflation a lingering issue, not just overall valuation but also sector balance need consideration. Diversification and balance between growth and value seem likely to be long duration issues in contrast with the momentum focus of the last decade and a half since 2008. As such, the Financials are likely to be weighting performance crucial for the capital markets and equally important, are likely to place emphasis on basics like loan loss provisioning and capital strength and which also argues against assumptions of a continued momentum phase.
As demonstrated during 2023 momentum had once again flared, this time via stratospheric P/E multiple expansion even for seasoned Information Technology companies. In order to stress diversification in growth exposure, we have Healthcare as an overweight and Consumer Staples as a market weight and capped Information Technology at 25%, using S&P 500 weights as benchmark.
Much as for Communications Services on social media undergoing change, we forgo an overweight in Consumer Discretionary and in the consumer space, instead favor Consumer Staples on a return to basics theme. We have within the cyclicals, overweight Industrials in recognition of a likely and sustained increase in defense spending and an increase in infrastructure spending in recognition of climate change and other logistics imperatives. We overweight Energy on the basis that hydrocarbons are likely not at risk of imminent replacement by alternate energy sources which would include participation by companies like the integrated companies.
Small in weightings within equity markets, Materials are often overlooked. We would overweight in recognition of the tense realities of strategic food and raw materials (including for 5G evolution) considerations, alongside a precious metals role during volatile capital markets. Within our underweight in Real Estate, we have favor for the industrial segment but are underweight in the consumer and commercial segments. Under conditions of stability of demand and in allowed rates of return, Utilities can be considered to be defensive but such is not presently the case, political pressures flare worldwide and we are underweight.
Communication Services: Both the telecommunications and social media segments of Communications Services face challenges to overcome. It requires prolonged execution. We are underweight Communications Services, with restructuring favor instead for Consumer Staples. For close to two decades now and despite heavy business outlays, the telecommunications industry has wrenching changes in footprints and business plans. As with many infrastructure outlays, revenue delivery seems to be a longer term proposition than was posited from 5G investments. Business diversification strategies into content have been complex and mixed on earnings delivery – resulting in disparate and sizeable divestments. On social media adjacent spaces, the attempts to engage into age old advertisement and subscription options point to urgency and stress. Much like print media in its infancy many decades ago, regulatory pressures also loom to address fake news and political interference from unfettered social media. Physical entertainment complexes like movie theatres and theme parks face their own health pandemic and disposable income challenges to revenue growth.
Consumer Discretionary: Much like for Communications Services, we underweight Consumer Discretionary. In the consumer space, we instead favor Consumer Staples on a return to basics theme. In recent quarters and in line with prior cycles, the U.S. consumer has been resilient and spent handsomely out of savings accumulated during the pandemic. Still, in the present post phase of higher inflation and residential costs, further such leverage may be soft. Domestic Europe seems skimming recession. Aspirational spending was a strong consumer driver from emerging countries, China in particular being a major contributor in the last two decade,. The drive against corruption and the tribulations of excess real estate leverage as well as less boisterous times being in many living memories suggest more focus on basics and less so on secondary brands and less so on whimsical or impulse spending such as for fashion.
Consumer Staples: Among consumer spending areas, we prefer Consumer Staples, albeit at market weight. In their business operations, the pleasant surprise has been the ability within selective Consumer Staples to navigate higher raw material costs even as business lines undergo long dated restructuring. At the revenue level of income statements, consumer favor for basics and value have primacy. Even as employment levels rise from the depths of pandemic induced layoffs, higher inflation and residential costs continue to take a bite globally out of consumer wallets. Product positioning and private label brand growth appear likely to continue in the strong long term strategies from the big box purveyors to grocery chains. In this shift to basics, whimsical spending such as for fashion and high end entertainment could face stronger and prolonged headwinds. The major brand companies from drinks to packaged goods are likely to have to emphasize aspiration less and value more .
Energy: We have overweight Energy as hydrocarbons are likely not at risk of imminent replacement by alternate energy sources. Evolution is instead likely to evolve over decades. As businesses, the current energy sector contains integrated companies that are fully capable of participating in ferreting out alternate energy parameters, on a risk adjusted basis. After all, energy pools have long involved the allocation of massive amounts of capital and diverse engineering skills. From an investment point of view, still a work in process is a precise definition of environmentally sensitive growth. Effective allocation of capital has proven difficult in areas like solar power. Similar evolution on the large scale necessary has been the case for wind power and green energy. For consuming countries, clean energy target completion dates appear being postponed. Among the oil and gas energy producers for production, distribution and political reasons, OPEC plus has appeared capable of maintaining pricing well above our floor estimate of $60-70 Bbl. level which remains crucial for the development of alternate energy sources.
Financials: There have been periods, sometimes extendedly so, in which the Financials have lagged during the momentum phase of equity markets accompanied by massive quantitative ease and minimalist administered rates in advanced countries like the U.S.. With Fed Funds rates as benchmark now rising towards 6% and other central banks likely to follow therewith, much has changed. In Financials, it appears in terms of net interest rate margin management but also in navigating capital cost challenges amid the bifurcating abilities of borrowers to manage debt. Amid slow global growth, these pressures appear likely to extend into 2024 and perhaps 2025. Over the last several quarters , such pressures have appeared in a diverse set of financial activities. It underscores in our overweight that the Financials are likely to be weighting performance crucial for the capital markets and equally important, are likely to reward emphasis on basics like loan loss provisioning and capital strength.
