Even as Election Day has come and gone, the outcome remains uncertain with a Georgia runoff scheduled for December that may determine control of the Senate and multiple states still counting votes days after November 8 to decide control of the House. This partisan uncertainty, unfortunately, aligns with the macroeconomic and geopolitical uncertainty that has persisted throughout 2022.
The Current Market View
Inflation remains near an all-time high, though it’s showing signs of cooling off following the 7.7% data release on November 10th, which was greater than expected). Thus, the Federal Reserve’s hawkish undertone (with a slowdown to rate hike velocity) aligns with the current and projected economic data. U.S. housing remains hard hit along with used vehicles as mortgage rates surge to around 7% and use car demand hits cycle lows. Corporate earnings also remain subpar – especially from large-cap names such as Amazon, Disney, Meta, etc. – causing volatility shock waves throughout markets even with companies with earnings beats and forecast improvements. Unprofitable companies continue to be the hardest hit by tightening monetary policy, a looming recession, and persistent inflation. Credit spreads continue to widen as interest rate hikes persist, though the velocity is likely to slow in the coming Fed meeting. Additionally, credit risks continue to increase across the curve for corporate bonds. Mortgage spreads remain near COVID levels through the first week of November, presenting some opportunistic buying opportunities.
Equities remain volatile with election uncertainty still looming, disappointing earnings, and the cryptocurrency selloff weighing on risk sentiment on November 9th – pulling stocks lower – followed by a CPI beat pushing stocks higher on November 10th. Regardless, post-midterm and Q4 seasonality can help boost stocks into the new year. Though small caps have underperformed the overall equity market, the small-cap value remains poised to deliver the best risk-adjusted equity returns throughout the remainder of the year as core operational strength becomes increasingly essential to valuations. Credit markets will likely continue to tread water until a hawkish Fed ease on interest rate hikes and tees up a policy pivot, likely in 2023. Therefore, credit investors must remain diligent in minimizing duration risk, remain at the front end of the yield curve, and remain opportunistically cautious about credit risk while identifying uncorrelated investments.
As treasuries increase beyond 4%, Agency RMBS, floating rates (bank loans), special situations, and short-term corporates remain the most attractive fixed-income investment opportunities. Commodities remain attractive as inflation will likely be stickier than expected. Energy markets will likely continue to remain rangebound, with geopolitical uncertainties lurking in the economic background. Agricultural commodities remain supported by inflation, with fertilizers likely to experience a seasonal slowdown in the winter months. Battery metals remain a crucial growth arena in commodities, with lithium demand expected to skyrocket through 2035 amid the electrification of vehicles and the associated infrastructure.
Economics remains murkier and more uncertain. As we have discussed the path toward stagflation since October 2021, many investors need to be made aware that the period leading up to stagflation is much more problematic. That troubling economic period: financial repression or an economic term referring to governments indirectly borrowing from industry to pay off public debts. In short, this is not the first-time financial repression was necessary. Following the American and European debt crisis after WW2 in 1945 through 1980, financial repression was necessary to bring down government debt levels (U.S. 120% debt to GDP) by keeping short-term interest rates below nominal GDP growth (short-term rates below 10-year Treasury) keeping deposit rates negative in real terms, helping reduce debt to GDP by 3% per annum throughout this period. Financial repression was again a reaction to the Great Financial Crisis (GFC), with short-term rates kept below nominal GDP growth to help reduce household debt. Unfortunately, corporations and the federal government increased their debt loads as the low-rate environment was easy money for self-interest growth measures. Thus, since GFC, the government debt-to-GDP remains at all-time highs dwarfing (3x debt to GDP) the 120% of GDP seen in the post-WW2 era. Covid-19’s easy money and stimulus, coupled with ultra-low interest rates, further propelled the debt to GDP levels beyond pre-COVID expectations.
Additionally, central banks’ aggressive purchasing of securities increased government spending during quantitative easing. Politically, low-interest rates are in high demand as the average maturity of the national debt-to-interest rate ratio increases as government costs remain a large percentage of relative GDP in interest costs. Therefore, the rate hike path of the Federal Reserve appears to have a half-life (a max terminal rate of 5.5%) even though inflation will likely remain one standard deviation above the long-pitched 2% target rate. Therefore, inflation will likely come down from the 9%, 40-year highs but likely remain rangebound around 4% amid the government’s attempt to tame their exceedingly high debt levels and an increasing money supply. In short, fiscal policy will overshadow monetary policy -highlighted by increased fiscal spending agendas and demand for lower interest rates – developing a new policy dynamic that can move markets.
Understanding Financial Repression
Though financial repression is strategic employment to reduce government debt with private sector money, it does have its downsides. Government creditors are hurt, and the government will likely assume a more significant role as credit becomes de-pegged from market prices, as yields are not adjusting for inflation. Bondholders remain overly exposed to the downsides, underscoring our focus on uncorrelated and short-term bonds. However, gold exposure remains a key diversification for increasing interest rates. Uniquely enough, equities are not directly affected by financial repression, and coincidentally, equities do well during these periods historically, as seen by post-WW2 and GFC periods. However, as bond yields rise, equity prices will normalize as valuations come in. Therefore, value investors (especially small-cap value) remain best positioned to outperform during financial repression and a stagflation dynamic. Furthermore, during financial repression, wealth is shifted between the old and the young, including pensions and insurers, when governments direct savings towards policy-driven ends such as green/sustainability efforts. Therefore, sectors on the other side of these politically oriented initiatives, such as climate change, sustainability, etc., can yield investors’ growth and value investment opportunities.
Furthermore, increased corporate regulations related to buybacks and leverage buyouts can be squeezed out as the means to use financial engineering, as using cheap credit will likely be prevented to meet governmental goals. Capital flight may follow, paving the way for potential capital controls not seen since Bretton Woods. Additionally, persistently high inflation may lead to unionization, paving the argument toward stagflation. If the political process drives capital development (with inflation and slowing economic growth directly), financial repression leads to stagflation.
Though this topic is highly debated, it is prudent to illustrate the dynamic necessary throughout history to reduce government debt levels. Though the 1990s’ wave of liberalization increased interventionist policies as an alternative impartial governmental process, the current dynamics of high inflation, slowing growth, record high debt to GDP, limitations to the interest rate hike, etc., sound some alarms of financial repression repeating with stagflation the longer-term outcome. If that is the case, investors must start positioning their portfolios to weather the economics.
Conclusion and Positioning
As we mentioned, in credit markets, uncorrelated fixed income (legacy NARMBS), special situations, short-term corporates, and floating rate bonds can help weather extensive down drafts and provide opportunistic outperformance. However, gold, small-cap value, and multi-strategy alternatives (the 20% of 50/30/20 allocations) remain poised to deliver the highest risk-adjusted returns through potential financial repression and, ultimately, stagflation.