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Market Diary – May 2022

We continue to see the hawkish Federal Reserve evolve before our eyes. Given their sharp stance, the ripple effects in all markets are dramatic. Unfortunately, if Jerome Powell wants to imitate Paul Volcker, he faces a long and difficult path. Let’s not forget that the recession of 1980-82 seemed endless. I don’t think anyone wants to sign up for that. Market participants are grasping at a narrative fallacy that this is 1980, the world is falling apart, and inflation is here forever.

Inflation has been near zero or even negative for most of the last 20 years. Disinflation has been the primary concern for policymakers over that time. The reasons for this are simple: technology and productivity. That iPhone you just bought for $1000 may be a bit more expensive than the last one but look at how much more it can do. The chip is faster, the memory is far larger. That movie you are streaming on 5G is much clearer than the TV you grew up with (I don’t care how old you are). Examples abound of items that have remained the same price yet deliver far greater utility. Let’s face it dis-inflation has been the scarier monster since 2008. Can you remember cash for clunkers? That was directly targeted at the sagging auto market.

Be careful what you wish for

Central banks have been desperate to create a slow steady inflation rate with a target of 2% being the ideal. They thought that once inflation appeared they were ready with the tools to maintain that steady price climb. This has never been achieved over any meaningful amount of time.

So why is today so much different? The answer is simple. Exogenous factors, which is a fancy name for current events that are not normal. The top two exogenous factors are the obvious culprits for our current problems:

1. Pandemic impact on the supply chain. We all know this story well. But the key takeaway is that the world is rapidly moving away from globalization. This adjustment is very painful and will take years or even decades to unfold. I will not bore you with the shift in the production of chips, batteries, nickel, and rare earth. The underlying uncertainty could cause disruption and inflation for many years to come.

2. The war in Ukraine is changing the world order before our eyes whether we like it or not. The supply shock to the energy market is one aspect, but there are many more which are not in the headlines. For example, the Russian demand that oil payments be made in RUB has forced the industry to navigate around sanctions by participating in an offshore RUB market. Russia will be part of a bifurcated financial system, and it remains unclear to what degree other countries will join them.

 Looking beyond the numbers and the constant headlines, it is important to keep an eye on other symptoms of the current rates/inflation environment. The best example is probably tech stocks. Why are they going down faster than other sectors? Simple, since you are taking the NPV (net-present-value) of a cash flow that is so far in the future, increasing the interest rate used has a dramatic impact on that NPV. If the market expects much higher rates, that tells you everything you need to know about where the NASDAQ is going so long as interest rates keep rising.

We have all taken low-interest rates for granted for two decades. This is true for small businesses, angel investors, banks, students, and home buyers. Literally everyone. The ripple effects of a hawkish fed are impossible to predict.

So, what to do?

Watch the FOMC for signs of slowing down on the hikes. Watch other countries’ central banks for clues on when they will try to play catchup. Pay attention to inflation and GDP data everywhere. If growth and inflation falter enough to knock the Fed off this course, then watch for higher equity indexes, a lower USD, and higher bond prices. If growth and inflation continue to perform, then rates will go higher, and indexes and bonds will both suffer. It appears there is nowhere to hide right? Do not forget that equities are priced on their performance over the very long haul. A thriving, growing economy will nurture solid companies and they will have value no matter what.

Things to remember about FX:

A key area of focus is the value of the US Dollar. The FOMC has taken the lead globally on hiking rates. As such, the USD has been the biggest beneficiary. The strong dollar has insulated the US from even worse price shocks. Imagine that oil, priced in US dollars, went up 30% and your currency dropped 12% at the same time. That is the situation in Japan. And they are keeping rates at zero still!

The USD can rally substantially and much more quickly than it has done recently. USDJPY at 200? Completely possible. We can all remember USDCAD on the 1.60 handle. I am sure many can also recall EUR below .8500. These things happen. Volatility both implied and realized remain reasonably low. That can change. Prepare for dramatic uncertainty (and FX moves) and don’t be surprised when it happens. We have yet to see spillover into credit markets and there have been no margin call liquidations. There will be. We are in the very early stages of economic upheaval.

Have a plan

In times of uncertainty, it is especially important to have a clear idea of what you want to do in any eventuality. Any exposure needs to be accounted for and taken seriously. Hedging in advance is the most straightforward approach. If you plan to hedge with forward contracts, you may want to consider the funding impact if the hedge moves against you (which means your underlying position is moving in your favor). For example, you may need to post a higher variation margin if your hedge loses value.

Another approach is to leave a stop loss or a call level. A stop will give you some clarity on what your worst-case scenario can look like. A call level will still leave you with a decision, usually at a challenging time.

Lastly, while FX moves will directly impact your P&L and the value of your invoices, it can also impact your underlying business. When the FX changes, the terms change. Consider this carefully in forecasting revenue streams. Keep a close eye on revenue as markets change and be prepared for both positive and negative impacts from FX.

Talent Foreign Exchange stands ready to guide you through what lies ahead.

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