Note Mar. 6, 2024: A Quest for Balance

Note Mar. 6, 2024: A Quest for Balance – Early 2024 has contained massive upswings in capital markets, globally and across segments. Still, the global political environment from wars to trade to elections is the most tense since the end of the cold war and arguably since the end of World War II. In a quest for balance, market risk premiums need not solely the last decade but longer periods. Consensus seems fluid but amplified in expecting early ease. Globally, central banks appear preferring data dependent but slow change. It has been reemphasized on March 6,2024 in Congressional testimony by the Federal Reserve with its rate at 5 ½% and post its meeting by the Bank of Canada with a rate of 5%. Elevated volatility is likely.

Globally both amid multiple elections and for command economies, a fraught political environment appears. Into November 2024 U.S. elections, in a rematch of 2020, appears stalemate on budgets, bitterness and Congressional dysfunction. In China’s National People’s Congress from March 5 2024, challenges appear of asset deflation but also increased information technology and defense priorities. From Latin America to Europe to Asia are elections with fiscal discipline appearing secondary. Wars have exposed immediate and long term defense spending imperatives. Flexing perennial subsidy demands, rioting by farmers appears widespread, with sticky inflation a risk. Short term pressures to manage finances may be secondary but sovereign debt risk premiums hang in the balance.

At $79/Bbl. WTI with actively managed output, crude oil prices are not low. Its cost impact exists on operating margins, notwithstanding momentum markets. With annual global GDP growth of 2 ½-3%, key European countries like Germany in recession and both the U.S. and China at well below precredit crisis growth, revenue growth can be expected to be fractured and challenging still. Stronger growth in India and Southeast Asia are likely not to be a complete offset. Meanwhile, global defense spending schedules have increased as has subsidies cacophony in politically vocal agriculture. Since late 2023, with price gains encompassing a variety of existent balance sheet leverages, capital markets appear expecting central bank sustenance, especially in Federal Reserve policy.

The primary modus operandi has long tilted to ETF type activity and leverage across capital markets ss, but selectivity looms. Into 2023 as Federal Funds rates rose, relative valuation characterizations and corrections did arise. Since then, momentum has been buttressed by expectations of early rate cuts. Even reduced earnings gains seemed celebrated on meeting consensus and exuberance on Artificial Intelligence (AI) participation. On evolution from concept to robust delivery, recent experiences in ESG participation has lessons. In AI, one weakness is of modelling inadvertently reflecting preconceptions of the constructor. Cyber security can seep into fake/criminal/political interference. 

In the Information Technology coterie do appear strong balance sheets and operations, likely giving rise to expectations about strong AI delivery. Still, the close to twelve month lows in junk bond yields can be attributed to expectations of relief in business pressures. Both indicate complacency. As in cycles immemorial, both globally for SIFIs and smaller regional or centric entities, the hard truths for capital markets will likely come overtime in bank loan loss provisions.

We favor diversification among asset classes and especially in equity exposure.

The first quarter of 2024 to date has been a period of massive upswings in capital markets. Most recently, the capital market global upswing has swung from the U.S. as capital market leader, and into including a wide variety of instruments globally from equities to junk bonds as well as into Japanese equities that had long been dormant in this cycle. Since late 2023, in including capital price gains encompassing a wide variety of balance sheet leverages, the markets amplified factor appears to have returned to expecting central bank relief, in particular of a sharp ease in Federal Reserve policy. There has been greater market and policy cohesion earlier in the post credit phases.

Currently, markets appear ignoring central bank pronouncements globally in favor of slow, steady and data dependent policy change. Globally, central banks appear preferring data dependent but slow change. It has been reemphasized on March 6,2024 in Congressional testimony by the Federal Reserve with its rate at 5 ½% and post its meeting by the Bank of Canada with a rate of 5%. Elevated volatility is likely. Concomitant with consensus expecting early central bank rate reductions, equity valuation and credit spreads have appeared, once more, to be secondary considerations. Volatility seems being stoked.

A quest for balance is in order on the momentum that has been a such dominant overlay to this cycle. More consideration is due with respect to so-called exogenous developments. From wars to trade to elections, the present geopolitical environment seems to be the most tense since the end of the cold war and arguably since the end of World War II.Sequentially there were Korea, Suez and Hungary then Vietnam and other crises  but trade mechanisms also expanded. In a quest for balance, market risk premiums need to incorporate not solely the last decade of data that many seem to prefer but instead a variety of a longer periods.

War is flaring across energy and logistically crucial areas. First from the Black Sea and then the Red Sea/Indian Ocean, logistics costs and interruptions have come to the fore in a bigger replay of the logistical fragility demonstrated in March 2021 by a single ship accidentally blocking the Suez Canal. At close to $79/Bbl. WTI and sticky in a range, energy costs are not low. As seen in recent climate summits, transition is a work in progress at best. Tensions in the Indo Pacific are far from latent in being linked to economic and strategic jockeying for dominance.

