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October 2022 Monthly

The historic dollar rally accelerated in September. By some measures, it is as rich as it has been in the half-century since the end of Bretton Woods….

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The historic dollar rally accelerated in September. By some measures, it is as rich as it has been in the half-century since the end of Bretton Woods. Persistent price pressures, a robust labor market in many dimensions, and the Federal Reserve's latest forecasts warn that financial conditions will tighten into next year. However, we suspect that the market may have seen peak Fed hawkishness when it briefly priced in a terminal Fed funds rate of around 5.50% towards the middle of the next year. As September drew to a close, the market had re-adjusted and returned to about a 4.50% peak rate by the end of Q1 23. After dramatic gains in September, we anticipate a corrective/consolidative phase in October for the dollar.

The moves of the nominal exchange rates, as momentous as they may be, might not capture the magnitude of the overshoot that is taking place. According to the OECD's measure of purchasing power parity, the euro and yen are at historic under-valuation levels of almost 45% and 44%, respectively. Sterling is nearly 30% undervalued. Consider that the major currencies rarely deviate more than 20% from the OECD's fair value (PPP).   In the past, such an over-valuation of the dollar would spark concern by some US industries of unfair advantage to European and Japanese producers. Some multinational companies cite the decline in the dollar value of their foreign earnings, but the broader pushback has been minimal.  

US goods exports reached record levels in July despite the dollar's strength before slipping slightly in August. More and higher priced energy shipments have made up for slower growth in other goods shipments. Imports fell for five months through August and are off 6% from the record high set in March. This sucks away some of the oxygen of potential protectionist sentiment that has been heard in past periods of solid dollar appreciation.

Unlike the last big dollar rally in the mid-1990s, when then-Treasury Secretary Robert Rubin initiated the firm dollar policy, the current administration has been reluctant to resurrect the language. Some feared that it had lost its meaning and/or was confusing. However, the strong dollar policy is alive and well at the Federal Reserve. The dollar's strength is understood to be one of the channels through which the rate hikes tighten financial conditions, which in turn is to help bring demand back into line with the supply constraints. As a result, US officials have shown little interest in a Plaza-like agreement (to drive the dollar down as in 1985) that some think is necessary. 

Depending on where you sit, the Fed is either the hero or the villain of the bullish dollar narrative. However, there might be more to it than that. The eurozone and Japan are experiencing a dramatic deterioration of their external balances. Consider the recent trade reports. The eurozone's average trade deficit in the first seven months of the year was 25.3 bln euros. For the same period last year, it had an average monthly surplus of 16.6 bln euros. In the Jan-July period in 2019, the average surplus was larger, near 21 bln euros. Japan's latest trade figures cover August, and this year Japan has recorded an average monthly deficit of JPY1.53 trillion (~$11 bln). In the same period last year, it averaged a monthly surplus of JPY73 bln. 

Without getting too far ahead of ourselves, the forces that will change this, even if it takes a bit more time, have been set into play. The price of money adjusts quickly compared with the price of goods, trade flows, and investment flows. The unprecedented extreme valuations will encourage a change in the behaviors of businesses and households. They will be part of the broader narrative when the (dollar's) bull market ends.   

In 2008, a famous fashion model demanded to be paid in euros instead of dollars. A rap artist featured euros in a video. The press and financial research were full of eulogies for the dollar. We suspect that type of extreme sentiment, but its opposite, is being seen now, with claims that there is no alternative to the dollar, Europe is "uninvestable," or sterling is an emerging market currency.

Despite the US economy having contracted in H1 22, and the median Fed forecast chopped this year's growth estimate to 0.2% from 1.7% in June, the US appears to be emerging from Covid, the energy crisis, and Russia's invasion of Ukraine in a stronger position compared its allies and competitors. Yet, the insistence that cyclical forces are structural often seems to provide the last fuel for the move and, to mix metaphors, the last drop of tea that overflows the cup.

China is having a particularly difficult time. Most of it is homegrown. As Xi brought the tech giants to heel, the regulatory crackdowns used anti-corruption campaigns to get rid of opposition, coupled with the zero-Covid policy, have weakened the growth profile. In addition, its Covid vaccine was reportedly less effective than the ones more common in the US and Europe. The vaccination rate appears relatively low and slow to roll out boosters. 

Russia's invasion of Ukraine also may be encouraging foreign businesses to re-think exposure to China. The UN report on Xingjian, human rights violations, confirmed what many suspected. The property market, a significant driver of economic growth and development, has been hobbled and is still bleeding. In this context, Xi is expected to be granted a third term at the 20th People's Congress in mid-October. The PBOC has introduced measures meant to slow the yuan's depreciation. 

