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A short macro comment

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Karl O.Strøm
28 Jul 2022 | 7 min read
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Strong company results, rising interest rates and fears of recession. This characterizes the backdrop for investors in the summer of 2022.

Investors, asset managers, brokers and analysts are now holidaying in houses and cottages, and many are taking a long-awaited trip abroad after several years of shutdowns and travel restrictions. However, the markets are open as usual, and both company results, and macro figures are pouring in. It may be appropriate to look up to talk a little about what has led to the current situation, as well as guess a little about what the next moves can be expected to be. For a more technical commentary on this, see also the article "Some interesting charts".

In my opinion, the overriding thing in the macro environment is that we have had a situation of very good and in many ways steadily improving economic conditions for a long time. The last few decades have been characterized by increasing internationalization of production, optimization of supply lines, automation, robotization and digitization. Millions have been lifted out of poverty in a growing Asia, while an aging population in the West has reduced the need for investment and created a capital surplus. In sum, this led to long periods of low and falling inflation, as well as low and falling interest rates. These are long-term structural conditions that we still have with us, although it can be argued that several of the factors can be expected to give a weaker impulse in the times ahead than those we have behind us.

A prolonged state of low price fluctuations and low interest rates will mean that investments with stable cash flows in the future will be highly valued. This has been seen both in the property, share and bond markets. Falling costs for servicing debt can also be expected to lead to increasing debt levels. Furthermore, projects and companies that would not have received funding under a tighter regime will now be able to be established and achieve a high valuation.

Both the financial crisis in 2007-09 and the euro crisis in 2011 are visible examples of how high leverage creates problems. Both of these led to strong measures from the central banks in the EU and the USA in the form of interest rate cuts and "quantitative easing". This prevented a worsening of the situation but resulted in even lower interest rates than the underlying structural conditions would have indicated and again a boost to the valuation of financial assets.

On top of this, the Covid-19 situation worldwide was met with both a strong monetary policy and fiscal policy response. Interest rates were lowered, the money supply greatly increased and both individuals and companies received direct subsidies. Many private individuals used the extra money to buy shares, refurbish houses and cottages, as well as empty the shops of household goods, sports, and leisure equipment. Covid also caused problems in the supply lines. The sale of inventory before the price rise of the input factors has given a boost to both the top and bottom line for many companies that are reporting strong results these days. They are most likely unsustainably good.

All this is known in the market. I also think that most people agree that we can expect a less favorable development in the future for many of the developments that have provided a tailwind in the markets for quite some time. We are not even talking about the factors being greatly tightened, only normalized. Measured in terms of change year-on-year, this will however be seen as deterioration. But how unexpected is it that interest rates go from artificially low to low? That monetary policy goes from stimulative to neutral? That companies' sales growth goes from a record high back towards a long-term trend, or that the profit margin falls back towards normal levels? I would say that it is easier to guess that this will happen than that we will have a new boost in a further stimulating direction. Although one can never be sure. It is a fact in the world of people that the suggestion "should we have a party" creates greater enthusiasm than "should we do some hard and unpaid work". Measures that have a positive effect in the short term are often prioritized over those that make the most sense in the long term.

It will therefore be interesting to see what the politicians' response will be, and whether it will slow down, stop, or reverse the direction the central banks are now in. In July, for example, we saw the first interest rate hike from the central bank in the EU in more than 10 years. Already in advance of this, increased tensions were seen in the eurozone, and it became necessary to launch an "anti-fragmentation" tool to handle the differences in loan interest rates between the European states. The government in Italy has already fallen, and the whole thing is not a little reminiscent of the course we saw during the Euro crisis in 2011. Long-term, structural challenges have been pushed into the background with low interest rates. The skeletons in the EU closet are now rattling.

At the same time, the USA has begun its announced interest rate hikes, and the central bank, the Federal Reserve (FED), appears to have settled on a stricter course than previously thought. Their large holdings of bonds after years of supportive interventions in the interest rate market are also to be reduced. The first reductions are underway and will increase in the coming months. In sum, this results in a faster and stronger tightening than the one we see in the EU. This has also given a boost to the USD. So far, fighting inflation seems to be the thing that has the greatest focus among both the state leadership and the FED.