Healthcare: In order to stress diversification in growth, we have Healthcare as an overweight and Consumer Staples as a market weight in growth and have capped Information Technology at 25%, using S&P 500 weights as benchmark. Momentum had once again flared during the mid-2023 period, this time via stratospheric P/E multiple expansions even for seasoned Information Technology companies. On business prospects in Healthcare, the challenges of waste and excess inventory in Covid vaccinations have underscored that even in pandemic urgency, prosaic business operations management counts. New product development from devices to facilities utilization as well as new processes are crucial. Symbiotic cooperation appears between diversified pharmaceutical companies and those specialized in biotechnology. With a focus on efficiency, we expect both private and public spending to expand in advanced and emerging countries. We see valuation advantages in Healthcare in the growth versus value nexus.
Industrials: Within the cyclicals, we have overweight Industrials anticipating a likely and sustained increase in defense spending and a similar increase in infrastructure spending in recognition of climate change and other logistics imperatives for many companies and countries. Wars and tensions seem ever expanding in breadth from the Mediterranean to South Asia. The Ukraine war remains brutal and as in prior wars, has unleashed new tactics such as in the potential and requirements of drone warfare. With border demarcations consuming China and U.S. military plans in the Indo-Pacific, political and military tensions remain high. Meanwhile, new efficiency enhancement appears necessary for companies at large, Businesses are faced with logistics weaknesses already exposed and in the last several quarters, by cost challenges from raw materials to labor. We expect a shift by companies to operations enhancement and away from financial engineering. While the consumer component of most economies is larger and hence attracts much attention, we expect opportunities in cyclicals to lie broadly in the Industrials in equipment and processes.
Information Technology: For diversification,we have capped Information Technology at 25% weight, on the S&P 500 as benchmark. In a momentum gorged equity market, needed is balance incorporating fiduciary responsibilities and diversification. It is especially so for Information Technology, the prolonged posterchild of this cycle. After the euphoria linked debacles of Technology, Media and Telecommunications (TMT) into the 2000s, a period of vicious restructuring followed. It took place before and after the credit debacles of 2008. Imperative restructuring of Telecommunications continues. Still, momentum expansion has sequentially continued in social media, in concept lately but not limited to artificial intelligence and then in ascribing astronomical valuations to diversified Information Technology that had initially lagged. As the semiconductor subset bifurcation amply demonstrates, 5G technologies are promising but revenue and earnings delivery are likely not to be instantaneous nor universal. At the multitrillion dollar level, the ability of companies, splendid or otherwise, to sustainedly deliver 20% annual earnings growth is likely to be a challenge, hence our Information Technology weight 25% cap.
Materials: Due to its small weight in equity markets and geographical obscurity of useable reserves, Materials are often overlooked but we would be overweight. For years, Materials investment has been linked to an economic cycle. Currently, we would also assay security of supply, not least in food as well as in strategic and basic metals for the information technology space. Rising population levels and standards of living have been much discussed. The Ukraine war has demonstrated supply vulnerabilities for basic grains. Environmental changes appear exacting havoc even in hitherto considered stable and temperate areas. Rare metals have become pawns in the trade tensions between the United States and China ostensibly over strategic technologies. As the Federal Reserve and other central banks address inflation via administered rates towards Fed Funds at 6% by late 2024, and reduced quantitative largesse, we expect not just cryptocurrencies but also coventional currencies to be volatile. It makes for a diversification role for precious metals like gold and platinum.
Real Estate: Within our underweight in Real Estate, we have favor for its industrial segment but are underweight in its consumer and commercial segments. The winds of change in Real Estate sector arise as is traditional in response to policy. Quantitative largesse changes likely to be long standing are both of higher administered rates as well as quantitative tightening via lesser fixed income purchases for central bank policy reasons. Further realities of real estate operating changes loom. In the consumer area, vast amounts of mortgages had been assumed for residential properties, as seen in extremis in China. The ability globally of individuals is suspect to carry the levels of loans assumed, not least in countries where administered rates are at multidecade levels. Reverse mortgages could merely postpone the pain. Changed work, leisure and shopping patterns during the covid pandemic have the repurposing of shopping malls and office as being still a work in progress. In contrast, the urgency due to logistics vulnerabilities and efficiency enhancement prerogatives favor new expansion and rejuvenation of industrial spaces.
Utilities: We are underweight the Utilities. Under conditions of stability of demand and in allowed rates of return, Utilities can be considered to be defensive but such is not presently the case. As seen in water utilities and power where privatized, political pressures have erupted in intensity when consumer billing rates float upwards. In response to climate change requirements, new or rejuvenation of facilities is necessary to shift from fuel such as coal and to natural gas and then hydrogen. Utilities will be substantive ongoing users of fixed income capital. They face a rising cost of funds at least until Fed Funds in the United States stabilize around 6%, with global impact. Higher fixed income yields seem likely to also exert competitive investment return pressures on Utility equities.
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. For disclosures and more depth please go to www.subodhkumar.com .