The pound fell last week to its lowest level against the dollar since 1985 and five-year interest rates rose 50 basis points in a single day. The trigger was a £45bn package of tax cuts, the largest in 50 years. With the fall in the pound, Britain's economy is now smaller than that of former colony India. In reaction to the financial markets, Britain is also starting to look more and more like an emerging market, although more like a submerging market than an emerging market. Kwasi Kwarteng, the new finance minister and new prime minister Liz Truss is betting on tax cuts and deregulation with the aim of boosting growth in the UK economy. To pay for everything, Kwarteng wants to borrow tens of billions more. In this regard, it is unfortunate that the UK's two-year interest rate has risen from 0.4 to 4.0 per cent in a year. Moreover, the plan also frustrates the Bank of England's efforts to get inflation under control.The package of measures also aims to do something about high energy prices. In the UK, there will now be a cap of £2,500 per household and businesses will also get similar support. The top income tax bracket (from £50,750) goes from 45 per cent to 40 per cent and the lowest rate goes from 20 per cent to 19 per cent. The package goes beyond measures introduced by Nigel Lawson, Kwarteng's counterpart, under Prime Minister Margaret Thatcher. For instance, the stamp duty land tax on houses will be abolished or reduced, benefiting first-time homebuyers up to 625,000 pounds. Taxes on dividends are also reduced.Furthermore, the ceiling on bonuses in the City will disappear. This had been truncated at twice salary under pressure from the European Union and is now being released. According to Kwarteng, it is crucial that jobs in the financial sector return to London and that bankers pay taxes in London and not in Paris, Frankfurt or New York. Incidentally, in recent years, fixed salaries in London have risen sharply due to the bonus cap. Many bankers reacted approvingly to the announced measures. Overall UK tax revenue is likely to increase sharply as a result of this measure. Tax on entrepreneurs will remain at 19 per cent, the lowest level in the G20.Kwarteng is fully committed to the City of London as a growth engine for the UK economy. On top of tax measures, there will be 38 special economic zones with specific tax cuts and far-reaching liberalisation. Meanwhile, Liz Truss appears to be fulfilling her radical promises during her Conservative campaign. Because of Truss, there will be more diplomatic conflicts with Europe, the UK is belligerent towards China, Scottish nationalism will get a boost and relations with the US will deteriorate because it does not accept the EU protocol between Northern Ireland and the Republic of Ireland. Besides tax cuts and deregulation, defence spending also goes up by 1 per cent of GDP. This increases the budget deficit. Meanwhile, she blames rising inflation on the incompetence of the UK central bank.Inflation is a symptom of too much money looking for too few goods and services. It cannot be solved by improving Britons' disposable income. Yet Truss is not entirely alone in this. The extent to which energy is subsidised in Europe is striking. Meanwhile, Kwarteng is Britain's first finance minister with a PhD in economics. The question is whether Truss and Kwarteng's unorthodox approach to tackling stagflation is going to work. Ordinary macroeconomists cannot properly explain the combination of recession with inflation (stagflation). Truss' measures are aimed at tackling inflation through a cap on energy prices, more measures against unions and strikes, and putting pressure on the central bank to tighten. So at the same time, they are taking many measures to spur growth, but in doing so, unlike Thatcher, she is pulling out a package of Keynesian measures. As with Thatcher, Trump and Reagan, many economists are now declaring Truss crazy, but if her plan succeeds, she will go down in history as the only successful Conservative prime minister beside Margaret Thatcher.
Fears of a global recession have put pressure on oil prices. Some parts have actually seen a softening of demand, such as in China due to new lockdowns and the problems in the Chinese housing market. In both cases, the problem was caused by the Chinese government and so that is where the solution lies, but not before the congress next 16 October. So while demand is softening, little has changed on the supply side. On balance, energy markets are tight and China thus seems to be the main swing factor. In the event of a long global recession (not the base case scenario), oil demand could fall by about 6 million barrels a day, but that is still equal to 2015 production. The brake on investment in new oil production is on the one hand a consequence of a more volatile oil price trend, but also comes from social pressure not to invest in particular. Central banks, commercial banks, investors, action groups and even judges ensure that investment and extraction in new areas are unpopular.At the same time, the world continues to burn nearly 100 million barrels a day. Three-quarters of the world's population does not have the luxury of an energy transition either; they mainly want energy security. Yet the forward curve discounts a much lower oil price, which would mean that shortages would be solved quickly. That seems an illusion, especially now that in Europe just about everything combustible is used to generate energy. Germany's lignite-fired power plants are back up and running at full capacity. Incidentally, high investments due to high gas and electricity prices in Europe will result in a rapid fall in gas and electricity prices. For oil, there is more upside.Inventories are still low. This applies to inventories in the industry itself, but especially to US strategic inventories. Combined, they are at the lowest point in the past nine years.Downside risk in oil prices is mainly driven by demand slippage. The economic outlook for Europe is constantly being revised downwards and China continues to suffer from lockdowns and the housing market. Furthermore, a deal between the US and Iran is also possible. If the sanctions are ended, it will save 1 to 1.5 million barrels a day. Currently, OPEC members are struggling to meet production agreements. If they do succeed (especially in Nigeria) it will save 0.6 million barrels a day.Besides the downside risks with oil prices, there are also upside opportunities. Supply-side problems will ensure that oil prices remain relatively high. The physical oil market is tight and geopolitical developments such as a deal with Iran could cause OPEC to decide to cut production. At the last meeting, production was cut by 100,000 barrels a day. The G7 countries still want a price cap on Russian oil. Russia will then respond by cutting production further and may also use its influence with OPEC to further cut production there. Russia produced 10.9 million barrels per day last year. Furthermore, Russia is struggling to maintain that production level anyway. The departure of Western oil companies also meant the departure of Western technology. In Venezuela, this has caused local production