Introduction: Rolling Recession

The world has entered a “rolling recession” because of the high levels of government debt and low levels of growth as consumer demand is down due to higher interest rates and consumer prices. As the same time businesses inventory levels are fluctuating because of supply chain challenges and they are being cautious on further investment due to fears of a global downturn. It is our observation that not all sectors are simultaneously affected, e.g., retail is down whereas mining is up.

As outlined in newsletters of 2 February and 6 April 2023, US Money Supply (M2) is contracting as banks have tighten lending standards while the demand for USDs is increasing because higher interest rates mean more funds are required to meet interest payments. This is causing a disruption to the monetary system which recently culminated in the failures of Silicon Valley Bank, Signature Bank and Credit Swisse and it continues today with First Republic Bank, based out of San Francisco now in the spotlight. Banks are increasing their holdings of cash and cash like instruments, e.g., US Treasuries, and have tighten their lending standards which all adds to a contraction in M2. There are fears of an institutional interbank lending freeze becoming a contagion in the form of a run-on bank retail deposits, so central banks are pulling out all stops to prevent such a situation occurring. As with previous monetary crises, the price of gold has increased as investors seek out safe haven assets.

Even though the recent Australian Consumer Price Index (CPI) of 7% is down from 7.8% for the December 2022 quarter it remains stubbornly high, particularly in essential consumer goods. The most significant contributors to the March 2023 quarter's rise were medical and hospital services (up 4.2 per cent), tertiary education (up 9.7 per cent), gas and other household fuels (up 14.3 per cent) and domestic holiday travel and accommodation (up 4.7 per cent). A standard size takeaway coffee, e.g., flat white price has increased from $2.50/$3.50 to $4.00/$5.00 depending on where you may live.

Simply, the world is simultaneously dealing with both monetary and inflationary crises. This is unlike the Global Financial Crisis (GFC) of 2007/8 which was a monetary crisis only, there was no inflation even with all the fiscal and monetary intervention by governments and central banks, respectively. The Rudd Australian government introduced major fiscal stimulus that was split equally between cash handouts/short term projects and infrastructure, but this did not result in structural inflation which is starting to appear to be the situation today.

What’s going on in the Markets?

Debt markets which are significantly larger than the equity markets are in a state of flux. As previously reported in earlier newsletters, there is a shortage of collateral and the inversion of key yield curves continue to widen, as the market is saying that interest rates must fall; whereas the US Federal Reserve (Fed) is indicating that interest rates will continue to rise or stay on hold, but not fall. Who is right? Should investors not fight the Fed or will the market win out? This stalemate reflects the monetary crisis outlined above.

Equity markets appear to be ignoring the monetary crisis while they remain focussed on estimating future earnings after the recession. Some sectors are doing well while others are struggling.

Commercial property investors and Private Equity (PE) firms are having major problems because these sectors are significantly leveraged and the higher interest rates are having an impact. In the case of commercial property there are two factors in play. Many employers are allowing employees to continue working remotely either part or full time, as they did during the Covid lockdowns which has reduced the need for office space. The second factor being higher interest rates which have increased the cost of debt. Brookfield recently defaulted on a USD161m commercial mortgage, BlackRock has frozen redemptions on its UK GBP3.5billion property trust and Blackstone blocked redemptions on its USD71billion real estate trust. We expect more problems to surface in the unlisted property and infrastructure trust areas which industry funds are significantly invested, and it is well reported in the media that the returns of these asset classes are questionable.

The technology sector is recovering despite the layoffs and the likelihood of more to come. This recovery is driven by new technologies, specifically CHATGPT (artificial intelligence (AI)) and lower cost of production benefits that technology brings and companies focussing on their core product. The impact of AI is far reaching across many sectors, particularly possible job losses as the scope of its use and the massive change are understood. Nvidia, a dominant player in the AI space share price has recovered from the lows of June 2022 and is one of the best performing stocks on the S&P 500 this year.

Mining continues its upward trajectory as there is a recognition there needs to be a significant increase in exploration and development, if the metals required for the climate friendly technologies are to be brought on stream. The easy and high-grade ore has been discovered, removed, and is supplying the world. New deposits being found are of a lower quality and will be more expensive to extract. Energy stocks continue to perform well with oil trading around the USD80 per barrel, and as our research shows global oil demand rises each year by about 2%.

Industrial stocks continue to struggle because of a fall in demand as consumers spend less, supply chain issues and staffing shortages.

China/US tensions over Taiwan and Russia/Ukraine War

These geo-political issues remain at the forefront of peoples’ minds, as they should be. Their global economic and geo-political impact cannot be underestimated, so it is important to closely monitor developments.

LIBOR No More

The London Interbank Offer Rate (LIBOR) has now been replaced by Secured Overnight Financing Rate (SOFR). LIBOR has served for many years as the globally accepted key benchmark interest rate that indicates borrowing costs between banks. It was a primary benchmark in the Eurodollar market. SOFR is the new benchmark interest rate for dollar-denominated derivatives and loans.

Conclusion

Ultimately it is the monetary system that drives the performance of equity markets. We are moving into the northern hemisphere summer and holiday period which historically has seen a pullback and less volatility in equity markets; however, given the issues in the monetary system the next 6 months will be critical. 

As outlined in previous newsletters, we do continue to see opportunities in the store value assets. Please feel free to reach out to discuss.