Markets have made a much better start into 2023 than most of us have expected. Have markets and investors closed the annus horribilis and with it the market downturn?
For now, the market is in a bull trend with most investors adopting a positive narrative on the back of a) China reopening, b) inflation having peaked in developed markets, and c) Central Banks expected to enter, sooner than anticipated, into a new cycle of interest rate cuts. If so, it would result in the planned soft landing for the economies and economic prosperity, aka corporate profitability that supports higher EPS going forward. This sounds like magic, but wait a moment!
While we are bullish for secular growth trends ever since November of last year, we notice that the path of inflation and the monetary tightening process are far from clear and that investors should not precipitate into matters. Markets have rallied because of lower energy input prices, much more resilient discretionary consumer spending, and some important mean-reversions on low-quality stocks, which have correct by more than 70 % last year.
We assume that the reading of some key fundamentals is by no means clear. For instance, the 10-year yield has dropped by 0.7% p.a. to around 3.5 % p.a. now. This occurred on the back of lower than expected inflation and the expectations that Central Banks would start easing again. As for now, we haven’t seen the 3rd wave of inflation, i.e., wage inflation, which is slow to translate into statistics. Given this, we consider that the average rate of inflation may stall at much higher levels for longer than expected. This in turn would prompt Central Banks to keep up rates higher for longer, too.
Second, in terms of fundamentals, consumers have been spending on discretionary goods well above the expected level. In fact, consumers in the States and in Europe have been burning excess savings in excess of USD 2 trillion. With the US savings rates being at a 17-year low of around 2.4%, (down from 7.5% in December 2021), and Europe at 12.3% (down from 21% some two years ago), one can expect that spending would normalize and long-term savings ratios would build up again. If so, this would absorb around USD 1 trillion from the financial system.
Apart from the concerns around the fundamentals, investors’ actions were around the so-called seasonal patterns, which tend to lift laggards. These patterns are of technical nature, such as tax and average down operations. Statistics show that following a strong January rally, markets faded in the following months.
Finally, we note that the economy is not growing; in fact, the economy is slowing at an accelerated path. Four out of five industry groups are seeing cost growth in excess of sales growth, which in turn will lead to a lower EPS growth or even no EPS growth at all for a quarter or two. This is occurring not only in the IT sector, which is predominantly in the news right now, but all across other industries except Energy.
How to go forward:
Last Wednesday’s FED message of “it is gratifying to see things to start working out, but it’s going to take some time for disinflation to spread through the economy”, while being clear, disconnects somehow with the market action which is powering ahead on the assumption that there will be just one more rate hike! Historically, neither the FED nor the market have an immediate predictive record – while the first is normally late, the latter is precipitate things! For now, we think that the market is a little too hopeful about corporate profits as not every S&P500 company will be able to support, following the publication of below average results, its share price via a massive repurchase program – only a number of IT companies have this comfortable position.
Rather than running after the train that has left the station, investors should focus on risk, income, and sustainability. Typically, investing in secular growth trends helps investors to stay focused on a number of well-known companies that can fulfill investment requirements such as dividend growth and earnings growth even in difficult economic conditions. This may not sound exciting, but it appears to be better than investing on past conclusions which made the market rally.