1. Predicting the markets is tough, but we ought to at least understand our present position  

“When it comes to the financial markets, we never know where we’re going, but we ought to know where we are” – Howard Marks 

After all, who would have thought that we would see the following unfold in just the first half of 2023. 

1. A slew of US regional bank failures (First Republic, Silicon Valley Bank and Signature Bank) 
2. Rescue deal for the prestigious Credit Suisse (a global systemically important bank) by UBS 
3. Fears over the US debt ceiling crisis causing gold prices to spike at all time high and US credit default swaps rising to 175bps from 15bps 
4. China underperforming expectations despite reversal of its covid-zero policy 
5. Germany entering a recession 

Note that this piece aims to provide a high-level view on market conditions (i.e., more breadth than depth). This piece will be more narrative driven, less quantitative than usual and aims to keep things simple and cut through unnecessary noise. 

2.  Current market conditions are characterized by monetary tightening, waning investor confidence and alarming debt levels

2.1. End of easy money and going into liquidity squeeze

Period of easy money – Perhaps, too easy, too long 

Following the 2008 Global Financial Crisis, the Fed (and large parts of the world) consistently applied easy monetary policies (interest rates were kept at historical lows) to support the recovery of the economy from the crisis essentially by propelling risk-taking. Interest rates were cut to almost 0% in late 2008. As a result, the US saw its longest bull market in this period (2009-2020). 

End of easy money 

Central bankers were able to sustain this until inflation started to rise uncontrollably in late 2021 (signs of inflation already in early 2021 but was still deemed as transitory) when covid-19 lockdowns allowed excess money (savings + reliefs) to compete for a limited supply of goods (logistics and manufacturing hampered by lockdowns). This was further exacerbated by energy shortages caused by Russia’s invasion of Ukraine. The 15-month rate hiking campaign then began in March-22, with 2 more hikes expected this year. 

Today, as echoed by many famous investors like Howard Marks, we are unlikely to see base interest rates shifting back to the 0-2% as in the past. We are reverting from a highly stimulated and easy money environment to one that is increasingly tightening. The world is moving on and this is the new normal. 

Banking crisis and tightening 

The speed of the rate hike caused a series of bank failures in the US (although many argue that the crisis is largely also sparked by management failures). Credit Suisse, a prestigious bulge bracket Swiss bank had to be rescued by rival bank UBS (again, also largely due to mismanagement). 

In early May, both the ECB's Bank Lending Survey (BLS) and the Fed's Senior Loan Officer Survey (SLOS) revealed that financial institutions had tightened credit conditions further, particularly for businesses. In the past 30 years, this level was usually accompanied with a recession. 

Implications: 

• A tightening environment means that growth is expected to slow down. Though, we have not seen a US recession yet. 
• Perhaps, relatively strong macro fundamentals (e.g., unemployment edging up slightly, debt ceiling issue solved, etc.) are cushioning against growth headwinds for now. 
• Nevertheless, there are still many indications (e.g., inverted yield curve, rising interest rates, high inflation) pointing towards a looming recession. Read more in the US segment below.  

2.2. Investors are now exercising greater caution

Institutional and retail investors are hoarding cash  

According to Morningstar data, U.S. equity funds have experienced an outflow of $37b this year, whereas bonds have seen an inflow of $108b in assets, despite higher volatility in the bond market. Furthermore, an astonishing $404b has poured into money market funds. 

The Fed’s persistent interest rate hikes has caused equity risk premium (i.e., difference between expected returns from the equity markets and risk-free instruments) to decrease, resulting in diminished incentives for investors to take risk and invest in the equity markets. Why invest in riskier options when you can get a reasonable 5% return at almost risk free? 

Corporates are delaying M&A and listing plans

2023 marks one of the worst years of M&A and IPOs. Deal volumes continue to decline in 1H2023 (Down $1.3trillion or 42% y-o-y) are at levels similar to the start of the pandemic. 

Corporations anticipate an impending recession that they believe the markets have not yet fully priced in. Moreover, high interest rates mean valuations are down and it’s more expensive to finance M&A. As a result, they are adopting a prudent "wait and see" approach rather than deploying/raising capital and actively pursuing growth. Again, this signals very bearish investor sentiments on the markets.

Implications: 

• This means that there is significant amount of dry powder and idle cash awaiting deployment – which are very likely to eventually find its way into the markets. 
• Note that historical instances of peak money fund flows have often been followed by robust equity returns. 

2.3. Higher global debt levels than 2008 

Higher debt level than even pre-GFC

Low interest rate environment post GFC has caused global debt (households, financial corporates and nonfinancial corporates owed) to hit record levels. Global debt has reached an unprecedented level of $300t in Jun-22, which is equivalent to a leverage of 349% in relation to GDP. This translates to an average debt of $37.5k for every individual worldwide, while the GDP per capita stands at just $12k. Notably, government debt-to-GDP leverage has significantly increased by 76%, totalling 102% between 2007 and 2022.

