10 Summer Reflections – Looking Across The Valley

  |   Macro, Geopolitics

Dear Friends, 

2022 has seen dramatic changes of generational proportions including post pandemic effects, a war in Europe, sharply spiking inflation and major economic dislocations and capital market losses. 

For the time being we stick to our defensive investment stance, as initiated and published since December 2021. However, markets are already showing some signs of pricing ‘across the valley’, meaning into 2023. Out of the box thinking and playing different scenarios will be instrumental in timely tapping upcoming opportunities. 

We hereafter share our ten points of thinking to hopefully provide some guidance and reflection through testing times:

1) Russia won’t back down – European Winter of Discontent ahead 

Geopolitically speaking we live through history making times, characterized by the war in Europe and a global energy and food crisis. 

The unilateral Russian military attack breaking international laws and the established post WW ll order in Europe is a massive and appalling game changer that cannot and will not be tolerated by the West nor the relevant multilateral institutions. 

Russia will not back down as the regime in Moscow remains hostage to its imperial narrative and miscalculations. History tells us that appeasement strategies with rogue states mean complicity and that negotiations should only take place if and when full sovereignty is reestablished by military means. 

2) Sliding into a Recession with widely varying Outcomes

The global economy remains stuck in a perfect storm environment of supply chain frictions, demand destruction, painful inflation, rising interest rates, falling corporate earnings and a potential financial accident. 

Our base case has not changed. We are facing a global recession, yet with widely diverging effects on different regions, countries and sectors. Inflation rates so far remain materially higher than interest rates. Something will have to give – diminishing inflation to target inflation rates asks for lower economic activity and higher unemployment. 

Thanks to its energy and natural resources independence and much lower exposure to world trade, the US is much better off than Europe, in return facing a fast worsening macro environment – with painful fall outs –  and costly adjustment processes.  Worst off are heavily indebted developing countries that are exposed to the high and rising USD and suffer under sharply higher energy and food prices and respective shortages. Expect sovereign defaults, political upheavals, crashing economies and defaulting companies. 

3) Central Banks to Restore Credibility 

Monetary policy and liquidity conditions have been to loose for too long, largely because elected politicians have left the heavy lifting of structural adjustments and occasional financial crisis management to the central banks. 

The ongoing monetary tightening combined with fiscal tightening into a steadily declining economic activity will lead to significantly weakened consumption and investment. 

Central banks led by the FED are now determined to restore lost credibility. There will be lagging and prolonged negative economic effects to their tightening. However, a normalization of monetary and interest rates policy is a much needed and welcome development in the long run. 

4) The Specter of Inflation 

The trouble with inflation rates is that war related shocks in Europe and the starting wage spiral of the past months have led them exceedingly above interest rate levels. Yet, there is light at the end of the tunnel – the force of recently slowing upward momentum and favorable base effects will lead to lower levels in H2 2022.

No matter what, central banks will have to regain credibility in regards to their policy mandates. On the bright side, longer term inflation expectations remain rather well anchored looking at the performance of gold, long duration sovereigns and inflation protected securities. 

5) Energy – Paying for past Mistakes

The West is too often too greedy and too short term for its own good, lacking long term planning. Russia has ruthlessly exploited this weakness and wishful thinking. 

Europe, and Germany in particular, went into irresponsible dependence on Russian energy, exacerbated by the inexcusable structural mistake to quit nuclear and fossil energy before establishing alternative and renewable energy sources. 

The transition to a sustainable future without Russian energy will be costly, lengthy and painful but necessary. Rejecting Russia‘s blackmail and maneuverings is key. 

A cut in well coordinated, principled and pan-European energy consumption is the first and very digestible step. 

6) Corporates – The Turkey Comes Home to Roost

The corporate sector remains on a downward trajectory. For the foreseeable future we can forget about the easy days of rampant deal making in IPOs, M&A, LBOs, SPACS and fundraisings. 

The combination of restrictive monetary conditions, tightening lending standards, falling economic activity and growing investors’ risk aversion will lead to lower valuations, widening credit spreads and rising corporate defaults. 

7) The Danger of a Major Financial Accident 

Risk assets move in cycles from overshooting to undershooting in prices and valuations. Along the way over-hyped assets with no intrinsic values crash and investable bottoms in markets are only reached once weak links break and investors capitulate. 

The list of weak-links candidates is rather long and includes zombie-type European universal banks, LBO financed corporates, over-leveraged shadow banking players and over-indebted emerging market sovereigns.

In addition we might face the unwelcome surprise of a major financial accident posing a risk to financial stability, leading investors to capitulate and relevant policymakers blinking into action. 

8) Resilience followed by Adaptability 

There is little doubt that democratic and capitalistic countries will adapt and emerge stronger and that the sheer resilience and capacity to absorb shocks and changes but rather innovate should not be underestimated. 

The historic irony is that Russia has been and can be expected to be quite resilient, yet will emerge much weaker geopolitically and impoverished economically. 

Sanctions have led to much controversy and misunderstandings on all sides. Sanctions don’t aim at regime change in Moscow – see Cuba, Venezuela, North Korea and Iran, for that matter. Yet, they serve to isolate, contain and reduce Russia’s capacity for unlawful aggression in the future. 

9) Markets on a Roller Coaster 

Today’s environment still warrants a largely defensive investment stance focused on cash in reference currency, high quality equity and, to some extent, sovereign bonds.

Let us remember, equity markets look ahead and are discounting mechanisms, therefore, sectors including energy, infrastructure and aerospace & defense are structurally attractive. A relief rally, on the other hand, could benefit battered sectors such as technology, finance and consumer discretionary. 

10) Extraordinary Times – Extraordinary Opportunities 

Times of emotional, intellectual and financial dislocations and distress are the ideal breeding ground for extraordinary investment and entrepreneurial opportunities. 

The big new trends in H2 2022 and 2023 won’t be the same as 2022 YTD. We have reached high risk aversion in risk assets, strong negative consensus in the inflation outlook and the USD trade has become very crowded. 

It is a matter of fact that there is a wide range of potential macro outcomes depending on data, events and decisions being taken by policymakers and corporate leaders. Remaining vigilant and prepared remains of the essence.

Article by Beat Wittmann, Chief Investment Strategist at Key Family Partners SA