to be decimated. Furthermore, Libya is expected to deliver 0.5 million barrels per day again from the fourth quarter, but the situation there is not really stable. An opportunity for the oil market is also the swap from natural gas to oil in Europe. According to research, this quickly amounts to just under a million barrels a day. Low inventories are likely to amplify the oil price swings. The real upside is the end of Covid restrictions in China combined with more air in the Chinese housing market. If the Chinese then also start flying internationally again, things could go fast.There is still an investment and particularly by non-Western oil companies. A major field owned by Hess and ExxonMobil is the oil field off the coast of Guyana and Suriname. Its contribution to the total is now relatively modest at 115,000 barrels a day, but this is likely to increase sixfold in a few years.The soaring profits of oil and mining companies make the broad equity market's earnings trend look optically better than it actually is. Without oil, little earnings growth remains. This does not involve an 8 per cent rise in profits this year, but only 1 per cent. If the mining companies are also taken out, corporate profits would actually shrink. The same also applies to valuations. With oil and mining, the P/E stands at 18, without oil and mining at 20. That while energy accounted for only 2.7 per cent at the beginning of the year, now it is 4.8 per cent. Only because of the extremely low valuation of oil companies, the weight of profits the in the index is many times greater (more than 10 per cent). Oil companies are valued as if they could collapse at any moment, not when they are companies reporting record profits. The key to the energy transition lies with the oil companies, they have the cash flows, the engineers and the knowledge of major projects to make the energy transition succeed.
Higher interest rates good for the economy, not the stock market
Today, the Federal Reserve will raise interest rates by 75 basis points and possibly by 100 basis points. After last Tuesday's US inflation figures, it has once again become clear that inflation is anything but a temporary phenomenon. It was immediately the worst day for the US stock market since June 2020. Just a few weeks ago, the narrative in equity markets was that a global recession was looming, but 3.5 million jobs have been created in the US labour market this year and industrial production has been rising at least 3 per cent all year. While consumer confidence is at an all-time low, consumers continue to spend. One of the reasons consumers are spending more and entrepreneurs are investing more is that interest rates are rising. When interest rates fell to zero or even below, central bankers wrongly assumed that people would stop saving and start consuming more. The opposite was the case, low interest rates and the accompanying signal that these were special times actually caused people to save more. Entrepreneurs also knew that zero per cent interest rates could not be right and it was impossible to make investment decisions on that basis. Now that interest rates are rising, commercial banks are also willing to extend credit again. With interest rates at zero per cent, there is little room to pass on margins, but they are succeeding thanks to rising interest rates. So the unusual phenomenon now occurs that interest rate hikes also have a positive effect on economic growth. To curb growth, interest rates will have to rise much further until there is a positive real interest rate and interest rates are also clearly above the neutral rate.Inflation data put US interest rates back at the level of the peak in June. The S&P 500 index was down 5 per cent at the time. Second-quarter results were better than expected (courtesy of inflation). Still, there are plenty of companies indicating that the economy is doing fine. According to Delta Airlines, there is plenty of flying, according to JP Morgan, there is plenty of borrowing and according to Apple, the list of people who have ordered the iPhone 14 pro-Max has not been this long in six years, including in China. This is while in China, lockdowns and housing market problems have reduced oil demand by 2.7 per cent. The wait is for the Chinese party congress to start on 16 October.About half of all income in the United States comes to households earning more than $100,000 a year. Most of these households own a house that they have paid off or financed with a mortgage at a historically low-interest rate of less than 3 per cent for the next 30 years. The fact that the same mortgage rates have risen above 6 per cent does not affect these people. At the same time, their wages are increasing by about 6.5 per cent. These people do not have less, but rather more to spend due to high inflation and rising interest rates. Not surprisingly, shops that cater mainly to the high-end are doing fine. Lower-income earners are much more affected by higher rents and higher food prices, an additional dilemma for the Federal Reserve.Higher-income earners often also invest part of their assets and now have more to choose from. They can safely invest it again in short-term US government bonds at an interest rate of 3.75 per cent. The earnings yield on equities (the inverse of the P/E ratio) is 5.9 per cent. That gap has been bigger before.Higher interest rates are not good for equity valuations, but obviously, neither is an (earnings) recession. It does not seem to matter much then whether the fire of inflation or the ice of recession will put pressure on share prices.Earnings valuations for the S&P 500 still look high and high-profit margins look vulnerable. That is not the case for Chinese stocks where all the bad news does seem to be discounted in valuations. Europe is a bit of a case apart. European equities are cheap, but there are plenty of reasons why they should remain cheap. Yet a more positive scenario is gradually creeping forward. High gas and electricity prices may cause them to fall sharply as early as this winter, and since inflation in Europe is actually largely due to energy prices, inflation in Europe may therefore fall much faster than in the US. This also means that the ECB will need to raise interest rates much less than the Federal Reserve and could possibly stop earlier. Now, the war in Ukraine and the elections in Italy still hang over Europe like a dark cloud, but all two are by definition temporary. If then also the US dollar turns, that might be the moment in the sun for European equities.The preference is for value stocks. Defensive value stocks are valued lower than the market average and the question is whether this is justified in the current market environment. In the more cyclical value stocks, a solid recession seems discounted. Furthermore, Big Tech, in particular, seems to have to take even more pain and that is also the reason why the stock market could still go down at the index level. Commodity stocks remain extremely cheap. In the short term, a recession or the standstill in the US and Chinese housing markets could throw a spanner in the works, but the long-term outlook is actually improving as a result.
