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The London Brief - September 26th, 2022

The London Brief

September 26th, 2022

Wine consumption fell for the first time in twenty-five years as people turned towards spirits. People are probably careening to the harder stuff because they own bonds. This year’s bond losses are the most since 1949 (the Marshall Plan), 1931 (Credit Anstalt bank default) and 1920 (the Treaty of Versailles).

Where Are We Going?

Commentators are universally bearish. Normally, when it’s this one-sided the contrarian trade works, and in the 2001-2002 rate tightening period, there were 14 ups and downs. But I thought Andrew Garthwaite of Credit Suisse reflects my highest probability call on what is likely to transpire in the months ahead.

A recession looks inevitable in Europe and the U.S., but sticky inflation prevents a policy response. In the U.S., housing inflation and services continue to be strong, but the Fed’s hawkish note and rising rates is starting to create a slow-down. U.S. mortgage rates are now at 6.5% for a 30-year mortgage and construction activity has slowed. David Faber of CNBC spoke to corporate restructuring experts and noted that there are big layoffs coming. This should allow for the labour market to loosen. There is still a long way to go from an 8.4% inflation rate but coming prints should show a moderate slow-down and potentially a slower Fed rate hike path. Weak markets should continue to early 2023 with the potential for rates to rise to 4.5%-5.0%.

The UK is adopting Reaganomics. In 1981, Reagan implemented an aggressive tax cut plan when inflation was high and interest rates were at 19%. Liz Truss imagines herself to be the Gipper. What she misses is that in 1981, the dollar was strong, which was helping to bring down inflation. The dollar was also the world’s reserve currency and other countries praised its prudent monetary management. In the UK’s case, the pound has been falling sharply against the dollar and other currencies. The UK is running a 8.3% current account deficit. The Bank of England (BOE) is expected to lift interest rates to 4.5%. More expensive imports will boost inflation even more. Unlike the run-up to the election, where she seemed to want to muddy the bank’s independence, she seems to be singing a different tune recently where she says the BOE is “independent” to set its policy. In his letter to the BOE, Chancellor Kwasi Kwarteng said, “you have my full support in your critical mission to get inflation under control. The government’s commitment to a 2% CPI inflation target, and the independence of the Bank remains absolute.” Given her Reagan precedent, Truss probably thinks the BOE should manage the inflationary pressures while she seeks to focus on growth. Reagan’s tax cuts, however, did not prevent a steep recession; high rates had their impact. By forcing the BOE to raise rates more quickly, the tax cuts may create even worse pain. The BOE, also known as the Bank of Easy Money, is dangerously behind the curve. The Monetary Policy Committee only went for a 50 basis points hike despite an inflation rate of over 10%. The Fed in contrast went to 75 bps at 8.3% inflation. The BOE is still undertaking quantitative easing; the Fed has stopped and is now quantitatively tightening. Larry Summers said, “It makes me very sorry to say, but I think the UK is behaving a bit like an emerging market turning itself into a submerging market.” In afternoon trading Friday, the volatility market in sterling shut down. Deutsche Bank believes the BOE will have to do an emergency hike this coming week. The BOE said they didn’t agree on Monday and the pound fell another 3%. Liz Truss should ask herself why people invest in the UK if its currency volatility looks like a technology stock.

In Europe, the situation is dire. Energy prices have sharply risen creating great hardship. Industrial production in the euro zone fell by 2.4% in July from the year before. Yet currencies have fallen creating inflationary pressures. Other countries are also suffering. South Korea has had a sharp, disorderly drop in the Korean won, as exports to China have ebbed and it’s had to nurse a rising currency account deficit. Their central bank has recently asked for direct Fed swap lines. The Bank of Japan also made several clumsy interventions in the yen last week. China’s RMB hit a new low against the dollar as their central bank struggles to contend with currency outflows and maintaining the dollar peg.

The real money supply is contracting, and people are underestimating the impacts of quantitative tightening. Quantitative tightening is hard to price, but it could increase rates by anywhere from 50 bps to 150 bps depending on the economic commentator. The Fed’s belief is that it will raise interest rates by 50 bps. This may be credible in that the market will have to absorb about $1.5 trillion of securities that the Fed was buying but there is $4.6 trillion sitting in money market funds.