Among the G10 countries, Japan stands out. It still has a negative policy rate, and not only has it not raised rates, but Bank of Japan Governor Kuroda also insists that policy will not change soon. A few days after the BOJ increased its bond-buying (expanding its balance sheet), the Federal Reserve delivered the 75 bp hike. As a result, the dollar surged above JPY145, and the Ministry of Finance intervened to support the yen for the first time since 1998. However, the intervention did not meet the three conditions that would boost the chance of success: surprise, multilateral, and a signal of a policy change.

The BOJ policy appears riddled with contradictions, including adjusting the foreign exchange rate while fixing interest rates under Yield Curve Control. The intervention did stem the dollar's appreciation but could not knock it below JPY140, which means that it was unlikely to have inflicted the kind of pain that would discourage further yen weakness. Volatility did not subside very much, either. Benchmark three-month implied volatility set a high before the intervention near 13.4%. It was near 12.3% at the end of September, which is still more than twice the year-ago level. 

Japanese policymakers may have complained the most in the G10 about the dollar's strength, yet even before the September 22 intervention, it was not the weakest or most volatile currency among the G10. By September 21, the yen was off nearly 3.5% for the month. The Swedish krona was off 3.7%, the Norwegian krone was down almost 4.1%, and the New Zealand dollar had lost more than 4.3%. Sterling had traded at its lowest level since 1985, while the yen was at its weakest since 1998. The three-month implied volatility (embedded in option prices) for the yen on September 21 was 11.1%. The Scandinavian and Antipodean currencies were more volatile, and the euro's volatility (10%) was not significantly different.  

Aside from the Bank of Japan, central bankers have persuaded investors that the need to get inflation in check is the paramount objective, even if it means economic pain. As a result, higher interest rates and weaker growth are anticipated. However, the pace of tightening may moderate soon. Among the G10, both the Bank of Canada and the Reserve Bank of Australia have been explicit about this, and the Fed may have another 75 bp hike in it, but it too is seen slowing the tightening later in Q4.

The European Central Bank may hike by 125-150 bp in Q4, while the new UK government's aggressive fiscal policy will most likely spur the Bank of England to raise rates more forcefully, maybe 150 bp, though it does not meet until November 3. Even before Truss-Kwarteng's mini-budget, many expected the BOE to move quicker than the two half-point moves delivered in August and September. Three of the nine MPC ministers favored a 75 bp hike in September.  

Truss had campaigned for Tory Party leadership at least in part by advocating an unwinding of the tax increases of the Johnson-Sunak government. When she carried through her promises, investors seemed gobsmacked. While some observers noted that fiscal and monetary policy were moving in opposite directions, we see similarities with the policy of Reagan-Volcker, or when the Berlin Wall fell (leading to the uber-mark, which eventually paved the way for the European Economic and Monetary Union itself). More recently, former US President Trump delivered significant tax cuts as the Federal Reserve was tightening policy. While the Truss government is taking a considerable gamble, expanding fiscal policy and tighter monetary policy has often seen the respective currency appreciate over time. 

The relationship between currencies and policy rates is more complicated than it may seem looking at the yen's weakness. The Bank of England raised rates more than twice much as the Swiss National Bank. As a result, the Swiss franc eclipsed the Canadian dollar in September as the strongest major currency this year, and sterling is among the weakest. Sweden's Riksbank delivered a 100 bp hike last month, and the krona sold off to new record lows.   

The dollar rose against most emerging market currencies in September.    The JP Morgan Emerging Market Currency Index fell by about 3.2% in September, which brought the year-to-date loss to 7.8%. The theme for most of this year has been the outperformance of Latin American currencies. It stalled in September. The Mexican peso posted a minor gain (less than 0.2%), making it the second best performer among emerging market currencies after the Russian rouble. Brazil, which had been a market favorite, succumbed to pressure ahead of the presidential election. Leaving aside the Hong Kong dollar, three of the top five performing emerging market currencies in Q3 were from Latam:  Brazil, Mexico, and Peru.  

Bannockburn's World Currency Index, a GDP-weighted basket of the currencies representing the 12 largest economies, fell slightly more than 2% in September as all but the Russian rouble and Mexican peso fell against the dollar.   The BWCI took out the 2020 low. With a strong dollar, tighter Fed policy, and economic weakness in China, one may have expected emerging market currencies to have fared worse than the G10. Yet that is not what is happening. In September, the major currencies in the index fell by an average of 4.4% (excluding the dollar), and the emerging market currencies in the index fell by about 2.5%. 

