"Don’t fight the Fed.” This mantra has been the holy grail that has served market investors well for years, that is, until recently. US stocks rallied strongly at the start of 2023, even as the Federal Reserve continues to hike interest rates. Investors are betting that inflation has peaked, and that the Fed will pivot to cutting interest rates in 2H2023 — never mind that Fed officials have consistently pushed back against this view.
Notably, the technology-heavy Nasdaq Composite is up 16.6%, almost double the 8.9% gain for the broader Standard & Poor’s 500 index and well above the 2.7% increase for the Dow Jones Industrial Average (at the time of writing). This relative performance would be rational — and the correct strategy for investors — IF interest rates do start falling, as the market expects. Cash flows of high-growth, tech stocks are typically farther into the future. Thus, their valuations would see the biggest boost in a falling interest rate environment. The question, though, is this: Are interest rates going to fall in the coming months? The answer is key to determining whether this rally is sustainable or a false dawn.
The Fed, as we said, has been quite consistent in its messaging. While inflation appears to have peaked, it remains well above the central bank’s 2% target. (As expected, there are now many commentators who argue that the 2% target should not be followed.) As such, there is still tightening to be done (see Chart 1). The fear is that inflation has become stickier, and that a further decline from hereon will be harder — and slower.
A major concern is the remarkably robust labour market, which is driving wage growth and keeping consumption fairly robust, at a time when the Fed is actively working to suppress aggregate demand. Although wage growth is off its peak, wages are still rising at a faster clip compared with pre-pandemic averages. Indeed, real disposable personal income, after taking into account inflation, has been rising anew after hitting the lows in mid-2022 (see Chart 2).
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The latest monthly jobs report for January 2023 shocked the market with a net addition of 517,000 non-farm payrolls — far ahead of the expected 188,000 while the unemployment rate fell further to just 3.4% (the lowest in more than five decades, since 1969). We have previously discussed some of the contributory reasons that the job market has been so tight amid growing consumption, including an ageing (baby boomers) population, early retirement/geographical dislocation/lower immigration due to the pandemic and behavioural changes.
Consumer spending has risen at a steeper clip post-pandemic, compared to the previous decade, and has remained robust even with rising prices — bolstered by massive excess savings during the pandemic. That left many businesses scrambling for workers, especially in the services sector, to meet demand.
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The prices of goods are likely to adjust lower as pandemic disruptions continue to ease, especially with China reopening. But wage inflation is notoriously sticky. We have previously explained why we think inflation in the short term could stay elevated, at higher levels than pre-pandemic, owing to acceleration in deglobalisation, the US-China tech war, geopolitics and so on. In short, there is still a great deal of uncertainty.
Why, then, is the market calling the Fed’s bluff — so confident that the central bank will cut interest rates by no less than 0.5% this year, based on prevailing futures trading? Hope — that the global economic slowdown will be short and shallow. And yes, there are some positive developments in this respect: The International Monetary Fund recently raised its economic growth projections for 2023 and 2024 in its World Economic Outlook report, as inflation eases. Europe is weathering higher energy costs better than expected and China’s reopening will boost the economic recovery process.
Analysts are generally an optimistic lot — and it pays (literally) to be positive on the market. That is the reason there are always significantly more buy than sell recommendations. Case in point: Even as analysts are cutting corporate earnings estimates, they are raising target prices — justifying higher valuations on expectations of falling interest rates (see Chart 4). According to data provider FactSet, the average (price-earnings ratio for the S&P 500 has risen to 18.4 times currently, from 16.7 times at end-December 2022 — in other words, stock prices are rising while earnings are falling.
Also, we suspect, the fear of missing out (FOMO) is embedded deeply in investors’ psyches — and driving risk-taking. We are witnessing a strong rebound in some of the riskiest corners of the market, including cryptocurrencies and loss-making companies, suggesting the return of speculative activities and probably some short-covering as well (see Chart 5).
Markets are forward-looking. So, while prevailing data underscores a global economic slowdown — falling global industrial production, trade volumes and shipping rates, sharply lower demand for consumer electronics such as smartphones, PCs and laptops, excess inventories throughout the supply chains, slump in property sales and prices and so on — investors are looking beyond this soft patch to the eventual recovery.
