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As we are heading towards 2023, supply chain issues, war in Ukraine, ongoing COVID-19 lockdowns in China, persistent inflation, and rising interest rates / per se capital costs for corporations continue to be the key challenge for financial markets in 2023. Ever since Spring 2020, markets have gone through shocks and after-shocks, while geopolitical tensions have added an even higher level of disruption throughout the global supply chain. The main concerns are by how much growth deceleration there will be and what will be the impact on corporate earnings.
A new playbook After almost 40 years of global cyclical prosperity, markets have most likely reached a structural inflection point; long-duration assets may be outdated for some time because as interest rates head in the opposite direction, the era with ample liquidity ever since the GFC may come to an end sooner than expected, and managed inflation belongs to the past too.
The new paradigm is expected to offset the effects of the central bank liquidity that helped stabilize markets and economies each time there were some concerns. Market participants were relying on the latter to support standard valuations methods with a low level of inflation and a low level of interest rates. As for the immediate future, the higher rate of inflation will impact energy and food. The higher expenses for these basics are expected to impact consumer financials, the main engine for global economic growth. For corporations, higher interest rates mean that earnings need to grow faster to support positive equity performance. Yet, higher input costs (raw materials and salaries) are expected, all things being equal, to cut into profit margins. As we each the end of the last cycle period, further valuation adjustments may occur in the tech sector, and the broader industry may suffer from labor, respectively a skill shortage. To cope with the latter, manpower will be more expensive but not necessarily more efficient.
What about inflation? The central point is when inflation is peaking and, if so, whether deceleration is fast enough to get the economy off the need for crutches. Surrounding conditions still look optimal; the labor market is buoyant and home prices are expected to keep progressing – remember, home prices have risen in some regions by more than 20% during the past two years. There is no change expected to this; In the past financing rates were lower, today, the offers are limited.
In the event the rate of inflation settles soon around the long-term average of 3%, then it is equity supportive. Otherwise, should the rate of inflation escape further and approach a double-digit figure, Central Bank would be required to do much more to keep stopping the inflationary spiral; if so, equities would be expected dip deeper into bear market territory.
Finally, it is worthwhile to consider the present geopolitical tension. Beyond the destruction and human suffering inflicted by the conflict itself, the war threatens to worsen the already imbalanced food supply chain for the world’s poorest countries, spur a new arms race, and block cooperation on problems like climate change and nuclear proliferation. Taken individually, any of these concerns is merely inflationary – yet all of them together support concerns for an inflationary regime. What kind of inflation? Inflation is a concern to many of us. Yet, we have to distinguish between an excess debt-based recession and an excess liquidity-based recession. In the past, recessions were mainly debt-based, and it took corporations almost decades to overcome the impact. Today, if there is a recession, it will be a liquidity based recession and we would expect the latter to impact the valuation of overpriced corporations.
Recognizing the difference is key, as mere companies will run into deep trouble while the majority will still bank on solid footing. The outcome is that the recession will be less severe. In fact, we note that a) the housing and the auto industries are still strong, b) the labor market dynamics are good, c) the average corporate entity has an excellent balance sheet status, and d) corporate revenues, though lower, are solid.
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