A Wealthy Insight April 2022
You spoke we listened.
During our last client survey, although you had mentioned that you enjoyed reading our insights on a quarterly basis, you found the Newsletter format a bit long. This version is an effort to reduce the reading time. Believe me for those that know me, it’s been a challenge.
"There are decades where nothing happens; and there are weeks where decades happen"
?I think the aforementioned quote sums up the first quarter pretty well. To call the current macro backdrop challenging would be an understatement. There is so much currently to grapple with. From geopolitical conflict, generational high inflation, skyrocketing energy prices, to a change of direction from central bankers and from love to hate to love again of the technology stocks. Ouf! Asset prices started the year on the backfoot where at one point some indices were down close to 20%. And it all changed during the Federal reserve meeting. Equities moved from an oversold standpoint to an overbought in the matter of two weeks. The old speculative mania is back to the fore.
?In the next few lines, I will try to convey my view.
Central bankers and the US Federal reserve (Fed) in particular; why do I focus on the Fed, well implicitly this institution, by its power and impact, is pretty much the world’s central bank. The Fed will be raising rates aggressively during its next few meetings to curb inflation. The market is currently expecting over 8 quarter points hikes so that at the end of the year the Fed Fund Rate (FFR) should be at 2.5%. Doesn’t sound like a big deal? Well, just as a reminder, rates were kept at 0% over the last two years. The rate of change (ROC) is an important factor here. Moreover, the problem here is not the tightening per se, it’s the combination of the ROC and the timing of the hikes. They are projecting to raise rates into an economic slowdown and where we could very well see close to ZERO growth in the second quarter. Historically central bankers are starting to raise rates when the economy is improving to avoid an overheating. With inflation currently close to 8% and the FFR at 0.25%, pundits are right to call the Fed behind the proverbial eight ball.
There were plenty of indicators showing that the economy was slowing and that the labor market was tight. The Fed’s action could potentially tip the economy into a recession. If you’re like us and think about investment in terms of probability, consider the following points: Although with various lags, every Fed hiking cycles the economy ended up in a recession. Every time inflation ran above 5% (7 times out of 7) the economy tipped in a recession. 80% of the time when housing affordability is in the lower decile, you guessed it, the economy fell into a recession.
Aside from the Fed there are other indicators pointing to a slowdown:
One: The current shape of the yield curve. Typically, in the early phase of an economic expansion, short term rates are anchored to the lower bound and longer-term rates are moving up, hence what we call a steepening yield curve. Currently, when market participants sense an economic slowdown the yield curve does the opposite; It first flattens then inverts. That’s when short term rates are moving higher than long term rates as you can see on the right side of graph 1.
Two: Housing. Over the last 6 months, the combination of much higher mortgage rates and sky-high valuations is weighing heavily on housing affordability, and housing affordability leads housing starts.
Three: Another leading indicator that we are paying close attention to and follows housing is the ISM manufacturing survey New Order index (graph 2). Albeit still at an elevated level currently, it started rolling over.
Four: The three biggest components of inflation (shelter, food and transportation) are stubbornly high. This weighs on consumer sentiment. This is something to pay close attention to since consumption represents close to 70% of GDP.
Five: Credit spreads are widening. Historically, when the economy is improving, the rate differential between Treasuries (consider this the risk-free rate) and either corporate and/or high yield are narrowing to reflect a rosier outlook and hence less default risks. Currently, we are witnessing the opposite.
Six: Negative Real earnings. ?The termination of government transfers to individuals are not being offset by higher wages.
Seven: Corporate earnings have been the biggest contributor of equity outperformance in 2021. Currently looking at the most recent Bloomberg Aggregate Earnings Per share Growth Estimates from the first quarter of 2021 to the first quarter of 2022, earnings are expected to fall from 45% down to 6.3% and from Q2 2021 to Q2 2022, from 87% down to 6.2%.
Eight: Small business confidence is slowing?
Nine: The termination of the quantitative easing (QE) program (the Fed buying Mortgage-backed securities and Treasuries to keep real rates negative) is an additional form of tightening.
?What happened Mid-March?
Well, bearish sentiment had become consensus and stock prices rebounded. As you can see on graph 4, at one point the NASDAQ and the S&P 500 were down 20% and 12% respectively.
As for the outlier, our beloved S&P/TSX Composite?finished the quarter up over 4%. No surprise here when looking at the commodity overweight of the benchmark. The war in Ukraine has greatly benefited sectors such as energy, materials, and soft commodities
Notwithstanding the mid-March bounce, based upon the reasons mentioned above we are positioned as follow: overweight in cash, underweight equities, and we are adding to defensive sectors such as utilities, health care consumer staples, gold and treasuries. Having said that bear market bounces are powerful both in terms of scope and time and afford the opportunity for profit taking. Recent history has taught us that when equity markets dive, central bankers and government officials are coming to the rescue. I don’t think it will be any different this time, except that they might wait until there is more pain before acting. We are positioned to participate in the rallies while still protecting capital.
?Parting words
Confusion is probably the right word to describe market behavior. We are either in an environment where the expected rise in interest rates is creating a massive sector and style rotation out of the longer duration assets (AKA: Growth) towards more cyclical sensitive industries that tend to perform better in a higher inflation/higher rate backdrop. Or maybe we are slowly moving into something more dreadful. I don’t think anybody knows. Time will tell.
The hardest thing to do when investing is to remove the emotion from the equation (for some time you can look foolish) and risk-manage the short term while having a long-term play book.?
I read this book about a year ago soon after it came out. I think the topic is timely. I enjoyed Marko’s framework when analyzing geopolitical risk using his self-described constraints as opposed to preferences. Here’s a quick summary:
Geopolitical Alpha - An Investment Framework for Predicting the Future?provides readers with an original and compelling approach to forecasting the future and beating the markets while doing so. Persuasively written by author, investment strategist, and geopolitical analyst Marko Papic, the book applies a novel framework for making sense of the cacophony of geopolitical risks with the eye towards generating investment-relevant insights.
Geopolitical Alpha?posits that investors should ignore the media-hyped narratives, insights from smoke-filled rooms, and most of their political consultants and, instead, focus exclusively on the measurable, material constraints facing policymakers. In the tug-of-war between policymaker preferences and their constraints, the latter always win out in the end. Papic uses a wealth of examples from the past decade to illustrate how one can use his constraint-framework to generate?Geopolitical Alpha. In the process, the book discusses:
What paradigm shifts will drive investment returns over the next decade Why investment and corporate professionals can no longer treat geopolitics as an exogenous risk How to ignore the media and focus on what drives market narratives that generate returns Perfect for investors, C-suite executives, and investment professionals,?Geopolitical Alpha?belongs on the shelf of anyone interested in the intersection of geopolitics, economics, and finance.