4th Quarter, 2022
Excessive leverage must be removed before a new growth cycle can emerge.
THE MARKETS
As inflation loomed in early 2022, stocks began a pullback that accelerated when the Federal Reserve began raising interest rates. At the end of 2021, the 10-year US Treasury yield was 1.5%; by year-end 2022, that rate was 3.8%. The 232 basis point move in the 10-year Treasury resulted in heavy losses in fixed income markets. The S&P 500 dropped 19.4% on a price basis while the NASDAQ lost 33.1%. Overall, 2022 saw the worst sell off since 2008 and the worst performance for a combined portfolio of stocks and bonds in nearly 40 years. The question now is how well has the market priced in the confluence of current risks?
As we enter 2023, the prevailing issues of global inflation and interest rates continue to dominate investors’ minds. It is worth looking back some fifteen years into the history of financial markets to see how conditions have morphed into the concerns of today.
In 2008, we experienced the bursting of a global investment banking bubble. This bubble was fueled by a real estate boom, which supplied the ingredients for pools of mortgages that were sliced and diced into securities appealing to varying levels of risk, some with the highest credit ratings. The illusion was that underlying risk could be managed and diffused by proper packaging. Other derivative instruments, intended to mitigate risk, did the opposite and exacerbated the near financial collapse around the globe. Thus began the Global Financial Crisis (GFC) and the concomitant central bank and Treasury actions to restore market liquidity. Their actions included taking over insolvent institutions and extending the Federal Reserve’s balance sheet to keep markets functioning. The era of cheap money was born, and the stage was set for negative interest rates in Europe, which peaked near $18 Trillion in assets.
The availability of nearly free money fueled a rapid expansion of investment strategies in which leverage was used to enhance returns. Just as it seemed that the cost of money might increase to a more “normal” level, COVID-19 descended on the world, causing central banks to once again intervene, this time to ease the unprecedented liquidity strains caused by the pandemic. The quest to keep the economic engine going during COVID-19 suppressed concerns about the ultimate return to interest rate normalization and the growing risks of the onset of global inflation. As inflationary pressures emerged globally, they were deemed transitory. However, as global inflation increased dramatically to 10% and more, central bankers were forced to use the interest rate tool and to use it aggressively. Negative rates disappeared, base rates started to rise in most countries, and currencies began to fluctuate wildly.
As we enter the New Year, we find ourselves with a confluence of events: interest rate policy is focused on taming inflation, dollar strength is reversing, monetary and fiscal policy lack coordination, and evidence of credit and liquidity pressure is growing.
As long-term investors, the current state of leverage, liquidity and credit leads us to take a cautious stance, particularly towards the equity market. While we have already endured a gradual compression of equity multiples, we think the broader financial conditions create risk of further contraction. The Federal Reserve’s interest rate posture still leaves too much leverage in the system, and many short-term market strategies are likely unprofitable in a rising rate environment.
As markets contend with the prospect of some ten years of record borrowings being rationalized, we expect continued volatility. Overall market pressures seem to suggest that the likelihood of leverage accidents remains elevated.
In the last quarter the markets were prone to short spikes of over-exuberance as they misjudged the Federal Reserve’s resolve to keep rates higher for longer. The prevailing expectations now are that global markets will experience a series of rolling global recessions during 2023 and perhaps longer. In the US, we appear primed for an earnings recession in 2023, which depending on other events could push us into a broad recession as the Federal Reserve’s upward moves face stubbornly resistant inflation. We do not feel that there is sufficient evidence at present to call the end of the pivot phase in 2023. It seems more likely that inflation will not return to acceptable levels (2-3%) for at least another two years, taking us into 2025. Domestic markets will likely have to reprice to the downside as a result of these risks. Thus, we remain cautious about expectations for the start of a new global business cycle.
THE ECONOMY
The domestic economy continues to demonstrate resilience in many sectors, notwithstanding numerous global headwinds and the Federal Reserve’s aggressive interest rate actions.
