Market Musings 010423: Q1’s Frequently Asked Questions

Market Musings 010423:
Q1’s Frequently Asked Questions

Six of the questions I have been asked the most of late…

Summary:

• Is the banking crisis over yet?

• Is a US recession nailed on to this year?

• Can inflation really return to 3% or under by the end of this year in Europe and in the US?

• Are you still positive on Stocks today despite all the concerns?

• Is it time to return to investing in property?

• What benefits from stress in the banking sector?

Podcast this week:

The silver linings to the banks’ stress cloud

• March : all about the Banks

• How stock markets are surprisingly resilient despite banking stress

• What are the silver linings to the banking stress cloud?

• A Fed pause can be good for stocks over 6-12 months

• Look again at equities

Frequently asked questions

I present below 6 questions that I have been asked several times of late, together with my answers...

1. Is the banking crisis over yet?

No, this is rather unlikely. The stresses in the US regional banking sector remain evident.

There is still deposit flight as deposits leave low yielding deposit accounts at smaller banks and either go to larger banks for safety reasons or go to money market funds. These funds yield up to 4.7%, which is over 4% higher than the average bank deposit rate today. So, there clearly remains stress in the US banking system as a result of this deposit flight.

Accelerating deposit outflows from US banks

Source: St Louis Fed

The second area of concern is commercial real estate i.e. offices, warehouses, shopping centres and so on. The US regional banking sector has been a very large lender, in particular to this commercial real estate segment.

Vacancy rates post COVID remain relatively high in particular for offices in many US cities.

C. 25% office vacancy rates in Atlanta, Dallas, San Francisco and Washington DC

Source: JLL

So there is a risk of a wave of defaults on debt that has been lent to these commercial real estate funds. Office vacancy rates remain elevated in big cities where the return to work trend has not been that strong, such as San Francisco, Dallas and Washington DC.

If we look at the performance of bank stocks or bank bonds, by looking at, for instance, the KBE US Bank ETF or the XLF US financials ETF, we can see that there has been a fragile stability, but not really much of a rebound.

Only a very modest rebound in US banks thus far

Source: tradingview.com

So I think investors realise that the stress is not over. The collapse in banks’ share prices has not continued, but there has not been a real rebound as of yet.

In Europe we can look for instance to the iTraxx Europe Financials CDS indices, which are a way of tracking the cost of insurance to protect financial bonds against default. These have come down a little bit, but they need to come down a lot further in the wake of the Credit Suisse forced merger. Equally well, the AT1 CoCo bonds that were hard hit when Credit Suisse effectively defaulted on them when the merger with UBS was announced, have rebounded a little bit but again remain far far away from where they were before the start of the banking stress. So I think we can say that there is some emerging stability in the banking system for now but it is somewhat fragile.

European AT1 (CoCo) financial bonds are still a long way from February levels

Source: tradingview.com

2. Is a US recession nailed on to this year?

One of the key conclusions from this banking stress is that credit conditions are going to tighten yet further, as a result of the pressure on regional banks. They will have lower deposits and as a result, they will be forced to tighten lending standards further and give out fewer loans.

Generally when credit conditions tighten, this means less credit is issued, and less credit being issued means less growth. So it usually is a clear signal of at the very least a very sharp slowdown in growth, if not outright recession.

US credit conditions were already tightening even before the SVB failure

Source: US Federal Reserve

Our base case remains a modest recession in the US in the second half of this year, then returning to sub trend growth in 2024.

These tighter credit conditions are one reason; the second reason is the delayed impact of the full rate hike cycle by the Fed. Normally, it can take 12 to 18 months for the full impact of a rate hike to be felt in the economy. So over the next few months we are still going to feel an increasing impact from the rate hikes that were already done up to a year ago. And that will slow the economy from now to the end of the year.

It is difficult to imagine at the moment when you look at current economic data as US economic data is tracking for Q1 at around 3% annualised growth rates are actually pretty strong.

