Everything we thought might go wrong at start of the year, has.
Divided government The polls and pundits aside, the likelihood remains that the GOP will recapture the House and very possibly the Senate. The outcome is a likely ramping up in rhetoric on both sides while nothing of substance, and no new big tax-and-spending initiatives, get done. This would be market positive.
China reopens Once the 20th National Party Congress ends later this month, with Xi Jinping emerging with an unprecedented third term as president, it seems likely China will move to ramp up the economy and ease Covid restrictions, providing a catalyst to global growth at a time Europe is in a quagmire.
Ukraine wins How that manifests itself is less certain, but it’s becoming increasingly clear that Russia and particularly Putin are heading for the bad end of a war they started. It could make for some dark days, certainly, but also could lift global sentiment if not animal spirits.
The Fed could thread the needle, even reverse quantitative tightening Given the strength with which consumers and corporations entered this tightening cycle, it’s still possible the Fed gets lucky and achieves the rocky landing we bearishly forecasted six months ago and which would now be considered an upside scenario to the full-on recession that’s all the rage on business channels. Removal of excess liquidity could just remove excesses (housing, employment) rather than drive things into a severe recession. And like the Bank of England stepping in to support the LDI market, the Fed could pare/pause quantitative tightening or even restart quantitative easing—even as it holds rates at 4-5% most of next year. Messy, but consistent with a rocky landing, and from where we sit today, probably market positive.
As the market lurches nervously toward third-quarter quarter earnings season, with the chorus of bears now growling loudly and in unison, we thought it might be instructive to review our beginning-of-year list of market risks and assess where we stand against that list. Our assessment: most of the big risks that we envisioned for 2022 as we turned cautious on markets have now been discounted. Readers may recall we called these potential risks “The Four Fs” and regrettably, the market somehow managed to run the table with them. Straight Fs, if you will.
Unfortunately, still more problems beyond our “Four Fs” are percolating and, in our view, are likely to push the market yet lower. Therefore, we are maintaining our cautious stance with these following recommended positions: near max underweight bonds, max overweight cash/money markets, max underweight growth stocks, overweight defensive value stocks. And we are watching closely for an opportunity to begin buying back into risk assets as the market enters its final months of this dreadful year.
One ugly report card
Let’s review the original Four Fs. While some might view this exercise as depressing and/or self-serving, it’s instructive. The market has truly absorbed and discounted an avalanche of very bad news:
- Fed Policy Error Our concern at the start of the year was the Fed would recognize too late that it needed to begin a tightening cycle to dampen inflationary pressures already unleashed on the economy. At the time, we were months past the point where we and others thought policymakers should have started to reverse their easy money program, so we frankly felt this risk already had begun—it was just a matter of how much worse the Fed made it from there. Unfortunately, the Fed took longer still to get going, and by June had no choice but to lurch forward in big 75 basis-point chunks that are simply too large for company managements, consumers and investors to adjust their activities smoothly. In short, this one came up as a very big, fat F. Check.
- Foreign policy error Again, when we wrote this in early January, we had this one partly sandbagged because of the disastrous pullout from Afghanistan. This debacle had opened the door, we thought, to a potential aggressive move in the Ukraine by an emboldened President Putin or an invasion of Taiwan by the dictator running China. Either risk would likely unsettle markets and in particular drive oil prices above $90. Sure enough, Putin sent in the tanks expecting America to cave and Ukraine to fold, and oil temporarily soared above $120 before coming back to our $90 target, unsettling further the global economy and possibly pushing Europe into a recession this winter. Gulp. Check.
- Fiscal Policy error The concern here that, celebrating their 2020 presidential election sweep against a deeply unpopular Donald Trump, the Democrats would overreach and pass a big additional spending bill that would simply pour fuel—lots of it—on an already blazing inflationary forest fire. And while, in typical Orwellian fashion the resulting “Build Back Better” bill got ironically renamed “The Inflation Reduction Act,” what we really got was the old “Green New Deal” with more than $485 billion of new inflationary spending. More upward pressure on supply chains, more demand-creating “stimulus checks.” Ugh. Check.
