A World in Turmoil

November 10, 2023

Monthly View 

Harmen Overdijk

War in the Middle East and Ukraine, defaulting Chinese property developers, mixed economic data in the U.S. and China, and sharply rising and then falling bond yields. It all created a lot of volatility in financial markets. After the negative market sentiment continued in October, the price action last week was pivotal. It was almost as if the Federal Reserve had announced a rate cut at the November FOMC meeting. For US equities, it was one of the strongest weekly gains since 2020. The price action was an impulsive reaction to the Fed meeting comments. While there was clearly an element of short covering for U.S. Treasuries there was also a fundamental shift in short term interest rate expectations that contributed to a belief in a lower discount rate for equities.

A Macro Slowdown

The shift in interest rate expectations was warranted by the recent macro news flow. The weakness in key leading indicators such as ISM new orders, employment and non-farm payrolls suggests that growth momentum is clearly slowing. The leading indicators of the labor market are consistent with a slowdown in demand for labor.

The U.S. Nonfarm Payroll report indicates that labor market conditions cooled in October. The 150,000 increase in payroll employment fell below expectations of 180,000 new jobs and marks a slowdown from the 336,000 September number Moreover, the cumulative increase in the prior two months was revised down by 101,000. The employment report added further downside pressure on U.S. Treasury yields which have been falling since the November 1st FOMC meeting.

Although the unemployment rate is now 0.5 percentage points above where it was at the start of the year, and is now at its highest level since January 2022, it is nevertheless still near historic lows. Additionally, the number of job openings per unemployed worker remains elevated (1.5:1 ratio), signaling that labor market conditions continue to be tight.

A cooling of the labor market reduces the need for the Fed to hike interest rates further. That said, considering that employment conditions are still tight, it is likely too early to bet on a pivot to a policy-easing stance and a significant decline in Treasury yields. Instead, yields are likely to be rangebound over the coming months until there is clear evidence of a meaningful breakdown in the jobs market. By mid-2024, the unemployment rate could rise towards 4.5% but at the same time, we will likely see inflation continuing to come down.

So far, the disinflation process has been primarily driven by supply-side dynamics. Core PCE inflation has dropped 200 basis points from its top without any meaningful weakness in the broad economy, and this is consistent with the fact that supply-driven inflation has led the disinflation process. Going forward, our conviction is that core PCE inflation will continue to fall, probably to levels of 2% or lower, by the summer of 2024, because of softening demand.

This will test the Fed’s “Higher for Longer” resolve, as there will be a moment when it will be unnecessary to keep high interest rates to reduce economic growth. The risk is that the Fed will keep rates high for too long and that the economic slowdown will become a recession.

Despite the global turmoil, we think there is a possibility that the combination of a softening jobs market, lower inflation, and falling bond yields, as well as still positive economic growth, creates a short-term “goldilocks” environment that will be positive for stocks. While September and October are historically volatile months, November to April is historically a much better seasonal period for risk assets. Financial markets are anticipatory and any meaningful softness in the labor market will lead to rising expectations of a Fed policy pivot in 2024. The recent sharp rally in both stocks and bonds could signal that the first condition is starting to fall into place.

We think that international stock markets could outperform the U.S. market in the coming months, helped by the strengthening of local currencies. The main risk for global financial markets is a possible escalation of the war in Israel and Gaza.

U.S. Government Shutdown?

The U.S. is facing another government spending deadline on November 17th. House Republicans chose to avoid a government shutdown on October 1 and instead extended government funding until November 17. However, this caused the ousting of House Speaker Kevin McCarthy. He was replaced by Mike Johnson, who enjoys greater party goodwill. Johnson is now attempting to steer the annual government appropriation bills through the House and wants to further slash discretionary spending, beyond what was agreed with Democrats during the June debt ceiling deal. Johnson might seek another short-term funding extension, until either mid-January or mid-April 2024, as more time is needed to craft the 12 government funding appropriation bills. Potential Republican House resistance to another short-term government funding increase could lead to a government shutdown after November 17, though a short-term funding bill seems likely for now. Nevertheless, even if Johnson’s proposals pass the House, they are expected to be rejected by the Democrat-led Senate and the White House. Thus, a shutdown, either later this year or in early 2024, remains possible.

However, depending on the duration, a government shutdown might not even hurt equity market sentiment much, as it would have a cooling effect on economic growth and inflation, which could lead to a further dovish turn by the Fed.

How Will Israel & Hamas Impact Markets?

Following Hamas’ surprise October 7 attack on Israel, its indiscriminate killings of civilians and hostage-taking, Israel has begun to retaliate through air strikes, military raids and a blockade of the Gaza Strip.

Israel’s primary objective is the eradication of Hamas as the dominant military and political actor in the Gaza Strip. Given the severity and sophistication of Hamas’ attack, Israel perceives a robust response as an existential issue, needing to reestablish deterrence vs. Hamas, Hezbollah, and ultimately vs. their main backer, Iran. Letting the precedent set by the Hamas-led attacks go without severe retaliation, could jeopardize Israel’s security and viability longer-term. The newly formed Israeli unity government has articulated this sentiment.

The key question, however, is how widely the conflict will spread, and if it would impact global markets. This is impossible to predict. The U.S. Government seems to be playing an active role in deterring other actors from entering the conflict.