Implications: 

• Lower headroom for taking on further productive debt to finance critical infrastructure projects like the green transition. This may mean slower growth and longer gestation time to develop certain infrastructure and technology. 
• A need to manage debt by reducing spending. May also require increasing tax to fund interest if debt rises faster than economic output.  

3.  Market conditions around the World 

Again, note that each region/country deserves a piece on its own, so I am keeping this concise and high level, without too many confusing numbers and noise. 

3.1. United States of America 

Looming recession 

• Over the past 3 decades, instances of hiking cycles coupled with stricter lending standards have consistently resulted in recessions in the US.
• Still-inverted yield curve continues to signal recession. Every US recession over the past 50+ years was preceded by a curve inversion. On average, recessions started 16 months after the inversion, and the market peaked 11 months after. Since the Yield Curve first inverted in Jul-22, a recession can be expected late 2023. 
• While these are not preconditions for recession, there has also been no false signals so far. 
• Implications: Markets have yet to fully price in the looming recession. Some experts forecasting that the US has averted a recession. President Biden also came out last week to say that the US economy is strong, and he does not expect a recession.   

Worsening US-China relations 

• Trade War: The Trump administration started a trade war with China, where most Chinese exports to the US were subject to 25% trade tariffs. Numerous Chinese technology companies were included in lists that prohibited them from accessing US technology and conducting business in the US unless explicitly authorized. President Biden has maintained the existing tariffs and expanded the reach of the policies introduced during the Trump era. 
• Start of 2023: At the start of the year, there was also the spy balloon fiasco coupled with potential ban of TikTok. A comprehensive timeline can be found here. 
• Worsening tensions: President Biden made a comparison between Chinese President Xi Jinping and "dictators", which China responded by calling the remark a serious violation of “China’s political dignity”, an “open political provocation” and "extremely absurd and irresponsible". 
• Implications: US-China decoupling will cause significant loss in economic output (resulting in loss of jobs, economies of scale, R&D, and competitiveness) on 4 fronts – trade, investment, people and idea flows. Without a doubt, the continued tension will lead to greater volatility in the markets. Read more in this report here. 

Commercial Real Estate could deliver the next shock to the economic system

• As vacancy remain high in the US (office vacancy at 18.6% in 1Q23 vs 12.7% in 4Q19) and valuations falling, property owners may find it difficult to refinance debt. Thus, leading to a high risk of default. 
• According to the Mortgage Bankers Association, approximately $1.4t of commercial real estate loans are set to mature this year and the following year in the US. 
• Prominent institutional owners such as Blackstone, Brookfield, and Pimco have already made the decision to suspend payments on certain properties, as they believe their cash and resources could be utilized more effectively elsewhere.
• Implications: This may cause a shock to the economic system, especially since much of the outstanding commercial loans are on the books of small, regional US lenders – the kind that recently caused a banking crisis. Nevertheless, a mitigating factor is that office debt only consist of c.30% of total commercial real estate debt market. 

Threat of de-dollarization 

• World’s reserve currency: The USD being the world’s reserve currency gives the US significant influence on shaping the global economy. Approximately 60% of the foreign reserves held by central banks worldwide consist of USD assets, and a significant 88% of global trade transactions are denominated in US dollars.
• Eroding confidence: The numerous QEs (QE1-4) and use of the USD as a financial weapon against Russia (US government’s decision to freeze much of Russia’s more than $600b in foreign reserves) alerted nations to the risk of holding the USD 
• Still peerless as a reserve currency: While there are talks such as BRICS nations working on creating their own common currency, Saudi Arabia expressing that they are open to trading in other currencies and others, there still isn’t a real challenger now. Even now, the euro capital markets remain fragmented due to the absence of a fiscal union. China’s lack of free capital movement also makes the yuan a major threat to the USD.  

Sustainability of constantly raising debt ceiling 

• Few months ago, the US hit its $31.4t debt ceiling. A whole fiasco of whether the US will default due to internal politics between the Republicans (proposing cutting spending) and Democrats (proposing a clean bill without preconditions) came about. 
• While the crisis was averted as a deal was struck between McCarthy and Biden, the root issue is yet to be solved. It still raises the question of sustainable constantly raising the debt ceiling is – especially with the high interest rate environment now. The US is spending too much and needs to work on restructuring its debts and budget.  
• Note that debt is already 3x higher than in 1Q 2010 and c.35% higher than in 4Q 2019. 

3.2. China

Lacklustre rebound not up to investors’ expectations… 

• Following China's reopening in Oct-22, there were high hopes for an economic recovery. However, although there was an initial rebound in the 1Q 2023, subsequent data has been underwhelming, leading to concerns regarding the future outlook. 
• Industrial production and retail sales in April fell short of expectations, and business confidence surveys in May have also been disappointing – indicating that the initial rebound from reopening is indeed losing momentum. 
• Manufacturing purchasing managers' index (PMI) unexpectedly declined to 48.8, marking its lowest reading since Dec-22. Additionally, the non-manufacturing index, which includes the services and construction sectors, dropped to 54.5 from 56.4, falling below expectations as well. 