There is a growing imbalance in the world. Large trade surpluses are offset by large deficits elsewhere. In the face of monetary prudence, there is the monetary madness that seems to result from the idea of modern monetary theory, a concept that is neither modern (namely many centuries old) nor monetary (as goes via taxation) and not a theory at all. The question is often asked how it should end with ever-increasing debt anyway. There are various solutions and central banks tried for years with their reflation policies (or financial repression) to keep debts bearable. Still, the ultimate outlet is the exchange rate of their own currency. No matter how big the debt is, countries with their own currency can always pay off that debt to the last cent. Coins are simply reprinted, only one can then rightly ask what the value of such a currency still is. High inflation is often accompanied by a weak currency. Apart from the euro, all currencies in the world are linked to a national state. This immediately explains the inherent weakness of the euro. The national state is a product of the 19th century. According to German thinkers, the national state was based on race and ethnicity, according to the French, on the "will to live together, a shared history and shared culture".In countries where King Charles III's head will soon be on the banknote (UK, Canada, Australia and New Zealand), there is such a will to live together. Regardless of distance, they all seem to accept the new British king as the national symbol elevated above politics. This while in the European Union, but also in the United States and Hong Kong, for example, that 'will to live together' is much less present. The situation is most acute in the euro. The euro cannot survive without transferring much of the sovereignty of the national member state to Brussels. This means that especially in fiscal matters, Brussels must be given much greater power to preserve the euro. At the same time, it means that the Netherlands with 60 per cent national debt and Italy with 160 per cent national debt will be treated equally. All those Calvinist years of austerity and neatly minding the shop will then have been for nothing. The Italians work to live and the Dutch live to work.In the United States, there is an increasing divide between Democrats and Republicans, not a reassuring thought in a country where an average of three guns are present in every household. While in Europe it is mainly the Southern member states (with Italy at the forefront) that are feeling the financial impact of the corona crisis, in the United States it is cities like New York, Chicago, Baltimore and the state of California that are bearing the burden. These are Democratic cities and California is as blue as it gets. Just as if it is just a question of whether Northern Europe wants to pay for Southern Europe's debts, it is also a question of whether Republicans want to pay for these cities' debts (let alone California's). This phenomenon does not make the currency stronger. It means that currencies with Charles III's head on the note are better protected, including the currencies of countries like Switzerland, the Nordic countries, China, Japan, South Korea and Singapore. Besides the US and the EU, the currencies of Hong Kong, Mexico, Brazil and South Africa are also inherently weak for the same reason. They are divided and this division is reflected in a growing mountain of debt needed to iron out the folds.The US dollar has risen some 20 per cent over the past 12 months. Historically, this means that the stretch is pretty much over. The euro has fallen over the same period, largely due to the strength of the dollar, but do not underestimate its growing weakness either. The surge in gas and electricity prices is making the euro weaker. Compared to a year ago, Europe receives only a fraction of the amount of natural gas from Russia. At the same time, drought and Europe's inadequate energy infrastructure are actually increasing the need to fuel gas. Energy from Russia used to be paid for overwhelmingly in euros. Much of that money came back to the eurozone in the form of investments and deposits in various banks. A lot was also invested in real estate, luxury yachts and a football club here and there. That money has disappeared. Now Europe has to buy the energy it needs in hard dollars, this mechanism creates an additional supply of euros towards the dollar. On top of that, because of the sanctions against the Russians, the Arabs and the Chinese will also become more reluctant to hold their reserves in euros. The Russians had counted on rule-of-law protection, which is also a major reason for Arabs and Chinese to invest in Europe.The euro may start hitting the lows of the year 2000, which means that some 20 per cent could still come off. There are enough people in the financial world who believe that holding investments in foreign currencies causes portfolio risk to increase. Only this time, the euro is the source of the risk. Even in the short term, a fully euro-hedged portfolio of stocks and bonds actually creates more rather than less risk. This is because when the world is turbulent, investors take refuge in the reserve currency, the dollar. Those who hedge that dollar to euro do not benefit from a strengthening dollar and actually lose twice in their portfolio. It is often argued then that the average citizen in Europe mainly has liabilities in the euro, but that has changed greatly thanks to the recent energy crisis. Energy must now be purchased in hard dollars. Given Europe's widening trade deficit, Europe needs to start earning those dollars first. Otherwise, the euro will become even weaker. The Chinese have increasing arguments to be less dependent on the dollar. This started back in 2008 when problems in the Chinese financial system had a major impact on the Chinese economy. By using the dollar as a weapon against Russia, China will realise that its trillions in dollar reserves will become worthless in a short time if the US seizes them. So the Chinese want to get rid of the dollar as soon as possible, but that is difficult because the dollar has a reserve currency status. Now a reserve currency is not something that is formally confirmed, it is a status that a currency can achieve. For that, a currency has to be especially popular. The most popular currency to do business with internationally achieves reserve currency status. This is not always the same