Note Jun 14 2024: Fractious Environment Requires Steady Hand Central Banks

Note Jun 14 2024: Fractious Environment Requires Steady Hand Central Banks – Well into 2025, capital market selectivity is more likely than is an encore for momentum. We suggest diversification in equities and short duration in fixed income. Since the breaking of the $35/oz. compact over a half century ago, Gold bullion has recorded just over 8% gains per annum. An unintended effect of enacted sanctions/ currency policies may have been to stimulate direct central bank ownership of bullion reserves. We favor an asset mix role for precious metals.

Several events appear likely to stimulate reapplication of bonus risk premiums that in the 1980s/90s augmented credit spreads and flowing into equity risk premiums. Into mid2024, wars and border disputes have expanded. Within and among democratic and autocracies have appeared fractious pressures. They have differing origins but do appear stoking volatility. Still flowing, the electorates in the democracies appear expressing protest about their situation to newly or reelected incumbents of whichever stripe, size or geographical region. Upcoming in July are stress tinged snap French and British elections with the U.S. one due  November 2024.

Adding to domestic populist pressures exist geopolitical, trade and tariff tensions amid global GDP growth only 2½-3% annually.The so called peace dividend has been spent. In many countries, quantitative ease and minimal interest rates appear not to have engaged fiscal restructuring. Now appear major policy needs to address electorates feeling left out and increased defense requirements. Amid fractious change, stirrings in currency markets appear.. Fiscal dissonance and international spreads could also increase currency stresses, as already existent in Japan. Fiscal and monetary priorities potentially appear in flux. It is likely to require steady hands from central banks

Momentum markets have appeared driven saliently by the interpretation of central bank policy largesse. The central bank focus has been on data and inflation of 2% being achievable. The FOMC meeting ended June 12,2024 left Fed Funds unchanged at 5.50% and which could still be 5% in mid2025. Likewise, U.S. 10 year Treasury Note yields are well above their 2021 lows but are likely still to be 5%. Recently, the Bank of Canada and the ECB have cut rates. The Bank of England is to meet on June 20,2024.The Bank of Japan appears tentatively moving to tighten ultraloose postures. Change  appears for the currency milieu existent since 2008.

Readjustments are likely to flow still into most sovereign and other bond markets. For even the G-7 in the mid-1980s, policy dissonance caused severe market breaks and exposed weaknesses arising from excess complacency about seamless give-and-take. In capital markets, it is the tail end push that often attracts angst. While political and other tensions unfold, in Fixed Income allocations, we favor short duration.

Geographically, equity markets appear acutely linked to perceptions about U.S. Fed Funds rate policy. A few stocks have appeared dominating momentum. Similarities appear to a previous purvey of emergent and unseasoned markets being subject to the whims of momentum. Whether based on premiums on risk free rates or on a P/E and earnings growth interface, valuation seems high.

The latest momentum tryst has shifted from alternate energy as challenges in earnings delivery cycles came to be appreciated. It then shifted to social media with similar delivery as opposed to usage challenges. It lately has been linked to artificial intelligence, arguably incorporating sustained several fold earnings gains compared to the S&P 500. Yet, competition in Information Technology remains Darwinian. Life cycles of competitive advantage have been shortening. Instead of the traditional interface of value versus growth, we favor selectivity, quality of delivery and balance sheets with reduced leverage. 

Despite a veneer of market stability, the start of summer 2024 has had fractious events. It includes those that are global and domestic politics in nature, encompassing both democratic and autocracies regimes. Fiscal and monetary priorities appear in more flux potentially than has been the case for a decade and a half. Meanwhile, credit risk spreads appear unusually sedate. The exceptions and partly after the fact have been those in several highly stressed emerging country markets and which subsequently forced to change such as in Argentina and Turkey.

