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In last week’s post, I made the comparison between the recent movie Everything Everywhere All At Once and today’s markets. Now awash in new realities, the world is starting to feel like the film – existing in a realm of lucid dreaming, liminal spaces, and the outer wilds of imagination.
One topic in our bulging in-box focused minds far more than others: problems in the global banking sector. Lat time, I addressed questions about Silicon Valley Bank, whether the concern about “contagion” is warranted, and whether higher rates will “break” anything else.
This week, we continue with four more of the most common questions we’ve been asked and our responses.
Since the middle of last year, when recession fears surfaced, we have pushed back on the consensus view that the global economy faced imminent recession. Market participants were underestimating economic momentum resulting from the trillion-dollar fiscal packages during the pandemic.
That view has proven right. However, we also update our outlook when the evidence suggests we should. The new data point here is that financial crises, like the one we are having, do create demand destruction. Banks reduce credit availability, consumers hold off large purchases, and businesses defer spending.
Is all of this enough to tip the global economy into recession in 2023? Perhaps. But recession is a catch-all term. It comes in many forms. It can be a mild decline lasting a few quarters or a sustained contraction. If recession does arrive, we are firmly in the camp that it will be of the mild variety simply because of the lack of major economic and financial imbalances. In fact, most imbalances had largely been worked out in the post-2008 crisis period.
Put another way, we expect an “income statement recession,” in which spending and profits cool in the face of tighter policy, rather than a “balance sheet recession” like we saw in the 2010s, which involves an extended period of debt reduction, cleansing of previous excesses, and financial system repair.
Every central banker is fully aware that banking stress tightens credit conditions and does heavy lifting for monetary policy. That means the recent crisis will hasten the end of central bank tightening cycles, at least for now. The Fed hiked its target federal funds rate by 25 basis points, to 4.75%-5.00%, as a final bone toss to its inflation mandate. From there, they will likely insert some language in their communications about deflating commodity prices, tighter bank lending and big base effects. That will put them on hold for a period of time.
But don’t be fooled: The longer-running battle with inflation is not over. We have written extensively on the stickiness of inflation. Even though some disinflationary dynamics are taking place today (goods and supply-driven pricing), other inflationary dynamics are still persistent (services and demand-driven pricing). The lesson from history is that when prices rise as much as they have over the last year, reverting back to a period of benign sustained inflation takes time. And so, the looming policy risk that should be monitored is central banks taking their foot off the brake too soon.
For more than a decade now, U.S. assets could do no wrong. Starting from a base of undervalued stocks and an undervalued currency in 2008, U.S. equities soared along with corporate profits, while the cost of capital steadily declined. The U.S. also had a crown jewel and a huge comparative advantage: Silicon Valley. With the slow global growth backdrop of the 2010s, the sector engaged the market’s collective imaginations. and investors bid up everything tied to U.S. technology. In fact, anything America outperformed: stocks, bonds, and even the U.S. dollar was a chronically strong tailwind to total returns.
All this is changing. For one, the tech sector is struggling. And, now, we have financial stress in the U.S. Bank runs aren’t a good look for any country. Bailouts aren’t either. With each successive government intervention, the U.S. becomes less attractive as a destination for capital. The U.S. has even been the venue where the most bankruptcies and even fraud have taken place (SBF and crypto exchange FTX).
By contrast, financial conditions were far more constrained in the Eurozone, Japan. and across emerging markets. The cost and access to capital never reached the levels seen in the U.S. Stock markets never caught a steady bid. In fact, many local stock markets in those regions remain at levels seen over a decade ago. Local currencies were obliterated as capital rushed into the U.S.
These regions, many of which did not pull out fiscal bazookas during the pandemic, are now primed for a long period of outperformance. In fact, this is already happening with U.S. equities underperforming the MSCI World ex-U.S. since July 2021. Emerging market bonds have even massively outperformed over the last year.
And yet investors continue to chase past winners in 2023. Profitless tech, cryptocurrencies and even Big Tech have all outperformed this year. But these are classic “echo bubbles,” a pattern that can be seen in periods after all the biggest manias. The psychology behind it is that, as Steve Eisman recently said, people don’t give up their paradigms easily. Many refuse to abandon the assets that have made them a lot of money in the past. And so they continue to pile in. But the echoes gradually fade as serial disappointments kill the faith.
Ever since The Matrix, the multiverse has been having a moment. These films readily defy the laws of probability, plausibility, and coherence. But the parlor trick of parallel universe cinema is to make all the loose plot details come together for the finale.
Markets do this too. Bear markets, like the one over the last year, always create higher volatility as investors attempt to discern the new, durable trends ahead. We are living through this in real-time and it can be a frustrating process. But over time the new macro environment will become increasingly clear. Volatility will subside.
A key trend to recognize is that the era of low interest rates is over. With secularly higher interest rates, investors will no longer be able to rely on the continuous re-rating of many asset classes, especially long-duration growth stocks and leveraged investments of all stripes.
The good news is that the return prospects for balanced portfolios are much higher than they have been for a long time. For the income side of portfolios, investors no longer need to suffer low rates or even take big risks. Staying short duration and high up on the credit spectrum is now well compensated. For the growth portion, echo bubbles in 2023 are an opportunity to further align with the new investment leadership – assets with tangible exposure to the real economy such as resources and value stocks. Investors should look past current volatility. Banking panics always create buying opportunities. And, increasingly, it will become clear that the big macro trends have changed everywhere – and all at once.
Tyler Mordy, CFA, is CEO and CIO of Forstrong Global Asset Management Inc., engaged in top-down strategy, investment policy, and securities selection. This article first appeared on Forstrong’s Global Thinking blog. Used with permission. You can reach Tyler by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at tmordy@forstrong.com. Follow Tyler on Twitter at @TylerMordy and @ForstrongGlobal.
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Content © 2023 by Forstrong Global. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. Used with permission.
The foregoing is for general information purposes only and is the opinion of the writer. The author and clients of Forstrong Global Asset Management may have positions in securities mentioned. Performance statistics are calculated from documented actual investment strategies as set by Forstrong’s Investment Committee and applied to its portfolios mandates, and are intended to provide an approximation of composite results for separately managed accounts. Actual performance of individual separate accounts may vary with average gross “composite” performance statistics presented here due to client-specific portfolio differences with respect to size, inflow/outflow history, and inception dates, as well as intra-day market volatilities versus daily closing prices. Performance numbers are net of total ETF expense ratios and custody fees, but before withholding taxes, transaction costs and other investment management and advisor fees. Commissions and management fees may be associated with exchange-traded funds. Please read the prospectus before investing. Securities mentioned carry risk of loss, and no guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
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