currency; it often depends on a country's economic power. For instance, the guilder was the world's reserve currency in the 17th century, then succeeded by the French franc, the British pound and eventually the US dollar.Since 2008, three-quarters of all international transactions have been in US dollars. The dollar is also the currency of 60 per cent of all debt and 60 per cent of all central bank reserves. Yet the dollar's power is gradually declining, although no other currency has a status even close to the dollar. China would like the renminbi to have such a status, but like the Windows operating system, it is difficult to compete against it with a new operating system. Even Apple never succeeded or did. With the mobile operating system IOS, Windows' monopoly was quickly broken. By adding something, Apple managed to push Microsoft aside. Now the dollar relies mostly on traditional payments, a powerful system as evidenced by the recent SWIFT sanctions against the Russians. But it is not a flexible system suitable for all the portable micro-payment options made possible thanks to the internet. A digital version of the yuan could do this.In the meantime, the yuan (or the renminbi) has become Russia's de facto reserve currency. Other countries that do not have such a good relationship with the Americans will also prefer the yuan. In that context, it is remarkable that only 1.5 billion people live in the countries supporting the sanctions against Russia. Six billion people live in countries that did not support them before. Those countries often have a greater trading relationship with China than with the relatively closed US economy, many of which will then gradually switch to the renminbi. It is possible that the renminbi will never reach reserve currency status. Fundamentally, enough investors still hiccup against property rights in China and the lack of Democratic rule of law. In practice, the situation is not that bad and property rights are trampled by governments, especially in Western Europe and, to a lesser extent, in the United States. Also, the rule of law seems to be working less and less well here. What China's efforts could potentially lead to, however, is the dollar no longer having the status of a reserve currency. In a multipolar world, multiple systems can co-exist without any one currency being able to be labelled as a reserve currency. If that reserve currency privilege is going to disappear, Americans will have to scramble to keep their economy competitive.
Normally, in finance, good news for the economy also means good news for financial markets. Only when the economy overheats and inflation rises is there too much good news. Then, on the contrary, bad news for the economy is good news for financial markets. After all, central banks have to raise interest rates when inflation picks up and bad news brings closer the time when central bankers stop doing so or even cut interest rates. This year is a choice between two evils. On the one hand, the fear of rising inflation and, on the other, the fear of recession. Both good news and bad news are then not good for the market; no news still seems best. This situation does not make it easy for investors either. Fundamentally, it is difficult to make a good story out of it, but at the same time, this causes extreme caution, which means that a lot of bad news may have already been discounted. After all, if everyone is negative, the market can only go one way and that is up.Inflation figures in the United States probably peaked, but in the latest European inflation figures, the recent surge in energy prices caused a further rise. Those European energy prices are the result of a perfect storm. In addition to the sanctions against Russia, the drought caused many of Europe's power plants to shut down because they are not allowed to discharge cooling water hotter than 33 degrees or because low water levels mean coal cannot be brought in. Less precipitation also means less hydropower. The drought is caused by high-pressure areas that also mean hardly any wind, resulting in less wind power. Fortunately, the sun is shining in abundance, but due to overloading the electricity grid, it is not benefiting sufficiently. Only one fuel remains to fill these gaps and that is expensive natural gas. However, many of these effects are temporary and will improve in the coming months. Added to this is the function of price in financial markets. All available liquefied natural gas (LNG) in the world is currently sailing toward Europe. So the best remedy against a high gas price is a high gas price. With that, inflation in Europe too will fall rather than rise next winter. Except that the inflation impulse will ensure that inflation will remain well above 2 per cent in the coming years and possibly even this whole decade.The only way central banks can fight inflation is by causing a recession. Central banks cannot produce natural gas or oil, their supply depends mainly on geopolitical factors. All they can do is depress demand by raising interest rates. The dilemma for the ECB is that supply-side problems are already causing an economic contraction. A recession is therefore our base case for Europe. Then it makes little sense to start messing with the demand side as well by raising interest rates. A complicating factor in the eurozone is that for some heavily indebted member states, current interest rates are actually too high already. Nevertheless, Lagarde raised interest rates by 0.75 per cent last week, a unanimous decision of the ECB's policy committee. Such a unanimous decision means that the doves (that is, the proponents of accommodative policies) at the ECB got something in return. The hawks (the proponents of stricter policy) may quickly raise interest rates to the ultimate target, but the ECB is waiting to wind down its bond portfolio. The proceeds of this portfolio, including, for instance, maturing German government bonds, will be used to buy Italian and Spanish government bonds. The ECB indicated that at least two more rate hikes will follow, possibly in six weeks' time interest rates will go up again by 0.75 per cent. Remarkably, the ECB does not see a recession, but then that depends mainly on energy prices, something the ECB has no influence over. In the United States, on the contrary, the Fed needs to cause a sharp recession to get inflation under control. The chances of such a recession starting this year are slim, given the