US equities plunged by almost double digits on fears that persistently high inflation will force the US Federal Reserve to more aggressively hike interest rates. Five rate hikes together adding 1.25% to borrowing costs are now expected after US inflation hit a record 7%.
Normally a significant market wobble would tempt investors back into the market while stocks are cheaper. They should however watch their step, as four headwinds stand in the way of the bull market resuming.
The overarching question bothering investors now is when is it time to buy the dip? That’s a valid question, because when you look at the sell-off in developed market equities in the year to date, it roughly matches the historical average sell-off around the time of a first Fed rate hike, which we envisage will come in March.
The historical drawdown averages at 11%, and the S&P 500 Index lost 9.8% in January, so that’s close to bottoming out. Nonetheless, there are four main risks that markets need to navigate now, which keeps us a bit cautious about buying this dip in the multi-asset fund. Basically, this dip is not as easy to read as previous corrections.
Inflation is the big problem
He says the main problem remains inflation, which has spiked following supply shortages as the Covid-19 lockdowns ended and energy prices soared, leaving companies and consumers with much less purchasing power.
The first risk is that we think inflation risks are still skewed to the upside over the next few months, although we expect them to drop steeply after that. Financial markets are recognizing that the Fed is now in inflation-fighting mode and have priced in five rate hikes for 2022 to address this inflation risk.
This could create some further turbulence, but afterwards we think the markets will recognize that inflation is decelerating, at least in the cyclical parts of the economy. When you look at the base rate effects of oil prices dropping out, then overall CPI inflation should still drop to about 3.5%. This means it will have halved compared to current year-on-year levels.
The inflation risk premium – the compensation investors are demanding to shield them against unexpected inflation – has been declining lately. The inflation story has been top of mind over the past year, but this signal from the bond markets tells us that the market can navigate this.
Consumers are key
The second risk is decelerating demand for durable consumer goods such as household appliances and cars as the pandemic ends and the service sector reopens.
Durable goods consumption has skyrocketed on the back of all the elevated lockdown intensity over the last 18 months, when people could not go out to fancy restaurants, so they ramped up spending on durable goods instead.
‘People could not go out to fancy restaurants, so they ramped
up spending on durable goods instead’
That will likely come down as economies further reopen once the Omicron wave has fizzled out. Declining goods consumption could result in declining manufacturing indicators such as the ISM. That could raise the risk of a growth scare, especially if the ISM were to drop below the 55 level (a reading above 50 signals growth).
The consensus real GDP growth forecast this year of 3.8% is consistent with an ISM of around 56. If we were to see a drop below that level, then the markets could be negatively surprised by it. Any growth scare could be short lived because a rebound in services activity should keep growth above trend, so it’s a risk that could be overcome by markets.
Then there are the current tensions between Russia and Ukraine, though investors would do better looking at the value of credit default swaps (CDS) than the 100,000 Russian troops massing on the Ukrainian border.
The current Russian government CDS spreads are only one-third of the levels observed around the peak of the 2014 crisis when they annexed Crimea. Back then, CDS spread levels were at 600 basis points, and now they’re about 210 bps. We can therefore be quite confident to say that this risk is underpriced.
Putin could try to conquer the disputed Donbas region of Eastern Ukraine after returning from the Winter Olympic Games in Beijing, but his broader ambitions face constraints given severe retaliatory sanctions from the West. One thing to remember is that any country with a disputed border is very unlikely to become a NATO member. So this could all be short lived.
The crisis is therefore unlikely to create a new bear market, though it could push the oil price up from the present USD 89 a barrel above the sensitive USD 100 level. But all in all, that seems to be a manageable risk.
A less-friendly Fed
The fourth and final risk is more serious, and not that easily countered, and this circles back to what caused the January correction in the first place – a less market-friendly Fed. Hiking rates is one thing, but quantitative tightening is quite another.
Stock market multiples could decline accordingly with a shrinkage in the Fed’s balance sheet, reversing the process observed during quantitative easing.
The US stock market valuation is still historically elevated when you look at the conventional price/earnings ratio of the S&P 500. Multiples all fell when the market sold off in January, but the S&P 500’s P/E ratio is still 30% above its 40-year historical average.
The big question is whether the Fed is indeed becoming less market friendly, and that remains to be seen. If inflation risks are decelerating then the Fed guidance could become less aggressive in the second or third quarter, and that could also lead to rate hikes moving further out.
Still constructive on equities
So long as growth rates in developed markets remain above trend – and that is our base case – we think that equity markets can handle a further rise in real interest rates and take all this in their stride.
Though dips are not as easily bought as in recent years, this correction does not herald the end of the bull market in equities, nor does it signal the passing of the expiration date of the TINA (There IS No Alternative) trade.
Current relative valuation metrics like the equity risk premium tell us to be guarded, as downside risk is rising, though history shows that stocks typically still outperform bonds at these levels. We are still constructive on equities for the next 12 months and retain a modest overweight in the multi-asset portfolio.