Last year around this time when you spoke about market valuation excesses and inflation, probably 50% of market observer had only a shy smile for you. This has changed: recently Jamie Dimon, JP Morgan Chase chief executive, kicked off the company´s investor day that he saw big storm clouds on the economic horizon that had yet to reach hurricane strength.

Obviously, he does not only speak about the high inflation figures, nor about the recent crypto crash (bitcoin dropping below the hallmark of USD 20000)

M2 Money Supply: Key Driver of Inflation

Let me remind you that when I started my career as a portfolio manager in the City during the 80s, a highly expected data series for the trading floors was US M2 money supply growth (a metric to measure money supply). This was the driving metric both for equity and bond investors back in the 80s and 90s!

Who has looked at M2 money supply over the last 10, say 15 years? And if the answer is no one, you may understand why inflation has surprised the financial world.

The growth rate of nominal GDP is the sum of inflation plus the growth of real GDP. The average growth rate of M2 over a ten-year period tends to be close to the ten-year average growth rate of nominal GNP. Growth of M2 that is higher than the real output tends to show up as inflation. With hindsight it seems reasonable to attribute the surge in US inflation in the 70s primarily to the surge in money growth…

The annualized M2 growth rate over the past three months has fallen to a mere 1.3% down from an average of 14.3% annualised growth over the past three years. So, inflation might soften and be milder during the coming months…

Characteristics of the Financial Environment

Looking back over the last 15 years, the financial environment has been characterised by two factors:

– Low real interest rates: these led to capital misallocation (see long duration stocks), and we saw the creation of massive (cheap) debt.

– An extremely easy money macro regime: the money supply has grown along with the economy, rising from USD 4.6 trillion in January 2000 to USD 18.45 trillion in August 2020. We saw a double-digit asset inflation as a result: the FT mentions, over the past 15 years, the US median Price to Earnings (PE) multiple has been 19.6 times, but over the very long run, it has been more like 17.5 times.

Some potential Storm Scenarios

So how shall we position ourselves? If I must make one-dimensional statements, carefully watch the price of energy/gas, especially this coming autumn as western European economies are not yet ready to use alternative sources. Energy prices could easily jump another 50%. Already during the summer heat of June 2022, some European countries start to panic that Russia is slowing down gas deliveries. If gas is missing or simply too expensive to burn, selected industries stop to produce; industrial power houses such as Germany (including neighbouring countries) will fall into recession. The sad news is that there might probably be a synchronised recession among the major economic blocks under this scenario…

A mild recession takes corporate earnings growth down by some 22% and a strong recession takes it down by some 34% on average. With a 10% earnings growth forecasted for this year (FactSet), the forward SP 500 PE ratio is 16.9 times. If we are wrong on the earnings forecast, we might see another 20% to 35% correction in the value of shares over the next 24 months to have an average PE of 17.5 times. Market sell-offs are known to be overshooting, and it is not uncommon, that in a major sell-off, we will see the SP 500 dipping to a PE of 15 times or lower.

However, the financial world very rarely turns to the most drastic potential outcome.

Let me highlight a milder scenario. Energy prices will remain at current levels this coming autumn. We see a slow-down in economic growth, but this reflects a minor economic cycle with a potential recessionary character. Inflation will come down over the next months. The fact that M2 is high, and the consumer saved a lot during the pandemic, will translate the slow-down not on a one-to-one basis into the real economy and buffers any initial consumer slow-down. The more time passes by, the better the Western world is prepared to use alternative energy sources, and the current dependence on Russian gas would trigger a revival in alternative sources of energy for Western Europe. Probably rather than a sagging break in corporate earnings, we could see earnings growth hovering between 0% and 5% and any short term market down-side might be limited to a level of 26500 to 28000 on the Dow Jones Industrial Average.

Let me state the obvious, I do not have a crystal ball, and it is probably fair to say that both scenarios are quite realistic. And another crucial factor is that capital market corrections tend to clean up with the heart of excesses; massive sovereign and corporate debt was created over the last years…

Specific Dangers for the Eurozone

What are the specific economic dangers for the Eurozone? A weaker Eurozone with a weaker Euro will feed any inflation. The ghosts from the past are reappearing, and we note that Italy must roll over some Euro 700 bn of sovereign (twice the amount of Greece´s sovereign debt refinancing of 2010/2011) debt over the next 5 years. Sovereign spreads between Italy and Germany are already widening by over 200 basis points. Italy is once more the focus of concern with its low potential growth, large deficits and enormous public debt. According to Nouriel Roubini, a permanent rise in Italian debt servicing costs looms as the ECB withdraws its ultra-accommodative policies.

In this context, the ECB fights with actions and words by stating that its willingness to deal with this risk has no limits (Isabel Schnabel, June 2022). As of today, I cannot see what is in the ECB´s toolbox to overcome this degree of fragmentation among EU sovereign issuers.

Note that the SP 500 has had a correction of nearly 25% year-to-date and mid and long term US treasuries are above 3%. Many investors do say that the market starts to look appealing. It is perfectly possible that we will see a small rebound limited to a few percentage points from here. However, like so often in markets, the psychological momentum is key: there has been no investor capitulation, and the hope of recouping lost gains is still strong. As the visibility is extremely low, and even experienced men, like Jamie Dimon, do speak about storm clouds that can reach hurricane strength, I for my part will stay on the sidelines as far as equities are concerned.  Any assets that have massive debt need to be avoided or duration shall be reduced. Let me stress that mid term US Treasuries start to look interesting; maybe soon it is time to dip my toes…