October 2022 Market Outlook
In late October 1991, the fishing boat Andrea Gail set sail from Gloucester, Massachusetts only to be engulfed and destroyed by a late cycle unnamed hurricane which became known as the Perfect Storm, whose ferocious conditions produced 100-foot waves. Several economic journalists have recently invoked the “Perfect Storm” metaphor when describing current economic and financial market conditions. Is this journalistic hyperbole or rather a sober warning to investors that further precedent-setting market dislocation lies ahead?
To be fair, current economic conditions are producing headline grabbing attention sparked by the confluence of four developments: the COVID pandemic, the massive monetary and fiscal policy response, supply chain disruptions, and the Ukraine war. Core inflation last week hit a 40-year high, and the Federal Reserve raised rates another 75 basis points for the third consecutive time with their fifth-rate hike in 2022 bringing the Fed Funds rate up +3.00%. The rapid move up in rates has sparked a surge in the USD driving the $/Yen and $/Euro to historical highs and producing a “flash crash” in the $/GBP and UK fixed income markets so severe that the Bank of England had to temporarily resume quantitative easing.
The unprecedented growth in the money supply since February of 2020 (M2 up +41%) has been a driving factor in core inflation being higher and likely lasting much longer than the Federal Reserve and some economists expected. While M2 growth has slowed this year, helped in part by the U.S. Treasury keeping large cash deposits at the Federal Reserve, the Federal Reserve balance sheet remains extremely high ($9 trillion) with M2 at $23 trillion and excess reserves held by banks in the $5 – $6 trillion range.
At the risk of dropping into graduate level monetary policy details, it is worth noting that since 2008 the Federal Reserve Open Market Committee administratively sets the level of interest rates. This contrasts with periods prior to 2008 when the Fed allowed banks to bid on excess reserves at quarter end, thereby establishing a market clearing price in terms of short-term rates for “Fed Funds.” Why does this matter? There are two reasons.
First, the Federal Reserve has never applied this administrative approach – “The Abundant Reserve Framework” (first adopted in 2008) – in a highly inflationary environment. Therefore, some economists are concerned that the Abundant Reserve approach might result in excessive economic slowing leading to a hard recession because rates are set by a committee and not the market.
Second, the Abundant Reserve approach also relies upon paying banks via high overnight rates to hold reserves at the Fed (keeping them out of circulation via loans or bond purchases). In addition, the Fed has raised bank reserve requirements within its regulatory framework which further precludes excess reserves from entering the economy.
Consequently, for excessive M2 levels not to produce unwanted inflation, the multiplier effect of reserves (bank lending vs. bank reserve requirements) and the velocity of money (the frequency that one dollar of currency is used to purchase goods and services in a given period) must be contained either through quantitative tightening, reduced economic demand, or economic growth to absorb M2 with greater output from the economy. Not a simple task!
One of the challenges in the current economic environment is the distortion caused by shutting down the “services side of the economy” during the pandemic lockdowns. The economy is not in a recession currently, driven in part by the “services side of the economy” coming back online post lockdown. This explains in part why the outlook for third quarter corporate profits growth (up +2.4%) remains positive though declining from prior quarter growth levels.
However, the consensus view among most market economists is that recession is coming, bringing with it a drop in corporate earnings. There is divergence with respect to the timing and severity of the recession.
Where does this leave decisions about investment allocations? Markets appear range bound particularly to any significant upside appreciation while the timing and severity of recession remains uncertain, and the length and level of inflation remains unclear. Midterm elections could provide a relief rally in the near term, but election results will not drive this market.
Downside risk does not face the same constraints in the current environment. Though some economists now view the equity market to be “fairly priced” relative to bonds and forecast corporate earnings, “fairly priced” does not rule out the possibility of equities becoming “cheaply priced” before investment inflows provide a calming rebound for equity market instability.
Rates will most definitely go higher, and corporate earnings and economic slowing are likely on the horizon. The market is poised to anticipate and front-run an eventual Fed pivot on tightening but can easily go lower as the possibility of recession severity increases or the length of high rates and inflation extends.
Finally, we should point out a few troubling observations on the geo-political landscape which could contribute to ongoing market volatility should incidents unfold, further diminishing investor confidence.
First, the alignment of OPEC+ with Russia on an agreement to cut oil production with prices at high levels will not help headline inflation nor provide any softening to a “hard landing” recession scenario. It also underscores American foreign policy challenges among the Sunni Block countries in the Middle East.
Second, Russia’s continued veiled threats about nuclear retaliation as well as their recent indiscriminate bombing across a wide geography of Ukrainian cities heighten the possibility of military contagion in Europe including a NATO response.
Third, bad state actors, presumably aligned with Russian interests, are committing sabotage which has resulted in Nord Stream pipeline leaks and the interruption of Bundesbahn rail service in Northern Germany. These will continue to threaten the stability of infrastructure and alliances.
Finally, China has appointed Chairman Xi to a record third five-year term, and his focus on confronting the West and gaining more influence or control of Taiwan could be a source of a market surprise.
In summary, we believe current market conditions call for reduced risk, taking advantage of higher fixed income rates particularly in the shorter end of the yield curve, and assessing one’s investment horizon and risk appetite. We have reduced equity exposure in all of our multi-asset class, diversified models throughout the year which is contributing to outperformance against broad market benchmarks.
While the unanticipated weather system ultimately overwhelmed the Andrea Gail, it was determined the ship’s seaworthiness also contributed to its fateful end. Modifications made prior to the trip caused the ship to travel lower in the water, and the weather siding did not allow for proper drainage, causing water to be trapped on the deck. While we cannot fully weatherproof investment portfolios, it is important to ensure they remain seaworthy, paying careful attention to risk management, staying focused on long-term objectives, and making course corrections to accommodate changing market conditions.