Note Jul. 24,2024: Q3/2024 –Eddies Swirl In Market Waters

Note Jul. 24,2024: Q3/2024 –Eddies Swirl In Market Waters –

The role of risk premiums is to cushion against hitherto unknown developments and not just precisely defined uncertainties. Complacent market behavior has appeared in pining for minimal administered rates and momentum. Being seen are 12 month junk bond yield lows and feverish momentum in a tiny proportion of equites. We expect the role to rise of adequate risk premiums.

In geopolitics, within and between democracies and authoritarian countries relations appear in flux. Hot wars continue as do feints in Asia. Into U.S. November 2024 elections the leadership in both parties appears to favor tariffs. The Democratic Party with changed leadership is likely to still emphasize climate change, infrastructure and health with not rectitude but deficit management. The Republican platform appears favoring tax cuts, little regard for near term deficits but hopeful for consumer spending growth. From post Brexit Britain are lessons for the U.S. and globally well into 2026. It is about inward tilt stymieing prosperity. Unlike the early 1990s, there has been global political reluctance to discuss deficit management. Amid slow global economic growth in the 2½ -3% annual GDP range, it behooves capital markets not to ignore politics and risk premiums.

The capital markets appear focused on the rate of change of inflation. The broad parameters of central banks is on getting inflation down to 2%. over time. Inflation in expenses is of angst for many populaces,. Currently appears policy bifurcation with some central banks such as the Bank of Canada in the G-7 and the People’s Bank of China having recently opted for ease amid real estate pressures. Meanwhile others such as the Federal Reserve, the ECB and the Bank of England in the G-7 and others like India have opted for no change. Japan mulls tightening.  Amid policy bifurcation risk,  we expect currency volatility to flare. With geopolitical trade pressures amid slow growth and sanctions, we would be watchful for currency volatility. Within political watchfulness on the U.S. and trade, the currencies of Japan and China and others like Canada appear at levels bearing monitoring.

In asset mix, we envision a role for precious metals amid more currency turmoil than in the last cycle. In fixed income we would favor shorter duration. Amid large deficits, present consensus parameters appear to not fully appreciate credit quality driven facets. Consensus earnings for the S&P 500 appear at 10- 15% annually into 2024/2025, not implausible but above our 5-10% annual gain range. Sharper valuation expansion would be problematic. Yet to be proven during all three concept euphoria streams has been concrete delivery of revenues and earnings adequate to justify sharply elevated valuation.  

Considering our sector weight capped in Information Technology at 25% for diversification with market weight for Consumer Staples and the particulars of geographical weightings, we expect quality of operating delivery and strength of balance sheets to supersede. It is paramount over traditional growth versus value considerations. Also, we have underweight Communications Services and despite political cost cap risks, we favor Healthcare. In cyclicals, we favor Industrials over Consumer Discretionary. Amid systemic risk considerations especially from non-bank financials leverage, strong Financials remain key.

Asset Mix

The role of risk premiums is crucially one of a cushion against hitherto unknown developments and not just precisely defined uncertainties. Arguably since the apex of the great credit crisis and massive quantitative ease, this aspect has appeared as being secondary to pining for minimal administered rates and momentum in the capital markets. Complacency still emerges in the form of 12 month junk bond yield lows and feverish momentum in a tiny proportion of equites. We expect the role of adequate risk premiums to rise for reasons linking valuation to evolution in geopolitics, central bank policy and corporate deliverance.

During times of turmoil or fear thereof, an imperative in global capital markets becomes one of refuge such as in U.S. dollar based assets or precious metals or shorter duration fixed income. In the present environment, capital markets face concurrent swirling eddies from politics, from growth bifurcation and from extended valuation. The immediate prior post 2008 period in response to the credit crisis and beyond has certainly been one of extreme focus on cohesive central bank policy for deliverance. Until growth parameters become clearer,  uncertainty is likely to be the case well into 2025 and even 2026.