Complacency appears hardly considering events turning even slightly less favorable and augmenting risk for balance sheets or business prospects. The same appears the case about sovereign risk differentials and extended fiscal deficits. In likely flux from stressed politics and internal capital market basics into well into 2025, we suggest focus on quality and diversification in equities and including short duration in fixed income. Since the breaking of the $35/oz. compact over a half century ago, Gold bullion has recorded just over 8% gains per annum. Further to other facets, an unintended effect of sanctions policies enacted due to wars  may have been to stimulate direct central bank ownership of bullion reserves. In present circumstances, we expect an asset mix role for precious metals.

Especially after the credit crisis, it has oft been enunciated that so-called exogenous factors are hard to model and hence can generally be recognized after the specific event of import. We consider this interpretation to be a misnomer. In fact, a precise delineation of an exact event is not required  for adjustments to be made for unknowns via equity risk premiums and credit spreads. In the real world, such so called vigilante behavior took place as recently as in the 1980s/90s. In capital markets, there resulted in bonus uncertainty premiums being allocated in credit spreads and flowing into equity risk premiums. A number of currently unfolding events appear likely to stimulate reapplication of such risk premiums.

Over the last twelve months into mid2024, wars and major border disputes have expanded. Within and among democratic and autocracies have appeared fractious pressures. The fractious pressures have differing origins but nonetheless appear stoking volatility. In an arguably massive sequence of elections still flowing, the electorates in the democracies appear to have expressed protest against incumbents of whichever stripe, size or geographical region. Despite strides to unity of purpose, pressures on newly elected or reelected incumbencies can be seen on left and right leaning governments and not least in the far right gains in European Union elections. By no means complete within a kaleidoscope of types of governance, electorate rancor has included countries like Argentina Brazil and Mexico in the Americas; Hungary, Poland and Spain as well as Turkey in Europe; South Africa and largest of all, oth Indonesia earlier and now India. Usually a sign of concern about incumbency prospects becoming more dire in the future, both Britain and France have announced snap elections for July 2024.

Still to come but also with fraught competition are the U.S. general elections in November, 2024. While including a wide range of growth prospects, among countries that have held elections already, the commonality of feedback from electorate appears to be angst of being left out of the potential economic gains and about accentuated inflation in basic living costs. Not to be outdone in reflecting concerns below the surface, even within the autocracies like Iran, China and Russia have emerged  unmistakable signals. The signals appear for instance about pensioner poverty in Russia and property stability in China. Real wars rage on in Ukraine and close to key trade routes in the Indian Ocean/Red Sea. Conflict remains about demarcation especially in the south China seas.

Combined with massive domestic populist pressures, there exist geopolitical ,trade and tariff tensions amid global growth still slow at close to 2½-3% annually. Competition to harness new technologies appears even within allies and causing tariff changes to increase. In fiscal matters in many countries, the so called peace dividend has long ago been spent. Generally, the period since 2008 of quantitative ease and minimal interest rates appear not to have engaged governments into fiscal restructuring of size. Now in requiring major expenditure allocation changes are the angst of electorates fearing being left out and of global events forcing increased defense spending loom ahead.

The source of such funding is likely to be a fractious work in progress. Fiscal policy bifurcation looms. It could include depending on political stripe, changes in personal and corporate tax incentives as well as the general like goods and services (GST). Authorities like the IMF, BIS and OECD as well as private nongovernmental organizations point out that eschewing adjustments comes with risks  for companies and countries alike. As the quantitative easing of prior decades eases into quantitative tightening howsoever ratcheted, the extended valuations of capital markets are likely to be under stress. In response to potentially fractious change, the first stirrings in currency markets appear.

Fiscal and monetary priorities potentially appear in more flux than has been the case for a decade and a half. It is likely to require steady hands from central banks, led still by the Federal Reserve. Momentum markets have been driven saliently by interpretations of central bank policy largesse. We expect that capital markets will have to take a broader balance in their driving modalities. Capital markets have focused on rates of change in inflation and as recently as Q1/2024 were pining for several rate cuts from the Federal Reserve in particular over 2024 alone. The central bank focus has instead been on data and on the level of inflation  down to 2% being an achievable target and as agreed upon years ago.

