Nicholas Bohnsack
Chief Executive Officer
Patrick Rista
Distribution Manager
prista@strategasrp.com
(646) 292-7984

The Great Margin Call

10/20/2022

In their 1977 hit[1], “Torn Between Two Lovers,” U.S. folk trio Peter, Paul & Mary sing, “loving both of you is breaking all the rules.”  While it was unlikely songwriter Peter Yarrow’s muse, this sentiment would seem to hold as much for monetary policy as it does for affairs of the heart.  Our decade-long affair with easy money has been exposed and it turns out there exists no modern theory to spin monetary vice into virtue. Strategas Asset Management (“we” or “our”) has felt for some time that sorting this all out is very likely to be messy.  By our lights, two related though increasingly distinct areas of focus deserve investors’ attention.

The remit and current preoccupation of the Federal Reserve (“Fed”) – and because as much, the primary focus of most investors – is the gnawing tension between the regressive scrooge of inflation, on the one hand, and the recession-inducing policy prescription necessary to wrestle it back to an acceptable level, on the other.  The degree of emphasis the Fed puts on anchoring inflation versus any attempt to engineer a soft-landing, or otherwise prolong the business cycle, would appear to directly impact investors’ handicapping of (and hope for) a Fed “pivot,” an increasingly desired salve for the second order effects of inflation fighting.  To this end, we took two interesting observations from our annual Investment Forum at Tucker’s Point in Bermuda earlier this month.  Aware that many of the Fed’s previous tightening campaigns were halted when they led to something abruptly “breaking,” we were surprised to learn from one guest – a former regional Fed bank president – that the Fed is often “as surprised as the market” when and where these fractures occur.  Hardly reassuring.  Moreover, there was consensus among our clients, even those who shade toward more optimistic outcomes, that for the bullish (or less bearish) thesis to take root global central banks, and the Fed in particular, would need to slow the pace of policy rate hikes if not begin to reverse them, i.e., “pivot,” entirely.  What would induce the Fed to do so?  Is ‘institutional pressure’ (e.g., the IMF, the UN, etc.) enough?  Perhaps ‘pressure plus some softer data’ or ‘pressure, softer data and the warnings or insistence of another central bank’?  How firm is Fed Chair Powell’s resolve?  His Jackson Hole speech was less than two months ago...  The September CPI print came in higher than the Street’s expectations at 8.2%.  Thus far, no offshore epicenter of dislocation has been enough.  That the intensity of focus appears fixed more on what the Fed can do for investors than the conditions necessary for the Fed to be successful at its stated objective would seem to support Strategas Chief Strategist Jason Trennert’s observation that investors have become conditioned to anticipate policy-supported “v-shaped” bottoms.  What’s more, that may not do the trick this time; it may not even be an offer.  As we wrote earlier this summer, we view the “anchoring” of inflation expectations as a pre-condition for the market to stop going down, first, and second for the level-setting of prices and fundamentals (i.e., valuations) in combination with the emergence of discernible organic drivers of growth to be present before the market can start going up.  There is work to be done.

 

 

Without being flippant, it has almost become a parlor game to try to handicap how much external pressure it will take or the degree of collateral damage necessary to induce the Fed to pivot.  This was never more obvious to us than at a recent dinner party.  Despite refreshingly few investors in attendance, and high hopes of talking about anything but, the discussion still turned toward inflation, politics (gulp), the economy and, ultimately, the expected Fed pivot.  After some clarification on what “pivot” entails technically, the supposed merits and costs were debated at some length. (All followed by a wonderful chocolate soufflé for dessert.) The discussion provides entrée, however, to a second – perhaps more worrisome – area worthy of investors’ focus.  An important point Strategas’ Fixed Income Strategist Tom Tzitzouris has made in recent months resonates in this moment: whether the stress appears in the sovereign, with state, provincial, canton or municipal credit, or in their pension systems, the “leverage” is in government.  Recessions, however severe, are manageable, but when fixing the problem risks killing the patient – and the doctor, perhaps the measure of policymakers’ actions on long-held global economic operating conventions should be more thoroughly considered.  We have already seen acute pockets of dislocation which hint at the systemic risk posed by such fault lines and the market pressure which results when counterparties and capital markets disagree on the appropriate marks for increasingly impaired collateral (e.g., U.K. pensions).  At the center of the storm is the ultimate form of off balance sheet liabilities, trillions of debt that would seem to stretch the limits of Westphalian monetary orthodoxy.  Much of this debt is U.S. Dollar-denominated though most of it was neither originated by U.S. banks for U.S. borrowers, invested in the U.S., or collateralized by anything remotely associated with U.S.; the only association the debt has with the U.S. are repayment covenants linked to the value of, or requiring, Greenbacks.  In our opinion, that’s the problem.  As the Fed continues to pursue tighter monetary policy under the cover of improved 3Q GDP data and a relatively strong labor market, the value of the U.S. Dollar increases and with it the cost of Dollar-denominated debt service.  With the knowledge that non-Dollar borrowers are under increased pressure, spreads widen and volatility spikes, the classic liquidity trap opens in the form of a global margin call.  

