Amid noisy and conflicting economic data, the fight between Bulls and Bears is raging. Signs of slower growth is considered as “good news” by optimist investors who see the case for a pause in Fed tightening or even rate cuts early next year. For the more pessimist ones, a renewed drop in US treasury yields is reflecting an upcoming recession. We admit it is difficult at this stage to say if we are heading to a soft landing, or a more severe drawdown. It is fair to say that we remain dependent on upcoming data to forge a view about the future direction of financial markets, as much uncertainties remain on the inflation and consumption front.
Inflation is showing signs of peaking but is unlikely to fade quickly
- Inflationary pressures are now broad based stemming from food, services to real estate. Wages, typically a lagging indicator, are also rising.
- As a glimmer of hope, the latest US CPI eased to 8.5% in July from 9.1% in June due to a more favourable base effect and largely due to a sharp fall in energy prices. US producer prices also fell to 9.8% yoy from 11.3% in June. However, the core PPI excluding food, energy and trades rose to 6.4% from 5.8% in June. US average hourly and weekly earnings declined to 3% yoy from 3.6%. Stress on global supply chains eased in July to the lowest level sincecentr January 2021 as port congestion eased. The speed of US supplier deliveries is also improving. That being said, inflation looks unlikely to drop substantially over the near term on a combination of cyclical and structural factors.
- US labour market conditions remains extremely tight despite tentative signs of softening (small increases in weekly jobless claims and layoffs). US employers hired far more workers than expected in July, with the unemployment rate falling to a pre-pandemic low of 3.5%, providing evidence that the economy was not in recession yet. Nonfarm payrolls increased by 528,000 jobs well above forecast for 250k jobs. The unemployment rate was steady at 3.6% in June. Economists do not expect a sharp deceleration in payrolls growth this year. The employment report points to a fairly healthy economy despite a 1.3% GDP contraction in the first half, largely because of big swings in inventories and the trade deficit tied to global supply chains. Still, momentum is slowing.
- Energy prices have fallen substantially over from a peak of USD 132 in March to USD 92 on August 11th amid heightened concerns about a possible global economic slowdown and greater supply, but remain well above pre-covid level. The International energy Agency (IEA) flagged that China overtook Europe for the first time as the main destination for Russia’s crude.
- Prices for other commodity like gas, wheat, copper, zinc seem to stabilize albeit at a very high level. Copper, which is typically seen as a good indicator of the economic activity, is hovering at a level well above pre-covid crisis. Natural gas and electricity prices have soared to new records incentivising the use of oil in power generation. The International Energy Agency (IEA) however said increasing demand is masking weakness in economies beset by recession fears.
- The second round effect of rising wages has yet to come.
- The transition to a greener economy and clean energy will be a long, slow and costly process, with huge investments needed as infrastructure needs to be put in place first before being able to distribute such energy. Prices for Lithium used in batteries for electrical vehicles are skyrocketing.
- Climate change is a global concern even more acute in some countries like India, Africa were water scarcity is endangering crops and hence grain prices.
With major central bankers obviously behind the curve, hawkish stances are likely to stay
- Most central banks have lined up in recent weeks with aggressive rate rises, the United States, Canada, New Zealand, Europe and Switzerland among others. Japan, which is yet to lift rates, is left as the dove among the 10 big developed economies.
- We think markets underestimate the Fed tightening cycle. Fed officials confirmed that they were not done with their liquidity tightening process, suggesting that inflation is still there and that monetary policy is still behind the curve. While signs are emerging that inflation may have peaked, there is still a long way to go to before inflation falls to the Fed’s 2% target. At best, headline inflation could hover around 4-5% by year end. As such, 10 year bond yields at 2.5% and short term rates at 3% will be too accommodative to tame underlying inflationary pressures. We expect Fed rates topping at 3.5 – 4% at best.
- Bets on ECB further rate hikes increased again after the European Central Bank hiked rates by 50 bps to 0% in July confounding its guidance for a 25 bps move. Another 50 basis-point hike looks likely at the September meeting. The ECB expects inflation to average 6.8% in 2022 before falling to 3.5% in 2023 and 2.1% in 2024, which looks optimistic in our view.