The key risk for global financial markets is a further escalation of the conflict. If Hezbollah and/or Iran would actively participate in the conflict it will highly likely trigger a military reaction from the U.S.

China’s Housing Slump

Contrary to popular belief, Chinese equities have largely kept pace with global equities in the second half of this year amid mixed economic data. Investors remain cautious, reflecting the deep confidence crisis the country is experiencing, as the emerging economic recovery is not yet solid. The good news is that Beijing is finally opening the fiscal valve to help growth. The bad news is it’s not yet enough and additional stimulus is still needed, given the scope of domestic growth challenges.

The housing slump still presents headwinds for China’s growth outlook, and the economy will not stage a strong recovery without improvement in the real estate market. However, it is also important to maintain a proper perspective. We believe China’s housing crisis has nothing to do with demographic factors, rather, it is a man-made disaster due to credit constraints imposed on developers.

After a two-year slump, Chinese home sales have plunged by a whopping 40% from the peak, mortgage borrowings have essentially vanished, and household deposits have skyrocketed. All of these suggest that housing demand has likely significantly undershot the underlying long-term trend, and pent-up demand has likely already begun to accumulate. Meanwhile, the government is mulling another round of social housing program in major cities, which could reduce excess supplies. It is probably not a question of “if” but “when” the housing sector will bounce back.

The bottom line is that the real estate sector remains a critical signpost to monitor China’s growth recovery, and so far, there is no clear sign of bottoming. However, expectations of a housing market collapse are also not warranted. Even if housing activity remains deeply depressed, on a rate-of change basis these indicators will likely begin to improve. Ultimately the drag of the housing sector on economic growth will diminish.

Typically, the combination of improving growth conditions and easing macro policies should create a sweet spot for Chinese stock prices. This cycle is not typical, however, and will take longer to play out due to the badly damaged confidence among investors. That said, Chinese stocks have become exceptionally cheap by historical standards, evidenced not only by the deeply depressed valuation indicators, but also by the record-high share buybacks from listed Chinese firms.

Fixed Income Opportunities

U.S. Treasury prices could rally, as the Fed will likely turn more dovish as GDP growth slows over the next year. Other threats to the U.S. economy or financial system could also bolster U.S. Treasury prices. While fiscal concerns are mounting, U.S. Treasury demand will likely stay robust. High foreign purchases and low U.S. CDS spreads indicate no fear of a looming sovereign debt crisis.

We expect periods of yield retracement, driven largely by a return to dovish Fed comments on mixed economic data and a flight to safety as conflict escalates in the Middle East. US Treasuries remain at attractive values as the absolute level of yields offers a buffer against additional rate hikes, while also offering scope for capital appreciation as the Treasury market will eventually discount rate cuts by the US Fed.

Municipal bonds (Muni’s), which have been shunned over the past two years, have seen a pickup in investor inflows as increased issuance has pushed absolute yields higher. The Muni yield curve offers attractive yields at medium to longer term maturities. At the marginal highest US tax brackets, Investment Grade Munis offer a +1.0% – 2.5% yield pickup over Treasuries and Corporate bonds across the curve. In addition, closed-end Muni funds are trading at a 10%-15% discount to value, three standard deviations below 25-year averages, due to investor outflows and the negative effects of fund leverage. While state and local government collections are down year over year, they have stabilized since Q1 2023 and do not pose a credit risk in our view.

Expected returns in bonds have no longer become lopsided – the high nominal yields provide a buffer in the event the Fed does raise rates. Spreads have widened modestly in both Investment Grade and High Yield and are likely to start to increase into year-end, offering less attractive values vs. their superior returns year to date. While the Fed has called for a higher for longer interest rate regime, we believe that higher real yields, anomalies in employment data, and falling inflation, place a near-term cap on yields and an opportunity to increase fixed income duration.

Is the U.S. Dollar Overvalued?

While we think the US dollar could weaken over the next few quarters if U.S. bond yields edge lower, it would probably strengthen again in the second half of 2024 once a global economic slowdown takes hold. As a countercyclical currency, the dollar usually strengthens when global growth falters. Any strength in the US dollar during the next slowdown or recession will likely be short-lived, as the dollar is overvalued relative to its Purchasing Power Parity (PPP) exchange rate, which has historically been a good guide to the dollar’s long-term direction. Structurally higher interest rates relative to the pre-pandemic norm will also lead to a deterioration in the U.S. balance of payments.

Commodity prices typically are inversely correlated with the U.S. dollar. This implies that crude oil and metals prices could rise further into 2024. Especially as a potential escalation of the conflict in the Middle East could have a large impact on the oil and gold prices.

Portfolio Actions

Current employment growth in Q3 is in line with GDP numbers, but forward-looking signs paint a picture of higher employment slack and lower bargaining power for employees in the future. Slowing growth is exactly what the Fed wants to see, which is why we believe they are done with this hiking cycle. As this becomes internalized by the market, we may see a Santa equity rally into year-end. For equity allocation, we continue to balance quality and growth stocks. We continue to overweight Japanese stocks, as the dollar should soften on a weaker economy while the JPY probably holds the biggest upside potential.

As we think economic growth will slow down in 2024 and, likely, bond yields will then come down too, we have added long-dated U.S. Treasury exposure to all the core portfolios that will serve as protection for continued deterioration in economic conditions in 2024.

DISCLOSURES

Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.

The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to this information’s accuracy, completeness, or reliability. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth nor the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.

This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

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