- Federalism gone wild Our last concern was to the extent a nearly divided Senate was able to slow the runaway fiscal train, Team Biden would resort to extraordinary executive branch powers to further constrain supply and stimulate demand, the precisely wrong way to slow inflation. The shutdown of U.S. oil exploration/production was Exhibit A of this bone-headed policy error, but others have been forthcoming since. For example, the cancelation of $1 trillion in student loan debt, if court challenges by the Republicans don’t hold up. Oh boy. Check.
Well, that was depressing. Not the sort of report card one would want to take home to show mom and dad. But here’s something to think about. While a short nine months ago the list above was considered debatable, maybe even remote by some, the full list is now largely accepted and acknowledged. Bears are loudly and in unison proclaiming all four risks, and the TV anchors are nodding respectfully. And markets have reacted. Stocks broadly are down 25% on the year as measured by the S&P 500, bonds are down 15% as measured by the Bloomberg US Aggregate Bond Index and growth stocks are off a whopping 30% as measured by the Russell 1000 Growth Index (and 34% in the Nasdaq 100). So, a lot of these risks are now discounted, in our view.
What’s left lurking out there?
A few reasons for remaining cautious are the following possibilities:
- Earnings We wrote our last piece on this topic (“The Anvil that could be coming”) and we do expect the coming season to be pretty rocky. And consensus S&P earnings for next year of $243 remains more than 20% above our own $200 guesstimate, so we expect the consensus number to creep lower as we battle through earnings season. The good news is Strategas Research and a number of other sell-side shops we respect have recently brought their 2023 number in line with us. So, the downward adjustment in the market’s earnings expectations is underway.
- Fed overdoes it Led as it is by academics with little capital markets experience, this Fed has demonstrated little nuance or “feel” for what is really happening on the ground out on Main Street or Wall Street. With Chair Powell clearly obsessed with not going down in history as a latter-day Arthur Burns (for being too dovish too long), our concern now is he risks overdoing his inner Volcker and crashing the economy. At this stage, policy should be shifting toward a period of more gradual hikes and/or an extended pause in the 4-5% range on fed funds. I am not sure we will get that. We’ll see, but for now, I fear the Fed is once again about to commit yet another fateful error, though in the opposite direction.
- Russia-Ukraine war gets worse This is hard to imagine, given how awful it already is. But with Russia clearly losing badly, army morale low, major symbols of the regime literally at the bottom of the sea (the Russian-guided missile cruiser Moskva and the Kerch Bridge), and internal infighting underway within the Russian regime, it is hard to predict, frankly, what a cornered President Putin might do next. Rational game theory would suggest a withdrawal to the pre-February borders and declare “victory,” using his control of the press to sell that idea to the public. We hope this is what he does. But he’s clearly not rational, and he has other chemical and tactical nuclear options that could result in a major escalation with NATO powers. This would be very market disruptive, even off these levels.
- Something breaks Our greatest remaining concern is one we cannot fully identify: that, given the too-rapid monetary policy adjustments of the last 10 months, some weak link in the global economy will simply break. In my 40 years of doing this, I’m sorry to say that when policymakers make sudden policy shifts without giving the other economic players time to adjust accordingly their own activities (trading books, goods orders, real investment plans, house purchases, etc.), something, somewhere, breaks. The good news is that so far, the various bolts popping off the hull as the Fed forces the global economic ship into a sharp 180-degree turn—crypto, LDIs (liability driven investments), emerging markets, the SPACs market, the IPO market—have not proven systemic. The last financial crisis in 2008-09 was so bad, regulators seem to have ring-fenced the core of the financial system, our big banks, this time around. Still, we don’t know what we don’t know, and at Federated Hermes, we are presently developing a realistic list of what could blow up, so we are ready for it.
Adding it all up, it seems to us that while much of the big risks out there have been discounted, others, particularly forward earnings downgrades, have not fully been. We fear, as they are more fully understood, the market is likely to plumb new lows toward our 3,400 downside target and perhaps through it. As we do, expect us to get more constructive. From those levels, even in the more muted post “Rocky Landing” future for economic and earnings growth that we envision, stocks would have several years of solid mid-single returns to look forward to. And, as noted in the accompanying short, there are some potential upside scenarios, too. So, watch this space. Even rocky landings land, eventually. And even straight F students can find redemption, sooner or later.