Pessimistic Optimism is the Only Way to Survive:
Although most of us are predisposed to being optimistic about financial markets and the economy, we are in an era of seismic change in interest rate policy, which will greatly influence the valuations of our financial assets and disposable incomes.
Given these shifts, investors are well-advised to adopt a healthy dose of pessimism to balance out our innately optimistic long-term views – an attitude that will help us maintain our wealth by avoiding the narratives peddled by policymakers.
Initially, central bankers stated that inflation was a temporary and transitory occurrence. When they realized inflation would be persistent, they assured us they had the tools to fight the inflation monster without damaging the entire economy; in other words, causing a recession.
But almost a year on, the prevailing view is that a recession is likely as central banks aggressively ramp up interest rates to get what has proved to be persistent inflation under control. The World Bank recently slashed its growth forecast for 2023 to 1.9%, saying that we are dangerously close to recession and Blackrock, in its fourth-quarter investment update, warned that a deep recession would be needed to get inflation back to the Fed’s inflation target of around 2%.
Up until recently, policymakers and several market watchers have pointed to the strong employment numbers as evidence that a recession is unlikely. However, I believe conditions will likely change rapidly as rates rise and companies start to rationalize workforce requirements to rein in expenses.
Cutting staff is low-hanging fruit. We are already seeing this in the tech sector, with companies like Netflix, Tesla, Shopify, Salesforce, and Robinhood cutting back their employee numbers. Crunchbase News statistics show Lyft at that lower end of the scale, cutting its staff numbers by 2%, and Robinhood at the upper end, downsizing its staff complement by 30%. By mid-October, job losses in the US tech sector had amounted to more than 44,000 workers. More recently, Microsoft also announced job cuts of approximately 1,000 employees.
Amid volatile stock markets and deteriorating investor sentiment, profit has become the new black. More and more companies realize they cannot continue to rack up losses into perpetuity because investors are no longer willing to fund such ventures. Profitless and zombie companies will likely announce more layoffs as they find it hard to meet fixed obligations, such as interest payments on debt.
However, cutting staff and expenditure as a way to achieve profitability is often futile as their entire business models have been built around lofty growth assumptions that no longer look achievable.
Another sign of the deteriorating business environment is the 50% drop in business openings in the second quarter of 2022, as credit reporting agency Equifax reported. This worrying turnaround bodes ill for the economy because it is a reversal of the bounce back in business openings that have been witnessed since Covid-19 restrictions began easing.
On the consumer front, higher-for-longer (HFL) interest rates have yet to have any impact on consumer debt levels, according to the recently released Federal Reserve Consumer Credit report. It shows that outstanding US consumer credit reached historic levels of US$4.7 trillion in August this year when consumer credit increased a hefty 8.3%, far higher than July’s 6% increase.
Generally, higher debt levels, particularly household debt, make the economy more sensitive to interest rate changes. Moody’s Investors Service recently noted that as of the second quarter of this year, global household debt amounted to US$8 trillion – US$1 trillion higher than its pre-pandemic level of about US$7 trillion.
While healthy household savings and strong labour markets are waylaying debt defaults, for now, the report noted, “higher interest rates do act as a drag on real consumer spending because households have to spend a bigger share on servicing debt.”
Consumer sentiment has been hard hit by the deteriorating economic outlook and the prospect of further steep interest rate hikes. As measured by the Bloomberg Nanos Canadian Confidence Index, Canadian consumer confidence fell for the seventh week by mid-October – its worst level since June 2020, and half of the Canadians surveyed expect the economy to weaken over the next few months.
Global economic risks are undoubtedly on the upside across various risk factors. In addition to the risk of central banks overtightening monetary policy and higher-than-expected inflation, the war in Ukraine could further undermine Europe’s economy, with the region already facing a winter of de-industrialization, according to Hans Juergen Kerkhoff, German steel federation WV Stahl president.
Against this challenging backdrop, the economic outlook looks horrible, with talk of economic collapse at the most pessimistic end of the spectrum. For now, there is little evidence to suggest that the US is in recession even though it has experienced two-quarters of negative growth – the technical definition of recession.
However, the National Bureau of Economic Research, the final arbiter of whether the US is in recession or not, has not yet seen the significant decline in economic activity spread across a wide range of indicators over more than a few months that would justify labeling it as a recession.
The IMF’s recent World Economic Outlook sees the global economy as experiencing a “broad-based and sharper-than-expected slowdown.” However, its growth forecasts don’t indicate a worldwide recession next year. It did downgrade its GDP forecasts substantially to 2.7 percent in 2023 – higher than the World Bank’s prediction and a rate that some considered optimistic. But it did warn that the worst was still to come and that 2023 would feel like a recession.
Until recently, investors have remained relatively sanguine about the prospects of a soft landing. However, emerging evidence supports that individual traders are losing interest in the markets. Trading volumes are down, and bullish option bets are falling.
The euphoria that gripped the markets during the COVID-19 lockdowns has mostly disappeared, and the Wall Street Journal reported that it had been the worst year for dip buyers since 1930.
The S&P has declined precipitously and remains in bear market territory for the year to date after falling 25% by the end of the third quarter, notwithstanding recent outsized volatility that has seen 500-point rallies in a day as investors grapple with the mounting economic risks.
Though equity valuations may have improved after the selloffs, it is still difficult to say this is the bottom of the bear market because price-to-earnings (P/E) ratios are still relatively high. In fact, Bloomberg calculates that at a P/E ratio of 17.4 times, this would be the loftiest valuation for any bear market bottom since 1957. Another measure that suggests stocks might be overvalued is the Shiller P/E ratio, which is still about 30 times, and higher than its peak before the 2008 financial crisis.
The bond market has also taken a beating this year, with US Treasuries rising to 4% in response to the Fed’s successive 75 basis point rate hikes. Strategas Research points out that it is the first time that stocks and bonds have fallen in tandem for three consecutive quarters since 1976 – boding ill for investors in the traditional 60-40 equity-bond portfolios, which have delivered returns that have been deep in the red this year.
Investors have been eagerly anticipating a Fed pivot in the lead-up to the last couple of Monetary Policy Committee meetings. However, in my opinion, a Fed pivot would be a very concerning sign that the economic conditions are grave enough to prompt the Fed to abandon their forecasted rate hikes.
With the fallout from the unprecedented events that have shaken the world over the past few years still unfolding, you really need to be a market historian to navigate the environment we are about to enter. Looking forward, I believe that pessimistic optimism is a viable tool, or investment philosophy, to survive the current market carnage.
Garnet O. Powell, MBA, CFA is the President & CEO of Allvista Investment Management Inc., a firm with a dedicated team of investment professionals that manage investment portfolios on behalf of individuals, corporations, and trusts to help them reach their investment goals. He has more than 20 years of experience in the financial markets and investing. He is also the Editor-in-Chief of the Canadian Wealth Advisors Network (CWAN) magazine. He can be reached at gpowell@allvista.ca