Where are Stock Markets Heading in 2023 and Which Investment Strategies are Likely to Protect Your Wealth in Uncertain Economic Times?

Despite tighter financial conditions the global economy remains on a solid footing. However, an inverted US yield curve suggests a recession is round the corner. Let’s analyse a raft of leading indicators.

LEADING INDICATORS

Yield Curve

The US yield curve remains inverted which is one of the best indicators of a looming recession. It has successfully predicted the last 7 recessions in the USA. However, the yield curve is not a perfect predictive tool. In 1966 the US economy averted a recession despite an inverted US yield curve.

 

 

Durable Goods Orders

Another leading indicator is durable goods orders which tell us when companies and consumers are ordering big ticket items such as furniture, cars and long-lasting appliances such as washing machines. January’s data came in very strongly @ +5.60% however February’s data declined by -5.10% the sharpest fall since April 2020. The data suggests the goods sector is experiencing price disinflation impacted by higher US interest rates.

However, a word of caution, you cannot read too much into this, orders can swing wildly, as a large portion relates to high value commercial aircraft orders which can easily distort the figures/trend.

 

 

Housing Starts

US housing starts are at a current level of 1.3M versus 1.37M a month prior and down from 1.6M (-21%) from a year ago. Shrinking demand for new housing suggests the economy is slowing which should bring down inflation as real estate is a significant component of the US economy.

 

 

ISM Manufacturing New Orders Index

This survey of more than 400 purchasing executives in the manufacturing industry is an indicator of the overall health of the sector and the economy more generally. If the reading is below 50 this implies the sector is contracting. Whilst the January data came in @ 42.20 which is deeply in contraction territory the February data saw a sharp rebound to 47.00 but still below the key 50.00 threshold.

 

The US Conference Board Leading Economic Index

The US Conference Board publishes a leading index which is a good indicator of where the economy is heading. It measures 10 economic indicators not all of which are leading but a good number are forward looking. The index decreased in February for the second consecutive month coming in @ 102.90 down from 106.00 in January. There are early signs that consumers are pulling back on spending in the face of higher prices and rising interest rates.

However, there is no evidence of an economic slump, perhaps a slowdown, although that assumption is questionable too, as the economy is holding up well. The jobs market and wage growth remain sticky. However, if the jobs market capitulates under the pressure of higher interest rates this may well precipitate a recession. Everything hinges on how far the Federal Reserve goes in terms of interest rates and how long they keep rates high for.

 

SUPPLY CHAIN DISRUPTIONS

 

How are supply chain disruptions contributing to the inflationary problem?

The war in Ukraine continues to cause supply chain disruptions in the food sector which feeds the inflationary narrative. This war can drag on for a long while as long as Putin stays in power.

 

The energy sector is also affected by supply side issues keeping energy prices well supported. Renewable forms of energy cannot be produced or stored in sufficient quantities to replace oil and gas. The transition period towards zero net emissions will take longer than envisaged. Meanwhile the oil majors are not investing in production (i.e. drilling new oil wells to preserve cash) due to the push towards clean energies. Incentivizing the oil majors to ramp up production would be advisable however this has not happened yet.

GLOBAL DEBT

The question is; are debt levels sustainable and what economic levers do governments have to get us out of this mess?

Nothing has changed in the past six months. Budget deficits and growing debt levels remain order of the day.

 

Nato, E.U. and liberal democracies are currently funding the defence requirements of Ukraine to expel Russia from its territories. This will exacerbate the debt problem – with no end in sight.

 Source:  Commons Library Parliament UK

 

FEDERAL RESERVE AND OTHER CENTRAL BANKS MONETARY POLICY

Are central banks in a position to continue increasing interest rates in a contracting global economy?

It will be interesting to see where US interest rates peak – the so called ‘terminal rate’ – before they pause.

 

Widely thought to peak at 5% there are calls from prominent economists for the Federal Reserve to start raising rates by 50 basis point at the next FOMC and for the terminal rate to go to 6% (more than the market is pricing in) and to keep rates restrictive for much longer than the market expects.

At the moment everyone is pricing in a federal reserve capitulation in the second half of the year.

Whilst that’s what we all hope for the economic data coming out from the US shows the  economy is holding up well. (the economic situation in Europe is not too dissimilar in this regard!) Unless, there is a rapid deterioration in economic activity rates will remain restrictive and there is a risk the market may be mispricing federal reserve intentions.

The graphs show the USA is leading the charge for higher interest rates followed by the UK and the EU.

We must not forget that central banks have a dual mandate;

• to maintain stable prices by keeping inflation at max 2%

• to achieve full employment.

These are conflicting objectives.

