The onslaught of market-making bad news seems almost a daily event. A gloomy picture of slowing economic growth, elevated inflation, and confusing fiscal and monetary policy has added a lethal mixture to the market’s performance. Fiscal stimulus is sidelined, and monetary policy is constricting economic growth and entrepreneurial innovation. It makes for a gloomy outlook and an even more depressing long-term perspective. The next 10 years look more like a lost decade. High-growth company valuations have been significantly discounted, and over time as discount rates drop, their valuations are likely to increase substantially. Higher-yielding fixed income securities will be a standout performer as interest rates are reduced, the higher-yielding BDCs, REITs, leveraged loan securities, and high cash flow instruments, along with high-dividend equities, will prove extremely attractive and are currently available at bargain prices. Providers of value and users of value will be the winners for the next decade. Those generating real cash flow and disruptive innovation will define the next decade.
While most of Europe and the United States suffer sweltering heat, darkening economic skies and bitter winter of discontent are looming. Threats to the world economy are chilling. Rising interest rates are slowing activity for discretionary spending while rising prices for nondiscretionary spending are also slowing economic activity. It would be miraculous if the compounding of both effects would not lead to a recession in both Europe and the US. China’s growth has stalled. The Ukraine conflict will resolve itself to the West’s dramatic disadvantage and the West seems to be willing to let it happen – much to each economy’s long-term disadvantage. Don’t count on anything miraculous.
Beyond 2022, higher interest rates and slower global growth most likely trigger a market correction, perhaps at an exorbitant cost. As discounts rates rise and growth assumptions lower, many stocks based assumptions that low interest rates and high growth would sustain for many years will see dramatic repricing and much lower valuations.
Energy and commodities, and the businesses associated with them, are in for a very bumpy ride, but there is a fundamental sustainability to their cash flow and long-term attractiveness as world supply reorders. That which is essential prevails.
The luxury of thinking we have halcyon days of global growth and geopolitical stability may not be with us for some time to come. It is perhaps time to plan for that now.
Transformation, Valuation, Employment, and Deflation
Disruption to some of the world’s most important industries, deflationary pressure caused by scaling lower-cost businesses, and sustained low interest rates challenge traditional valuation models. Technological platforms, from blockchain-based businesses to energy storage to DNA sequencing, enable unprecedented disruption to business and economic models.
Interest rates will remain low, equity values will remain high, innovation will drive deflationary pressure, and volatility will be intense and frequent. A new approach is required to understand dynamic global competition and sustainable value.
Investors expected that the Fed would not only end its bond buying program, but many believed it would also raise interest rates. While the Fed did agree to taper its bond buying, essentially decreasing its $150 billion monthly bond buying program by $15 billion per month, ending the program in 2022. However, the Fed kept interest rates the same and clearly signaled that it would not raise interest rates anytime soon, and almost definitely not until the taper of its bond buying was completed – in other words, not for at least one more year.
Investors who had been betting on the Fed raising interest rates wagered on the yield curve flattening for Treasuries. Therefore, they invested in short-term Treasuries believing those would outperform longer-term Treasuries, as well as 10-year and 30-year bonds. Instead, we are seeing the opposite happen. Short-term bonds are dropping in price and yields are approaching their highest levels since March 2020. Meanwhile, prices for long-term bonds have climbed. This same phenomenon is happening for government bonds that only in the United States, but also in the UK, Canada, and elsewhere.
There are warning signs that the stock market is transitioning from some form of reality to misguided euphoria. The S&P 500 is up almost 10% in the last 30 days. However, this broad optimism doesn’t seem to be matched by many forms of fundamental reality.
Earnings are barely moving, and profit margins are under pressure from higher wages and rising product costs. However transitory one imagines supply chain constraints and lack of available workers, the situation has certainly extended much further than most predicted.
Central bank independence and fiscal responsibility matter, even though the Western world is acting as if these rules no longer apply. Well, perhaps. But the world has given us three examples where the consequences are extreme when these basic foundations of economic policy are ignored or violated.