…Stemming from insufficient demand from weak consumer confidence 

• In Mar-23, accumulated excess savings were RMB 6.5t, or 15% of 2022 retail sales – an indication of excess savings from weak consumer sentiments. 
• Nevertheless, excess savings may provide a source of dry powder that boosts growth in the medium-term once investor confidence is revived. 

Lack of large stimulus package to revive confidence 

• Despite China’s recovery gradually losing steam, Beijing has shown no appetite for another “mega” RMB 4t stimulus package, like that implemented during the GFC. 
• China’s relatively large fiscal deficit also makes financing a major stimulus package less feasible. 
• Some also argue that the relatively low base makes China’s 5% GDP growth target achievable without large stimulus package – hence, less incentive on the government’s end to implement. 

Need to tackle long-term structural problems vs simply pushing out a large stimulus package

• Over the past 5 quarters, every 5 units of credit only generate 1 unit of GDP – according to China’s Incremental Total Social Financing. 
• This indicates a need to structurally transform China’s growth model and combat some of the structural issues it faces – high youth unemployment (c.20% for 16-24yo), property market crash, high debt load faced by local governments, which will continue to remain a drag on the economy if not addressed.   

Regulatory overhang 

• Chinese government has a track record of imposing sudden regulations that almost wiped-out entire industries (e.g., education, gaming). 
• My observation is that the Chinese government has been directing its regulatory grip towards industries that directly affect family-building (e.g., education, property, etc.), in response to addressing its structural demographic problem. Avoiding exposure to such industries will minimize regulatory risks. 

3.3. India

Deepening US-India collaboration to reduce dependency on China – a big catalyst for India 

• Indian Prime Minister Narendra Modi embarked on a high-profile visit to the US last month in a bid to strengthen US-India relations – as a counterbalance to China. 
• Modi and Biden unveiled a collection of defence and commercial agreements, including collaborative initiative between GE and India to manufacture F414 engines for Indian fighter jets (note: sharing of military tech is seen as a signal of trust between both parties). Modi also met with Elon Musk, who said Tesla is likely to make significant investments into India.
• Implications: With mounting apprehensions towards China, the US increasingly views India as a compelling substitute in terms of supply chains, innovation hubs, and JVs. This event further signals future deals and reforms in trade policies, tech transfer, and investment barriers. 

Adani case highlighted corporate governance issues within India

• Nevertheless, Hindenburg’s short sell report on Adani has highlighted some key corporate governance issues in India that one needs to be wary of. 

3.4. Singapore 

Inflation will continue to result in SGD being an outperformer  

• Early in May, Singaporeans rejoiced as the Malaysian Ringgit (MYR) hits an all-time low of 3.41 against the Singapore Dollar (SGD). While this is partly due to the weakening of the MYR as Bank Negara has not hiked interest rates as much to protect its export-driven economy, the strengthening SGD has also played a big role. 
• This is because due to Singapore’s import heavy nature, the MAS combats inflation through strengthening the SGD (to lower import cost) rather than directly hiking benchmark interest rates. The MAS does this by adjusting the exchange rate policy band known as the S$NEER. 
• Implications: Having our home currency in SGD is hence pretty advantageous in our current high inflation environment. 

4. Concluding thoughts 

Market cycle wise, we are likely currently in the middle of a contraction phase, working towards an early recovery in the medium-term. Given the current market conditions, these are some key things I would do. Note that there is no one size fit all solution. Everyone’s circumstances, risk tolerance and views are different.

1. Interest rates are nearing peak levels – hence, I would allocate a good portion into bonds funds for the medium-term (price increase when interest rate falls). However, I will be discerning and selectively invest into high quality credit given the imminent recession. 
2. I will also keep a good amount of idle cash (in T-bills/money market funds) while yields are currently still high. But more importantly, they will serve as dry powder for deployment into equities when/if the market trades at a further discount as global economic output contract. 
3. Equity market is surprisingly still holding up quite well, especially with recent hype around AI. I will continue to DCA long-term into the US and China market index in an effort not the time the market (i.e., trying not to take market cycles into account too much) and in pursuit of long-term value. Having a good amount in bonds/cash also acts as downside protection. 
4. Given the conclusion of the era of easy cash and the concerning levels of debt, it is unlikely that global economic growth will maintain the pace seen in the past decade. The impending US recession, combined with the lack of substantial stimulus to boost investor confidence in China, emphasizes the importance of identifying bright spots in the market. I prefer a top-down approach, focusing on sectors supported by structural megatrends, and searching for undervalued winners in those areas. (might do an article in the future on this)
5. Continue to closely monitor developments within India given the possibility of it potentially replacing China as the world’s factory.  

‍

Note that I relied on publications across Alliance Bernstein, Bank of China, Barclays, BlackRock, Bloomberg, Citi, HSBC, ICBC, JP Morgan Asset Management, KKR, Merrill Lynch, Morgan Stanley, Rothschild & Co, State Street Global Advisors to form my views above.

‍

Disclaimer: Information on this website is for educational purposes only. Skeptivest.com is not a financial adviser. Skeptivest.com is not liable for any loss caused, whether due to negligence or otherwise arising from the use of, or reliance on, the information provided directly or indirectly, by use of this website.