Central banks have turned their attention to fighting inflation at the expense of full employment.

The question is whether they can engineer a soft landing with minimal impact on the economy whilst reducing inflationary pressures to a more manageable level of perhaps 4% rather than 2% – instead of double-digit inflation that we are experiencing today.

Obviously, that would be a best-case scenario but if they make policy errors’ it could go horribly wrong!

INFLATION

There is disbelief in some quarters that inflationary pressures are not receding.

Why should this surprise anyone?

Easy money Q.E. was the spark, supply side constraints from post covid restart was the flame, global energy crisis is the paper and the war in Ukraine and ensuing food crisis is the petrol poured on top (and we haven’t even mentioned increases in national defence spending as a result of Russia’s expansionist policy!)

We also need to consider the negative impact of a policy error by the Federal Reserve who appear to be behind the curve, firstly, labelling inflation as transitory only to turn incredibly hawkish when the inflation genie escaped from the bottle – raising rates very aggressively and risking precipitating a recession down the line.

Historians will no doubt try to make sense of events, causes and effects and compare these to the oil crisis of the 1970’s.

Sometimes we have to go back to the history books to identify patterns which repeat themselves time and time again.

In the 1970’s which was labelled as ‘The Great Inflation’; there were 3 inflationary waves and interestingly each one was worse than the previous one.

The principal causes were the; (i) vietnam war and (ii) oil crisis/shock.

The inflation data which is coming out of the USA, Europe and UK suggests inflation remains sticky although heading lower.

No one should be surprised though, monetary policy may have been tightened aggressively in 2022, however we started from a basement zero interest rate.

More importantly

Today’s inflation is due to money printing (quantitative easing) and whilst financial conditions may have tightened the financial system remains awash with liquidity injected into it during the pandemic.

To put this into perspective

The size of the Federal Reserve balance sheet was $4.3 trillion on the 11^th March 2020 just before lock down.

It mushroomed to almost $9 trillion.

It started reversing that process in June 2022 reducing its balance sheet at a rate of $45 billion per month rising to $90 trillion in September 2022.

Essentially the Federal Reserve is allowing the bonds it holds in its balance sheet to mature without issuing new debt. A process known as ‘Quantitative Tightening’ which is basically draining money from the system.

In March 2023 the balance sheet was $8.3 trillion – exactly $4 trillion more than pre-pandemic levels. Recently due to 2 US bank failures the Federal Reserve has had to reverse its policy, temporarily discontinuing Q.T. and issuing $400 Billion of new debt to pump liquidity into the banking system in order avoid systemic risk resulting in an increase in the Federal Reserve Balance sheet which is again close to $9 trillion.

At this rate it will take the Federal Reserve a further 4 years or until December 2026 to reduce the balance sheet to pre-pandemic levels.

Why are economists surprised that inflation remains sticky and persistent? – it’s pretty obvious why.

Despite all the noise from the Federal Reserve and politicians, the reality is, that keeping inflation high relative to interest rates devalues the debt in money terms – which governments are keen to do – even though the by-product of this is a ’cost of living crisis.’ This is taxation through the back door.

The rate of inflation which is currently being reported by politicians is untrue and nowhere near the current level of inflation which is well into double digits and decimating living standards.

US DOLLAR

What is driving the US Dollar higher and what are the implications?

Higher US interest rates relative to the Euro and Pound Sterling, a flight to safety and the US Dollar’s role as reserve currency are key drivers.

The US Dollar Index (measuring the value of USD versus a basket of major currencies) has only been higher in 3 occasions over a 60 year period.

This is unsustainable for emerging markets and if unaddressed will trigger a financial crisis and a global recession.

In recent months the US Dollar has started to weaken a trend which must continue to avert a financial crisis – particularly in emerging markets.  We expect US interest rates to pause whilst the UK and the EU will continue raising rates for a while longer; these developments (other things being equal) should weaken the Greenback moving forward.

If it’s not the US Dollar what is the next big risk to financial markets?

Excessive debt levels may yet again trigger a financial crisis and a more deep-rooted recession.

Today’s elephant in the room are 2 US bank failures:

                        Signature bank

                        Silicon Valley bank

The global financial crisis in 2008 was fuelled by excessive risk taking by the US financial sector from mortgage originators to Wall Street banks. Fannie Mae and Freddie Mac extending credit to anyone looking to buy a US home with little concern about debt servicing ability.

The loan book was then sold at a discount to Wall Street banks which repackaged the debt as mortgage-backed securities (MBS) and sold to investors as AAA rated bonds based on their own credit ratings as issuers rather than the credit worthiness of the underlying borrowers.

When US housing prices began to fall, mortgage repossessions soared, exposing the sub-prime scam which eventually triggered a global financial crisis.