The equity risk premium should be 5.5% which would warrant a 15.1x-15.6x P/E multiple (this would essentially be around a 10% forward equity yield on 4.5% interest rates). Markets are almost there now, but the E has not declined significantly yet. The average decline in trailing EPS during recessions has been 19% since 1945. Garthwaite is estimating a 2023 earnings number that is 14% below IBES analyst consensus estimates. If he’s right, then the S&P should hit 3,200. As of the close of Monday, we hit 3665 which would mean we still have another 10% to go, which will likely be delivered during earnings periods to the first quarter of 2023. In the meantime, we could see some relief rallies.

Earnings are likely to decline. Downgrade cycles usually last 19 months with markets troughing 6 months before downgrades trough. While we saw some downgrades since June, we are coming off record margins, much of which came from interest rates and lower taxes (both are reversing globally). With higher rates likely to dampen spending, we will likely see earnings downward revisions over the next two quarters at least.

Bear markets typically last 14 months, with an average fall of 35%.

Credit is now pricing in a recession. High yield spreads typically get to 8%-9% and high yield credit and equity are closely correlated. The recent Citrix debt which priced at 10.5% is now trading at a higher yield than issuance.

The Fed Put is not there. Usually when the stock market has weakened, the Fed has tended to lower interest rates. Garthwaite thinks if the put is activated, it will be at the 3,500 level, but the Fed probably won’t think about the level of the stock market until it feels it has inflation under control.

What Could Change the Trajectory?

Immaculate Inflation. One theory is that the Fed raises rates and slows the economy successfully enough that we get back to 2% inflation. The Fed then lowers to around 3% and we have happy days. I give this a low probability, in part because of the views of another commentator, Zoltan Pozsar of Credit Suisse. He believes inflation will become structural driven by four mega-themes that will elevate costs. He calls these the four Rs: (1) re-arming; (2) re-shoring; (3) re-stocking; and (4) re-wiring that will create long-lasting inflationary pressures. Thanks to the nationalist, empires builders in Russia and China, democracies are now increasing military expenses. As a result of these geopolitical tensions, trade has been impacted and companies are being urged to decouple or reduce dependence on Chinese production. Europe is now re-tooling its energy complex away from Russia and towards LNG. Climate change is exerting real-world costs on food production and supply chains; re-wiring our energy industry to be carbon neutral, and dealing with the impact of hotter temperatures, will be costly. As a result, it’s likely that inflation stays elevated above 2% for a while.

Lower the Returns. Another possibility is that the market could accept a lower equity risk premium and accept lower returns. Antti Ilmanen’s book Expected Returns hypothesized about that scenario. But I think the probability is low because of quantitative tightening. The market will have to absorb about $1.2-$1.5 trillion of securities the Fed was buying. Real M1 growth has plummeted about 20%, which means returns need to be enticing to attract investors in a capital scarce environment. A 10% equity yield is not an unreasonable return expectation (versus 4% earlier in the year).

The Fed Put Returns. I put this at a low probability. The Fed wants to regain its credibility. It was behind the curve and the markets refused to believe their willingness to combat inflation. Based on a March dinner I had with Richard Clarida, I believe the Fed has learned its lessons from the 1970s and will hold firm until the real rate is positive.

So, my base case market prediction is that we see some relief rallies in the weeks ahead, but then the downtrend resumes at the next series of earnings reports and by March 2023 we see a 3200-3400 level in the S&P before we bottom. From that point, the market is unlikely to rapidly increase higher, but there should be a gradual appreciation and return to more stable markets.

End Note

Heineken bought out Led Zeppelin’s son’s craft brewery for over £200 million. That son certainly found his stairway to heaven and is giving Heineken a whole lotta love. And now he can get 10% yields on bonds and ramble on to Kashmir or go to California. Sorry. Until next time…

Zug, Switzerland

September 26th, 2022

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