How to find the real and important signal among all the noise?
In a short time, the market has gone from worrying about a hard landing to fearing overheating with higher interest rates as a result. How do you know what actually applies? What is noise and what is signal? Is the economy strong or weak? What is the likely development of GDP, corporate profits, inflation, interest rates and stocks for the rest of 2023? There are no obvious answers, but as always it is about money, about availability of liquidity and the eagerness to use it, more than about the actual creation of value (the companies' cash flow).
Do the companies have enough money and faith in the future to invest in growth, to build factories and hire staff? Do individuals have the job security and income enough to run both retail and the stock market after buying their tomatoes and paying their utility bills and mortgage interest? And do investment professionals have enough inflows to systematically support stock indexes when high bond yields attract more than falling corporate profits? As a small reminder, I note that it is easy to find bonds that give 5% interest in principle risk-free at the same time that the companies in S&P reported -5% in profit development for the fourth quarter of 2022.
The latest statistics at the time of writing (March 3, 2023) show that China's reopening is reflected in strong PMI (Purchasing Managers’ Index) numbers – the strongest in a decade, according to newspaper headlines. In Europe, at the same time, inflation has surprised on the upside, e.g. core inflation in the EU rose by 0.31 percentage points to 5.60 percent. Most would have preferred to see inflation fall, as this is likely to make the ECB more likely to tighten. Furthermore, the labor market figures are strong, not least in the USA where unemployment is at its lowest level in several decades. Americans don't hold back on shopping either. Partly they still have their jobs, partly a lot of money left over from the Covid cheques. With inflation adjustments, contributions increase while the tax collection falls. These two factors alone mean $350 billion in stimulus for 2023 compared to 2022. Sounds like the recovery is real. So there was no hard landing; there was no landing at all, was there?
Well, there are definitely other angles to consider. In fact, China's PMI reading should only be read as slightly improving compared to the total shutdown that was in effect before the reopening. In practice, there are quite small changes in the answers from the purchasing managers, and as I said only compared to an economy in lockdown. To get away from the noise, I like to keep things simple for myself. Rather than nailing hundreds of different macro data series in an attempt to figure out exactly how the economy is doing, I think about what is actually driving. The answer is money. Liquidity. Is there enough currency and is it eager enough to be put into risky work. Above all, I am wondering if the currency is more eager than before? Central here is partly the relative aspect of will and zeal, partly the question of lagging effects, i.e. a relativity in time.
We know, for example, that labor market data is always lagging. Virtually every recession begins before unemployment bottoms out. Companies prefer to keep their staff until the very end. The employees have been hired through many, long and annoying interviews. The last thing you want then is to lay off too many people too soon and have to redo the procedure if the economy turns out to be good. It is only when customers fail to show up and profits fall that the mass redundancies take off. We're not even there yet in this supposed recession.
We also know that interest rate increases operate with large lags. It takes time for higher interest rates to influence the decision-making of banks, companies and individuals. Everyone hopes in the end that it's just a temporary bump, or at least that you can continue as before by screwing up a little here and a little there on other expenditure items. But in the end, the loan interest eats through the bond periods, and into profits and disposable income. When 3.5 percent interest becomes 7%, there is less money left over for everything else, and when the loan mass is greater than ever historically, the effect is also greater than ever. It usually takes at least a year for interest rate increases to have the maximum economic effect.
Thus, there is still over a year to go before the negative effects of austerity reach their maximum, as interest rates are still being raised this spring. And yet we are already seeing, for example, -5% for corporate profits. In addition, there are profits that exhibit a characteristically low quality before recessions (S&P vs NIPA), i.e. are somewhat manipulated with various "temporary" adjustments and other creative accounting. There is a lag and cyclicality in this measure as well – the companies try to squeeze in the final result, but in the end the recession forces the underlying reality into the light. It will be a classic so-called double whammy, where you realize at the same time that it is both an economic downturn and that the companies have lied about their results.
So far, American consumers have both their jobs and savings to spare. This means that the companies experience fairly good demand. China's re-opening, however weak, is currently giving a bit of a boost to the global economy, but if you dig a little deeper you can see that there is very bad pressure there as well. One of the reasons is one of the world's most important sectors besides energy, namely real estate. In China, as in the rest of the world, property prices have lost momentum or are falling more or less sharply. It really goes without saying that prices and activity fall when the interest rates that finance the purchases have doubled in a short period of time. With lower property prices and higher interest rates, it becomes much more difficult to squeeze liquidity out of the home for other purchases – on the contrary, you may get a kind of margin call and need to increase the collateral or the amortization rate. In any case, the loans cost all the more and drain the ability, and the will, to spend the money on other things.
In summary, the signal is that, all else being equal, much higher interest rates mean much less liquidity. There will be less money left over both to shop for and to invest. The alternatives to shares have also improved at the same rate, partly because bonds are more appetizing in terms of risk in uncertain times, but now also give a substantial interest rate compared to before. As I said, it is the relative changes in liquidity that govern the financial markets: is more or less currency flowing into the stock market now than the period before.
It is that flood, that eagerness to exchange currency for risk paper that determines whether rates go up or down. As long as interest rates continue to rise, and as I said maybe for a few more years, the relative liquidity that is left decreases - both for the real economy's value creation in the form of corporate profits and cash flows and for share purchases.
In this environment, it is important above all not to expose yourself to permanent capital losses. Rule one is not to make losses, rule two is to remember rule 1. Warren Buffett is pretty wise sometimes. After almost 15 years of stimulus and surging stock markets, the economy is stretched and valuations (eg Price/Sales) unusually high. A re-set is needed, a time of normalization of relative levels of wages, profit margins, cash flows, market values and more.
The adjustment has been triggered by inflation and higher interest rates, a process that central banks do not seem to want to interrupt as long as financial markets do not become too chaotic. The rally that started in October 2022, combined with high inflation numbers has only increased their resolve.
Thus, all investors do best to steer clear of the train called recession and stock market crash that is likely headed in their direction. Those who in 2023 avoid being hit by cyclical and technology-heavy companies with inflated multiples, or vulnerable consumer companies, perhaps through parking in oil, gold and banks, may have quite a lot of liquidity left when other investors panic sell. This is when you can make your very best deals, "buy and hold", something which, when buying at optimistic multiples, risks leading to precisely panic sales in markets such as 2022 and perha
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