I genuinely think the stock market recovery of 2023 will go down in history as a false dawn. There are not many real reasons for the level of optimism we’ve seen in stock markets in 2023. We’ve taken this opportunity to take profit on growth assets along the way. It is difficult to see what the drivers are to support the narratives of a ‘soft landing’ or ‘no landing’ that has become the consensus for markets as they oscillate between possible mild recession and no recession.
However, there are a number of issues that could finally come to a head in the short to medium term and act as the catalyst for a crisis. This would lead to a material leg down in share markets and potentially tip the global economy into a recession. Many of these are interlinked but anyone of them could evolve into a serious issue in its own right. Inevitably, one or more of these issues will eventuate, the bigger concern would be if there was a level of contagion that subsequently evolved into a more systemic economic or geopolitical issue.
The most obvious issues are:
Higher interest rates for longer.
Inflation being stubbornly higher than everyone anticipates.
The flow-on effects of the economic slowdown in China.
The ongoing war in Ukraine and Russia’s next steps.
Any of these issues could be the epicentre of a major problem, at any time ahead. We are already seeing the price of oil pushing up headline inflation. While China’s debt and property market is a ticking timebomb that could explode at any point, as is the Russia situation. However, the one issue that stands out to me as having the most amplified impact and highest probability of creating a systemic problem is interest rates being higher for longer. If this does eventuate everything that has been building over the past 12-24 months will eventually come to a head relatively quickly.
Rates staying higher will negatively impact corporate earnings, slow lending, reduce consumer spending and dampen economic growth. Then there are the risks to all borrowers paying higher interest rates and the risk of rising defaults from all kinds of borrowers. We are already seeing this in the US commercial property sector and that would appear to be just the start. Corporate and government bond issuances are becoming increasingly expensive and there is the looming prospect of too much debt being needed from too few investors. Then there’s the flow on effect to banks from lower margins due to paying higher rates on deposits, to higher defaults through to liquidity requirements and losses on bond portfolios. The tentacles of higher interest rates touch every part of the economy.
That said, the biggest immediate impact on stock markets may simply be over the next 3-6 months if markets finally accept that interest rates will be going higher. In the initial share market sell-off in 2022, the share market (especially tech) adjusted to lower valuations that accompany higher interest rates. It’s pretty simple financial math. Except in 2023 we’ve seen ‘multiple expansion’ which is a fancy finance way of saying prices have gone up, but profits haven’t. In other words, while markets have improved in 2023 it’s on the back of financial smoke and mirrors because in many cases profits are actually lower.
In reality, the market was right to adjust lower in 2022 as interest rates went up. Then in 2023, AI and general hype led to multiple expansion, and everyone seemed to hope that as inflation started to fall the implication was that interest rates would too. That was wishful thinking in my mind but 9 months into 2023 and it’s still the implied view of share markets. Not bond markets though. Bond yields are moving higher. As I pointed out a few weeks ago there is a shift in long-term bond markets with yields going materially higher for 10- and 30-year US bonds. Bond markets are telling us rates will be higher for longer.
So, in the simplest terms what should happen (this does not mean it will happen!!) is that if bond markets are right, and I expect they are, then equity markets and especially the big tech that have rallied so hard, are in trouble. On a fundamental basis, if there are sustained higher interest rates on long-term risk-free assets (for example 10-year US Govt bonds) then, mathematically speaking the share market and those stocks are going to revisit those 2022 levels. Now there is nothing that says that does have to happen, even if fundamentally it makes sense. Multiple expansions can last a long time and the simple weight of money flowing into asset classes or specific stocks can hold prices at significantly higher prices than they should be. But I would err on the side of caution and look at the fundamentals.
If the hope of lower interest rates disappears and the penny finally drops for the share market that interest rates are going to be higher for longer then so does the support for the multiple expansion we’ve seen. Keeping in mind that there are also other serious issues from inflation and cost of living pressures to the China slow down through to geopolitical risks. Not to mention any black swan events we don’t even anticipate. We will continue to take a conservative view, taking profit on growth assets and holding an overweight position in cash in anticipation of increased volatility and rates holding higher for longer to provide us with opportunities in due course.
General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.