Pressure points
Equities rebounded somewhat at the back end of last week in what was mostly a relief rally. Far from being considered a full recovery, last week illustrates how high market volatility is and how fragile sentiment remains.
Looking at markets, it isn’t easy to ascertain a direction. While it is easy to say that sentiment is negative, history suggests that often we don’t recognise a rebound, especially after such a dismal year, until it’s well over.
Thus, investors should not be asking: “is it over?” Rather they should be focusing on “What is priced in?”.
At current levels, risk assets are pricing in aggressive quantitative tightening well into January 2024 and possibly an economic slowdown.
What they are not pricing in is a full-blown global economic recession and the rising possibility of systemic events as liquidity is withdrawn and economic pressures mount.
The last fourteen years have seen an explosion of debt, central bank balance sheets and the natural assumption that interest rates will remain low and liquidity will remain ample for a very long time. While it was a natural assumption to make, we always knew that its cornerstone was the re-emergence of inflation.
An unusual and largely unforeseen confluence of pandemic-related economic dislocations, from supply chains to stimulus checks, China’s turn towards consumption and the war in Ukraine, all unrelated events, have given rise to the most aggressive inflationary bout in over forty years. Central banks had to quickly retract money supply to slow down economic activity as means of fighting off rising prices (we will table the discussion as to whether this constitutes a policy mistake or not).
From a bird’s eye perspective, the central bank hit the monetary accelerator fast in 2020 and then equally fast hit the brakes in 2022. The abruptness of the moves alone is enough to cause dislocations in and by itself.
For stocks to capitulate, we would have to see the S&P 500, currently just below 4000 points, roughly at levels 3000-2600 points. These are the levels it takes to completely price out the last round of quantitative easing and for US equities to reach a 14x -15x trailing Price/Earnings ratio, the historical point of capitulation. They are still well over 70% higher than the highest point of the previous cycle.
However, we don’t have evidence to say that the market will, or will not, retrench that much, or even that this is not the beginning of a lasting rebound. A lot of what we are experiencing is noise, much of which is driven my algorithms.
What we are seeing is that investors are, of course, reticent to buy big drops for a number of reasons
Capitulation is still far
We are in Quantitative Tightening, not Quantitative Easing which made drops very shallow
Volatility cuts both ways
The outlook for recession is still prominent
We have yet to see the big dislocations
This last point is the one that keeps even the most bullish investors from placing too much faith in recoveries. Lehman Brothers collapsed in September 2008. However, the extent of the financial damage would not be properly assessed until AIG, the global insurance behemoth almost followed later in the year.
It’s not what we have seen but what we have yet to see
What investors need to follow up on is to find pressure points. Which structures and organisations put too much faith that interest rates would be near-zero forever? Which of these are the weakest and which may fail as a result of this global economic and financial crisis? Which of them have the potential to become systemic (i.e. affect all risk assets) and which are salvageable before they become so?
We have identified what we think are more likely to be the major pressure points: Where reliance on QE-perpetuity was significant.
The Euro is the market’s weaker point. It was imperilled and almost ended right after the previous financial crisis. It could do so again. After all, it was Quantitative Easing that alleviated pressures and removed the danger of a Eurozone breakup. Its architecture has strengthened but the banking union is incomplete and structural flaws remain. Currently, the ECB is in a conundrum. If it hikes rates, it imperils Italy and Greece and risks kicking off another Euro crisis. If it doesn’t, the Euro will weaken, and the EU will import further inflation.
Real Estate. Along with the Eurozone, global real estate markets have been the primary beneficiaries of a more-than-a-decade campaign to fix the damages from the last Global Financial Crisis. Already, we are seeing rising pressures in commercial real estate, with demand down as many companies opt for hybrid working models. Housing prices could also soon come under pressure. Already we are seeing “air pockets” between buyers and sellers in many markets, which usually come before price corrections.
Corporate defaults. Large caps are by-and-large secure from large defaults. A decade of cheap funding and very little expansion leaves most large caps in safe space. Mid and small caps are more in peril, however, they still have a healthy amount of cash sitting on their balance sheets. Nevertheless, it has really been mature companies that have managed to amass cash. The growing ones, as usual, poured earnings into expansion. They are now the more likely ones imperilled by the economic downturn. Private equities, who have shouldered a lot of risk post the GFC, and their lenders are thus also in peril. It is not unthinkable that, for all the protections in their balance sheets, banks could find themselves exposed again if big Private Equity vehicles fail.
Bond markets: Bond markets are roughly twice the size of equities. Bonds are not nearly as liquid as stocks and they trade over the counter, which makes price discovery more difficult. Economic dislocations, defaults etc always appear in bond markets first. We are already observing some (expected) dislocations in the high yield space, as well as rising dangers in the European periphery. Central banks have long dominated certain corners of the bond market and priced out private and bank trading desks. Now that they retract liquidity, organisations and even nations who learned to depend on them will find themselves faced with steep funding cost rises and concomitantly rising risks.
Certain economies are also in larger peril than others.
China: China is still attempting to transition from the manufacturing to the services sector. At the same time it is trying to hyper-regulate businesses in a bid to stop their interests from directing long-term state policy. It is doing so during persistent pandemic outbreaks and a stagnating global economy nearing the point of recession. The probability that Xi Jinping’s plan will succeed is reduced, as Chinese output continues to slow down precipitously. A Chinese recession would reverberate across the globe.
Britain: The British economy still has to deal with the consequences of Brexit. Technically, Brexit began during the pandemic, so the economic effects of the pandemic largely obfuscated those of Brexit. As the dust clears from the pandemic, it is becoming clear that Britain faces an uphill battle. The primary problem is the availability of skilled workers. As may have returned to their country of origin, the jobs market is now very tight. This could mean upward pressures in wages and lingering inflation, even after supply-side pressures on prices have abated.
Investors will probably spend the next few months looking at the potential emergence of systemic risks. Only when, and if, that danger has been removed will markets begin to see sustainable recovery.