Markets continue to see sharp falls.
A series of hawkish actions from central banks provided the catalyst last week, signalling their desire to raise rates more quickly. Some are interpreting the latest moves as signs of panic.
The Fed hiked 75bp. Their “dot plot” of expected hikes signals another 75bp in July, 50bp in Sep and then two 25bp moves to end year at 3.4%. Three months ago, this figure was 1.9%.
Elsewhere the Swiss National Bank delivered a surprise 50bp hike — their first in 15 years. The Bank of England increased rates 25bp and signalled they may add another 50bp in August.
There have been some decisive shifts in the way the market is behaving. Looking across asset classes:
The market is now fearing a recession. This is leading to two trends:
The core issue is whether the US ends up in recession. Investor surveys suggest an 80% probability. CEOs are suggesting 70%.
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The market is concerned that the Fed has been cornered — it can see the risk of recession is rising, but needs to restore inflation credibility and raise rates quickly to at least get to neutral. We are all paying the price of central banks getting policy so wrong in 2021.
The Fed’s emphasis on spot inflation is concerning. This approach is flawed because it is driven largely by fuel and food factors where Fed action has little influence.
Chair Powell referenced the University of Michigan survey on inflation expectations, which is known to be correlated to fuel pump prices.
The combination of this backward-looking focus and the size and pace of rate increases means there is a high probability of over-tightening and a recession.
Under this scenario the S&P 500 is likely to fall through the 3500 support level at least to 3200, consistent with pre-pandemic levels.
The ASX is better protected in this scenario given lower valuations in a historical context, support from a weaker Australian dollar and index composition.
It was a busy week for central bank watchers:
There was only one dissenter against the Fed move. Ester George of the Kansas Fed argued for a 50bp hike given the uncertainty a 75bps hike could cause.
The remaining members of the Federal Open Market Committee justified the 75bp hike on the basis of a higher CPI print and the University of Michigan inflation expectations gauge.
They now expect rates to be a “moderately restrictive” 3.4% by the end of 2022, up from 1.9% in March. The ultimate peak rates are seen as 3.8%, previously 2.8%.
In their economic projections the end CY23 PCE inflation forecast rose 10bp to 2.7%. It is expected to be 2.3% (below the 2.5% target) by the end of 2024 and 2.3% at the end of 2024. Unemployment is expected to rise to 4.1% by the end of 2024.
It is worth bearing in mind the Sahm rule — that a 0.5% rise in unemployment signals a recession.
In an effort to soften the message Powell said in his press conference that the Fed would be flexible in implementing policy. But containing inflation is the priority.
As much as the Fed says it does not have to lead to recession, all logic suggests it will if the rate hiking path continues as signalled.
The central banks of the US and Australia continue to emphasise that the economy remains in good position to withstand rate hikes.
While this sounds reassuring, it’s also a problem since policy makers need to create slack in the economy to ensure the second-order effects of inflation don’t flow through. This implies even tighter monetary policy.
There were two important developments last week.
First, the RBA indicated their modelling (using current commodity prices) has inflation at more than 7% by the year’s end.
Second, we saw an increase of about 4.7% in the minimum wage and low-end award rates.
These show Australia faces similar challenges to the US with high inflation triggering second-order inflationary pressures in areas such as wages.
The RBA hopes that easing commodity prices — combined with companies being prepared to absorb cost pressures through lower margins — will stop an inflationary loop. For that to occur the economy needs to be weaker. By definition that would lead to earnings weakness.
The hope for Australia is that lower inflationary pressure, a looser job market and more exposure to variable rates means sufficient cooling can occur without rates needing to rise to the 4% level the market is predicting. But this would require a material slowdown in growth.
Our sense is the RBA is three months behind the Fed in gauging what they need to do.
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The ECB held an emergency meeting to signal they were working on a mechanism to backstop the peripheral bond spreads.
Italian spreads did fall. But the important point was that through controlling the spread they would enable policy rates to be pushed higher without creating another periphery crisis. So this is a negative signal for tightening.
The rate increase here is more technical in nature since it does not apply to local borrowers. It is believed to be a signal that they want to stop further weakness in the Swiss franc to help contain inflation.
This may lead the Swiss central bank to liquidate offshore investments, where they have holdings in German Bunds and US equities.
The Bank of Japan continues to dig in and remain committed to yield curve control. This is putting a lot of pressure on the Yen, which is heading back to its lows and approaching levels last seen in 1998.
We could see a major crack in terms of FX markets given the divergence between Japan and other regions. This adds to overall uncertainty.
It is increasingly hard to see how the US avoids a recession from here.
First the lagged effect of inflationary pressures means we are unlikely to see much relief on this front given fuel, food and shelter components are still rising. This gives the Fed little room to back off hikes.
Second, the lead indicators of activity are deteriorating:
Putting these factors together, you can see why the Atlanta Fed GDP tracker is deteriorating and is well below market consensus on growth.
This is also coming through at a global level with GDP growth forecasts for 2022 and 2023 rolling over.
This is an important issue for commodities.
Copper is a key indicator to watch. It has weakened recently and while it hasn’t broken through technical support measures, it is sitting on them.
This economic risk has implications for the market.
The market is discounting a material drop in earnings while they continue to hold up. Since 1987 we have only seen this disconnection twice (in 2002 and 2011) where markets overstated risk.
However in 2000, 2008 and 2020 earnings caught up with the market. Therein lies the risk if the US and global economy go into a recession.
Valuations in markets other than the US — including Australia — are lower and provide some protection. But we remain wary of how the market performs as downgrades come through.
While the risk is material, this bearish scenario is not a certainty. Factors which could see a better outcome include:
Should these factors start to play out we may see the Fed swerve again and be less aggressive on rates.
It’s unclear if this would be enough to avoid a recession. But in the market’s eyes it would at least signal the depth of the downturn could be lower.
The medium-term outlook is still bearish but there are signs the US market is tactically oversold — as you would expect after such a big move.
However we are not seeing signals to suggest the market is forming a bottom.
Put/call ratios are not at extremes. The number of stocks putting in a 52-week low is still expanding.
One signal to watch is the divergence between stocks and the market. Note the top was formed well after the average stock had rolled over. A similar outcome is likely at the bottom.
The other flag which is likely to mark the low in this cycle is the passing of time.
This market looks closer in nature to 2000 and 2008 where the market had to consolidate near its lows for a number of months before sentiment improved – unlike the sharp policy-driven bounce of 2020.
It is also worth noting that energy stocks could see a decent correction following a period of strong relative performance.
We’d likely see this as an opportunity, given supply issues remain severe with no sign of resolution.
There were few places to hide last week. The 20 largest stocks were as weak as the smaller caps.
Mining and energy underperformed. The gold miners held up well, as did some interest-rate sensitives among the financials and the defensive telco space.
Miners, industrials and tech were all hit hard. Most of the selling was largely indiscriminate. We are in a relatively quiet period for corporate news so expect the macro factors to dominate for now.
Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.
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