This is slightly different in that there has been a run on the bank’s money due to a lack of confidence in the financial system.

Why?

 

It’s very simple.

High level of debts and rapidly rising interest rates.

Banks have capital requirements.

This capital is invested in low-risk short term debt instruments like US Treasuries and other similar securities.

Under normal market conditions that’s a perfectly reasonable thing to do.

In a highly manipulated market where interest rates have been artificially anchored at zero for a long time; reversing this policy abruptly and raising rates excessively is a ‘high-risk’ game.

Bonds are inversely related to interest rates so when interest rates rise rapidly these investments suffer capital losses.

If there is a run on the banks; it may force financial institutions to dispose of their investments at a loss reducing their own capital and putting depositor’s money at risk.

This is exactly what happened with these 2 US Banks. Credit Suisse had similar problems resulting in the UBS takeover. Policymakers are concerned about ‘Systemic Risk’ – the problem spreading very quickly through the bank system due to interconnectedness between financial institutions.

There are similarities with the global financial crisis in that banks balance sheets became so strained that capital injections were needed to create confidence in the banking system and safeguard the entire financial system.

The next graph shows how capital ratios at top banks have dropped due to rising interest rates and falling bond prices.

The other point to remember is that US banks are essentially competing with US treasuries to attract capital. When interest rates go up and US Treasuries start offering better yields; banks have to raise interest rates on deposit to attract depositors which puts further strain on profitability.

This is all coming to roost.

Ridiculous high levels of debt coupled with aggressive rate increases is an explosive combination which most advanced economies cannot sustain unless more money is printed and the can is kicked down the road for future generations to pick the tab – deferred taxation.

This is what we get for thinking the solution to a financial or economic crisis is to print more money and that this policy comes with no risk as some economists appear to suggest.

If anything, it can break the financial system causing a deep recession and severe stock market correction.

It’s the new elephant in the room everyone needs to be wary about!

The Federal Reserve now needs to tread very carefully as a policy error at the next FOMC can negate the opportunity to engineer a soft landing.

 

FINANCIAL MARKETS OUTLOOK

Where are stock markets heading from here? 

That’s a great question.

The financial markets have held up well.

But at best are trading sideways.

 

The US economy has proven to be more resilient than anyone expected but that’s because of excess liquidity in the system (which has not been drained out!) and a strong jobs market. Whilst the durable goods and housing markets are showing signs of disinflation; wage growth and consumer spending remain.

The question is for how much longer…

The answer depends to a large extent on how restrictive monetary policy becomes and for how long.

The US economy is expected to weaken moving forward as the weight of higher interest rates takes its toll. We expect a short V shaped recession in 2024 however if monetary policy remains restrictive for too long then a deeper recession cannot be ruled out

INVESTMENT IMPLICATIONS

What are the investment implications and how does one go about protecting their wealth?

Well bonds have become positively correlated with equities and are no longer seen as a safe haven.

In the past you would buy government bonds to provide diversification and reduce portfolio volatility.

But last year alone the 10-year UK gilt (a so-called safe haven) lost 20% in value.

Further rate increases in 2023 will result in further losses in the order of 10% for every 1% rise in interest rates.

Later in the year the traditional inverse relationship between bonds and equities may be restored – when rates peak.

If there is a recession and central banks cut rates that would be good opportunity to buy short dated government bonds.

However, we must wait for a more opportune time.

At the moment there is ‘duration risk’ which measures the sensitivity of the inverse relationship between bond values and interest rates

PROTECTING WEALTH AND ASSET ALLOCATION STRATEGIES

We like inflation sensitive assets generally.

We have a positive outlook on food, energy and defence security.

We like infrastructure which is less vulnerable to economic shocks as well as industrial metals and precious metals including gold and silver (which is a monetary metal too!)

We keep saying that investors need to be patient as the high level of global debt is not sustainable and throughout history high levels of debt, highly inflationary periods and economic uncertainty is hugely supportive for gold.

We cannot predict the exact timing of a rally however we seem to be getting closer and closer as macro-economic conditions are hugely supportive. When it does happen expect it to be quick and explosive.

History tells us that these assets will perform very well under these conditions – just need a lot of patience to capitalize on the opportunities.

We are in a commodities super cycle we just need to keep our nerve.

We continue to recommend thematic investments with long term growth opportunities; such as battery storage, clean energy and electrical vehicles – shift to green economy – as well as artificial intelligence for longer term investors.

We are bidding our time to buy shorter dated bonds, once interest rates peak, we can secure a fixed high return. In the meantime we remain on the side lines waiting for interest rates to peak;  to avoid duration risk. There is inflation risk to consider too.