Dollar:   The labor market's resilience boosts the Federal Reserve's confidence to raise rates to bring inflation back to its target. Encouraged by the latest Fed projections, the market looks for a 75 bp hike in November to be the last of that size before slowing to 50 bp in December. Most of the heavy lifting will be done this year, but rates are expected to be hiked in Q1 23 when the market sees the peak. The Fed anticipates cutting rates in 2024 while the market continues to lean toward a cut late next year. Inflation may be near its peak, but rents and medical services will likely keep core inflation sticky. The dollar's appreciation will reduce the value of foreign earnings for US multinational companies. Nevertheless, the dollar's appreciation is one of the channels through which financial conditions are tightening. As a result, we expect the dollar to be more vulnerable as the end of the monetary cycle approaches.  

Euro:  The eurozone economy is on the edge of a recession. The energy shock and broader cost-of-living squeeze are taking a toll, yet with inflation at 10%, the European Central Bank has little choice but to continue to tighten policy. After a 50 bp hike in July, the ECB hiked by 75 bp in September, and it looks poised to deliver another 75 bp hike in October and at least another 50 bp move in December. Many eurozone members are trying to protect households and small businesses from the surge in energy prices. The euro's decline exacerbates inflation, but the depreciation against the dollar overstates the case as the trade-weighted index has fallen by less than half as much. As widely expected, following the collapse of the Draghi government, Italy has elected among the most right-wing governments in modern times. The more conservative forces also won the Tory Party leadership contest and Sweden's general election. In anticipation of rising tensions with the EU, the premium demanded by investors for Italian assets has risen sharply. ECB President Lagarde has been explicit that the new Transmission Protection Instrument will not be used to save countries from their policy mistakes. This will be a potential flash point in the period ahead.

 

(September 30 indicative closing prices, previous in parentheses)

 

Spot: $0.9800 ($1.0055)

Median Bloomberg One-month Forecast $0.9800 ($1.0065)

One-month forward $0.9825 ($1.0025)   One-month implied vol 13.3% (10.3%)    

 

 

Japanese Yen:   The Bank of Japan increased the amount of 5–10-year bonds it regularly buys a couple of weeks before the Federal Reserve delivered a 75 bp hike and a hawkish message. Several hours after the FOMC meeting concluded last month, Governor Kuroda confirmed no change in BOJ policy. The dollar, which rose broadly after the Fed's decision, was almost at JPY146 when the Ministry of Finance ordered intervention to buy yen for the first time since 1998. The operation drove the dollar a little below JPY140.50. While late yen shorts felt the pressure, the underlying drivers (policy divergence and a negative terms-of-trade shock for Japan)- and sentiment have not changed. We suspect the market wants to challenge Japanese officials. The key is still US interest rates, which might help explain the decision to intervene against the odds. Japan is playing for time:  moderate the pace of decline as the peak in Fed policy and US rates are approached. 

 

Spot: JPY144.75 (JPY138.90)    

Median Bloomberg One-month Forecast JPY143.10 (JPY137.30)     

One-month forward JPY144.30 (JPY138.55) One-month implied vol 12.1% (11.1%)

 

 

British Pound: The Bank of England was the first G7 central bank to hike rates (2021), but the aggressiveness of the Fed and other major central banks left it behind and contributed to the weight on sterling. However, the mini-budget delivered by the new government was panned by economists and snubbed by investors. Sterling dropped like a ton of bricks to a new record low of about $1.0350. UK interest rates soared. The Bank of England has signaled a significant rate hike when it meets next in early November. The swaps market has nearly 150 bp discounted. Worried about the twin deficits (current account and budget), interest rates soared in a destabilizing fashion that threatened financial intermediaries, like pension funds. The Bank of England stepped and bought bonds. This, and the promise to hold back from selling bonds, which it had planned to begin in October as part of the effort to unwind the balance sheet that had expanded during the pandemic. The sentiment is extreme, and several banks now see sterling breaking below parity this year or early next year. We suspect this will prove to be an exaggeration.  