Decades of wrangling have not assuaged the cacophony emergent in politically vocal agricultural protectionist segments that often exert grass roots pressures globally. For instance in Europe and despite continued subsidies of hundreds of billions of euros in Common Agricultural Policy (CAP), farmers have been rioting over agricultural exports from Ukraine and separately over competition from temperate south Atlantic countries. In India rather than consolidating holdings within families in order to invest in efficiency, farmers appear pressing for guaranteed sales prices and rioting to exert political pre-election pressures. Not to be outdone in Japan, agriculture keeps raising taste and strategic reasons for subsidies and import control – aspects that are vehemently opposed in its manufacturing export sector.

With annual global GDP growth of 2 ½-3%, key European countries like Germany in recession and both the U.S. and China at positive but well below precredit crisis growth, revenue expansion for companies (and countries) can be expected to be fractured and challenging. Stronger growth in India and Southeast Asia are likely not to be a complete offset to other major economic entities experiencing slower growth.

In China at its National People’s Congress starting March 5 2024, the challenges appear to be deflation in assets and fiscal discipline when shadow deficits are also considered. Even including increased focus on defense and information technology spending, prior locomotives like China target 5% annual GDP growth, compared to over 14% in 2007, its peak global growth contribution year.

In the runup to November 2024 elections in the United States, key country priorities appear in a stalemate about budgets and fiscal policy, immigration and even defense. Amid even more bitterness in the March primaries adding to Congressional dysfunction, the Presidential protagonists appear already clear as a likely rematch of 2020. From Latin America to Europe to Asia, many countries face elections with fiscal discipline appearing to be secondary to suitably bending the rules. As well, multiple wars have exposed defense spending imperatives for current requirements and to rebuild armament industries. Short term  pressures to manage finances appear being regarded secondary but long term restructuring is imperative. Despite seeming amnesia, sovereign debt risk premiums hang in the balance, with changes potentially being swift.

Agriculture and energy developments may make inflation more sticky than generally expected. Other aspects also have market valuation relevance. General wage demand increases appear, partly in response to increased personal living costs including basics like shelter and food in advanced and emerging countries alike. The cumulative impact remains cloudy of massive fiscal deficits undertaken in a period when governments should have controlled largesse. For these reasons alone and from the experiences of the 1980s/90s, the central banks are likely to be data driven and to opt to be in a steady policy mode. It contrasts with the twitching precipitously for which the markets seem positioned.

Since the apex of the credit crisis into 2008, the focus of capital markets has been on central bank policy, initially on quantitative ease which was massive and in its last few iterations, arguably excessive. Alongside the boosting of economic recovery and of company earnings, the capital market result appears to have been a sharp increase in asset prices. The primary market modus operandi has long appeared as one of ETF type activity and of leverage across capital market segments, but selectivity looms as quantitative ease ebbs.

Into 2023 as Federal Funds rates reached 5 ½%,  relative valuation characterizations and corrections did evolve along with global banking stress. Since then, as consensus expectations arose, of early rate cuts some early momentum factors have surfaced. Momentum has been buttressed first by significant earnings gains expectations to be followed by estimate cuts that were then being celebrated as results meeting expectations. Concept fervor aro)se. It was earlier in the form of that for Environmentally Sustainable Growth (ESG) exposure and has lately been in the form of Artificial Intelligence (AI) exposure. In retrospect, the ESG fervor has important lessons in realism about concept versus actual delivery in that the quantifiable and rigorous benefits have been scarce. For Artificial Intelligence (AI) much evolution remains from concept to robust delivery. For instance, one of the weaknesses of modelling has been that preconceptions of the constructor can seep in as can fake/criminal/political interference.

In the capital markets in early 2024, there have been significant developments. They include the sharp rise of valuations on AI concept for a small coterie of Information Technology equities in the United States. There has been the rally of capital markets extensively into the junk bond space. The commonality in the rallies within global equity markets has been one of an expectation of rate cuts early and large enough to contain internal market pressures for risk premium increases.

Contradictions do abound such as those of both better growth expectations and of interest rate reductions. In the main, the Information Technology coterie do have strong balance sheets and operations. Their market performance can therefore be attributed to concept likely expecting a strong AI delivery sequence. Tthe close to twelve month lows in junk bond yields can be attributed to consensus expectations of reductions in business pressures, however derived. Both indicate complacency assumptions. As in cycles immemorial, both globally for SIFIs and smaller regional or centric entities, the hard truths for capital markets will likely come overtime in bank loan loss provisions.

We favor diversification among asset classes and especially in equity exposure. E.o.e.