12 Oct 2022
Investors should remember that monetary policy always works with a substantial lag and the Fed, who first started raising rates in March, were at that stage easing slightly off the accelerator rather than putting a foot on the break, with monetary policy only moving to restrictive levels at the last Fed meeting. On this basis, the current resilience of the US economy should not come as that much of a surprise with the US not experiencing the same degree of energy and cost of living price shocks as Europe, including the UK. The impact of higher US rates on the economy is likely to be only fully seen in the latter part of the fourth quarter and going into next year. There are tentative signs in the labour market though and PMI surveys indicating a slowdown in the US economy taking hold and anecdotal reports of job layoffs and hiring freezes, especially in the previously buoyant tech sector.
Voluntary quit rates have returned to more normal levels and the most recent data showed a rapid pullback in advertised job vacancies, so we may be at the cusp of a turn in the US labour market. The Fed has clearly been concerned that an overly tight labour market is leading to wage growth out of kilter with longer-term 2% inflation expectations. With rates due to rise faster than previously expected over the remainder of this year, and perhaps continuing in a similar vein early in 2023, it is likely that the US will enter a short but shallow recession at some time next year which will no doubt drive up the unemployment rate. Ironically, this should prove to be good news for financial markets. Consumers are under pressure from rising prices, but in the US, they have been shielded from the extreme volatility of energy prices and the relatively strong employment position once again suggests that this time, recessionary conditions should be relatively shallow, certainly compared to the 2008 or 2000 periods.
Perhaps the sector of most concern or risk to the US economy is housing where mortgage rates, having started the year at or around 3%, have risen to over 6%. Over the last century in the US, housing has been an influential driver of economic growth, whether one looks at investment, employment, or consumption.
All in all, it appears likely that the US economy is now starting to slow, and the rate of slowdown will accelerate as the fourth quarter progresses. This is likely to lead to an easing of inflationary pressures which, with investors anticipating changes in monetary policy and the economic cycle at ever earlier stages, could well be the catalyst for improved investor sentiment before the end of the year.
Economic prospects in Europe remain more muted with significantly higher energy costs (natural gas prices are reported to be around 10x those of the US for industry). Consumers and businesses will face a greater squeeze to their cash flows, and it seems likely that Europe, certainly core countries such as Germany, are already in recession and there’s a greater risk of a much more severe downturn than in the US, even without the possibility of a serious escalation of hostilities in Ukraine. Continued inflationary pressures and relatively high levels of wage growth are likely to force the ECB to continue to tighten monetary policy aggressively, even in the face of rapidly slowing economic growth.
The UK has embarked on an economic experiment with policy now dominated by the theories of right-wing economic think tanks with no empirical evidence that these will work in practice. A government run by ideologues does not auger well for an economy already suffering from post-Brexit fallout where negative predictions may have just taken longer to come to fruition rather than being completely wrong. For the UK economy, the cost of capital has risen, the spike in interest rates will have a significant impact on the housing market, and the fall in Sterling will raise inflation for a large percentage of the population.
Falling commodity prices have typically been a positive for most consumers at times of economic slowdown. Since its June peak, the oil price had pulled back by over 25%. However, the complicated world of geo-politics today means that Opec + (with the top producers’ autocracies no longer favourably disposed to the West) have seen promises of quite drastic production cuts to stem the fall in the oil price. To date, Opec+ has demonstrated strong production disciplines to maintain oil revenues at high levels, although a more significant global economic downturn might raise tensions within the cartel. Clearly, a rise in the oil price at a time of slowing economic growth would not be a positive for the global economy. Elsewhere, most industrial commodities have been weak with significant falls in the iron ore price and copper trading well off its highs. Downward moves in commodity prices are typical of most recessions.