 

Spot: $1.1170 ($1.1625)   

Median Bloomberg One-month Forecast $1.1250 ($1.1700) 

One-month forward $1.1180 ($1.1630) One-month implied vol 18.5% (11.8%)

 

 

Canadian Dollar: The combination of the slowing of the Canadian economy and the drying of risk appetites (using the S&P 500 as a proxy) saw the Canadian dollar fall out of favor. The Canadian dollar fell to new two-year lows last month. The economy's outperformance in the first half is ending, helped by an aggressive central bank that surprised the market with a 100 bp hike in July and followed up with a 75 bp move in September. The swaps market anticipates a 50 bp hike in October and a 25 bp hike in December before the central bank pauses. The market looks for a terminal rate between 4.00%. This is to say that the Bank of Canada could be the first G10 central bank to reach its peak, possibly at the end of the year. The Canadian dollar's exchange rate continues to be sensitive to the general environment for risk. Stability in the US equities seems to be a precondition for a Canadian dollar recovery in October. Otherwise, the US dollar looks set to test the CAD1.40 area. 

 

Spot: CAD1.3830 (CAD 1.3130) 

Median Bloomberg One-month Forecast CAD1.3610 (CAD1.3070)

One-month forward CAD1.3835 (CAD1.3135)    One-month implied vol 11.4% (7.7%) 

 

 

Australian Dollar:  The Reserve Bank of Australia delivered its fourth consecutive 50 bp hike last month to lift the cash target rate to 2.35%. The impact of the hikes is beginning to materialize, and Governor Lowe has suggested that the pace of hikes may slow. With the weakness of the Australian dollar and with most central banks still moving in 50-75 bp increments, the market still favors another 50 bp hike at the October 4 meeting (~60%  probability). The terminal rate is seen around 4.00%-4.25% in mid-2023. Australia's two-year yield approached a 100 bp discount to the US, double what it was at the end of August. Since the mid-1980s, it has only once traded at more than a 100 bp discount (May 2019). The Australian dollar has broken through our $0.6600 objective and dropped to about $0.6365 before recovering. It needs to resurface above the $0.6550 area to take the pressure off the downside, which could extend toward $0.6200.  

 

Spot: $0.6400 ($0.6845)     

Median Bloomberg One-month Forecast $0.6540 ($0.6890)    

One-month forward $0.6405 ($0.6850)    One-month implied vol 16.4% (12.3%)   

 

 

Mexican Peso:  The peso was bowed by the dollar's surge last month. It still managed to eke out a minor gain  The currency had been less volatile than several G10 currencies. There was a fear last year that President AMLO was going to stack the central bank with doves, but this proved wide of the mark. As the Federal Reserve turned more aggressive, so did Banxico, and its reputation enhanced. It delivered a 75 bp hike in late September to 9.25%. The swaps market sees the terminal rate between 10.50% and 10.75%. If Banxico matches the Fed, it could be at 10.50% at the end of the year. The peso is still among the best-performing currencies this year, and yields on hedged and unhedged basis look lucrative. The Brazilian real has fared even better for the year as a whole (~4% vs. .2%)). Lula is expected to be elected President even if it requires a run-off. He appears chastened, and investors seem to still feel comfortable that moderate policies will be pursued.

 

Spot: MXN20.14 (MXN20.15)  

Median Bloomberg One-Month Forecast MXN20.19 (MXN20.24)  

One-month forward MXN20.25 (MXN20.27) One-month implied vol 12.3% (12.2%)

  

 

Chinese Yuan:  China is one of the few countries easing monetary policy. The divergence of monetary policy goes a long way toward explaining the pressure on the yuan. At the beginning of the year, for example, China's 10-year bond paid around 125 bp more than the US. Now, it is near a 100 bp discount. After trading broadly sideways in the first three-and-a-half months this year, officials accepted about a 6% depreciation of the yuan. There was another period of stability from mid-May until around mid-August. Since then, it has taken another leg lower. Though the end of September, the yuan has fallen by about 6.0%. The PBOC has moved to moderate the pace of the descent by cutting reserve requirements on foreign currency deposits, discouraging speculation, and consistently setting the dollar's reference rate below projections. The dollar is allowed to rise only 2% away from the fixing. Nevertheless, the divergence of policy can continue to weigh on the yuan. As the dollar pushed above CNY7.20 and as it probed the upper end of its band, the PBOC reportedly threatened to intervene directly in the foreign exchange market. The zero-Covid policy is taking a severe economic toll, and economists continue to revise down Chinese growth. Outside of the property market, the economy appears to be stabilizing, and the mid-September re-opening of Chengdu and Dalian may be reflected in next month's data. Rather than having to explain it away, as Xi takes a third term, he might use the economic challenges as a stick to stir up nationalistic sentiment.  