Market prices are affected both by the current conditions, guesses about future development paths and the short-term positioning of the various players in relation to this. Briefly summarized, and grossly simplified, my perception of the current situation is as follows:

 

  • The fall that has occurred in many stock indices in 2022 is essentially a mathematical reaction to increased interest rates, which I described in more detail in the blog post "The effect of interest rate rises". This is a view that is also promoted by several economists and strategists at home and abroad. The policy interest rates (short-term interest rates) are expected to be raised further in the coming quarters.
  • Long-term interest rates have come up a lot since the bottom in 2020. The end of quantitative easing and the gradual reversal of the central banks' balance sheets will contribute to further upward pressure on long-term interest rates in the future. At the same time, any recession will give a negative impulse, and the level e.g. the US 10-year government yield has now reached is perhaps in a zone we can call a "normal level" (see the image below). In that case, perhaps most of the immediate negative effect of interest rate increases is now behind us, but the interest rate cannot be expected to be a positive impulse going forward.
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Yield of US 10-year government bonds (in percent). Source Infront. Past performance is no reliable indicator of future results.
  • The profit figures that are coming in these days for the first half of the year are generally good. For many companies, sales growth has been strong, profit margins high and financing costs low. If this had continued, the stock market might not seem so unusually high priced. However, we know that financing costs (interest) will rise, that any stimulus-driven increase in demand will not repeat itself, that inflation will push up the prices of companies' input factors, and this, together with increased competition, will drive profit margins back towards normal. This seems to be reflected to a small extent in the analysts' estimates, and we can expect cuts in growth trajectories and price targets as the companies guide a weaker development.
  • Most economists now expect the West to enter recession, which is defined as more than 2 consecutive quarters of declining economic activity. This is a plausible scenario, but it is important to remember that going from "very good" to "good" is a deterioration, but not necessarily a crisis. Economic conditions are still good for most people.
  • Many now share this view, which is reflected in the fact that indicators for investor sentiment turned very negative a month ago. This has historically led to good short-term buying opportunities, which was pointed out by many brokerage houses (there is a reason why this side of the market is called the "sell side"). We therefore had the paradoxical situation that "everyone" became optimists because "everyone" was a pessimist. This has led to a slight opportunistic rise in the markets through mid-July but can hardly provide a basis for a long-term positive turnaround.

We are still in a bear market with challenging market conditions for investors. We may have seen most of the immediate effect of rising interest rates, but it seems unlikely that there will be any tailwind from interest rates in the first place. Margins and turnover growth for many of the listed companies can be expected to come down towards normal in the future, which is reflected to a limited extent in analysts' estimates. Downgrades should be expected. There is no tailwind in sight for a while.

However, it is important to remember that such periods are common. One could easily draw a more negative scenario as the pendulum effect after many years of extra good times can be expected to produce a stronger hangover. Drawing a more positive scenario in which record-high margins and record-high growth are to be further increased and interest rate cuts are to give a boost to financial assets seems a bit difficult to pull off. I choose to believe in normalization. That means we may not be at rock bottom yet, but we've come a long way toward it. It also means that a decline in the markets is not replaced by an immediate (V-shaped) rise but passes into a more sideways consolidation phase for a while. There will be good opportunities for trading in such a market, but the general "buy the dip" will work worse than we have been familiar with in the years behind us. You have to be more picky about timing in general, and which sectors and individual shares you focus on. It is healthy.

For a technical comment relevant to some of the points mentioned here, see this article.

Disclaimer: After many years in the brokerage industry, in 2021 I published "Paleo Trading: How to trade like a Hunter-Gatherer” and launched a hedge fund that trades according to the principles described in the book. Vontobel asked if I would write posts for their blog, similar to what traders and managers do in other countries. It is emphasized that nothing written on this blog is to be regarded as personal advice or a concrete call to take positions. Everyone must be responsible for their own decisions and familiarize themselves with the products they use.

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