US stocks staged a remarkable turnaround rally on Thursday, Oct 13. The Dow Jones Industrial Average fell nearly 550 points at the opening bell in an immediate knee-jerk reaction to hotter-than-expected inflation numbers. The global bellwether index then proceeded to recoup all lost ground, and far more, to close up 828 points. It registered a historic 1,508 points trough-to-peak intraday rebound — all for an ugly inflation report!
Market analysts scrambled to provide the narrative for this apparent contradiction. Some suggested that the huge price surge was due to traders closing their positions, having sold ahead of the inflation data release. Indeed, all three major indices — the Dow, S&P 500 index and Nasdaq Composite — had been declining for several straight days and hit their lowest levels in a year last week. Perhaps, some investors were bargain hunting, betting that the higher-than-expected inflation rate means it is near peak and, if so, the worst of rate hikes may be behind us.
Regardless, the huge swing seems to be a portent of even greater volatility to come. And in fact, the Dow closed broadly lower the next day, giving back about half of Thursday’s gains. But the question as to whether US stocks are near bottom, after this year’s selloff and precipitous valuations decline, is one that we too are asking ourselves. The answer, after considering various factors, is not yet, we suspect. And probably by quite a far distance.
Chart 1 tracks the yields for the benchmark 10-year US Treasury and trailing price-earnings (PE) multiple for the S&P 500 index for the past 60 years. To be sure, stock valuations have gotten much cheaper over the past 18 months, from a peak of 32 times earnings to the current 18 times — with stock prices falling as interest rates rose.
The US Federal Reserve has hiked rates very aggressively — from near zero to 3%- 3.25% in just six months — and is now, after the latest inflation reading, expected to raise rates by another 1.5% over the next two policy meetings in November and December. Depending on upcoming data, it may not be quite done. Minutes from the September policy meeting showed Fed officials emphasised the risks of doing too little outweighed that of doing too much.
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That said, we think that markets have mostly priced in higher yields — futures trading suggests the interest rate may top out around 5%. What we are more concerned about is that stock prices have yet to reflect the imminent economic slowdown and possible fallout from rising geopolitical risks.
According to FactSet, EPS for S&P 500 companies are expected to increase by 7% this year, boosted by outsized growth in the energy sector and airlines turnaround. More importantly, earnings are expected to expand 7.6% in 2023, with all sectors growing, save for the healthcare (marginally negative), materials and energy (due to high-base effect in 2022) sectors. Revenue, meanwhile, is projected to increase 4.2%. That suggests profit margins expansion — into a rising interest rate environment (higher debt-servicing costs) and what will most likely be a global economic recession. Surely such an assumption is unrealistic.
As we explained in our previous article (“Central banks cannot address supply disruptions, the cause of global inflation”, in Issue 1440, Sept 26), without the ability to influence supply, the Fed can only push aggregate demand sharply lower (translation: recession) to bring down inflation.
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A slew of retailers, from Amazon to Walmart and Nike, have recently warned of margin squeezes due to markdowns on excess inventories on slowing demand.
There is growing evidence of a global demand slowdown, from manufacturing PMI (Purchasing Managers’ Index) to container shipping-freight rates, commodity prices and semiconductor and car sales. See Chart 2.
Recent inflation figures indicate that some of the key cost components are sticky, especially labour and shelter (due to the sharp appreciation in home prices since the pandemic). The US labour market remains surprisingly tight, with businesses continuing to hire briskly. There are approximately two job openings (some 10 million at end-August) for every unemployed worker currently. September’s unemployment rate fell back to 50-year lows of 3.5% after inching marginally higher in the previous month.
The size of the workforce recovered sharply after the economy reopened but has stagnated in the past few months while participation rate remains below pre-pandemic levels. We have previously discussed some of the key reasons behind this phenomenon, such as ageing population (a structural problem) and early retirements, and behavioural changes induced by the pandemic, large government handouts and excess savings (including from asset price appreciations) as well as displacements, career changes, lingering effects of long Covid and so on.
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Anecdotal evidence also suggests some behavioural changes for employers. Many have struggled to fill positions after laying off staff during the pandemic. And it has been very costly to recruit and retrain. So much so that businesses are now much more reluctant to pull the trigger again, even if they expect the economy to cool. That means workers are still in a strong position to demand better wages.
In the words of the Fed’s vice-chair, “This may mean that slowing aggregate demand will lead to a smaller increase in unemployment than we have seen in previous recessions.” If this is the case, and businesses carry this increasing cost amid weakening demand-sales (that also likely means harder to raise selling prices), then margins must fall further. To be sure, the forecast margins have been falling over the past months, but very, very slowly, and remains well above the 5-year average.
In other words, we think it is far more likely that margins and profits will contract than grow next year. Even if the recession turns out to be mild in the US, the economic situation is looking much worse for wear in Europe and across the developing world — which will, eventually, spill over into the US. Europe is almost certain to be in recession soon, if not already, buckling under the weight of record-high energy costs, thanks to sanctions on Russia. Emerging countries too are struggling with high energy and food costs, made worse by the turbocharged US dollar. According to the International Monetary Fund (IMF), many may be on the edge of a debt crisis.
