The year of 2022 was “The Year of Reckoning”, and we are still fully embedded in it, but 2023 will be “The Year of Resilience” at best.
Powell’s and Lagarde’s recent hawkishness ended the shortest Santa Rally on record. It started spot on on December 6th and 11th, perfect empirical dates. Santa was sent home by the central bankers, the Grinch heads. This is happening at mathematical and structurally vital levels, which now has turned into concrete resistance above for all bull attempt going forward, both short term and through 2023, clearly visible as blue horizontal lines in the S&P500 chart below.
In short, the bull case for stocks in the West has no oxygen and life below 4115 and 4155 in the S&P500 which equates to 34,007 and 34,713 for the Dow Jones Industrial index. If the central bank heads wanted to kill the wealth effect in the market, they succeeded and timed it brilliantly, and the outlook nearer term is a revisit of the October low, and probably one step further towards 3,250.
Source: TradingView weekly S&P 500 with 52 week MA and mathematical price targets
This year’s political and economic activity will have implications far beyond 2023. The extra energy bill alone already amounts to a staggering $1 trillion for Europe, and it has not even started getting really cold yet! This combined with recent technical price action paints a dire outlook for 2023. The period of free money and low inflation is over; 2022 felt hard, but it can get much worse.
“The Year of Resilience” is the positive interpretation. The negative interpretation is more like “The Year of Pain” and it can have deeper and longer negative price implications, think the year 2000 and forward or even 1930-32 if the structural issues are not handled; it might just have started!
The “Resilient” interpretation relies upon no or very mild recession and no more yield surprises to the upside. That should then provide for certain sectors doing OK, but that can only happen IF energy prices keep inflation and yields in place around current expectations, and that does not look very likely. The Fed and ECB certainly reminded us about this last week, and they seem determined on breaking the market’s back.
The chart technicals on the Resilient Interpretation indicate a sideways year below the concrete ceiling of 4,115 and 4,155 on the S&P500. Taking on the rosy glasses maybe a vacuum explosion upwards into 4.315 could happen, but that would require good inputs from energy and inflation, no hard QT, and probably even a solution on the Ukrainian situation. For sure, the free money from the Magic Money Tree (MMT) experiment seems to be over, in front of us comes QT, patience and the will to solve hard and fundamental problems.
The more bearish outlook for markets, which currently seems most likely, will have a dire impact on investment portfolios and all asset classes, but also for societies, their citizens, and governments. Politically we have since 2008/14 dialled back the clock to the 1970´s (-ish). At this point Europe and Ukraine plus Russia and the US need to decide if the current conflict in Ukraine shall carry on and wreck continental Europe´s economy, not to mention totally ruin Ukraine and kill more Ukrainian civilians. I for one had hoped that the lessons from the war in Afghanistan would have refrained us from new destructive military conflicts.
What is to be expected politically?
The US, which is driving the war for the West in Ukraine, is making tons of money here, but it is still printing record deficits on trade and fiscal accounts. It is not yet clear if this is a war on Russia or on China and Europe as well, but at one point people and politicians will be forced to make up their mind on this point. Europe does not have the same agenda as the US does in the conflict.
For Ukraine the current situation will only have a bad or a very bad outcome, the political question is more now about continental Europe and Russia, where will they end up?
What is to be expected structurally?
One of the big questions out there is inflation, partially driven by the war in Ukraine. Will it stay high, will it find new levels, or will we return to the low rates from the last 20-30 years?
I for one do not believe we will return to the 2% level, and I see it as a challenge for the markets that central banks have this as a target. The average inflation rate during the last 100 years was 2,9% and 3,1% in the US, and the sub 2% we have seen in some years during the last period is unlikely to return unless we enter deep recession.
There are THREE structural changes that have worked for the sub 2% inflation scenario in recent years. These tides are now shifting and will work against low inflation going forward.
- The outsourcing we in the West did to China, Eastern Europe and Asia will most like reverse and to a large extent return home through “domestication”, which I believe is the right thing to do. The outsourcing policies that have been cheered over the last decades will now come back to haunt us. We have built up industrial knowledge and expertise abroad. We have paid these countries for our own demise, boosted their education, and their industrial capabilities. What a policy error! Capitalism at its worst.