The main source of strength has been consumers’ willingness to spend cash built up during the pandemic. Going forward, we sense the consumer is going to be much more selective in spending as they deal with the realities of reduced purchasing power. Credit card data shows significant extensions of consumer debt in the last couple of quarters despite a sharp rise in the cost of consumer credit. Banks are now making increased provisions with the expectation of an increase in consumer defaults.
Businesses are facing multiple headwinds exerting downward pressure on profit margins from both inflation and the Federal Reserve’s efforts to curb its effects. Supply chain disruption, while moderating from the COVID-19 peak, continues to be a rolling problem. However, the larger issue facing business is the leverage taken on during the prolonged period of global quantitative easing. A significant portion of borrowed capital cannot produce a real return in today’s rising rate environment. Companies with strong balance sheets and appropriate leverage will continue to do well despite macro headwinds. While recessionary conditions may disrupt earnings for a brief period, strong companies are likely to keep their dividend policies intact.
Our outlook for the global economy in 2023 is for a series of rolling recessions or periods of reduced growth, which will vary by country and region. To compound the issues facing the global economy, currency fluctuations have been sudden and dramatic, further obscuring operating profitability. This is likely to continue in 2023.
In the present state of domestic and global headwinds, it is probably best to avoid forecasting for 2023. Rather we should concentrate our focus on the progress of central banks in reducing inflation to a level that will sustain real GDP growth on a G-20 basis. This is a multi-year campaign, which suggests meaningful results by mid-year 2025. There is no quick fix with lasting implications. Recent observations by economists Lawrence Summers and Mohamed El-Erian suggest that interest rates must rise above the level of inflation and stay there for a period of time for inflation to be licked. Let’s hope the silver punch bowl stays shined and kept in a velvet sack until then.
INVESTMENT STRATEGY
As we enter 2023, our policy is one of caution, with particular focus on asset quality. We hold the view that standing fast and maintaining positions in high quality stocks and bonds will serve you well. The Federal Reserve and other central banks are explicit that the back of inflation must be broken and price stability achieved, even at the risk of a weaker economy. As always, there are market participants who think they can game Federal Reserve policy. Such activity heightens investor anxiety and market volatility, increasing the likelihood of further liquidity and systemic market risk. Investors who doubt the resolve of the central bank do so at their own risk. We believe the Federal Reserve will cling to this strategy with the same tenacity as an eel about to be caught grips a rock.
Long-term investors must be patient and allow time for these coordinated policy actions to achieve their objectives in a sustainable way. We must accept that it may be necessary for restrictive policies to last beyond the next eight quarters to achieve the safe harbor of well-anchored inflationary expectations and a new interest rate equilibrium. One must remember that the present financial mess has been nearly fifteen years in the making.
In the meantime, we have the opportunity to invest in short-term Treasury securities producing 4.3% - 4.5% returns and high quality dividend paying stocks with excellent long-term prospects and yields as high as 3%-4%.
SOME THOUGHTS ON THE CURRENT STATE OF CREDIT RISKS
According to a recent Bloomberg analysis there is now some $650 billion of distressed debt outstanding. Further, there is data that show the largest systemically important banks have upped their loan loss provisions in the third quarter by 75% over the prior year. This would seem to indicate that banks have been unable to offload loans underwritten for leveraged transactions. In 2022, leveraged loan underwritings exceeded $834 billion in the US. This was twice the amount issued in 2007 just before the crash. The leverage to earnings projections on this class is also at a record high at the end of 2022.
Recent property credit meltdowns in Asian markets have begun to take their toll. The South Korean Legoland default, for example, involved government backing. In the UK, the Bank of England had to intervene in the gilt market to maintain stability after it emerged that billions of pounds of long dated bonds had been bound up in a derivative protection scheme that ignored rising interest rates and the threat to solvency of pension funds.
The potholes of global credit risk created by over-leveraged credit issuance are beginning to surface and will loom larger as rates continue to rise. In the US, we think it is unlikely that the Federal Reserve will intervene in any private sector credit meltdowns. This raises the risk of more market volatility - another reason to stay short and liquid. Excessive leverage must be removed before a new growth cycle can emerge.