 

Spot: CNY7.1160 (CNY6.8900)

Median Bloomberg One-month Forecast CNY7.0755 (CNY6.8660) 

One-month forward CNY7.1025 (CNY6.8930) One-month implied vol 8.0% (5.6%)  

 

 

 




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Government

George Santos: A democracy can’t easily penalize lies by politicians

When candidates can get elected to Congress based on a mountain of lies they’ve told, is it time to reconsider whether such lies are protected by the…

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George Santos, in the middle, lied his way to winning election to Congress, where he took the oath of office on Jan. 7, 2023. AP Photo/Alex Brandon

George Santos is not the first politician to have lied, but the fables he told to get elected to Congress may be in a class by themselves. Historian Sean Wilentz remarked that while embellishments happen, Santos’ lies are different – “there is no example like it” in American history, Wilentz told Vox in a late-January, 2023, story.

Columnist Peggy Noonan wrote that Santos was “a stone cold liar who effectively committed election fraud.”

And now Santos has taken the dramatic step of removing himself temporarily from the committees he’s been assigned to: the House Small Business Committee and the Science, Space and Technology Committee. The Washington Post reports Santos told his GOP colleagues that he would be a “distraction” until cleared in several probes of his lies.

While Santos’ lies got some attention from local media, they did not become widely known until The New York Times published an exposé after his election.

Santos’ lies may have gotten him into hot water with the voters who put him in the House, and a few of his colleagues, including the New York GOP, want him to resign. CBS News reported that federal investigators are looking at Santos’ finances and financial disclosures.

But the bulk of Santos’ misrepresentations may be protected by the First Amendment. The U.S. Supreme Court has concluded that lies enjoy First Amendment protection – not because of their value, but because the government cannot be trusted with the power to regulate lies.

In other words, lies are protected by the First Amendment to safeguard democracy.

So how can unwitting voters be protected from sending a fraud to Congress?

Any attempt to craft a law aimed at the lies in politics will run into practical enforcement problems. And attempts to regulate such lies could collide with a 2012 Supreme Court case United States v. Alvarez.

A large, columned white building at the top of a grand, white set of stairs.
The U.S. Supreme Court has ruled that some false statements are ‘inevitable if there is to be open and vigorous expression of views.’ AP Photo/Manuel Balce Ceneta, File

Lies and the First Amendment

Xavier Alvarez was a fabulist and a member of a public water board who lied about having received the Congressional Medal of Honor in a public meeting. He was charged in 2007 with violating the Stolen Valor Act, which made it a federal crime to lie about having received a military medal.

The Supreme Court rejected the government’s argument that lies should not be protected by the First Amendment. The court concluded that lies are protected by the First Amendment unless there is a legally recognized harm, such as defamation or fraud, associated with the lie. So the Stolen Valor Act was struck down as an unconstitutional restriction on speech. The court pointed out that some false statements are “inevitable if there is to be open and vigorous expression of views in public and private conversation.”

Crucially, the court feared that the power to criminalize lies could damage American democracy. The court reasoned that unless the First Amendment limits the power of the government to criminalize lies, the government could establish an “endless list of subjects about which false statements are punishable.”

Justice Anthony Kennedy, who wrote the majority opinion in Alvarez, illustrated this danger by citing George Orwell’s dystopian novel “1984,” in which a totalitarian government relied on a Ministry of Truth to criminalize dissent. Our constitutional tradition, he wrote, “stands against the idea that we need” a Ministry of Truth.

Lies, politics and social media

George Santos, unlike Xavier Alvarez, lied during an election campaign.

In Alvarez, the Supreme Court expressed concern about laws criminalizing lies in politics. It warned that the Stolen Valor Act applied to “political contexts, where although such lies are more likely to cause harm,” the risk that prosecutors would bring charges for ideological reasons was also high.

The court believed that the marketplace of ideas was a more effective and less dangerous mechanism for policing lies, particularly in politics. Politicians and journalists have the incentives and the resources to examine the records of candidates such as Santos to uncover and expose falsehoods.

The story of George Santos, though, is a cautionary tale for those who hold an idealized view of how the marketplace of ideas operates in contemporary American politics.

Democracy has not had a long run when measured against the course of human history. From the founding of the American republic in the late 18th century until the advent of the modern era, there was a rough division of labor. Citizens selected leaders, and experts played a critical gatekeeping role, mediating the flow of information.

New information technologies have largely displaced the role of experts. Everyone now claims to be an expert who can decide for themselves whether COVID-19 vaccines are effective or who really won the 2020 presidential election. These technologies have also destroyed the economic model that once sustained local newspapers.

Thus, although one local newspaper did report on Santos’ misrepresentations, his election is evidence that the loss of news reporting jobs has damaged America’s democracy.