strength of the US economy. A recession is not our base case for next year either, and if it comes at all, probably not before the second half of the year. This does mean that inflation could remain high in the US for longer too.For the portfolio, this development means that there are two risks that can have a major impact on returns. Inflation is a bond investor's worst enemy and, given the current gap between interest rates and inflation, the portfolio's interpretation is to avoid this risk as much as possible. This means bonds are underweight in the portfolio and the interest rate sensitivity (duration) is well below the market average. There is a preference for countries such as emerging markets and China where inflation is not a problem or where inflation has been addressed in time by central banks. In principle, a recession means that interest rates could fall, but given the still negative real interest rate, it is too early to position the portfolio accordingly. However, a recession could cause credit spreads on corporate bonds and high yield bonds to rise further, two segments we are currently still avoiding as much as possible, but where an interesting entry opportunity could suddenly unfold.Equities can handle inflation much better, but rising interest rates may depress the valuation of the more expensive stocks. A major source of inflation in the coming years is shortages in the commodity complex, which means higher oil prices, higher metal prices and higher prices for agricultural products are on the horizon. This is while right these stocks are up to 60 per cent cheaper than the stock market average. Furthermore, in the portfolio, we emphasise defensive companies that manage to achieve good results even in a recession. In a rising market, such boring stocks often lag behind, but in a recession, they are more likely to show a plus, also because consumers focus on basic necessities and discount shops. Finally, there are shares of companies that have been punished so sharply in recent months that a recession is already largely discounted. This obviously presents opportunities. The extent to which the average stock has been punished more than the stock index in recent months is striking. So while opportunities do exist, equities at the index level still look vulnerable, especially in the coming months as more news follows on inflation developments and corporate earnings trends. The weight of equities in the portfolio is therefore also lower than usual. This means the focus is on alternative investments such as real estate and private equity. Both components are relatively resilient to higher inflation and are naturally less sensitive to developments in the financial markets due to their lack of a stock exchange listing.
This bear market is similar in many ways to the bear market that followed the 1973 oil crisis. Then too there was an oil shock. In a short space of time, the price of oil tripled, and during the entire 1970s oil became nine times more expensive. Today, the world consumes six times as much oil as in the 1970s, yet on balance, the global economy is less dependent on oil. Looking at the explosive rise in natural gas prices and electricity prices in Europe, one could argue that things are worse now than they were in the 1970s. Yet it is often said that things are not nearly as bad as in the 1970s and that it is unlikely that the mistakes of the 1950s will be repeated.According to Niall Ferguson, this time it is worse than in the 1970s. According to him, the mistakes central bankers made then are very similar to the mistakes they make now. Inflation was seen as temporary and insufficiently combated. But no negative interest rates and quantitative easing then, post-Corona, monetary madness has struck. He also pointed to higher geopolitical tensions. The current war is lasting much longer than the Arab-Israeli war of 1973. Then it was over in 19 days, now we are already six months further after the Russian invasion in a war that already started in 2014.The important difference between then and now is that productivity growth is now even lower, while global debt has risen sharply. Demographically, too, our situation is much worse. In the 1970s, the baby-boom generation started working. At the same time, these people started saving for retirement, which meant that although they were productive five days a week, they were soon working one day a week for retirement. Not surprisingly, inflation then starts to fall. Now the baby boom generation is retiring. That means they are no longer productive, but thanks to the well-filled savings pot they are going to consume five days a week, which causes more inflation.Since the Cuban crisis, there has been a steady decline in tension between the Soviet Union and the United States. The rapprochement with China ultimately ensured that the Soviet Union stood alone. Now, on the contrary, tensions are constantly rising and, while sleepwalking, the likelihood of greater accidents is increasing. Furthermore, Ferguson points out that such geopolitical shocks occur in clusters, just like shocks on the stock exchange. The financial crisis and wars coincide remarkably often. The mistake people make is that in such an environment they do not give sufficient consideration to extreme outcomes, because they rely on the relative stability of the immediate past.The Gini coefficient also peaked in the 1970s. Not since the start of the industrial revolution had incomes been so evenly distributed. Since then, this has gradually decreased and an increasing part of the population is no longer able to buy a car or a house. That creates polarisation, just like in the 1970s. But in the 1970s there was lively politics, and in the end, the battle was fought in parliament. Nowadays, many countries are democracies in name only and the contact between politicians and citizens has been diluted. Moreover, democracy must be constantly defended, but now many government leaders seem intent on dismantling it.What is important for investors today is that there is a good chance that we are in a different environment, a different regime, away from the forty years of falling interest rates and constantly rising profits, with Goldilocks as the ultimate ideal. The outcome need not be worse in the long run, by the way, but it does mean that we should not rely too much on rules of thumb that worked in those forty years and that we should take more account of extreme outcomes.