The backup in government bond yields has meant that there is now a real alternative to equities and one of the more damaging influences on valuation during the third quarter was the significant rise in US real yields where 10-year TIPS at one stage offered a real return of 1.5% over the maturity of the bond, something not to be sneezed at (for US$ based investors). Around a year ago, real US inflation protected bond yields - 10-Year TIPS - were negative to a level of around -1% and this upward move has hurt equities.
As long ago as May, the US Federal Reserve had indicated a more focused approach on containing inflation. During the Fed press conference following the May rate setting meeting Chair J. Powell had stressed how much he had admired the tough decisions Paul Volcker had made to contain inflationary pressures. At the most recent Fed meeting, Powell emphasised that a return to periods of long economic expansion inflation needed to be contained. Post the Fed’s Jackson Hole briefing and the most recent interest rate setting meeting, the market realised that the risk of recession on the back of a hawkish Fed had risen significantly. The last few weeks have seen geopolitical risks increase as the Ukrainian successful counter offensive puts Putin’s back to the wall and the Russian leader cannot afford to be humiliated. In the short-term, these may well remain difficult times for investors and a 3,600 level on the S&P 500 is still above the sort of base level where there would be strong valuation support. In today’s world it is unfortunate but true that the greater the Ukrainian success on the battlefield, the higher the risk to markets from Russian use of non-conventional weapons and the stronger the US jobs market, the higher US rates need to go to contain inflation. For now, seemingly good news is bad news for markets.
Market commentators and investors both now see a primary downward trend in equity markets together with gloomy investment commentary. Furthermore, sentiment indicators in the short-term are at bearish extremes. While the immediate news flow looks extremely negative, markets anticipate change in policy and in recent years have moved to discount a changing scenario ever earlier in economic cycles. Thus, markets may once again anticipate a change in Fed policy well before their occurrence even if the visibility for this is currently low. This was seen to strong effect in the Covid-19 pandemic when markets anticipated further monetary easing and fiscal support for economies by governments, even before policies had been definitively announced with the market rallying at an earlier stage than most investors anticipated.
The mood of the market is often to focus on one economic influence or key variable which today is inflation. When investors think inflation is coming under control and interest rates can stop rising, both bonds and equities are likely to see a meaningful rally, particularly if sentiment indicators remain deeply negative. This can occur well before the Fed Funds rate reaches the likely 4.5% – 4.75% terminal rate indicated in the latest minutes. Signs that inflation is peaking may once again persuade investors that the Fed will change tack on interest rates earlier than they have indicated. Other key economic indicators to watch are both the housing market and employment levels. In the past, housing has been a key driver of US economic activity as discussed earlier and this is a potential catalyst for Fed policy easing.
The prospects are reasonably good for an initial rally on signs of weakening in the US economy, which will ultimately result in lower inflationary pressures, but for this to turn out to be more than a bear market rally and the start of a new prolonged market upswing, in other words the start of a new bull market, it will depend on which economic scenario is viewed as likely. At present there are, in reality, three options: a soft landing, a hard landing, or stagflation. It is likely that markets will see an initial rally well before the economic outcome is certain. For an initial rally to continue, the economic environment going forward will be critical. A soft landing would be where inflation is coming down steadily towards the Fed’s 2% target without a significant downturn in economic activity. In other words, while there is an economic slowdown, corporate profits will not come under severe pressure. A hard landing would be where inflation stays stubbornly high and economic activity falls sharply but the Fed would be forced to continue to raise interest rates to get inflation back under control. This would have very negative implications for corporate earnings and the fair value PE valuation. Stagflation would be where inflation settles at a level well above 2% and economic activity, while positive settles at a very modest level, even lower than in the post GFC period. This would see the rally stall and the stock market move into a prolonged period of volatility with little in the way of gains at the index level. In this scenario, markets would trade on lower valuations than the post GFC period.
Forward looking investors need to identify catalysts for thinking inflation is coming under control and a possible time when these might become more apparent. Inflation and economic activity data releases will be watched closely and continue to have outsized influence on short-term market moves. The markets will also be very sensitive to any softening in the Fed’s hawkish positioning, although this seems very unlikely in the remainder of 2022. After the criticism of the Fed for moving so slowly, it cannot afford to back down too early.