A piece of newspaper, burning up
With the news business in serious decline, citizens don’t get the information they need to be informed voters. iStock / Getty Images Plus

Lies that harm democracy

The election of George Santos illustrates the challenges facing American democracy. The First Amendment was written in an era when government censorship was the principal danger to self-government. Today, politicians and ordinary citizens can harness new information technologies to spread misinformation and deepen polarization. A weakened news media will fail to police those assertions, or a partisan news media will amplify them.

As a scholar of constitutional law, comparative constitutionalism, democracy and authoritarianism, I believe that Justice Kennedy’s Alvarez opinion relied on a flawed understanding of the dangers facing democracy. He maintained that government regulation of speech is a greater threat to democracy than are lies. Laws that targeted lies would have to survive the most exacting scrutiny – which is nearly always fatal to government regulation of speech.

Justice Stephen Breyer’s concurring opinion argued that a different test should be used. Courts, Breyer said, should assess any speech-related harm that might flow from the law as well as the importance of the government objective and whether the law furthers that objective. This is known as intermediate scrutiny or proportionality analysis. It is a form of analysis that is widely used by constitutional courts in other democracies.

Intermediate scrutiny or proportionality analysis does not treat all government regulations of speech as presumptively unconstitutional. It forces courts to balance the value of the speech against the justifications for the law in question. That is the right test, Justice Breyer concluded, when assessing laws that penalize “false statements about easily verifiable facts.”

The two approaches will lead to different results when governments seek to regulate lies. Even proposed, narrowly written laws aimed at factual misrepresentations by politicians about their records or about who won an election might not survive the high degree of protection afforded lies in the United States.

Intermediate scrutiny or proportionality analysis, on the other hand, will likely enable some government regulation of lies – including those of the next George Santos – to survive legal challenge.

Democracies have a better long-term survival track record than dictatorships because they can and do evolve to deal with new dangers. The success of America’s experiment in self-government may well hinge, I believe, on whether the country’s democracy can evolve to deal with new information technologies that help spread falsehoods that undermine democracy.

Miguel Schor does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.

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International

Australian small companies outlook for 2023

Having not long finished the festive season and commenced a new year, many of us take the moments shortly after to reflect on the year that was, and also…

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Having not long finished the festive season and commenced a new year, many of us take the moments shortly after to reflect on the year that was, and also consider what we would like to see in the year ahead.

With that in mind I thought I would take a look back at 2022. Last year will likely be remembered for three key events, firstly it generally saw the world exit the pandemic cloud of COVID-19. Secondly, we saw the commencement of the war between Ukraine and Russia. Thirdly, we saw inflation return with a vengeance being quickly followed by one of the fastest tightening cycles in history by Central Banks. The official cash rate in Australia increased from 0.1 per cent in April 2022 to 3.10 per cent by the December meeting of the RBA.

This mix of events led to one of the strongest risk-off years we have seen since the Global Financial Crisis, there are few places for investors to find sanctuary with losses occurring across both growth and defensive assets alike.

Investor sentiment was broadly very negative during 2022, it is always a challenge for any growth (or risk) asset to perform well when the market doesn’t have an appetite for risk of any kind. 

 If we look specifically at the Australian small ordinaries index, its return for the calendar year of 2022 was negative 20.7 per cent. To give this context the ASX 100 declined by 3.9 per cent and the ASX 300 return was negative 6.1 per cent. It is fair to say that the risk on trade in Small Companies over the last few years moved into reverse in 2022. This was a consequence of the above macro factors, coupled with a more bearish investor and market.

What to consider for 2023?

In moving to our outlook for 2023 we need to initially consider the 3 points above and ask where we see them today and where they may evolve to over the next 12 months. With the final question being what impact this will have on equity market performance?

As a starting point it is fair to say that the impact of COVID-19 continues to pass and become more of a memory than a current issue. Even China who were the final strong hold have now moved to accept an existence with COVID-19 and they cope with re-opening and reintegrating with the rest of the world. As it stands today, we would expect the impact of COVID-19 to continue to diminish from here. One datapoint that has been interesting to follow over the pandemic has been a UBS Composite Supply Chain Indicator which is now in a strong downward trend and moving closer to pre-pandemic levels.

Supply chain stress

Source: UBS

A second example where we can see this is in spot indexes for international container freight costs which are now off roughly 80 per cent from their peak 18 months ago. This is interesting as it was one of the early contributors to the increase in inflation. As a leading cause it is positive to see this returning to more normal levels.

