“May You Live in Interesting Times”: April 2023 Update

While purporting to be a blessing, this statement (“May You Live in Interesting Times”) is a curse. The expression is always used ironically, with the clear implication that ‘uninteresting times’, of peace and tranquility, are more life-enhancing than interesting ones. The most fascinating periods in history were filled with tumult and upheaval and were very difficult for the people that were living through them.

We certainly are living in interesting times as investors: A global pandemic and subsequent consumer price inflation rising to 40-year highs/aggressive rate hiking cycle, Geopolitics/War, U.S. Regional Banking crisis, and now, a late-cycle oil price supply shock. We move from one crisis to another. We suffer one shock after another.

Presumably, lower near-term energy demand caused OPEC+ to make this most recent decision, with oil prices up 5.4% today. This does not appear to be bullish for risk assets, as its another cost that will compress earnings margins and put further pressure on consumer budgets which appear to be stretched as it is. The Strategic Petroleum Reserve was used last year to reduce inflation pressures and given current capacity unlikely it can be used again to the same extent.

April 2023 Update:

Global Liquidity/Monetary Policy: Central Bank balance sheets (reduced QT pace since October/22 in US) appear to be expanding and used to maintain financial stability while slowly withdrawing support without creating significant bond market volatility/sovereign issuers and strongly rated corporates. Supporting equity markets appears to be a by-product of supporting financial stability and credit markets. Earnings multiples (P/E) are altered by liquidity/interest rates/monetary policy.

Does China’s liquidity impulse kick off restarting the global manufacturing cycle that would support corporate earnings and further global consumption and/or another wave of global inflation via higher commodity prices? Overnight rates/tight monetary policy are being used to manage demand/inflation. Weakening of demand in end clients (U.S., Europe) via higher interest rates and inflation does not support cyclical uplift in the global manufacturing cycle. U.S. Liquidity has continued to decline close to 5% per annum. At this point, it appears that China’s re-opening is not offsetting the weakness from the rest of the world.

Banks are also tightening credit standards in light of deposit outflows, which has reduced demand as well historically as credit becomes less available (a credit crunch).

Almost 45% of banks are tightening credit standards in Q1/23 (even before SVB and Regional U.S. Bank Deposit Run), in addition to higher interest rates, to reduce credit risk. Historically, this has tended to be associated with recession as customers/businesses cannot roll debt and default, and tend to occur when 50-75% of banks are tightening credit conditions and credit growth eventually collapses to 0% or below. It appears we are moving to a credit cycle downturn and lower employment in the next few months rather than a cyclical upturn – investors should remain cautious.       

Leading indicators have continued to decline and have bottomed and point to a recession in H2/2023. Coincident indicators are barely positive and growth is slowing. The labor market has yet to see significant stress, though lower hours, fewer temporary staff, part-time, and fewer job openings. These trends tend to occur before full-scale layoffs. Corporate profits expectations will need to deteriorate further before higher layoffs. Our yield curve recession model has estimated a 71% probability that by June 2023, a recession will begin in the next 6 months. Walmart and McDonald’s are the latest large companies to announce layoffs and we are seeing a general broadening across the economic sectors of the economy, which tells us despite what we read about consumer strength, they are starting to see demand wane.

An uncertain macro environment is supportive of a trend-following strategy (short-term bonds (<1-year), U.S. Dollar, and Gold for the current month) in our Wave Runner/Safety Portfolio strategy.

U.S. housing has yet to bottom. Usually for the economy to bottom, housing sector will need to bottom. Jobless Claims tend to follow housing on a 10-15 month lag. Housing and Manufacturing sectors appear to be in recession (industrial production -2% on 6-mth smoothed change). We note higher inventory-to-sales ratios, which point to more disinflationary trends in forms of price discounting and lower future manufacturing activity. Retail sales appear to have taken another leg down in March and credit tightening tends to weaken retail sales.   

Bear markets are about uncertain earnings outlooks. Current U.S. corporate operating earnings estimates for FY2023 of $219/share or up 12% YoY and earnings recession in H1/23 of (3%), and the consensus appears to price a soft landing.  We have seen signs of higher costs reducing profit margins that cannot be recouped via higher prices. Revenues have held up given the monetary illusion of inflation, though higher energy costs may reduce revenue in the near term. Based on our models, we believe consensus EPS may be optimistic based on the tightening of credit standards and suggests a hard landing.  

Disinflationary trends remain: Given the pace of the rate hikes in 2022 and lagged impact on the economy, we likely have not seen the full impact of the tightening yet. Monthly coincident data (based on Feb/23) data and high frequency data and leading data point to further deterioration. A late-cycle oil price supply shock may cause central banks to continue to keep rates elevated despite disinflationary leading indicators and actual evidence of credit cycle downturn. 

As we cover in the previous posts, historically, bear markets lasting > 1 year and subsequent recessions have resulted in significant drawdowns (~45% for S&P 500 on average) and last 18 months on average as first earnings multiples are repriced, then earnings expectations repriced. The current bear market has been about 15 months, so we may be only halfway through the bottoming process and start of a new bull market. Highly inflationary pre-recession conditions tend to have longer Bear Markets/Recessions. Recessions tend to slow inflationary pressures.

Generally, a market bottom is formed when liquidity turns positive and the yield curve slope starts to steepen and has positive momentum, and Coppock curves are at their lows and have bottomed. We are starting to see indications of a bottoming process but do not appear to have had the final capitulation. We have yet to see a real re-rating of earnings expectations lower and expect that the S&P 500 2023 Consensus EPS is expected to come down in the near term, possibly as Q1/23 earnings reports are released. However, maybe this time is different, however, usually the same themes re-emerge time and time again and short memories make it all too easy for crises to recur. Therefore, it is likely, not different this time, and business cycle phases remain.

See attached below for our positioning update for April 2023 and additional analysis. Happy investing.


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