In geopolitics into the second half of 2024, within and between democracies and authoritarian countries  there appear developments that signal considerable flux. Hot wars continue from the eastern flank of Europe into west Asia as do proxy fencing like feints through all of the south China seas. Assaying developments in the many democracies with elections already held and even in semi authoritarian states from Europe to Asia and in between, there appears a flourishing of an anti-incumbency tilt. in some cases shifts to the left and in other cases to the right. In the authoritarian states, the internal machinations appear linked to corruption and or power politics.

The U.S. enters a fraught period into its November 2024 elections. The leadership in both parties appears to favor tariffs, unlike the 1990s. Neither party appears emphasizing fiscal rectitude. The Democratic Party with changed leadership is likely to still emphasize climate change, infrastructure and deficit management. The Republican platform appears favoring tax cuts with little regard for near term deficits but hopeful of consumer spending growth. From post Brexit Britain are lessons for the U.S. and globally well into 2026. It is about an inward tilt stymieing prosperity. Unlike the start of the 1990s, there has been a global political reluctance to discuss deficit management. Amid slow global economic growth , it behooves capital markets not to ignore politics and risk premiums.

As envisaged by the IMF, OECD, the World Bank and others, global economic GDP growth appears in the 2 ½-3% range with considerable bifurcation. As well, deficits offer up a less static and more likely fractious 12 –18 months. Capital markets broadly and globally have become attuned to expectations of reductions in the rate of change of inflation. The broad parameters of central banks are different. With the bitter experience of the 1970s/1980s as backdrop, central bankers appear considering not just rate of change in but also on getting inflation down to 2% over time.

Inflation is closer to 3% or more in many experiences. In the angst of many populaces, inflation in expenses is a greater concern than many in capital markets acknowledge. Currently appears policy bifurcation with some central banks such as the Bank of Canada in the G-7 and the People’s Bank of China having recently opted of ease likely due to real estate pressures. Meanwhile others such as the Federal Reserve, the ECB and the Bank of England in the G-7 and others as well as India in emerging countries have opted for no change. Japan mulls tightening.  Amid policy bifurcation risk, we expect currency volatility to flare.

In this cycle, currency markets have been relatively sedate. With geopolitical trade pressures amid slow growth and sanctions, we would be watchful for currency volatility. Within political watchfulness on  the U.S. and trade, the currencies of Japan and China and others like Canada appear at levels bearing monitoring versus the U.S. dollar.  In the fixed income, currencies and commodities (FICCs) areas, there has been an upward movement in precious metals that is likely due not just to inflation as often ascribed but also to a general fog of uncertainty and reaction to financial sanctions. In fixed income, U.S. Treasury 10 year Note yields as benchmark have moved closer to our 5% target. Yields in many other sovereign issues are lower. In junk corporate bonds are closer to 12 month lows.

In asset mix, we envision a role for precious metals amid potential for more currency turmoil than experienced in the last cycle. In fixed income we would favor shorter duration. Amid large deficits, present consensus parameters appear to not fully appreciate credit quality driven facets.

In equities, momentum appears as driver alongside infatuation for deliverance from central banks. Consensus earnings for the S&P 500 appear at 10- 15% growth annually into 2024/2025, above our 5-10% annual gain range. Yet to be proven during all three concept euphoria streams has been concrete delivery of revenues and earnings adequate to justify sharply elevated valuation.Rather than traditional growth versus value tilts or geographic tilts, we expect quality of delivery and strong balance sheets to supersede.

Equity Mix

Global economic growth expectations by institutions like the IMF, OECD and World Bank appear to  be around 2½-3% annually into 2025. Consensus earnings for the S&P 500 appear at 10- 15% growth annually into 2024/2025, above in our 5-10% annual gain range. Equity market action has been one of valuation expansion. It seems being led by concept over artificial intelligence at this time  Recent prior ones having been on climate change and social media. A narrow coterie of equities appears disgorging momentum. Yet to be proven during all three concept euphoria streams has been concrete delivery of revenues and earnings adequate enough to justify sharply elevated valuation. It adds up to an eddy swirling in equities.

