Last week we had the pleasure of hosting George Boubouras, one of our independent Investment Committee members, for a few days with us in Auckland. George is an investment industry veteran, a highly sought-after market commentator and adviser to a number of Family Offices globally. He shared his valuable insights on financial markets, including the recent casualties of 2023, where we are in the tightening cycle, the future for the economy and investment considerations when constructing your own portfolio. Below is a brief summary of George’s thoughts on current market conditions. If you’d like to know more, please contact us at info@pauawealth.com.
On the world and global economy
Last year, uncertainty reached a peak in October when markets began pricing in a global recession. This caused global equity markets, and risk assets in general, to fall between 20%-40% (from their recent peak just 9 months earlier) with some sectors such as technology and other high growth companies experiencing even greater declines. The USD strength was also a feature last year given the market uncertainty. The flight to USD safety created additional strain for many countries, with emerging economies facing the most stress.
However, between October and January, we saw the market slowly reprice the very pessimistic outlook as the regular economic data profile continued to show resilience vs expectations whilst the Federal Reserve (The Fed) continued to tighten. Corporate America also adjusted their behaviour ahead of the tightening of credit conditions and were realistic as inventory levels did not expand. Despite rising cost pressures, earnings downgrades were not as severe as previously thought. Further, clarity regarding the rate hike trajectory helped to create some additional certainty and predictability around the future of interest rates.
The consistent array of better economic data vs expectations continued to come through, including data highlighting the resilience in the labour market and in corporate earnings and margins. The fact that the labour market has, so far, remained robust in the face of a slowing economy is a rare occurrence that’s worth noting. The unemployment rate will rise in 2023 and 2024 as a consequence of tighter monetary policy, however the labour market remains strong vs long run historical averages.
Ultimately, global central banks need to solve for the greatest risk facing markets – inflation. Allowing inflation to remain well above targets only creates sub-optimal outcomes for all. Price stability is critical.
With inflation detrimental to households, unemployment, corporations and earnings, by the end of January, interest rates had risen sharply from their lows with the RBNZ leading the world on cash rates. These actions by the RBNZ, the Fed and other central banks leads to demand destruction, effectively pulling the handbrake on the economy to engineer price stability or more predictability for future economic conditions.
IMF economists are anticipating global GDP of 2.9% for 2023, from 3.2% in 2022. This clearly indicates that a global recession is not expected. However, we should anticipate further shocks to the system, as well as pain in households and in certain sectors as the current tight credit conditions are set to be in place until year-end. However, in aggregate, economies should hold up reasonably well. Company earnings look robust – again, in aggregate – as margins have contracted less than expected with such strong headwinds. Again, markets are pricing in future conditions. Equity markets are looking for the earnings recovery in 2024 from the lower earnings profile this year. Bond markets will remain more cautious and are beginning to price in more stress later in 2023.
Of note, the second largest economy, China, is doing the opposite to the Western world, having cut interest rates for the past 18 months and with a slowing inflation rate. China, and its expanding domestic demand, should operate as a cushion for global growth and to recession risks – although less so than it has been in the past. There is, however, still uncertainty over long-term investments in China and, despite potentially extraordinary value, this uncertainty is too high for many.
George is also seeing a shift in approach of many Middle Eastern nations, as they continue to change from petrodollars to non-petrodollars and look to turn their economies into savings centres. Savings are an asset which the world needs. Many are transitioning and innovating their economy, with key focuses on ESG and clean technology.
On the tightening cycle and inflation
Last week, the Federal Reserve raised interest rates by 25 basis points – taking the Fed Funds Rate to a 4.75%-5% target range. We anticipate that they will begin to pause soon with another 25 basis point hike at their next meeting. The market had begun to price in a 50 basis point increase, but the issues surrounding SVB and other US regional banks caused expectations to drop. Some were forecasting the Fed to keep rates flat. A decision to do this, however, would signal to markets that the Fed is concerned about credit risks. Again, central banks must address inflation first and foremost. There will be some unintended consequences along the way.
The Federal Reserve is set to remain hawkish with their language, however we are approaching the top of the rate hike cycle for now (noting that China is doing the opposite). Once central banks reach their peak in interest rates, it’s unlikely that we will see cash rates fall below 2% in the decade ahead. Keeping interest rates at 0% was problematic (in hindsight), as it increased the wealth of the top 1% globally and has led to less than ideal policy outcomes for younger generations and opportunistic governments who may adjust policies on the run. By holding interest rates at higher levels, and therefore maintaining a higher risk-free rate, this will have the result in repricing risk moving forward.