In the short-term, there will be a focus on data releases. Even with inflation, there are multiple moving parts, many of which are opposing, so forecasts should be viewed with some degree of scepticism. Even today, the global economy is dealing with opposing influences from the lagged effects of the Covid-19 fiscal stimulus which is positive and the negative effects of monetary tightening which always works with a significant (12-18 months) lag. Over the remainder of the year, the odds favour future data releases on both inflation and economic activity being lower, particularly from mid-November onwards. In this environment, investors need to be prepared to act quickly if necessary.
The other key influence in the near term is developments in the Russia/Ukraine war. Ukrainian successes have in some ways made Putin more dangerous as he may want to take retaliatory measures to avoid humiliation and loss of face. Putin will also be aware that if European support for the war holds until next summer, Russia’s energy bargaining position loses its potency, even ahead of next winter. As well as announcing a mobilisation of a further 300,000 troops, Putin has also raised the possibility of a nuclear strike, and if this occurred, the US would have to respond in some form. The implications for stock markets in such an eventuality do not need to be spelled out.
On a more positive front, it is conceivable that the recent Ukrainian advances, together with cautionary comments from China, Russia’s principal backer, and nominally neutral countries such as India, may encourage Putin to look for a face-saving exit strategy. There remains an outside chance of regime change at the Kremlin. Investors need to be prepared for both adverse and positive developments in the Ukraine war which would have strong implications for markets generally, but for Europe in particular.
At this stage it is impossible to make a call on which US economic scenario will evolve. There are sharply differing opinions by many well informed and intelligent market commentators and economists and the Fed itself are divided on this, illustrated by the wide range of interest rate dot points for 2024. However, in the current pessimistic environment with negative sentiment among individuals and institutional investors, there is a need to be prepared for a rally as and when lessening of inflation concerns occur. This is likely to be in the second part of the fourth quarter of this year.
Traditionally, investors would look to historical precedents for guidance, but this is extremely difficult in today’s world. The pattern of the bear market this year does have some resemblance to the TMT blow up of 2000/02 as technology stocks initially bore the brunt of decline in both market downturns. In 2000/02 there were several shorter bear market rallies and if the economic environment weakens, a fall below 3,600 in the short-term remains possible. Bottom-up earnings estimates in the US for 2023 are still expecting an increase which is unrealistic. The expected 2022 earnings outcome for the S&P 500 is around $225 which if using a 15x multiple (a conservative valuation level) would see an Index level of 3,375. The same multiple on a 5% decline in earning would see an Index level of 3,200.
Investors should remember that significant bear market rallies are not unusual and when they are occurring it is impossible to be sure whether this is the end of the bear market or just a short-term bounce. Back in 2009, the initial market rally which started in Q1 and continued over the remainder of the year, drew scepticism from many commentators that this was only a bear market bounce, when in fact it ushered in one of the longest running bull markets in the US. It is also impossible to be dogmatic, and certainly unwise, to try and predict the level from which a rally could occur.
Investors should continue to try and ignore market noise and try to focus on a combination of fundamentals, both economic and geopolitical, valuation and sentiment for broad guidance. This suggests investors should be prepared to commit funds during the fourth quarter, particularly if the market retreats to the levels indicated above for the US.
Other markets today selectively offer good value on a 5-year horizon, particularly in the Asia Pacific and certain emerging markets where valuation support is much stronger versus historic levels and compared to developed markets than occurred pre the Financial Crisis.
As well as thinking about overall market levels, investors need to also consider who will be the specific beneficiaries of a lessening of US inflation concerns, subject to how events in Ukraine unfold. In terms of currencies, the overcrowded US$ trade is likely to reverse in favour of the euro and even the yen. There is potential for Asia Pacific, Emerging Market, Japanese and European Equities to perform well.
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