A Monetary U-Turn Looming?
In our last edition of our InSights report, we were focusing on the rapidly rising inflationary pressures, as well as on the expected rate hikes from central banks around the world. We would like to revisit the points we raised back in spring and present an outlook for the coming months.
“A Monetary U-Turn Looming?” is an excerpt from the Q4, 2022 BFI InSights, a quarterly newsletter created by BFI Infinity AG. You can read this entire InSights, as well as previous issues, by visiting the following website: https://www.bfiwealth.com/insights. All invested clients and partners of BFI Infinity receive the InSights automatically, but you can subscribe to be part of those recipients every quarter, and learn more about BFI Infinity in the process, by visiting their website.
The big picture has changed rather dramatically since then, with inflation reaching levels between 8% and 10% in the western world, something that was unimaginable just a year ago. The rate hikes we have seen in the meantime also added to the pressure, with major markets now having dropped between 10% and 35%. The drop was especially pronounced in markets like the Nasdaq, which typically consists of growth companies. The Nasdaq is down 33% year-to-date, European markets are also down as much as U.S. markets, so we are dealing with a global bear market. This bear market is now almost 10 months old, and it might persist for a while longer, so investors are certainly well advised to hold some downside protection for the time being.
Besides inflation and rate hikes, the market is also burdened by geopolitical concerns. The war in Ukraine continues without an end in sight and recently the tensions between Taiwan and China (and therefore China and the U.S.) have escalated again. While the geopolitical concerns are hard to overcome at the moment, investors are waiting for a market recovery. What could trigger such a recovery?
Our readers remember that we talked about a potential monetary U-turn in the past, as we expected and still expect the interest rate hike cycle to end sooner or later. In the morning of October 4, 2022, the Reserve bank of Australia was the first central bank to slow down the pace of its rate hikes, pointing to lower inflationary pressures. A reversal in the inflation trend and in falling yields would certainly be a very positive factor that could drive a potential recovery. Indeed, we think that the inflationary pressures will soon begin to ease. In fact, we believe that this process has already started in recent weeks. A lot of commodities have seen substantial drops in prices in recent weeks, with oil and gas down 20%+, nickel and iron ore down 30%, global shipping rates down 60%, etc. These lower input costs will only now find their way into the official statistics and with the global economy continuing to slow down, the deflationary tendencies will become even stronger.
Despite the fact that we don’t expect inflation to fall to the extremely low levels we had in the past, we certainly see it dropping much lower than 8%+ levels we have now. And as lower costs begin to show up in official statistics, central banks will probably soon refocus on the support of the economy, once they are confident that rising prices have been tamed. We might see this policy shift between now and the end of Q1 2023.
The chances for a substantial market recovery should therefore not be underestimated, however, the short-term risks remain and we recommend that investors still keep a downside hedge for the time being. Should the monetary U-turn indeed materialize, we would not only expect stock markets to bounce strongly, but also the Dollar to face more resistance. We are not sure yet to what extent, but after its steep rise over the past few months, it is absolutely possible to see a substantial correction of the greenback.
As for the geopolitical factors and mainly the Ukraine war, they appear to have had a muted effect as of late. While Europe seems to be finding alternative sources for its energy needs, mostly countries in the Middle East, the sharp increase in energy costs has also caused inflation to spike and created serious financial strain for European consumers. In recent weeks, however, natural gas prices in Europe fell rather dramatically, as can be seen in the following chart.
Prices have almost been cut in half from the peak seen in late August. Gas-saving initiatives, almost full storage facilities and an increase in supply from non-Russian sources seem to be driving prices further down. While we are more confident on the European energy situation than we were a few weeks ago, we still remain concerned in the short run. In the long term, however, a positive effect of the energy crisis is that most European countries have embraced a more pragmatic approach and seem to have made securing ample supply a top priority.
Even with the positive market start in October, with major indices rising by almost 5%, we remain careful as long as we are still in a bear market. However, the current market environment presents us with entry opportunities and we want to take advantage of this. We will continue to phase in some of the cash we have been holding on the sidelines. While steadily increasing our equity allocation again, we are also planning to roll our equity hedges in order to have strong downside protection. While our outlook has improved somewhat, we still need to see a full monetary U-turn (combined with easing inflation).
Still, we see the current market situation as a window of opportunity to pick up long-term investments at very reasonable prices. The opportunities that we find are all connected to so-called “Supertrends” or “Megatrends”, for example industries like cybersecurity that will see huge growth opportunities for years to come, because of rapidly rising digitalization. Rather than simply holding the broader market, it will be key in the future to focus on these megatrends. Of course, we will diversify, but never at the expense of conviction. In the second part of our investment update, we are providing you with an interesting summary on the cyber security industry that will explain why we are so positive on the sector long-term.
Source: Refinitiv, ECR Research
With the easing of inflation, we are also expecting sliding bond market yields. However, we are of the opinion that yields will fall temporarily but see a risk that they will go up again in the future. In the precious metals market, prices have also seen a decline, with gold falling to a level of almost USD 1600/ounce. However, this level was holding up really well and prices have since then rallied above the USD 1700/ounce.
While we do see a silver lining on the horizon, we also want to reiterate that the current bear market is not over. Since 1928, there have been 28 bear markets, lasting around 9 months on average and with markets falling around 35%, so the current bear is pretty much average. Of course, this bear market can go on for longer, but what it seems to have in common with its predecessors is that it presents an excellent buying opportunity for the long-term minded investor. This is especially true from the point of view of an American investor that can sell some of their overvalued U.S. Dollars and buy into cheaper and more attractive currencies long-term.
Investment success is based on long-term vision, and it requires the discipline to go through bear markets like this one. Investors who have these qualities will be rewarded once the markets start to recover. Typically, the rally after a bear market delivers substantial gains within a short period of time.
We wish you a nice fall and we remain at your disposal for any questions you may have. We will also be working on our year-end 2023 outlook in the coming weeks, which we will share with you soon.