Global markets have come under pressure over the past few weeks after a solid rally from mid-July to mid-August.  As we enter what are historically the most challenging months of the year (September and October), it is important for us to zoom out and look at the bigger picture rather than get caught up in the headline-to-headline or day-to-day noise.  Success in investing comes from remaining calm and evaluating the long term opportunities that present themselves during periods of short term duress.

What’s the case for optimism?

• Borrowing rates are levelling off.  The cause of the market turbulence has been inflation, and rising interest rates, as global central banks combat inflation with the only tool in their arsenal – increasing borrowing costs to slow down growth.  In the U.S. inflationary pressures are levelling off, and with the Federal Funds rate set to be at least 3% by September 21, this is just a handful of hikes away from where the market expects it to remain (current Fed Fund Futures have yields peaking at 3.61% in mid-2023).  Likewise, the Bank of Canada meeting this week may signal that it is closer to the end than the beginning of this hiking cycle.
• The situation in Europe isn’t nearly as bad as the news flow makes it sound.  While  electricity costs recently surged across the Eurozone, there are some signs of hope.  As you can see from the chart below, gas storage facilities are in line with seasonal averages for the past 15 years – which means that target levels were achieved months earlier than anticipated, and a key source of electricity supply have ample resources already in place. Plans to mothball coal and nuclear facilities across the Eurozone have also been put on hold.  Russia’s war in Ukraine is at a crucial inflection  point – one way or another, the current counteroffensive in the southern part of the country should hopefully pave the way for some type of a resolution.
• China is stimulating their economy as much now as they were in during the lockdowns of 2020.  While “zero tolerance” is still being enforced, it is being buffered by an avalanche of stimulus measures. The degree of COVID-related restrictions is far less than it was in 2020, and the recent US-China accounting agreement signals relations between the two countries aren’t spiraling.
• Earnings have been resilient.  Corporate America will face revenue headwinds in the short term but easing supply chain strains should provide meaningful cost relief, preventing earnings forecasts from being slashed.  While business confidence is falling, there is evidence in the recent ISM survey and corporate comments (Broadcom, Cisco, Lululemon) about an uptick in business during August.

What’s the case for being cautious?

• Stimulus is being withdrawn at an unprecedented rate while the recovery is still fragile.  The world is still undergoing an enormous adjustment as pandemic-era stimulus gets rapidly withdrawn and policymakers combat decades-high levels of inflation.  This could pressure economic growth globally for several quarters, and recessions look more likely than not in Europe, the U.S. and elsewhere.
• If inflation remains stubbornly high, central banks will not pivot towards easing as quickly as the market is currently predicting.  Unlike the U.S. Federal Reserve, the European Central Bank is just getting started on its hiking cycle (at a time when European CPI just printed above 9%).  If inflation remains above target levels (2%), central banks will come under pressure to keep borrowing rates higher for longer, or risk a repeat of the errors of the early 1970s, when central banks cut rates before inflation was stamped out.  Right now, the market, by way of the Fed Funds Futures, is expecting rate cuts to begin in the fall of 2023. 
• The energy market has changed forever due to the Ukraine invasion.  Even if the Russia-Ukraine war ended tomorrow, the gas relationship between Brussels and Moscow has changed forever, which should result in structurally higher power prices in the E.U. for years to come. The oil market is also seeing a structural shift that could bolster prices after a prolonged period of underinvestment in capacity.  The revelation that nations like China, India and even Saudi Arabia were amongst the buyers of Russian oil, despite the embargo, is evidence that new alliances are being formed that will unsettle the old order in the global energy market. The silver lining in this re-alignment is that it has kickstarted badly needed investment in alternative energy sources like nuclear, LNG, hydrogen and renewables.
• China’s battle with COVID is far from over and further changes can be expected from the upcoming 5-year plan.  While China may not impose multi-month wholesale shutdowns of major cities like it did earlier this year, virus-linked restrictions will remain a constant presence for the foreseeable future. Stimulus can only go so far to offset the damaging effects of zero tolerance.  The upcoming U.S. mid-terms aren’t the only major political event we’ll be monitoring this fall.  We will be keeping a close watch on the Communist Party of China’s 20^th National Congress, slated for mid-October, where current President Xi is expected to further consolidate power and delineate plans to boost economic development and sustainable energy laid out during last year’s 5-year plan.
• Earnings should face growing headwinds going forward.  Rising borrowing costs should impact companies and consumer alike, as more money is dedicated to servicing mortgages and lines of credits, and less on new goods.  Excess inventory is not just a big problem in retail (especially apparel) but also in technology – like the Y2K surge, the COVID spending boom of 2020 – 2021 may have represented a pull-forward in demand, rather than a “new paradigm.”

(source: Piper Sandler)

While market pullbacks are never welcome, they have improved the odds for better long-term returns going forward across a variety of asset classes by increasing implied yields on investments.  It is tempting to get caught up in the moment and become distracted by the volatility that inevitably accompanies downturns in the markets.  We would encourage you to focus on the quality and resilience of your holdings, the opportunities available in a changing market landscape, and your long term plan.