Pain Or Gain

July 20, 2022

The past two weeks have been marked by a lot of hand wringing about the direction of the markets. Many financial market heavyweights have been recalculating their expectations for markets at year end and looking at a wide variety of metrics to come to terms with where we are and imagine where we will go.

For those that read these musings, it is unlikely that all of that reading is on your todo list, so here are some highlights:

  • JP Morgan – In Mid June, JPM expected a sharp jump in markets and a return to 4,900 by year end. The bank’s CEO, Jamie Dimon, has reiterated many times that the economy is facing significant hurdles. JPM is the largest bank in the USA by far
  • Bank of America – Lowered their target to 3,600. It was 4,500 before this cut. Worst case, according to BofA is 3,000-3,200. BofA is the second largest bank in the US.
  • Wells Fargo – Dropped their year end target to 3,900 (from 4,300) [July 13]. They are the third largest bank in the USA.
  • CitiGroup – Also sticking with 4,200 as of late June. Fourth largest bank.
  • UBS – Cut their target to 4,150 in 2022 and 4,300 in 2023 [Jul 11, 2022]. This is in contrast to a June 6 report that forecast a year end target of 3,900. Even within UBS it looks like they have a difference of opinion. In December they thought 4,850 would be the year end number.
  • Credit Suisse – Sticking with a 4,300 target.
  • Piper Sandler – Holding onto their forecast for 3,400 on the S&P at year end. Notably, in May, that was considered their bear case, but now it is their baseline case.

Most, if not all, of these banks were very positive on the outlook and the economy at the start of the year, and continued to sound positive while the economy encountered it’s many difficulties. Their acknowledgement that markets are unlikely to go much higher is still (STILL) being met with optimism.

Anyone who is trying to figure out whether it is safe yet is faced with the constant dilemma in investing; ‘Am I paying too much?’ Over the past year it was pretty clear that asset prices were too high and would come down, however the difficulty is figuring out how high they will go before they turn down and how low they will go before they stop falling. The analysis is harder now.

With markets now down about 18% (US) and 14% (Canada), the answer is not so clear. A lot of risk has been taken out of the markets (leverage has been cleared out), and the factors that lead to the excessive rise in asset values are moderating. Most investing activity is driven by excess cash (investment capital), earnings, interest rates and taxation. The negative effects of these actions have mostly been accounted for now and human activity is returning to normal after COVID restrictions.

The plan by the federal reserve to perform quantitative tightening is finally underway now, and markets know largely what to expect. While the impact of that plan will take years to work through, the information provided to market strategists allows them to model the future with these details. The current expectation is that any changes would be to REDUCE purchases (increase liquidity) rather than to become more stringent. Of course liquidity is affected by many other things, and interest rates, inflation, profit margins and capital spending all affect liquidity at various levels. Some of these effects will remain volatile, but the federal reserve’s reduced liquidity was the largest factor in recent market declines.

Earnings estimates have been revised substantially over the past two months. With second quarter earnings season currently underway, the lack of significant downside to markets (indeed upside) suggests that the earnings outlook is stabilizing. Given the changes to liquidity, there is plenty of room for market volatility, but the market levels seems to accommodate the current outlook.

Headlines are full of stories about inflation, and that is a constant worry for markets. Inflation is measured after the fact, and once it enters the system it is hard to measure and manage. At the same time, it is reported after it has already impacted prices making it very difficult to predict its affect on major economic factors such as profits and demand. Inflation will cause significant uncertainty for months into the future.

The last piece of the puzzle will be taxation. Regulations, including laws, rules, and taxation are slow to impact economies, but their effects are long lasting. Rational analysis suggests that taxation will have to increase, but these changes haven’t really been implemented effectively. Contrary to the necessity of increasing revenue for government, tax holidays are being offered to blunt the impact the inflation impacting individuals.

Markets take all of this into account early, and the reset in valuations is clearly leading to increased investing activity again. As one strategist highlighted, when the turn comes it could happen very, very quickly. Matching this with a massive amount of liquidity (cash) on the sidelines and there is fuel for a significant bounce in markets.

This space isn’t too hopeful long term though. In line with the pessimistic view from others, there is still a lot of room for downside surprises. Surges in the market are being met with significant selling, and there are a lot of problems still popping their heads up. Two barometers worth watching are commodity prices (which surged earlier in the year on expectations of increasing demand) that have come down sharply in just a few weeks. This will reduce inflationary pressures, but also reflect reduced demand and a slowing economy. The other is the US dollar which is rising rapidly in a sign that investment is leaving other parts of the world for the ‘safety’ of the US and its prowess as a financial center. This rise also has negatives, but it is a sign that there are few better places to invest.

Some of the risks are still systemic risks and outcomes can be significant and drastic. They are also difficult to predict. Here are some of the issues that have little by way of resolution:

  • Sovereign nations are in dire financial straights. The Euro zone (Italy specifically) is the most worrisome, but there are over a dozen countries that are either in default or close to it.
  • China’s economy is facing many difficulties. Their real estate problems continue to worsen, and their Covid restrictions are having a dramatic negative effect on production, consumption and social structures. Many of these problems could cause significant social unrest.
  • Bond Markets appear to have stabilized but the massive amount of debt that needs to be absorbed to support the world economy is likely to be a drag on investment for years to come.
  • Weather warnings have been ongoing for at least a decade, but the impact of extreme weather is becoming ever more obvious. Extreme heat may seriously impact humanity in 2022, with death and destruction happening in a wide variety of places.
  • The ability for people to get adequate nutrition is also becoming worse rapidly. There are problems with availability, affordability and distribution of food in many parts of the world. When people can’t eat, unrest is sure to follow.
  • Finally, the possibility of geopolitical unrest is a significant, with Russia and the Ukraine already involved in a major conflict, there is room for further outbreaks around the world.

Investing is always hard, and while the odds of getting a ‘good price’ on an investment now is much higher than earlier in the year, the global outlook is not flashing an all clear. There are many worrying signs about the world, and so focusing on companies that provide must have products and services is likely the best course.

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