- The distribution of corporate earnings between workers and owners, including management, has gone from workers to leadership and ownership since the latter part of the 1970s. This owner favoured-financial distribution, supported tax-wise, has seen a partial change since Covid, and it could be argued that this shift and distribution of the cake of our joint efforts and profits could drive back in the direction of the workers again.
- The participation in the labour force went up significantly after WWII, when women entered the workforce.
These structural changes, through outsourcing, earnings distribution, and the labour market entrance of women all had a positive impact on inflation and capacity and cannot be repeated.
Therefore, I see little chance of returning to 2% inflation without recession or an impressive positive impact on productivity, which might happen further down the road, but not in 2023 nor in 2024. I would even argue that, if the central banks seek to meet these former low inflation numbers, they will crumble the world economies through recession and with less ability to repay our debts, with mega defaults as a result; this in not only relevant for the indebted West, but will be felt the most in the West, because of our dire debt situation combined with unfortunate demographics. There is literally no one to leave the burning debt torch to.
- UK investors are adapting investment strategies to cope with high interest rates
- What makes index-linked bonds different from conventional bond investments?
- US bond ETFs continue to bounce back as Fed looks like it has paused on rates
The rise of the East
I fear everyone will now start to clearly see the relative decline of the West and the rise of the East and other emerging markets is in the making. This process did not start yesterday or yesteryear, but it will become more and more apparent to everyone through this decade. There is really not much to do about it, except maybe slow the development down, which is what the US probably is trying with the Ukraine/Russia conflict. Inflating the debt away seems to be the only way out, and that again means higher yields, which neither the economy nor the stock market pricing would like, nor have discounted in yet.
This potential huge impact from the discounting factor towards asset pricing going forward, has really put us all somewhere between a rock and a hard place. Families with housing could get especially hard hit, since it’s the largest asset class for most families because of mortgage finance. Not only do states need negative real yields to stay alive, but house owners are also not much better off. This is just another factor that will impact the demand side, together with the earlier mentioned heating costs.
The energy and mobility transition
We cannot talk future asset prices without talking energy prices and the ongoing energy and mobility transition going forward. This area might be one of the better performing sectors in the near future, since this development is structural, and it could end up as the most important asset area and sector over the next 20 years, both financially, but also for the quality of our own lives. The challenge and opportunity here is enormous. The question remains if we have the mental and industrial capacities to fix the climate threat in proper time. There is no arguing about the direction here, the question remains how fast and efficiently we can develop and implement solutions that will have a positive impact on our lives, our economies and our surroundings.
The investment opportunities from the energy and mobility transition are enormous, but so are the financial risks. The ecological and quality of life risks are substantial if we are late and do not do enough in time on this matter. It is a very asymmetrical subject where science still has too little room in the public debate. If the nay-sayer´s on the potential climate catastrophe are right, then we will just end up with cleaner air and reduce the CO2 and particulate matter in the air, and thereby reduce the 12-15 million yearly early deaths we currently see from respiratory issues.
IF the climate change deniers are wrong, then the subject and sectors cannot get enough attention. Sadly, large legacy industrial entities in, for example defence or oil and gas, plus the automotive sector, do not have the wellbeing of you and me and our common globe as their objective. Many leaders just seek their own comfort with their golf clubs and tennis lessons. Their new boats and mansions are paid as I write here, remember the trillion dollars from above!
Therefore, it is very important that our financial resources get allocated to the right solutions and technologies, and preferably in time, meaning now. We have seen the Biden administration allocate resources lately, but they did not seem thought thorough or well distributed, and the amount of $2.8 billion is just a drop in the ocean, but let’s acknowledge their start.
Investing in sustainable energy sources
The problem is here that the West is 30 years behind the energy industrial and ecological curve, only China has invested properly in the resources, energy tech and production space, we either gave or sold our IP to the Chinese. Luckily they are doing something about it.
The Western energy complex nearly needs a total rebuild into sustainable sources like wind, solar and nuclear, and it needs to be carried through updated grids, and managed and stored in batteries and hydrogen (carriers). On this transition alone we are talking trillions of dollars invested and even more earned going forward. This is where some investment opportunity lays, it will probably be the new oil-rush. I believe that both the tech as well as the resource side will have glorious times in this space, but it is not immune to downswings in the overall market. But the resource and energy tech side will be one of few proper inflation hedges you can introduce into your portfolio, just remember resources are pro-cyclical in their behaviour, this transition in the energy and mobility space is structural and will have to happen, both its ups and downs.