The year 2022 is not an easy one for investors. European investors have the 'good fortune' of a strong dollar and, as a result, the global equity market in euros is only down 6% this year. However, the eurozone has the misfortune that the sanctions targeting Russia are mainly hitting the European economy, to the point where a recession is the base scenario. Whereas in the United States demand has a major influence on overall inflation, something that a central bank can do something about, in the eurozone inflation is determined by Putin first and foremost. Thanks to the strong dollar, the US market is once again doing better than most major markets. Only commodity markets such as Canada, Australia and the United Kingdom are performing better. In dollar terms, the US equity market is 16 per cent negative, with growth (-22 per cent) performing worse than value stocks (-9 per cent). In addition, bonds are doing worse than equities, and in a neutral portfolio, this quickly means that price losses hit much harder than with past corrections. Only 24 per cent of shares are in the black. By comparison, at the end of 2008, 48% of shares were in the black. These figures show that, once again, it has not been wise to 'hedge' currencies. When there is a crisis, the dollar tends to rise in value; people simply take refuge in the reserve currency. Moreover, the dollar is also strong when the US economy performs better than the rest of the world. That is exactly the reason why interest rates have to rise. Exposure to the dollar provides a cushion, although that role will be partially taken over by the renminbi in the future.The market has recently been moving back and forth between the fire of inflation and the ice of recession. In the past week, the market has again been preparing for an ice scenario, as Powell, in his speech a week ago, left no room for a turn in monetary policy. As a result, for the first time in a long time, the global bond market is now in a bear market, a bear market that could last until the end of this decade. It would be much better, also for long-term returns, to take the pain now and allow interest rates to rise sharply. At least then it would be possible to reinvest at higher interest rates. Not that the Fed is not making great strides; who would have expected at the beginning of this year that the Fed would raise interest rates several times by three-quarters of a per cent?We have probably not seen the bottom of this bear market yet. September is not a great month for equities either and much of the recent bear market rally was unjustified. That potential for decline applies mainly at the index level, by the way. It is possible that many individual stocks have already seen their provisional low in June. From this point on, it is less about the development of interest rates, but more about the development of profits. Analysts are still counting on positive earnings growth and with a severe recession on the way, such a development is not so likely. Higher interest rates and a recession also require a higher risk premium (read lower valuation). The valuation has clearly come down but on the basis of the now valued (too high) earnings. The risk premium has decreased due to the rise in interest rates. Higher risk premiums and lower profits give room for further price falls. However, the moment is approaching when inflation will also peak in Europe. The ECB will undoubtedly raise interest rates next week but does not need to make much effort to push Europe into recession - leave that to Putin. Today starts quietly with US stock markets closed, although Friday's close does not help and the indefinite closure of Nordstream 1 will also weigh on prices.