While inflation in the goods sector is decreasing, inflation in the services sector remains stubbornly high. Demand destruction caused by the tightening cycle will lead to more people, in aggregate, falling into financial distress. Monetary policy tightening can cause things to break, although at this stage it is unclear what that will be. It will be important to review the wage cost indices in the US payroll data that comes out, and the ongoing composition of inflation data.
Over the past 15 years, the Federal Reserve’s balance sheet has increased from $1 trillion to $9 trillion due to its quantitative easing program. Over the past year, the Federal Reserve has undertaken quantitative tightening, reducing its assets to around $8.3 trillion. In the last few weeks, this has increased again to $8.65 trillion which has had a stabilising effect on the market. We can expect that the Federal Reserve will have to resume quantitative tightening again.
Regarding SVB, the issue was a key duration mismatch between its assets and liabilities (borrowing short by receiving deposits and lending long by investing in highly rated US long bonds) and the result of a bank run, with US $42 billion withdrawn in one day. In essence, too much cash in the 2018 – 2021 period and not enough loans. For Credit Suisse, its downfall was due to its ongoing underperformance and controversies from their investment bank in recent years, such as Archegos Capital and Greensill Capital. Of note, their wealth management division has consistently been a great performer for generations. Also, they had good regulatory capital (Tier 1) and were well provisioned. Despite having sufficient regulatory capital and the backing of the Swiss National Bank, the Swiss authorities demanded its sale to UBS to help prevent disruption and stabilise global markets. Timing was very unfortunate.
Both of these decisions have been characterised by the speed in which authorities acted, the innovation in approach taken by authorities, and respect for the capital structure. Equity holders have lost out, holders of Credit Suisse “contingent convertible” bonds were marked to zero, while depositors have been made whole. This signals a shift in approach from the Global Financial Crisis, where taxpayers capital had previously been used to save the banks. This is how risk should be priced. The result of this is that the rest of the world may now expect an implicit guarantee of deposits.
On the endowment model
The solution to investing through the noise and volatility is taking a long-term view and adopting a model not unlike endowment funds. That is, diversifying your investments across different asset classes with low correlations, that can protect capital through volatility and across different market cycles. This model has been employed by prominent endowments, such as Harvard and Yale, as well as pension funds, as a way to build wealth over time without the excess volatility of just equities.
The process makes money slowly, reducing the volatility for a similar level of return and limiting large drawdowns in periods of market stress. When volatility increases like it did in March, this diversified asset allocation approach works as a defence mechanism. While cycles will continue, it’s also important to control how we respond to them. What we experienced in markets in the recent volatility was largely driven my emotion, rather than fundamentals like valuations.
Going forward
Going forward, we should anticipate more volatility in markets, largely driven by behavioural factors. So far in 2023, we have already seen Bitcoin up 50% from 1 January, gold at near all-time highs and a forced sale of Credit Suisse.
The innovative and swift approach by governments and regulators to the banking issues may prove an example for how they will deal with future issues, as they look to protect areas of the economy during periods of painful demand destruction.
Equities can rally as their pricing adjusts to changes in future expectations and future credit conditions, reflecting a positive outlook for the future. Forward earnings estimates are looking at calendar 2024 not the lows in 2023. However, expect continued volatility in equities in the short-term.
Strategic asset allocation should be your starting point for diversification. Although there may be periods where asset allocation struggles, having low correlations across different asset classes is crucial to growing wealth slowly. The challenge lies in reacting appropriately to changes in the market, hence being clear on your appetite for risk is critical.
Key take-aways are as follows:
- Get comfortable being uncomfortable.
- Just like every endowment fund and family office, wealth is accumulated slowly and over time, so starting early is crucial.
- Your strategic asset allocation is your protection, so it is crucial to maintain a diversified approach to protecting hard-earned capital.
- As an investor, you need to understand where the safe custody and the jurisdiction of your assets are.
- Now is a good time to invest if you hold cash – but be wary of the volatility and invest gradually.
- It’s important to understand your appetite for risk and how much volatility you can handle.
- Once you have a plan in place, stick to it.
For a recorded market update from George, from Pāua Wealth’s office, please follow this link.