But this is unlikely to be maintained through the second quarter, and even more unlikely to be maintained into the second half of the year. We still expect a sharp slowdown in growth which incidentally should lead to a sharp slowdown in inflation as well, but a sharp slowdown in growth leading to negative growth in the second half of the year.

If we look to Europe, a recession is still not certain, but there are some warning signs in terms of the slump in the volume of retail sales, for instance in Germany. It seems that consumers are spending less as a result of the high inflation rates, particularly caused by energy prices.

The good news for Europe is that the energy crisis is subsiding. The full impact of falling wholesale energy prices has not been passed on to consumers yet, but should be passed on to consumers over let's say the next six months. So there will be some form of relieving of pressure on consumers from energy prices in the next six months in Europe, which again should help maintain consumption.

We should also remember that excess savings in house for households remains extraordinarily high in Europe. In addition, the level of employment in continental Europe remains pretty much at an all time high. So again, that's good news and with increases in wages and salaries as well. This should help underpin consumption and could potentially therefore avoid a recession in Europe. But there will be a sharp slowdown in growth, no doubt.

3. Can inflation really return to 3% or under by the end of this year in Europe and in the US?

Yes, we certainly think so.

While it is true that current inflation rates remain far too high for comfort, certainly for central banks in the US and in Europe.

But, remember that there are a number of disinflationary forces at work, which will play out over the next six months.

Energy prices have slumped in Europe from the Ukraine conflict highs, down over 85% in terms of both natural gas and electricity wholesale prices, which should eventually be reflected, as I said, in household prices.

This will provide relief both for companies and for households in the European economy over the remainder of this year.

In the US, we see a similar pattern in energy prices - not so much in gasoline but more in natural gas prices, which are at multi-year lows in the US.

European, US natural gas prices slump from post-invasion highs

Source: tradingview.com

So again, over the second quarter US households should obtain quite a lot of relief from lower energy prices, calming down the rate of inflation.

Secondly, food prices should start to calm down - at the moment, they seem to be running very high. Certainly if you look at your local supermarket you can feel the impact of much higher food prices.

However, if we look at the FAO index of world food prices, these have been falling for quite some months now.

FAO world food prices continue to fall, led by vegetable oil and cereals

Source: FAO

And this eventually should be reflected in food inflation in the high street. So again, this represents a second source of potential relief for household budgets.

Thirdly, we can talk about the price of goods. Good prices, including the price of transportation of these goods, for instance from Asia, have fallen sharply.

So we expect this disinflationary effect from the price of goods, particularly goods that are imported from abroad should come down sharply as well over the next few months.

Then we can talk about housing rents. Well, housing prices are definitely falling all across Europe and indeed, quite sharply in the US as you would expect, given the much higher mortgage rates that are now being offered. But rents are also coming down. So the housing component of CPI, which is a very big element of US inflation, should be coming down quite sharply over the remainder of this year.

The last question to see for inflation therefore remains, services and wages because wages are the biggest proportion of services.

This, it has to be admitted, remains sticky. But we would still expect the indirect effect of lower energy prices to feed into services and thus bring services inflation down.

We also expect wage inflation to calm as companies, particularly in the US, start to lay off more people not only in the tech and financial sectors but elsewhere. This should then bring the jobs market a little bit more back into balance and reduce the intense wage pressures that we have been seeing up until recently.

So overall, yes, we expect CPI in the US and Europe to fall really quite sharply over the next few months and return closer to 3% by the end of this year.

4. Are you still positive on Stocks today despite all the concerns?

Yes, we believe that stocks globally are climbing so a so-called “wall of worry”.

This is typical - there is always something to worry about. At the moment clearly it is firstly the war in Ukraine, which is ongoing, and secondly, the banking stresses in the US spilling over also into Europe.

It is remarkable to note then, that the Euro STOXX 50 index has returned to its recent highs, despite the big drop in banks. The same can be said also for the French CAC 40 index.

