Dear Readers,
Hope everyone had their buckles on in the last couple of weeks in which we had some of those big market movements.
Russia had decided to march into Ukraine and this has increased market uncertainties in the midst of a high inflation reading. The inflation numbers are expected to be worsen as a result of this ongoing war with food prices hit as both Russia and Ukraine are top exporters of wheat globally. Not forgetting Russia is also a major exporter of hard commodity like palladium, platinum, oil and natural gas.
The ongoing war has exerted an upward pressure on inflation in which the global central banks are trying to deal with prior to the conflict. And of course, this is another unknown, whether the FED is behind the curve and if they are able to contain that inflation and bring it down to their long term target of 2%. Powell had mentioned that he is proposing a 25 basis points hike this month.
Perfect storm in the market creating market volatility and fear!
I am seeing a number of factors that is creating a perfect storm in the market.
- The ongoing inflation pressure
- War in Ukraine exerting to existing inflationary pressure
- FED interest rates hike cycle
- Supply chain disruption ongoing
- Commodities supply disruption as a result of ongoing war
- Russian assets prices crashing resulting in a credit tightening situation in the global market
- European market disrupted as a result of the ongoing crisis in Ukraine and subsequent sanctions on Russia
Oil prices hit above US$100 a barrel after Russia invaded Ukraine, further adding to inflationary pressure. From the above chart, we see that this is not the first time that we are having a high inflation number. Post WWII, we had a total of 6 prior experiences excluding the one that we are seeing now. Episode 1 draws the closest parallel that we are experiencing today as the last 3 that we have seen were largely a function of of oil shocks.
The rapid post-war inflationary episode was caused by the elimination of price controls, supply shortages, and pent-up demand. Not surprisingly, supplies were running low or were exhausted entirely during the war. Instead of focusing on consumer or industrial durable goods, manufacturing capabilities were concentrated on military production. Families had trouble buying cars and household appliances because they were essentially unavailable. Today’s shortage of durable goods is similar—a national crisis necessitated disrupting normal production processes. Instead of redirecting resources to support a war effort, however, manufacturing capabilities were temporarily shut down or reduced to avoid COVID contagion.
Pent-up demand also put upward pressure on prices following World War II. During the war, households were limited by the widespread rationing of consumer goods. The government rationed foods such as sugar, coffee, meat, and cheese as well as durable goods like automobiles, tires, gasoline, and shoes. Personal savings increased significantly and were spent soon after the war ended. Between 1945 and 1949, a population of roughly 140 million Americans purchased 20 million refrigerators, 21.4 million cars, and 5.5 million stoves. During COVID, businesses were shut down and households mostly stayed indoors. Expenditures on entertainment, dining at restaurants, and travel fell dramatically (from March 20–26, 2020, the entire U.S. box office made roughly $5,000 as compared to $200 million during the same week in 2019). Personal savings increased during the pandemic as well, and now retail sales are booming.
One substantial difference between the inflation dynamics of World War II and today is that price controls were a wartime policy tool that were not implemented during COVID. Those price controls reduced the price level 30 percent below what it would have been otherwise, according to Paul Evans (1982). When the caps were lifted in 1946, prices climbed significantly. For example, food prices alone rose 13.8 percent in July after food price controls expired on June 30th.
According to Benjamin Caplan (1956), the inflationary episode after World War II ended after two years as domestic and foreign supply chains normalized and consumer demand began to level off.
If history is something that we take reference, the current inflationary pressure as a result of supply-chain bottleneck and pent-up demand should ease with the reopening of the global economies post covid, which is already happening now. Of course, it’s still uncertain with the ongoing war in Ukraine, how long it will last. But my personal expectation is around 2nd half of 2023, after factoring in the ongoing Russia-Ukraine crisis. And i don’t expect this war to last long. Thus if there are any changes to the situation in Ukraine, it will affect my timeline.
Another concern that I have is the unwinding of Russian assets overseas, possibly causing margin calls. Rating agencies have subsequently moved to downgrade Russian sovereign debt to junk status which affected market valuation of these securities. Margin levels of collaterals for institutions holding them face the possibility of a heavy reduction in LTV from 80-90% to literally zero in a matters of days. Not forgetting that the Russian exchange are closed as well in which a MTM valuation of securities is near impossible.I will be watching this space closely in the coming months.
In the last rate hike cycle started in December 2015, we too had a number of macro shocks in 2016 globally, drawing similarities to current scenario in the market. In August 2015, we saw the Shanghai stock exchange pulling back total of 43% in two months, the Greek debt default and a sharp fall in oil prices as well.
Stock market performance on Monday, August 24, 2015
On Monday, August 24, world stock markets were down substantially, wiping out all gains made in 2015, with interlinked drops in commodities such as oil, which hit a six-year price low, copper, and most of Asian currencies, but the Japanese Yen, losing value against the United States Dollar. With the stock market plunge on Monday, an estimated ten trillion dollars had been wiped off the books on global markets since June 3.
The 8% drop in China on August 24 was termed “Black Monday” by the Chinese state media. The term gained wide usage in the next 48 hours.
In India, the Sensex recorded its biggest single-day fall of 1,624.51 points on August 24, ending the day down 5.94%. Indian investors registered losses worth over ?7 lakh crore (?7 trillion (US$93 billion)).
In Europe, the main stock markets dropped at least 3% on August 24. The FTSE lost -4.4% (£78bn) but upon opening on August 25, shot up 116 points (1.97%).
