3rd Quarter, 2022
Newton’s law of action and reaction will continue to prevail as markets shift.
THE MARKETS
Global market volatility that began at the end of the first quarter with growing inflationary concerns has since taken on more variables. We now find ourselves in a risk vortex driven by inflation, uncoordinated central bank rate increases, liquidity concerns and market participants fleeing risk assets.
The winds of volatility seem likely to persist for some time as variables continue to change. However, we should take some comfort in the unequivocal stance taken by the Fed to tackle inflation head on and accept their assertion that there will be a general level of economic pain that must be absorbed if we are to achieve a future with reasonable price stability and a fertile environment for our economy to prosper.
The runaway strength of the US dollar is increasing liquidity stresses on other currencies, particularly in emerging markets. These countries are importing inflation in paying for essentials like energy, food stocks, and base metals that are priced in dollars. The proliferation of new variables such as these presents a major challenge, as it is unlikely their risk has been adequately priced into the market.
Ongoing downward revisions to global GDP forecasts and the pressure of rising interest rates continue to drive equity valuations lower. Investors are searching for equilibrium in interest rates, which remains elusive, as some 80 central banks have joined the steeplechase of rising rates. Our expectation is that all of this will lead to an overshoot of interest rate hikes and a spreading of recessionary trends in many economies. Thus, we expect market volatility will persist in the near term but not to the extent the base level of demand suffers permanent degradation.
In these times of market stress, bouts of disorderly trading can be expected, and with them, opportunities to purchase high-quality securities at attractive long-term values can be found.
Newton’s law of action and reaction will continue to prevail as markets shift.
THE ECONOMY
The Federal Reserve’s interest rate pivot to a “take no prisoners” approach in restoring price stability implies downward revisions to economic growth. This is a global phenomenon as some 80 central banks deploy their policy tools to tame inflation and achieve equilibrium rates. We can expect to see many scenarios and time horizons, which are largely predicated on country specific conditions. Some will be in conflict while many others will be in harmony. The key trends to focus on are the terminal rate levels and the time horizons for those levels.
Some countries may become immersed in recession, while others may remain on the cusp of negative growth. All told, a difficult funding environment is likely for companies that have existed almost exclusively in an era of cheap and abundant capital. The standards of living in many countries will either stall or face real declines until a return to acceptable levels of price stability and new growth norms are verifiable.
In the United States, GDP growth peaked in 2021 at 5.7%, with near zero inflation. In 2022, projections fall in the range of 2.0% to 2.8% with inflation in the range of 5.5% to 8.0%, implying negative real growth. Forecasts for 2023 are in the range of 0.8% to 1.5%, with inflation peaking at or near current levels by mid-year. However, there are numerous points of inflation persistence, which may delay any anticipated rate of decline. Thus, we expect an extended period before inflation begins to decelerate to the Federal Reserve’s target of 2.0%.
Elsewhere, global growth trends remain low to negative and sentiment continues to sour. Such trends can be difficult to reverse and if left unchecked will hasten economic contraction and social unrest. This is particularly relevant in Europe, where they are in the midst of the Russian led invasion of Ukraine and are experiencing human suffering alongside the degradation of the Ukrainian economy and real declines in their own standards of living. These realities will bite heavily as winter unfolds. The likelihood of a seasonal COVID resurgence must also be factored in.
In Asia, China has serious economic challenges alongside continued outbreaks of COVID. Its previous record of double-digit economic growth has been roughly halved, spilling over into most of the Southeast Asian region.
Exacerbating the downtrend in emerging market growth is the unbridled rise of the US dollar, which is up nearly 20% against most major currencies this year, starving these economies of capital due to the excessive rise of dollar debt liabilities. Additionally, the strength of the dollar is dampening global trade and causing emerging markets to import US inflation in energy and basic food commodities, all of which are denominated in dollars.
In the more advanced G7 economies, the strong dollar is an unwanted brake on already declining growth as their economies cannot afford US produced goods and services. Hopefully as global inflation is smothered, the dollar will decline to a level that facilitates global trade.
While the Fed has the primary role in this fight, monetary policy must have the support and cooperation of fiscal policy to hasten the descent of inflation. The key fiscal challenges require curbing the growth of nonproductive spending, fostering tax policy that incentivizes capital investment, and the rationalization of regulatory drag that hinders GDP growth. To exemplify the last point, the federal bureaucracy has no less than twelve regulatory definitions of “rural” in current use, which collectively stymie the development of broadband services in regions that are in critical need of these services.
INVESTMENT STRATEGY
We continue to follow our investment strategy guidelines set forth in our April and July letters as we believe that the Federal Reserve’s terminal rate in the US has yet to be established and will have an major impact on both growth and asset prices. The federal funds rate has been increased five times, from .25% to 3.25% today, with the potential for two more increases in 2022. Currently the 91-day Treasury bill rate is at 3.4% and the latest two-year note carries a coupon of 4.25%. Mortgage rates have moved up to 6.5% while consumer credit interest rates have climbed above 20%. As always, the cost of capital will have a major impact on both economic activity and asset pricing.
Housing and durable goods have thus far borne the brunt of interest rate tightening and the expectation is that there is more to come. While we are not yet at a terminal rate, we are nonetheless well up the ladder where the economic pain is being felt more broadly. Reduced demand should follow. The key question is how much further does the Fed have to hike to achieve its goal. The answer lies in the level of persistence that must be overcome. Our expectation is that a Fed victory may be achieved with higher rates over a period of two or more years with an economy pushed to the brink of recession, or recession itself if a major shock occurs in the financial system.
Thus the prudent strategy is to continue to “stand fast” by rolling short duration Treasuries and holding on to the stocks of well-managed and adaptable corporations that can continue to grow in adverse economic environments. Equity multiple compression is likely as rates continue to move higher; however, the long-term case for owning great businesses remains intact. When and if the inflationary persistence begins to fold, we will be in a position to extend duration. In the meantime, we can benefit from the increased cash flow of the rate cycle and corporate dividend growth.
POTENTIAL GAME CHANGERS
Lately we have been showered with a spate of negative economic and geopolitical news that has served to push investor sentiment and consumer confidence deeper into negative territory. Over the last few months there have been several themes that could emerge as game changers given the present dour global mood. It is always worth taking a little time to think outside the box so we will put a few thoughts forward.
The unprecedented surge in the dollar relative to most currencies is distorting global trade patterns and is withdrawing capital from emerging markets. The dollar is in need of a catalyst to reverse this trend and level the competitive global trade channels. In the last two weeks we have witnessed four advanced economies embark on currency intervention actions: Japan, Switzerland, England and Norway. This is a highly unusual move. Might it be the beginning of a much needed rebalancing of currencies?
Putin’s invasion of Ukraine, notwithstanding the human suffering and destruction of capital, has all the hallmarks of a classic military misadventure, which has morphed into a geopolitical quagmire at home. As he faces the onset of winter, has he gone a bridge too far and are the odds rising that he may sue for a cease-fire or more?
There may be a silver lining to the global energy crisis. Will it shift the debate of fossil fuels vs alternatives to one of harmonizing orderly development of both to assure a balanced energy structure that can enhance responsible economic growth and help achieve climate stability?
The Fed’s inflation assault has already left its mark on public markets with price/earnings multiple compression and capital losses in fixed income sectors. In private equity, there has been a noticeable trend of promoters trading investments amongst themselves. How much longer can the Hans Brinkers of private equity keep their fingers in the dike as the Fed waters continue to rise and how severe will the write down be and will these be a new definition of liquidity in private equity?