 

 

With this as the backdrop, it is likely that risk assets will remain under pressure in general, and in some cases may even gap lower from current levels.  The best we can do is continue to offer some framework with which to consider intrinsic value.  To this end we have been surprised by the modest downward revision of the Street’s bottom-up earnings estimates.  While it is fair, given the prevailing rate of inflation to argue that the “money illusion” may prop up nominal levels of revenue and profits from the percentage declines historically associated with recession, inside the numbers we have already evidenced a good degree of margin contraction.  Though the preliminary read on 3Q’22 suggests broad economic data are modestly stronger than 1H’22 (the Atlanta Fed GDPNow tracker is running at 2.8%) we anticipate the forward guidance accompanying 3Q’22 earnings reports to be uninspiring.  The market tends not to do well when the outlook is being revised lower.  The percentage of S&P sub-industries estimated to post positive earnings growth over the next twelve months has fallen -15 pct. points to ~79% and the downtrend is accelerating suggesting weakness in broadening. 

As it stands the market appears to be comfortable trading roughly 15.0-15.5x S&P NTM and CY’23 consensus EPS.  This is consistent with the prevailing market multiple during historical inflation regimes of 4-6% Y/Y.  Is this too optimistic?  At a minimum we should consider that resolving the laundry list of global uncertainties may not occur quickly, without repercussion to corporate operators, or both.  The average TTM S&P multiple at both previous bear market bottoms and in historical inflation regimes of 6-8% Y/Y is 11.6x.  The symmetry is a coincidence, but can the Fed wrestle the regressive scrouge of inflation below 6% sooner than later?  Will something break before they’re successful requiring an accommodative (i.e. inflationary) policy response?  Should they proceed apace, in the absence of monetary or fiscal incentives, do substantive organic drivers of growth exist to call private capital to the economy?  Too many questions.  Too few good answers.  Tread carefully.  NB

 

 

 

 

This communication was prepared by Strategas Asset Management, LLC ("we" or "us" or “our”).  This communication represents our views as of 10/18/2022, which are subject to change. The information contained herein has been obtained from sources we believe to be reliable, but no guarantee of accuracy can be made. This communication is provided for informational purposes only and should not be construed as an offer, recommendation, nor solicitation to buy or sell any specific security, strategy, or investment product.  This communication does not constitute, nor should it be regarded as, investment research or a research report or securities recommendation and it does not provide information reasonably sufficient upon which to base an investment decision. This is not a complete analysis of every material fact regarding any company, industry, or security. Additional analysis would be required to make an investment decision. This communication is not based on the investment objectives, strategies, goals, financial circumstances, needs or risk tolerance of any particular client and is not presented as suitable to any other particular client. Past performance does not guarantee future results. All investments carry some level of risk, including loss of principal.

 

Strategas Asset Management, LLC is an SEC Registered Investment Adviser affiliated with Strategas Securities, LLC, a broker-dealer and FINRA member firm, and an SEC Registered Investment Adviser. Both Strategas Asset Management, LLC and Strategas Securities, LLC are affiliated with Robert W. Baird & Co. Incorporated ("Baird"), a broker-dealer and FINRA member firm, and an SEC Registered Investment Adviser, although the firms conduct separate and distinct businesses.


                                                                                 [1] #1 on the U.S. pop singles chart Feb’77, #4 in the UK in Mar’77