Euro STOXX 50 index defies banking slump to return to recent high

Source: tradingview.com

Similarly, if we look to the US, we can be encouraged by the recent upwards momentum both in the NASDAQ 100 index and also in theS&P 500 itself. Both seem to be moving higher in a series of higher lows and higher highs which suggests an uptrend is forming. Again, this has occurred in spite of the stresses in the banking sector.

Tech-heavy Nasdaq 100 shows surprisingly strong upwards momentum

Source: tradingview.com

We believe that the fall in long term interest rates supports stock valuations. Then the question becomes: how is the momentum of earnings going to turn out over the next few quarters? Because that should be the determining factor for the stock markets.

In Europe, the momentum has been strong - quarterly results up to now have actually surprised to the upside in general from a number of sectors, including of course, financials, energy, industrials, as well as consumer consumer goods such as food and beverage, all have given generally positive earnings surprises up to now in Europe.

In the US the picture is a little bit more mixed, but recently, earnings estimates have been actually starting to trend higher once again. This is surprising given that we're expecting a sharp economic slowdown over the next six months. There is pressure on profit margins in the US but nevertheless, earnings estimates seem to be rising. So analysts seem to be suggesting that things are not as bad as they had thought a few months ago

5. Is it time to return to investing in property?

This is a yes and no answer, unfortunately. The yes relates to listed properties such as REITs, which are listed on stock markets in the US and Europe. REIT share prices have already corrected a very long way. And so in the near future may present some value for investors particularly as they in many cases offer much higher dividend yields today.

US and European listed Real Estate has already suffered since start-2022

Source: tradingview.com

The no relates to the vast bulk of property which is unlisted. Unlisted real estate prices are only readjusting slowly, and I think that they will take several quarters more to fully adjust.

We are still at a point where we see a battle between buyers and sellers. Buyers are happy to buy but much lower prices, while sellers are unwilling to drop their prices much.

This sort of standoff between buyers and sellers typically takes 6 to 12 months to resolve. So it is probably too early to look for opportunities in the unlisted property market, p[articularly commercial property. I think we would need to wait another six to 12 months to really start to find those opportunities.

In the meantime, look to the listed REIT sector as a place where prices have already been “marked-to-market” extremely rapidly and perhaps where they do represent something closer to reality.

6. What benefits from stress in the banking sector?

The clear beneficiary from the current banking stresses are precious metals, principally gold. Gold acts as a safe haven. It acts as a refuge also from those who are worried about lower interest rates and about those who worry about the weakness of their own currencies.

For instance, gold tends to be inversely correlated to long term bond yields. So lower bond yields usually means higher gold.

The same is true with the US dollar - when the US dollar weakens, the gold price (of course in dollars) rises over time.

So we have three key drivers here. A safe haven demand, a weaker dollar and lower long term bond yields all of which are favourable for gold. It is also favourable for gold’s little brother silver.

Note that as of the end of March, gold has hit its highest ever monthly close at nearly $2,000/ ounce. I think that this positive momentum is likely to be maintained. And we have been for some time suggesting precious metals and gold as useful diversifying assets for investors, which is becoming ever more true today at a time when these banking stresses could continue. The effect of banking stress on the economy will also become apparent between now and the end of the year, pushing the US economy into recession.

Gold has just set a new all-time monthly closing high at nearly $2000/oz

Source: tradingview.com

So our conclusion is to continue to like gold, and to continue to remain invested. For a leveraged effect, look at silver which is only half of its all-time highs back set back in 2011, whereas gold is at its new all time high on a monthly closing basis.

One could also look at precious metals miners, which also are far far far below the high set back in 2011. So these miners have lagged the movement in the gold price up to now. But we think there could be a catch-up effect both for silver and for precious metal miners over the next few months.

Let’s hope for further advances in the week ahead,

Edmund