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Citation - Third Quarter 2022



George Herman
Chief Investment Officer: Citadel Asset Management
Estimated reading time: 2 minutes 37 seconds read

Since the previous edition of Citation, the United States’ (US’s) S&P 500 Index has gone from 3 800 to 4 300 and back to 3 800. If this was all you read, you’d ask, “What’s the fuss?” Well, the fuss is about central banks that are resolute in tightening global liquidity in an effort to curb decades-high inflation. In response, bond yields have risen sharply, causing much lower valuations of other assets which offer long-term returns. These constrictive interest rates have also placed downward pressure on economic growth and so the most important variable of all for equity investors, earnings, have come under the microscope.

Below you will see the same graph that I inserted in my last quarter. I have updated it to include the third quarter of 2022 to show you how the evolution of earnings against the actual stock market, as represented by the S&P 500, has been impacted by the current cycle of interest rate hikes. The graph shows the S&P Index (orange) along with one-year forward expected earnings (black) and illustrates how the equity market is indelibly linked to earnings and we know earnings are linked to economic activity. The current concern is that earnings haven’t shown meaningful deterioration yet, despite the clear negative response of the global economy to tighter liquidity. Which means that the US Federal Reserve (Fed) has the power, and a short window of time, to decide on which way the economy and equity prices are going to move.

The best-case scenario is that the Fed recognises that inflation has indeed rolled over and will soon halt their rate increasing cycle. This should allow the economy to achieve a ‘soft landing’, as economic activity in such a scenario should only experience a ‘shallow recession’. The bad-case scenario will be if the Fed is unperturbed by the growth slowdown and is solely focussed on bringing down inflation. Several external factors, like energy prices, are bound to keep inflation ‘sticky’ and its reduction slow, which will concern the Fed. Should the Fed continue this fierce hiking trajectory, the economy runs the risk of experiencing deep recession and earnings will contract meaningfully. This will see the very same entity that essentially underwrote or guaranteed the financial system for the last 15 years, now becoming its biggest threat.

The original igniters of the inflation flame, logistical bottlenecks and freight rates, have now returned to pre-Covid levels. This could be seen as the positive side of much more strained global trade relations and removes an important driver of inflation. The most important variables for inflation now are energy and compensation costs. Once again, higher wages are a double-edged sword as it improves consumer balance sheets but increases inflation that catalyses interest rate increases. Considering all of these moving parts, there’s a high likelihood that several of these dynamics will reach their exhaustion levels and eventual turning points, during the next six months. It is bound to be a volatile, but crucial, period for markets as we get to the conclusion of a painful rate hiking cycle, economic cooldown and revaluation reset.

I hope you enjoy this edition of Citation.