Meanwhile, the Chinese economy is grappling with its own set of problems, including continued disruptions due to its zero-Covid policy, overly indebted property developers and property price slump, all of which are undermining the people’s confidence to spend. Its decades of robust economic growth — which has also been a key growth driver for many other primary-intermediate goods export-oriented countries, including Asean — is slowing rapidly. The Chinese government has a lot more work to do to empower its traditionally savings-conscious consumers, in addition to industrial policies (where it has had great success historically) for a more balanced economic development model.
The US is exacerbating global economic woes by ratcheting up the tech war with China. Its latest broad restrictions on the sale of chips — whether manufactured domestically or overseas, and involving US technology, software, tools, equipment as well as services provided by US persons — to China has widespread impact on the global semiconductor sector given the complicated supply chains that cross many borders.
The ripple effects are being reflected in the sharp selloff in tech stocks in Asia. Make no mistake, US stocks such as Nvidia and Lam Research too have been hard hit — as the export restrictions effectively cut them off from one of the world’s biggest markets. Over time, non-US companies will eat their market share, by bridging the current tech gap and selling to China.
There is intense urgency for China to expand its domestic capabilities — the government has poured billions of dollars into next-generation technologies, including in semiconductors, advanced manufacturing and clean energy — to ensure future competitive advantage. Over time, it will build a rival market from which to source its requirements and sell its products and expertise.
This fracturing of the global ecosystem, creating friction and cost inefficiencies and slowing innovation, benefits no one in the near term. For instance, reducing sales and profits for tech companies will mean less being available for private-sector-driven R&D. That said, beyond the short term, competition between rival ecosystems will probably result in new ideas and inventions that could spur the next growth phase.
The US is playing the long game — to block China’s progress in foundational technologies for the 21st century (in IT, biotech and renewables) so as to secure its continued world dominance, militarily, economically and politically. Its intentions are crystal clear and, worryingly, seem to be at any cost. This is underscored by the ramping up in rhetoric by mainstream Western media (the likes of CNN and The Economist) — the name calling, warmongering and inducing fear that the Chinese Communist Party is a threat to the current world order, liberal democracy, human rights and individual freedom.
So far, China has yet to retaliate in any meaningful way. But it is far from certain this tech war will not eventually spill over into broader economic activities. Case in point, US banks are under growing political pressure for their operations in China. China is the world’s factory and the growing Chinese consumer market holds huge and lucrative potential, including for many US companies such as Apple, Nike and McDonald’s.
Both the US and China understand the danger and severe consequences of going down this path. The world will become increasingly unlinked. But non-contestation is not an option, as it means giving up their beliefs, ideology, values, culture and lifestyle. It is an existential threat. Though we do hope that some cooperation is possible in pressing global issues such as climate change.
We are fairly certain none of these risks are currently priced into stock prices, simply because it is too uncertain to predict, assess and quantify. Maybe also because analysts tend to be an optimistic lot. But we should, at the very least, acknowledge the rising risks. Don’t forget, rising risk premium will affect the discount rate, by which all future cash flows are discounted to derive the current fair value for stocks.
In short, we think there are more downside to stock prices. We believe the risks of a near-term earnings contraction are still too high relative to prevailing valuations. When profits fall, as we think they will, valuations will become much higher than they are currently. In other words, stocks will then not be as cheap as they appear today — even though we are nearer the bottom now than we were when we last wrote on this subject, in our article entitled “What are the costs of deglobalisation for equity valuations?” (published in Issue 1431, July 25). We will certainly reassess and revisit this again sometime in the next few months.
Plus, we are still at the very early stages of central bank quantitative tightening (QT) — to partially reverse all the excessive liquidity created from previous quantitative easing (QE) programmes. It remains uncertain to what extent liquidity tightening will affect markets. The stock market is a market for stocks — where prices are determined by supply and demand. When there is a liquidity crunch, demand falls (investors lack the capacity to buy even if they want to) as supply rises — hence, price declines. And in a liquidity crisis, no matter how cheap, nothing is cheap enough.
Investing is not just about returns or profits — but also managing risks. In view of all the prevailing uncertainties, capital preservation should be the priority, at least for the near term. As explained, this was the main reason why we recently sold all of our stocks for the Malaysian Portfolio (keeping 100% cash) and raised cash to more than 54% for the Global Portfolio. Ideally, investors would construct a portfolio of perfectly uncorrelated and negatively correlated assets to defray risks. Unfortunately, this is easier said than done in the real world. But whatever you do, do not borrow to invest, whether in stocks, bonds, cryptos or other volatile assets.
The Global Portfolio gained 0.3% for the week ended Oct 19. Apple (+4%) and Guangzhou Automobile Group Co (+1.8%) ended the week in positive territory while Alibaba Group Holding (-2.2%), DBS Group Holdings (-1.1%) and Yihai International Holding (-0.3%) lost ground. Total portfolio returns since inception now stand at 12.2%, trailing the benchmark’s 25.9% returns over the same period.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