Jerome Powell, the chairman of the Federal Reserve, told basically no news at the annual meeting in Jackson Hole. The only difference was that this time he needed few words and could therefore be quite direct. As a result, the Federal Reserve's message finally landed on the financial markets. The message is still the same: the fight against high inflation must be won at all costs. In recent months, the market has speculated on a possible turn by the central bank in the coming months, but the illusion that interest rates would be lowered again next year has been dispelled by Powell's speech. Price stability is the basis for a healthy economy and therefore also for financial markets.Investors can count on the US central bank to continue to raise interest rates until inflation is under control. Powell specifically pointed out the risk of letting go of the reins too soon. Given the underlying level of inflation, the Fed's policy rate will have to rise even further than the market has expected until recently. Ultimately, economic pain in the form of a recession is inevitable. However, a recession in the United States still seems to be something for the second half of next year at the earliest. Higher policy rates will also push up capital market rates, but ultimately the bond market will benefit from the fight against inflation. The gap between high inflation and comparatively low-interest rates is still so large that bonds are not attractively valued. Shareholders focus less on inflation and more on the consequences of rising inflation for interest rates. Higher interest rates depress not only economic growth, but also the valuation of the stock market. Growth shares, which have recently risen, are particularly vulnerable. The difference in valuation between growth and value shares is still historically large, but that gap will narrow.In Europe, there are rumours that the ECB will raise interest rates by 0.75%, but in view of the recent sharp rise in energy prices, a rise in interest rates in Europe is no longer necessary to cause a recession. Energy prices are now so high that they are in themselves a guarantee of a solid recession. Because high inflation is almost entirely caused by rising energy prices, the ECB's influence on this is very limited. The ECB can print money, but it cannot produce gas or electricity. It is mainly geopolitical factors that determine inflation in Europe. There is even a risk that high energy prices combined with higher interest rates will cause permanent capital destruction. For energy-intensive companies, in particular, there seems to be no future in Europe. Think for example of food (heated greenhouses), pulp and paper, the chemical industry, refineries, iron and steel, other metals like zinc and aluminium and also cement. Because of this development, there is ultimately little chance that the ECB will raise interest rates much further. As a result, European equities are attractively valued, but unfortunately, there are still risks that may not be fully factored in. For example, there are elections in Italy on 25 September and the right-wing coalition is likely to win an absolute majority. The right-wing coalition has already indicated that the hundreds of billions from the European Corona Recovery Plan must now be used to reduce the energy bills of the Italians. Brussels cannot and must not agree to this, which could boost the euro-sceptical attitude of the incoming Italian government. A combination of a severe recession in the eurozone, the growing refugee problem, sharply rising energy prices and a new political crisis will not only cause a lot of social unrest but possibly also another euro crisis.Unfortunately, things are not much better in Asia. As in other parts of the world, extreme weather conditions are weighing on the economy. In China, interest rates have already been cut twice this month and measures are being taken to stabilise the property market. In Japan, the number of corona attacks has risen to a new record and in China, too, whole cities are still being shut down because of the corona. Furthermore, it has never happened before that so many high-ranking American politicians have visited Taiwan in such a short space of time. The big difference, however, is that Asia is not plagued by inflation and therefore has time and space to stimulate the economy. This stimulating policy, combined with an extra credit impulse, has traditionally been a boost to Asian markets, although they will not be immune to developments in the European and US economies. At the same time, China has become more important to the global economy and in that context, important issues will be discussed at the upcoming Communist Party congress, including the fight against corona and the development of the Chinese housing market.The message of the western central bankers regarding the fight against inflation is clear. There is no point in fighting the central bank. As a result, there are market segments that look vulnerable, but at the same time, this development also creates new opportunities. The most beautiful flowers grow in the valley. As a result of the price decreases that actually started at the beginning of last year, more and more segments - both on the bond market and on the stock market - have become more attractively valued. In many cases, it can even be assumed that the bottom has now been reached, but as long as central banks tend to raise interest rates further than the market currently expects, the recovery potential is limited.
Meanwhile, 1 in 6 Americans is behind on paying their energy bills. In the United States, you are simply disconnected from the grid if you cannot pay the bill and if the air conditioning stops working at 35 degrees, there is a considerable incentive to pay. It has never happened before that so many Americans could not or would not pay the bill. In Europe, the number of defaulters is much lower, but that is the calm before the storm. The fact is that energy prices are rising much more steeply in Europe than in the United States. This is mainly due to the sanctions against Russia. It now ensures that Russia can earn twice as much from the sale of fossil fuels compared to before the Russian invasion of Ukraine. There are, however, a few logistical problems. For example, $10 million of natural gas is now flared daily at the border with Finland. That gas would actually have to pass through the Nordstream pipeline, but that is closed.Europe is the biggest buyer in the LNG market and buys everything that is not tied up in contracts. To do this, the price of natural gas has to go up because the drought in China and the Amazon is causing demand for LNG to rise in other countries as well. Europe wants to have the gas storage facilities filled before the winter at all costs. The fact that this currently expensive gas is in storage means that the prices that are being paid now will soon be passed on to the consumer with tax and VAT.Until recently, electricity was still an alternative to natural gas, but that has long since ceased to be the case. Electricity prices have risen more than gas prices this year. British households were told last week that electricity prices will rise by 80 per cent in October. On the electricity market, prices have already risen much more steeply. Last year the 1,000 euro per megawatt (1 euro per kilowatt) mark was broken quite easily in France, Germany and the United Kingdom. These prices are so high that they point to supply problems next winter. As far as electricity supply is concerned, Murphy's Law is at work. The weather is dry and quiet. That means less hydropower and less electricity from wind. The drought is causing rivers to dry up so that coal can no longer be transported to coal-fired power plants. The heat means that several power plants (including many nuclear power plants) are no longer allowed to discharge hot water into the rivers and are therefore shut down. Furthermore, so many solar cells have been added that they regularly have to be switched off because the grid can no longer cope. The only spare capacity left is gas-fired power stations. And the Russian oil and coal boycott has yet to begin. At current prices, at least half of Europeans will soon be unable to pay their electricity bills. Companies that consume a lot of energy will have to leave Europe, also because of the risk for the future. These companies produce many semi-finished products that will have to be purchased from outside the EU with expensive dollars. The supply problems caused by this are much bigger than supply problems caused by the shortage of semiconductors or the shortage of containers. It is no longer a question of a delay, but of things simply not being delivered. Normally, a doubling of the oil price in one year is enough to cause a recession. Then a tenfold increase in electricity and gas prices is soon good for severe depression. Now, in addition to gas, other things are liquefying under high pressure. Russia is still prepared to supply Europe with a lot of gas, but of course, it wants something in return. The various European countries (apart from Hungary) can reject Russian gas on principle, but that means that many governments will probably not make it through Christmas. Furthermore, it makes no sense for the ECB to cut interest rates from this point on. A deep recession is guaranteed with these energy prices and higher interest rates will only cause more capital destruction.