Using many metrics, momentum has carried equity valuation to lofty levels. On tangible reality, a long term S&P 500 P/E of 16x has accompanied 7% earnings annual growth. In our estimation at the present 20x P/E for the S&P 500, 12% annual growth would need to be delivered, admittedly not far from consensus. Individually, a 30x P/E would be problematic and need a lofty and steady 20% annual earnings delivery for the long term.

Including 2024 so far, momentum and especially concept euphoria has recorded prolonged market dominance. Amid extended valuation has been the buildup of eddies from politics and from schism potential in central bank interest rate policy. We would dampen growth versus value tilts. We espouse a diversification with a tilt favoring strong quality of delivery and financial statements. It would contrast with the last several years that have had winds favoring leverage and globally, even zombie companies.

In current markets, considering our sector weight capped in Information Technology at 25% for diversification with market weight for Consumer Staples and the particulars of geographical weightings, we expect quality of operating delivery and strength of balance sheets to supersede. In the interface between concept euphoria and tangible revenue/earning streams as being the next market phase, we have underweight Communications Services as still in sector restructuring. Notwithstanding political cost cap risks in services and on financial strength, we favor Healthcare.

As defensives and admittedly with issues over deliverable rates of return, despite its political uncertainties for Healthcare and Consumer Staples as still restructuring, we prefer them over underweight Utilities. We also see sufficient well managed Consumer Staples companies to favor them alongside underweighting Consumer Discretionary ones. As demonstrated in aerospace, engineering challenges remain potent. Still, from design to build to operational expansion, we see benefits to overweighting the Industrials.

We are overweight energy on the basis that the capital markets have underappreciated the rigorous operating controls required in the energy business. Unlike a traditional view through a prism of inflation and cycles, we overweight Materials broadly on political, financial policy and climate imperatives.

In our overweight Financials, we favor the strongest as being likely to lead even now, a decade and half since the credit crisis erupted. Systemic risk from non- bank financials leverage is potent. Non or weak performing loan assets are of concern.  Business fundamentals appear less favorable for shopping malls and office than are those making state of the art industrial space more attractive within leverage linked Real Estate.

Communication Services: Commenced by the European Union and spreading appear regulation requirements for the social media segment of Communications Services. Despite resistance from industry and over freedom of speech, it seems analogous to the unveiling decades ago of standards for print media. The evolution of social media has been rapid with controversy. They are on the veracity of claims being made, concentration of ownership, facilitation of large scale cybercrime and political manipulation. The global political environment may be tilting towards requiring breakups. Meanwhile, development of revenue streams have been difficult. Despite the recent euphoria, similar issues exist about Artificial Intelligence. In telecommunications, much i investment has been made to facilitate 5G. Recent outages show a need for more robustness and not just expansion. Communications revenue is likely to be a work in progress. The ownership of content such as entertainment and news appears headed for restructuring.  Expecting the next market phase as being in the interface between concept euphoria and tangible revenue/earning streams, we have underweight Communications Services as still in restructuring.

Consumer Discretionary:  Broadly from emerging to advanced economic regions alike,  the last consumer cycle was driven by aspiration. In emerging economies, many were able to participate via basic global brands and domestic ones. It raised standards. At many price points, broad luxury benefitted from a “bling” impulse factor even if only in sneakers or couture jewelry. Currently, across many global consumer cohorts, there appears consternation about income levels versus affordability even in daily use items and not least, housing. A consumer fallback seems in place to basic rather than prepared foods and to do-it-yourself activities, Even in entry level luxury, we believe recent company reports demonstrate wind back on impulse purchases. At global GDP growth rates of 2½-3% annually and even if recession is avoided, consumer rewind appears likely  with unknown duration. Online shopping continues to afflict shopping malls. Prior overbuilding of mall space globally detracts from assumptions of stable cash flows for investors in malls. Even in luxury retail discretionary, consolidation in brands looms. Likely to take time is redeployment for example into entertainment venues or repurposing into housing  that could attract consumer spending. We are underweight in Consumer Discretionary.