Next, we move to the war in Ukraine, which continues to grind along, and will no doubt continue to influence energy prices and broader speculation. Having said that, although the outcome is unknown, this is what at times in markets is called a known unknown. We are all aware of what is happening, many governments and countries are working around it. This is best seen in Europe where they continue to diversify their sources and supply of Energy, along with continued fast tracking of non-Russian dependent infrastructure. Short of a shock surprise, this event we can largely say has been priced into markets.

Finally, inflation and interest rates have been a biproduct of the above two events. These two arguably caused the most disruption to equity markets in 2022. At the time of writing the most recent inflation data for Australia was released last week and came out higher than consensus expectations with trimmed inflation (removing the most volatile items) coming in at 6.5 per cent against an expectation of 6.1 per cent.

At this point most major market commentators have the belief that we are likely to see two further interest rate increases in the first quarter of this year. Post this timeframe the speculation begins to grow; a portion believe inflation is going to be more stubborn and require further effort from Central Banks. Other market commentators believe that the remaining two expected rate increases will be sufficient to manage inflation, particularly given the delayed transmission mechanism we have here due to the nature of Fixed Rates and their term to reset.

Some also believe we may see interest rates start to fall in late 2023, which would become a tailwind for equities, in particular some of the growth names which had the toughest performance over 2022.

What can we expect from small caps?

Looking through all of this noise and to our outlook for Australian Small Companies for 2023 we think as always the starting point is important. At a market level we started 20 per cent cheaper than the same point in the prior year. Further to this we have seen some earnings downgrades in some parts of the market, where others have proven to be far more resilient than expected. Sectors like the Resource sector managed to grow their earnings over 2022. So in some pockets, we find valuations from a fundamental perspective to be very attractive.

While there is a belief that interest rates have further to go, we still see some significant risks in the more speculative parts of the market. This is mainly around companies that will have little control over their earnings power in the next 12 months, or are less mature and as a result less capable to weather the economic conditions ahead. Increasing interest rates are also not favourable for building stocks, or some consumer stocks (although some of the high-quality names will be resilient and based on valuation look interesting).  

Any companies that missed the market’s expectations on earnings were punished, if the company had to go as far as an earnings downgrade the market showed little mercy. We think this trend will likely continue into the February 2023 reporting season. These are risks we are aiming to avoid by assessing the quality of our investments and their earnings streams.

Looking further out, there is an argument that Australian Small Companies offer a significant investment opportunity for investors over 2023 if they wish to add some risk to their portfolios. They were the most sold down part of the market in 2022 so the valuation of this sleeve of the market looks attractive.

History tells us that once the economy has reached peak inflation, the peak of interest rates is usually not too much further into the future. If we do in fact only see two further rate rises from the RBA and inflation is contained then we will start to have a foundation that would be more solid and look to underpin a backdrop that would be conducive to a rally in equity markets.

As always we are not out of the woods and do expect some earnings challenges to come to the fore in February’s interim reporting season. Stock selection and active management will be critical to navigate this.

Should we see an improved outlook and also a reduction in interest rates later in the year we may start to see an improvement in investor and market sentiment. This is likely the final ingredient needed to see capital flows return more strongly to equities and in particular Small Companies.

Overall we continue to have a meaningful exposure to the Resource sector as we think that with China reopening and supply shortages still an issue for Europe in the medium term, coupled with the continued drive of decarbonisation that 2023 should be another supportive year for the sector.

We have quality exposures to structural growth companies that over a medium term investment horizon represent excellent value and are growing quality businesses. We believe we are closer to the end than the beginning of the inflation and interest rate story which over the course of 2023 we think will provide a favourable foundation for the market and the Montgomery Small Companies Fund.   

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Researcher helps build center for avian-influenza pandemic preparedness with NSF award

LAWRENCE — As humanity tries to find its footing after the COVID-19 pandemic, the University of Kansas is taking steps to help ready the United States…

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LAWRENCE — As humanity tries to find its footing after the COVID-19 pandemic, the University of Kansas is taking steps to help ready the United States and the rest of the world for future global health crises.

Credit: A. Townsend Peterson

LAWRENCE — As humanity tries to find its footing after the COVID-19 pandemic, the University of Kansas is taking steps to help ready the United States and the rest of the world for future global health crises.

A. Townsend Peterson, a University Distinguished Professor of Ecology & Evolutionary Biology and curator of ornithology at the KU Biodiversity Institute and Natural History Museum, is part of a team of researchers that earned funding from the National Science Foundation to establish the International Center for Avian Influenza Pandemic Prediction and Prevention, dubbed “ICAIP3.”

