Despite a terrible fall season in both stock and bond markets, we’ve seen a strong recovery over the last 3 weeks which has left most investors relatively flat for the year. The year-to-date performance shows the importance of strong professional management, especially when volatility is high. The majority of our client’s portfolios have remained largely resilient, which we’re very pleased with – given we’ve seen the worst bond markets in 30 years.
We’re not done yet, however. The effects of substantial rate hikes are always lagging. This will likely force the economy to tumble into recession over the next two quarters.
And while the typical explanation is that rates need to be higher to curb inflation, we believe that the reasons are far more widespread than just inflation.
Let’s have a look at a few of the concerns on the horizon and why we expect more of the volatility that we’ve seen over the last number of months.
The Elephant in the Room
‘Higher for longer’ is a typical mantra economists have batted around as of late when referring to interest rates. Why is this? Don’t Federal Governments typically cut rates when economies suffer? They do, if the markets will support it. This has been in some doubt as of late.
Although few saying it, if one were to look at the amount of American debt coming due both corporate and federally over the next two years it looks like a pig in a python. This is a big problem.
There’s a staggering amount of debt, at all levels, that needs to be rolled over within the next 2-3 years. It’s set to reprice at considerably higher rates. This is causing turmoil in the banking industry, in the real estate industry and others. Higher rates mean more costs for consumers and businesses alike, meaning that there will be less money for consumer spending. Now that the savings consumers accumulated during the pandemic are largely gone, we’d expect corporate profitability to recede along with it and this is likely to cause stocks to reprice along the way.
Then you need to add the concern that there is now de-dollarization going on. Meaning that companies and countries are no longer forced to trade in U.S. dollars.
While the U.S. is far from losing its reign as the reserve currency of choice, alternative financing and methods (such as those employed with the BRICS nations) will gradually erode the dominance of the U.S. dollar which will put additional pressure on the companies and countries that continue to use the dollar.
If the U.S. dollar eventually weakens in global markets, along with that will likely come the repricing of U.S. debt to be more in line with other currencies.
As an example, this fall we saw several weeks of selloffs in the equity markets and the bond markets in tandem. They normally do not correlate together.
There is real concern that the U.S. government is going to have considerable trouble refinancing much of its now $33 trillion dollar debt with the interest payments now equaling roughly the size of U.S. annual defense spending.
Basically put, U.S. debt has grown from $11 trillion to $33 trillion dollars over the course of the last decade. And it’s now approaching levels where it’s almost unserviceable. Accordingly, there’s a worry of additional loss of credit rating (which we just saw), which will mean further increases in rates to be able to atract the next round of financing.
To add to the pain, the U.S. is now stuck with the cost of financing two wars – with no real sight of rectification in sight.
Economic concern is further compounded by the restart of student loans. In the U.S. market, the average student loan payment, which has been in hiatus for the last two to three years from Covid, was restarted this October. This means taking an average of $400 USD a month out of tens of millions of people’s budget. This pulls large amounts of discretionary income off the table. This is important as consumer spending typically represents about 60% of economic activity.
Inevitably, we should see some rate cuts – quite possibly shortly as the number of Central Banks cutting rates has now eclipsed those raising . The Fed has not moved yet but is softening it’s tone. Rate cuts should help stem some of the short-term pain we will see from a likely recession, that is assuming global bond markets are able to keep up with the flood of new debt the U.S. continues to issue. Accordingly, many of our portfolio managers have added to their bond positions to be able to take advantage of these rate cuts – which some analysts believe a ‘generational opportunity’.
Using rates to manipulate economies is a blunt instrument that is far from a perfect solution. Remember that economies are like trains in that they take a long time to get going and a long time to get stopped. Unfortunately, they also come off the rails from time to time.
While we are cautioning investors about short-term volatility particularly in the equity market due to the likelihood of reduced earnings from a recessionary pullback, we remain bullish that new winners will emerge and your portfolio managers will find them.
In times of dramatic change, new market entrants appear as the need for change is the greatest during these periods. The large-scale changes that we’re seeing in things like AI, molecular biology, and material science stand to transform our society over the next 10 to 20 years. The next Googles and Amazons are often born during these times.
While we are recommending keeping portfolios relatively conservative at this stage, we would emphatically recommend those of you who have excessive cash on the sidelines or are putting in money monthly to aggressively buy equity positions as many continue to trade at significant discounts. Dollar-cost averaging has proven year in and year out to be a highly effective strategy, which takes advantage of markets in correction. We do not see this to be any different right now.
The approach of keeping larger-scale assets in relatively conservative positions while aggressively investing new capital gradually over a number of months to be able to buy out the bottom of the markets will likely pay off handsomely as we move forward.
As always if you’d like to talk about anything, we’re here for you. Don’t hesitate to give us a ring at the office to arrange a visit, a call or a video call.
All the best,
Mark, Sean, Cass, Nancy, Simone