We thought Covid was hard, but imagine the same kind of impact from the globe and its environment down the road, just not for 20-30 months, but closer to 20-30 years with billions of people impacted and hundreds of millions turning into refugees seeking their way inland and towards the old world. The size of this situation can be discussed, but that they will come in overwhelming numbers is a certainty, and we don’t have the savings and financial buffers on the Western world’s balance sheets to handle this; it could even be the grounds for future conflict.
Overall these political and structural developments should lead to harder economic times, and the “Resilience” that I was cheering for in the beginning of this article, will most likely not come from your government; this is why it is even more important that you, yourself, prepare for this.
As can be read here and in my earlier articles, I have little confidence in our central banks’ data driven methodology. They are always late, and it is why they always come out ignorant and wrong, fair or unfair. One thing to remember here is that they have become less independent in the latter decades, and they know that their longer-term contribution going forward will be to let debt default slowly through inflation. Fed Chairman Jerome Powell said on Wednesday 14th of December that “we will see no rate cuts until the Fed is confident that inflation is MOVING towards 2%”. He knows that implementing the 2% target will kill everything alive around him, if he goes that far.
So where does this leave us on the investment side?
Going forward, what will be more important than in many years are robust balance sheets, robust business cases, robust locations, and a good vision on a client’s needs; remember the free money will be gone and if QT arrives as planned, then the oxygen will be burned out of the market. Diligence and resilience will be key notions to be aware of. Maybe it can be summarized into old fashioned value investing terms.
If we follow the lead from above that inflation will settle at higher levels going forward and defaults both with private and public entities will become more apparent, the required yields on your debentures will have to be higher to discount both, and this will reflect in two ways on the companies, their earnings and their multiples.
- The higher yield costs to finance businesses will have a direct negative impact on the bottom line = lower earnings
- The discounting factor on future earnings will be higher = lower valuations / NPV.
If valuations become more attractive, then your current investments can work still, but the transitioning journey might be very painful.
Another point which is also implied from the above is that top line growth does not equal bottom line profits for you as an investor. One lesson here is China and their state-owned enterprises with their social licenses. These companies have become very big, but there has not been a clear correlation between big balance sheets and sales to big profits. Price is the worst parameter to compete upon.
Finally, on the US/Russian conflict on Ukrainian grounds and your heating bill. I will refrain from sharing my insights here, since I have family and friends in both Russia and Ukraine, but two things are to be considered.
- There are no winners in war, outside the military industrial complex. Winners of wars are found in the peace afterwards. Take Japan and Germany as your example.
- Allocation of money into war, not defence or tech, is probably the biggest misallocation of money that we can make, and we cannot afford it considering the real issues we are facing and our debt situation. The Keynesian impulse works at 30% debt to GDP, not on 130% debt to GDP. The budgetary part of the yields will be too high.
- The direct ecological and economical effects from war are disastrous. We are spending time, air, and resources on the destruction of people and nations, who could be our friends and customers, again recall Japan and Germany!
So, let’s stop this misallocation right away, one would think. Sadly, there are agents out there that overwhelmingly feed the political systems through lobbyism and other activities to their own wellbeing, at a loss for the globe and its population, us and our families.
Recalling from the beginning, the investment outlook for 2023 is not good, at best we will get a sideways movement between 4,315 upwards and down towards 3,233 on the S&P 500 like in the 1970´s and after 2000. These lows, most would consider a total wash out. But it might not end there because of the debt levels and our structural issues around demographics. Sadly, it is too early to cancel the very negative outlook version, but it can be argued both from a chart perspective as well as from the structural and political scenarios currently playing out around us in real-time.
The S&P 500 chart below shows lots of room, down to the rising logarithmic trendlines. Mathematical targets and rising channel and trendlines are down round 3,000 and even deeper down below the 2020 Covid low around 2,100.
Merry Christmas and have a safe entry into an exciting 2023. Be careful and try to keep your positions in check in 2023, stay patient and resilient.
Henrik Mikkelsen is a Strategist, Investment Advisor and Business Developer with Iridis AG, an investment management and corporate advisory firm in Zug, Switzerland. Henrik has more than 30 years of experience from investment banking and commodity trading, running strategies for clients and himself, as well as writing about markets and giving lectures on technical analysis and risk management.