Consumer Staples: In the consumer segments, we find that some purveyors of staples have been able to not just survive but to thrive by accentuating space management and private label expansion. In the emerging economy space, domestic brands appear to be holding their own by emphasizing product size and content that are convenience targeted for their consumers. By contrast, global brands have suffered when attempting to continue their strategies of the last cycle of offering standardized global packaging and content. Companies are likely to be forced to expand their brand pruning as long espoused by hedge fund and private equity investors. We see a sufficient selection of well managed consumer staples companies to favor them over consumer discretionary ones that have been dealing in impulse purchase expansion such as in fashion.

Energy: We are overweight Energy as capital markets seemingly underappreciate the rigorous operating measures required and developed over decades in the energy business. Massive sums have to be expended. The payoff can often be nonexistent or decades into the future. It behooves risk premium analysis. Once concept euphoria ebbs as a primary capital market driver into 2025, we expect more rigor in risk premiums that are deemed acceptable.  In the energy hydrocarbons segment and despite ostensible sanctions, Russian exports appear to have morphed into phantom tankers as well as into processed products. From OPEC, there appears greater discipline for crude oil closer to $80/Bbl. WTI , above our $60-70 Bbl. WTI expectation. Such levels are beneficial for high cost western oil producers like Canada and indeed for the development of alternate energy. More realism is emerging about the time frames and selections of energy alternates that will be required, be they wind, solar and others. In such energy source evolution, we favor integrated companies  with the business acumen and wherewithal to participate.

.

Financials: Business margins and nonperforming assets appear of risk for the Financials. In the rush for market momentum conduits, the Financials have appeared relegated. It contrasts with the capital markets at apex into 2008 of credit euphoria. Developments now have ranged from those in smaller U.S, banks to large institutions in Europe and China to individual lines of business such as factoring. They all indicate that capital market risk looms and indeed may be of latent systemic concern. High levels of sovereign deb that potentially stretch abilities to service them appear as one facet. Then, leveraged holdings in non-bank financials seeking yield are of concern additional to the traditional aspects of net interest margins, capital market volumes and new issuance activity. We expect that central banks will be gradualist in administered rates changes, especially the U.S. Federal Reserve and generally those in advanced countries as well as emerging ones. Currency volatility is also likely to unfold. A decade and half since the credit crisis erupted, we favor those strongest as most likely to lead even now for our overweight Financials.

Healthcare: In prior periods, Healthcare segments such as biotechnology were able to garner growth and concept euphoria interest that was akin to that in Information Technology. Stability has characterized the more diversified Healthcare segments. Currently, it has not been the case in Healthcare. The Healthcare environment may thus be one of consolidation pending more tangible developments such as in mRNA derived treatments well beyond Covid. Still, on the issue of diversification that already appears drawing the attention of investment portfolio supervisory bodies, we assess that a cap of 25% weighting in Information Technology may be appropriate to balance euphoria along with a counterbalance of overweight in Healthcare. Notwithstanding political cost cap risks in services,  as defensive categories and on financial strength, we favor an overweight but diversified mix in Healthcare.

Industrials: In parsing developments in the cyclical segments, our favor has been for overweighting Industrials over Consumer Discretionary. Still and as demonstrated in aerospace, engineering challenges remain potent. In the midst of intense country competition including exposure to the Information Technology space, stable infrastructure build remains vital. It includes stable electrical and even water supply. The so called peace dividend has long been expended. Then in modern warfare, shortage vulnerabilities have been exposed in ongoing wars. New technologies such as asymmetrical warfare using drones have demonstrated their utility in the Ukraine, Middle East and Asia conflicts. Many if not most countries have been unprepared for a robust warfare technology change and the massive expending of munitions and equipment. Design, build and operate for procurements and new supply facilities are globally still in early stages of being ramped up. We see benefits to overweighting the Industrials.