The FOMC meeting ended June 12,2024 left Fed Funds unchanged at 5.50% and reiterated data dependency for future policy. So have other central banks. Due to its sheer heft, the Federal Reserve has long been key participant for example in currency swaps during emergencies, including internationally. However, its key domestic responsibilities remain domestic and unlike many others, the Federal Reserve has no direct currency responsibilities. In light of the potential for more fractious fiscal policy and global trade parameters, central banks are likely to need a steady hand. It would contrast with the aggressive monetary posture that for years characterized quantitative ease, whether in Japan since the 1990s and others after 2008.  In our view, domestic considerations could mean minimal cuts with, even in late 2025, Fed Funds being close to 5%.

In recent weeks, currency markets have finally stirred, initially in Yen/US Dollar  exchange rates. Japan has muted an exit from extreme quantitative ease and warned about currency fluctuations. It is worth noting that in the G-7 in the mid-1980s, policy dissonance caused severe market breaks and exposed weaknesses that arose from excess complacency about seamless give-and-take in establishing capital market values. Meanwhile, credit risk spreads appear to be unusually sedate. Some give-and-take  appears in top rated sovereign credits, including U.S. Treasuries and in the EU. Individual highly stressed emerging country markets also flare and ebb. Yet, corporate junk bond yields have remained closer to twelve month lows. In capital markets, it is the tail end push that often attracts angst.

Geopolitical pressures appear as enunciated above. Domestically about the distribution of gains in many countries exist both replacement and anti-incumbent whiplash. Global growth is still low at around 2 ½ -3% annually according to many forecasts. From the late 2021 U.S. Treasury Note yield low, a majority of the increase may be done. Nonetheless, due to myriad international, factors and domestic fiscal matters, we believe stability is still to emerge. It could be closer to 5% for U.S. 10 year Treasury Notes as benchmark yield into 2025. Readjustments are likely still to flow into most sovereign and other bond markets. While political and other tensions unfold, in Fixed Income allocations, we favor short duration

With businesses and earnings in recovery and then moving into expansion since 2008 and except for occasional trysts with value, equities globally seem more moved on valuation gain and momentum. Even in seasoned markets like the U.S., aggregate valuation ratios are high. To an acute degree geographically, equity markets appear to be in immediate linkage to perceptions about U.S. Fed Funds rate policy. A few stocks have appeared dominating momentum. There emerge similarities to that which was the previous purvey of emergent and unseasoned markets of being subject to the whims of momentum.

In general for this cycle since the credit crisis of 2008, the basics of business prospects have improved but global growth in GDP appears slow and to be in the 2 ½ – 3% annual bracket. It is appropriate to review several parameters. Were equity risk premiums to be applied on a risk free rate of 5%, equity contraction risk appears. It would be alleviated if central banks, especially the Federal Reserve were to engage in an unlikely policy of rate cuts down to the 2% level  amid still positive growth. Separately, and not just using the last 5-10 years as a cycle, if one were to use the entire experience of the S&P 500 as benchmark, a P/E ratio of 16x has been associated with 7% annual earnings growth. At the present 20x S&P 500, we assess expectations of 12% annual earnings growth are incorporated. A few of the small coterie of momentum equities are around 30x P/E which we believe would need 20% annual long term earnings growth to preserve valuation. For the tiny sliver of equities around 65x P/E, the earnings benchmark for long term delivery would rise to around 40% per annum. Competition in Information Technology in particular has been Darwinian. Life cycles of competitive advantage have over time been shortening. Momentum fervor in this cycle shifted from alternate energy as challenges in earnings delivery cycles came to be appreciated. It then shifted to social media with similar delivery challenges well beyond just usage. Momentum lately has been linked to artificial intelligence. Instead of the traditional interface of value versus growth, we expect the favor to be for selectivity, quality of delivery and balance sheets with reduced leverage. E.o.e.