The mission of the new multi-institutional center is to tackle grand challenges in global health with a focus on avian-influenza pandemic prediction and prevention. Most famously, the 1918 flu pandemic showed influenza viruses that start off in birds can kill millions of humans. But avian influenza, or “bird flu,” has triggered outbreaks around the world in recent years that killed billions of poultry and wild birds, as well as hundreds of people.

“The COVID-19 pandemic has been a wake-up call for the world, highlighting the importance of investing in public health and the basic science underpinnings of public health,” Peterson said. “It has had a scale of economic and public health impact that is unparalleled in our lifetime. This center would have ongoing viral monitoring around the world, but particularly in regions that tend to give rise to pandemic flu strains. We would have a predictive understanding of which types of new bird flu strains have pandemic potential. You can imagine the value of monitoring wild bird populations and seeing all the standing variation in flu viruses, and being able to say, ‘Hey, this one virus — this is what we need to watch.’”

The ICAIP3 center will be supported by the Predictive Intelligence for Pandemic Preparedness (PIPP) initiative, part of the NSF’s efforts to understand the science behind pandemics and build the ability to prevent and respond to future outbreaks.

“We need to be thinking big-picture when it comes to pandemics,” Peterson said. “COVID-19 is just one example of many diverse pandemics that have occurred throughout history. The Spanish flu, the plague pandemics, typhoid fever and avian influenza are all examples of diseases that have had a significant impact on human health and the economy. We need to be proactive in our approach to understanding and preventing these types of outbreaks, rather than waiting for them to happen and scrambling to respond.”

The total award for the PIPP project is roughly $1 million. Aside from KU, the ICAIP3 project has partners at the University of Oklahoma, where the work is headquartered, as well as the U.S. Geological Survey, the University of California-Berkeley and the World Health Organization Collaborating Centre for Studies on the Ecology of Influenza in Animals and Birds with St. Jude Children’s Research Hospital.

Peterson said the collaborators aim to apply for additional funding once ICAIP3 has succeeded as a proof-of-concept during its initial 18-month phase, structured to align with the PIPP aim to explore ideas for later competition for center-level funding.

The team will work to establish ongoing viral monitoring around the world, focusing most on regions that historically give rise to pandemic flu strains. The goal is to build understanding of the types of new strains holding pandemic potential and help predict and prevent outbreaks in coming decades.

Peterson and his collaborators will test available computer models that track “spillover,” where a disease can spread between animal species (“reservoir-poultry spillover” happens when wild birds give a disease to chickens, for example). Next, the team will work to improve these modelling approaches and run spillover simulations.

“If we do this well, what will come out is a model of the geographic, operational and individual-scale behavior of a pandemic-potential virus,” Peterson said. “Part of that potential is — does it stay just in one place? Or does it spread? If it does spread, does it take years, or does it spread in days?”

In essence, the KU researcher likened the work to devising an early-warning system to benefit researchers and public health officials as they decide where to devote resources for maximum effect.

With avian influenzas, part of this work must incorporate data about birds’ migratory patterns.

“You get some early warning of an outbreak going on and you say, ‘Okay, we’re pretty sure it’s a specific hypothetical virus — now, what are its most likely patterns of behavior?’” Peterson said. “How quickly will it leak from wild birds into domestic birds? If it’s coming from Asia, where would we expect it to appear in the U.S.? If you had this thing spread in the summer and get up to Siberia, then the jump may be way down into the U.S. because some of those birds think eastern Siberia is western Alaska and migrate south into the Americas in the fall. We would have a model that’s far better than what we have right now.”

Along with integrating huge amounts of disparate data into improved computer models, the collaboration will aim to build a community of researchers around a “One-Health (Human-Animal-Environment Systems) approach” they said is needed take on “the complexity, dynamics and the tele-coupling of HAES across multiple spatial and temporal scales and organization levels.” Peterson said he hoped the work also would strengthen the nation’s ability to track disease in birds and other species, as well as safeguard public health and prevent societal disruption.

“What in our lifetime has had the scale of economic and public health impact compared to COVID-19?” Peterson said. “Maybe 9/11, if you could count the war efforts after that. We’re too young to have lived through the World Wars, which probably were on the same scale here in America. But what, since then — can you think of anything? If you want a stronger America, you make an America that has a strong public health system that can respond to socially driven health threats like vaccine hesitancy. Measles was gone, polio was gone, but now they’re popping up in communities that are less well-vaccinated. And we’ll see more mosquito-borne diseases — like West Nile virus, Zika, chikungunya and dengue — all of which have recently emerged in the U.S. and each in a very different way.”

 


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