 Information Technology: In order to balance portfolio mix, we espouse a 25% cap for the Information Technology sector. In this cycle, the concept euphoria that was bubbling in social media morphed into alternate energy for a shorter period through 2022 and subsequently in 2023/4 into euphoria about artificial intelligence. Concept euphoria cycles have eventually to face up to valuation, operating bottom line delivery and competition in the long term. Whether value added in software or in basic hardware like semiconductors, the narrow coterie of Information Technology equities driving euphoria are likely to come up against sharper equally adept international competition stoked by strategic imperatives. New technology life cycles have long been shortening. These issues raise challenges for the revenue and earnings growth that is essential to maintain, let alone expand valuation multiples. We would diversify within and versus Information Technology.

Materials: We have overweighted Materials broadly. A traditional view of Materials is to segment them utilizing a prism of inflation and cycles. For asset considerations, the global political environment appears brittle and internally so for many countries. Weaknesses appear both in democratic and authoritarian governments. Even small relative schisms in central bank policies present the potential for broad currency volatility. It has not been experienced for many years. These facets along with reactive responses in sanctioned countries to diversify financial reserves would favor precious metals like gold bullion. More developments in digital technologies are likely to enhance the strategic demand for precious, base and rare metals. Continued severe fluctuations in climate change from droughts to floods to hurricanes seems unabated. Not just for the poorest populaces, climatic pressures and global strife make policy changes urgent for agriculture and food and of favor for Materials.

Real Estate: Business fundamentals appear stymieing many expectations for shopping malls and office space real estate being favorable for stable investment. Not just the cost of financing and leverage but also fundamental changes in consumer preference form eddies. The Covid pandemic and technology developments have augmented changes that were already underway in consumer shopping and work form preferences. Demographic evolution is being led by Generation X and Z preferences. Repurposing is far from complete of office and shopping space. It is globally underway into entertainment and residential spaces. Such repurposing has still to demonstrate its ability to support the revenue streams of yesteryear and not become another government subsidy project. Global economic competition is stoking state of the art industrial spaces closer to end use venues. Industrial space has potential within an overall underweight in Real Estate exposure.

Utilities: Dealing urgency are several aspects to utility facility design and location. They include politics such as sanctions on Russia over its Ukraine war and turmoil in the Middle East, a crucial supplier of hydrocarbons. Increasingly wide climate eddies of hurricanes, droughts and ambient temperature appear adding urgency to diversification. Even coming into consideration in power generation has been nuclear power. It was until recently despised. In the power and water spaces, expenditures are also required to supply Information Technology manufacturing such as  forsecure semiconductors and data storage for cloud computing. Engineering and industrial companies are likely to be multiyear beneficiaries. Cost, financing and rates of return actually allowed could be a deep eddy for Utilities as previously seen in privatized water and power. As defensives, we prefer Healthcare despite its political uncertainties and Consumer Staples despite restructuring over underweight Utilities.

Asset Mix 

 

                        Global               U.S.

Equities-cash     49 %                 54 %

            -priv.      6                       6 

Fixed Income     25                     20 

Cash                 15                         15

Other                  5                       5

Total-%           100                   100

 

 

Geographic Mix

 

                      Currency/     Equities        Fixed     Cash

                         Real                             Income

Americas               61%              65%           67%     55%

Europe                  22                  20             26         37

Asia                        9                  13               6           3

Other                      8                    2               1           5

Total -%              100                100            100       100

 

 

 Equity Mix

 

                      Global      U.S.    Stance

Comm. Serv.     1.5%      9.3%   Under-weight myriad challenges

Cons. Disc.      10.2       10.0      Under-weight favor frugal basics

Cons. Stpl.        8.7         5.8      Market-weight for brand pruning

Energy              4.6         3.6      Over-weight favor strong cos..

Financials        17.3       12.4      Over-weight, restructuring

Healthcare       10.1       11.7      Over-weight across segments

Industrials       12.2         8.1      Over-weight, capex suppliers

Info. Tech.       27.6       32.4      Capped for diversification

 

Materials          3.52.2       Over-weight diverse and prec.

Real Est           1.8         2.2Under-weight, favor ind. rest

Utilities            2.5         2.3      Under-weight -rate risk.

Total-%       100.0      100.0         E.o.e.