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There is little doubt that corporate earnings forecasts remain too optimistic, even as they are being reduced over the past months. Net profit is now expected to grow by 3% this year on the back of a 2.5% increase in sales, according to FactSet — meaning net profit margin will expand. How realistic is this expectation?
A soft landing for the economy is easier said than done, though this is often obvious only with the benefit of hindsight. Clearly, inflation remains key. The Fed has been emphatic that it would rather err on the side of caution than suffer a repeat of what happened in the 1970s, when it took its foot off the brakes too soon and allowed inflation to reignite. Yes, the quantum of rate hikes has grown smaller, but slowing is not pausing. And when the Fed does pause, probably after a couple more hikes of 25 basis points in the next two meetings, it certainly does not equal cutting.
Of course, there are some who question whether the Fed’s aggressive stance is justifiable. Specifically, whether there is a need to engineer a recession, whether the high inflation was mostly down to pandemic supply disruptions that will eventually resolve themselves. In other words, that inflation is transitory after all, as most of us believed in 2021 — except that the transitory period is actually longer than we thought.
Regardless, it is doubtful that the Fed will now revert to its “inflation is transitory” thinking. In fact, with the unemployment rate so low, there is little motivation for the Fed to start loosening monetary policy, given the balance of risks. And if inflation turns out to be stickier than current market expectations, higher-for-longer interest rates will inflict greater damage on the economy — and corporate earnings — particularly with the mountain of public and private debt.
In fact, one of our biggest worries is that tightening financial conditions could trigger an unexpected liquidity crunch — when overleveraged companies, loss-making startups and long-shot bets face a reckoning, with the end of the cheap money era and as the flush of liquidity dries up. Deteriorating access to credit financing for highly indebted entities could have wider repercussions on the global financial system and capital markets. We saw some of that recently with the collapse in share prices of the Adani Group.
Much depends on continued resilience in consumer spending. Consumption has been remarkably buoyant thus far, shored up in part by massive excess savings from the pandemic. It is estimated, however, that more than half to as much as two-thirds of this excess savings have been spent. Indeed, for lower-income households, it is quite likely that most of their excess savings is depleted. Credit card balances are up and anecdotal evidence suggests that consumers are trading down.
There are also recent reports of a rising number of Americans tapping into their 401(k) retirement plans, under certain hardship provisions, to meet financial emergencies. Over the coming months, households will gradually need to normalise their savings rate, from current lows, and scale back on spending (see Chart 6). At the same time, higher borrowing costs will further reduce disposable incomes. That will mean lower volume demand, with the cost of living staying high even if the rate of inflation slows.
Managements, including those of the largest companies such as Apple, Amazon.com, Google, Microsoft Corp and Intel Corp, are warning of slowing sales and growth. Companies are hunkering down and cutting costs, including layoffs. No doubt, some companies will have stronger pricing power than others. But as demand weakens, even the strongest brand names will find it hard to maintain margins that are still hovering near record-high levels.
In summary, we think earnings have more room to fall — and current valuations are too high. As such, we maintain our cautious positioning in the Global Portfolio, pending greater clarity on the economic outlook — by balancing riskier stocks with safer bonds. If there is recession, bonds — with fixed income streams — will fare better than stocks. Though if interest rates have to rise by more than expected — that is, if markets are underestimating the terminal interest rate — it will hurt both stock and bond prices. At the end of the day, it is not about maximising absolute returns but maximising risk-adjusted returns. An eventual sustainable rally should be underpinned by improvement in corporate earnings, instead of valuations expansion.
Having said that, we too are on the lookout for companies that have been oversold — whose stock prices have collapsed by 50% or more, whose business models we like, and with sufficient cash resources to ride out the adverse environment. To be clear, these are high-risks investments and we have judiciously bought them, but balanced them with safe investments in the portfolio. You do not want to go bust before the next stock market rally.
The Global Portfolio fell 1.3% for the week ended Feb 8, led by losses in Alibaba Group Holding (-6%), Global X China Electric Vehicle and Battery ETF (-4.1%) and Grab Holdings (-3%). On the other hand, shares in GoTo Gojek Tokopedia (+5.2%), Oversea-Chinese Banking Corp (+0.3%) and DBS Group Holdings (+0.1%) ended higher. Last week’s losses pared total portfolio returns since inception to 31.4%, trailing the MSCI World Net Return Index’s 45.2% 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.