The DJIA opened 1,000 points lower on August 24, but gained nearly half of it back in the first 30 minutes. The New York Times used the term “upheaval” to describe the market situation. It remained down 588 points at the close of trading. Hedge funds, which, for the most part, had long positions on the eve of the downturn, suffered substantial losses as stocks such as Apple, Citigroup, Facebook and Amazon lost value.
Stock market performance on Tuesday, August 25, 2015
On Tuesday, August 25, the DJIA rose 442 points in early trading but plunged again in the last hour of trading, leaving the DJIA another 204 points off from its opening level. U.S. markets recovered 4% the next day and recouped the losses in October.
Tuesday August 25 was another day of sharp losses on the SSE Composite Index, which dropped 7.6%, making a 40% downturn in the market since June. The two day loss for the SSE Composite Index was over 15%. The BSE SENSEX fell 1,600 points on August 24 as the rupee fell to 66.69 per dollar.
Also on August 25, 2015, Asian and European markets finished higher, and the day began with a major 440 point upsurge for the DJIA; however, the gains turned to losses, with the DJIA plunging in the final hour to lose over 200 points for the day (1.3%).
What does History tells us?
The market experienced a volatile year in which we saw a double bottom established from 2015-2016. The correction then was about 13% with all the various events happening at one time. Currently correction on the S&P 500 stands at 11.85% which is very close to the 135 correction that we have seen in 2015-2016.
Since the start of the year, we had a correction of about 11.85% correction on the S&P 500 and a 18.8% pullback on the NASDAQ.
In the last rate hike cycle, NASDAQ corrected 15% and it recovered after about one year and break higher subsequently. In 2018, the NASDAQ corrected 21.2% as investors feared tightening of monetary policy and a slowing economy (sounds familiar). We had the intensifying US-China trade war in 2018 as well.
Currently, we see that NASDAQ had corrected 21.6% since the high established in November 2021. This is in fact more than what we had experienced in 2020 and 2018. The pullback is substantially more than what we seen in the last rate hike in 2015 (15%). Of course, what we are seeing in the macroeconomics front is different compared to what we had then.
Green lights, Red lights?
In the 4th Quarter 2021, the S&P 500 reported growth in earnings of 31% which is the fourth straight quarter of growth above 30%. This is a reflection of a strong recovery in the US economy post covid. I see that growth numbers coming down in the near future as economy normalised.
Another strong point is 76% of the S&P 500 companies exceed EPS estimates for 4th quarter 2021 as well. We had the nonfarm payrolls last night suggesting max employment and tamed wages. In February, nonfarm payrolls surged by 678,000 jobs, much more than the 400,000 economists polled by Reuters had forecast. Data for January was revised higher show 481,000 jobs created instead of 467,000 as previously reported. The unemployment rate fell to 3.8%, the lowest since February 2020, from 4.0% in January.
The S&P 500 forward 12-month P/E ratio of 18.5 on February 23 was below the five-year average of 18.6. However, it was still above the next four most recent historical averages: 10-year (16.7), 15-year (15.5), 20-year (15.5), and 25-year (16.5).
In fact, this marked the first time the forward 12-month P/E ratio was below the five-year average of 18.6 since April 15, 2020 (18.4). However, the forward 12-month P/E ratio of 18.5 on this date was still well above the lowest P/E ratio of the past nine years of 13.1 recorded on March 23, 2020.
At the sector level, five sectors had forward 12-month P/E ratios on February 23 that were below their five-year averages, led by the Materials (15.1 vs. 17.7) sector. On the other hand, six sectors had forward 12-month P/E ratios that were above their five-year averages on that date, led by the Energy (12.2 vs. 7.1) sector.
We can see from the economic data that the US economy is recovering well and US companies are expected to report growing earnings in the next 12-month period, though at a slower pace. With the recent correction, the valuation of the S&P and NASDAQ seems to be fair factoring in forecasted future earnings and a further global reopening of economies.
But of course, the growth was disrupted by the invasion of Ukraine by Russia currently and the market still has a number of uncertainties like how long this war will be, will inflation taper off in the second half of the year, how global supply will be negatively impacted by the ongoing war and Russian sanctions, which was all indicated at the start of the article.
Personally, I believe that the US central bank will eventually straighten out the inflation issue, which they had always done in the past. The war in Ukraine to be a short one and continued global reopening post pandemic. With the current high inflation, I believe that it will dampen pent-up demand consumption and slow down global economic growth in 2022. But if inflation numbers ease in 2023, the return of this pent-up demand should surface again. Cutting or selling at this level doesn’t seem to be the sensible thing to do in view of current market levels.
China, yesterday at its annual meeting has anticipate this slowdown and set the lowest economic growth target for 2022. Their target of 5.5% growth is the lowest since 1991.
The time for the rising tide to float all ships is probably over and investors will need to be selective in their stock purchases going forward. Some of the key points that i consider when buying companies, are ability to generate strong free cashflow, strong balance sheet, competitive-advantage in their business environment, good products and services, and sound management. Do be very selective going forward. But note that in an interest rate hike environment, though in economics theory, asset prices should depreciate but in real life scenarios, risk assets like stocks tend to do well as investors factor in continued growth in an economic expansionary cycle.
Last but not least, stay rational and manage emotions which is critical at this stage. History has shown that the world has always manage to overcome economical issues or natural disasters or wars. There is never one time the market has never came back from all these crisis and climb higher. There is a very clear trend post 2000 that the time that the market takes to recover is getting shorter.
Hope that this article is able to help you to make a better decision in the midst of this crisis and volatility. Have a great weekend!