Jerome Powell surprised the market by sticking to policy. In a nutshell, he explained that interest rates needed to be raised to keep inflation under control. Furthermore, according to him, the Fed should continue to do so until inflation is actually under control (i.e. no interest rate cuts next year). The consequence is that this will hurt the economy (a recession) and jobs will be lost. The market still saw room for a turn in monetary policy on previous occasions, but the obvious aim of Powell's speech was to leave no room for it this time. The small chance of a soft landing scenario disappeared like snow in the sun. This caused a spectacular fall in prices on US markets on Friday, although the gains from the bear market rally are far from being reversed.There is still a chance that the Fed will ultimately fail to take sufficient action to combat inflation, but after last week Powell is less on the path of Arthur C. Burns and more on the line of Paul Volcker. If the Fed can maintain this line, it means that after one inflationary surge it could be over and that many difficult years of rowing against the tide could be saved. This is excellent news for long-term investors. It is nonsensical to slow down immediately after the first drop in inflation. In the 1970s, inflation did not rise and fall in a straight line. Periods of rising inflation were followed by periods of lower inflation. In total, there were three waves of inflation before Paul Volcker put an end to it in 1982.In fact, last Friday's speech by Powell contained little new, but the market will need some time to take this into account. In the recent bear market rally, the stock market recovered strongly and the gap between the reality of the stock market and the reality of the economy is estimated by various parties at around 20 to 30 per cent. It will be some time before speculation about a possible turn by the Fed can resume. This means that investors will have to fall back on fundamentals. For now, earnings estimates may offer support. Helped by high inflation and the apparent ease of raising prices, earnings estimates for the S&P 500 are $227 this year and $244 next year, up 10.8% and 7.8% respectively. No recession is visible in this figure, but the earnings revisions are now clearly negative. The combination of a relatively high valuation with negative earnings revisions is obviously not positive, especially against the background of the war in Ukraine, extreme weather worldwide, problems in the European energy market and the difficult recovery in China.The advantage of this development is that there will be a greater difference between winners and losers. Energy-intensive companies with many employees are struggling. In an environment with zero interest rates, it does not matter much whether a company has a lot of debt or not, but with normalised interest rates the differences become bigger. Moreover, a recession makes market conditions less easy and this is usually a period when the strongest companies gain market share. The weaker companies will struggle to clear excessive inventories, suffer more from problems in the supply chains and also find it harder to find staff. A select group of companies with a concrete balance sheet, strong market positions and, above all, pricing power can now distinguish themselves in a positive way.Although the market is mainly watching the developments at the Federal Reserve, there is also plenty happening outside. Members of the ECB are speculating about an ECB rate hike of 0.75%, but this seems completely unnecessary after the recent rise in energy prices in Europe. As a result of the difficult development, speculation about a coming euro crisis is also rife and Italy's spreads against Germany are widening. There are also concerns about China because the combination of the zero-covid policy and the real estate issue is holding back growth. Nevertheless, there is plenty happening in China and soon there will be an important congress of the Communist Party which will not only determine the future of China but could also have a strong impact on the global economy. The likelihood of a recession in the United States has increased somewhat after Powell's speech, but the likelihood of a recession in Europe seems guaranteed by the spectacular rise in energy prices last week. Such a recession has not yet been fully discounted in the market for high yield bonds. A nice entry moment for these bonds is when the Vix index shoots up above 40 and September and to a lesser extent October are suitable months for this. Moreover, the quality of high yield is actually not so bad at all; the bigger risks this time are with the leveraged loans.Inflation figures from the eurozone will appear this week. These will not be good after the recent sharp rise in energy prices. Furthermore, purchasing managers' figures will be published on Wednesday and Thursday; these are forward-looking figures and will probably indicate a further weakening of the economy. It is also the week that the jobs report comes out and prior to that on Wednesday the ADP report. A less spectacular growth than last time is expected with about 350,000 new jobs, but the development of the jobs market should be seen more as a moving average. There is a fair amount of noise in the individual monthly figures. The job market is still far too strong to speak of a recession.