- The Bank of England will almost certainly hike rates for a sixth time in August following data showing inflation in June surged to a 40-year-high of 9.4%. The BoE forecast inflation falling sharply in two to three years as the recession saps demand.
Recession risks likely more pronounced outside the US
- While Global PMI data still point to economic growth, the forward looking components like new orders already point to contraction. Evidence is piling that stubbornly high inflation and rising interest is weighing on consumer confidence and business sentiment.
- Inventories are rising as consumers spend all their money on basic necessities such as food, drink and their mortgages is widespread. A positive aspect of higher inventories is that prices should come down.
- So far, much of the loss of purchasing power has been offset by a decline in savings and an increase in the amount of outstanding credit card debt. According to True Insights, the ceiling now seems to have been reached.
- US PMI data are still pointing to growth and business sentiment is showing early signs of bottoming, fuelling some glimmer of hope that a sharp downturn will be avoided. Economic data however remain noisy, paving the ground for boom and bust sentiment. The US yield curve, measuring the gap between yields on two- and 10-year Treasury notes and seen as an indicator of economic expectations, is deeply inverted at below minus 40 bps, near the narrowest since 2000. A flattening yield curve is usually seen as a sign of an economic slowdown and inversions as predictors of recessions.
- Europe is feeling the brunt of the Russian gas crisis. Western economic sanctions against Russia will have a long term impact on European economies as the EU faces the difficult task of finding alternatives to Russian oil and gas. European buyers have to look elsewhere, stretching supply from countries as far away as South Africa, Australia and Indonesia, where quality varies. This is likely to result in an ironic global scramble for coal, the dirtiest fossil fuel, endangering the path to a greener economy. Global ratings agency Moody’s forecast a cut-off of Russian gas supplies would lead to a contraction of euro area GDP of 2.5% to 3.5% next year. The ECB sees growth at 3.7% this year, 2.8% next year and 1.6% in 2024. The euro zone Consumer Expectations Survey showed households were bracing for the economy to shrink and for high inflation to continue eating into their income in the next year, with inflation expected to rise by 5% over the following year and 2.8% in three years’ time. The BoE said Britain would enter a recession at the end of 2022 and not emerge until early 2024.
Earnings estimates revised down
- Corporate profits have been solid so far this year. Of the 456 companies in the S&P500 having reported earnings to date for Q2 22, 78% reported results above analysts’ expectations. S&P500 Q2 earnins are expected to grow 9.7% from Q2 2021. Of the 229 companies in the STOXX 600 having reported earnings, 62.4% reported results above analysts’ expectations. Stoxx600 Q2 earnings are expected to grow 31.6% (+11.2% ex-energy).
- But expectations for the rest of the year are declining. While companies with pricing power have been able to pass on their higher production costs to their customers, others have not. Profit warning from retail giant Walmart is a worrying signal of slowing US consumption and a stagnant economy at best. Walmart pointed to a change in the spending pattern of American consumers. As a result of the continuing rise in food prices, they now spend more on basic necessities such as food, drink and their mortgage. In order to get rid of the increasing stock, Walmart has to lower its prices considerably, which results in lower profits.
- According to Refinitiv Q3 earnings growth for the S&P 500 has been revised down to 5.8% from 11.6% forecast at the beginning of the quarter. Q4 earnings growth has been revised down to 6.5% from 10.6 %. S&P earnings are now expected to rise by 8% in FY22 and in FY23.
- Earnings for the Stoxx600 are expected to grow by 28.4 % in Q3, 14.2% in Q4 before declining by -2.5% in Q123, -10.8% in Q223 and -1.6% in Q323 largely due to a sharp growth reversal in Basic materials, Cyclical consumers, energy, Industrials, real estate.
Flexibility is key
The recent U-turn in both equity and bond markets was quite surprising to us. After anticipating a marked worsening of the macroeconomic environment in the first half of the year due to rising inflationary pressures and more aggressive Fed tightening than anticipated, the S&P 500 has rebounded by 14% since June 16th’trough, suggesting that investors are betting on the end of the Fed’s series of interest rate hikes, which
- looks premature for us. Much confusion remains about macroeconomic numbers. This summer rally could be seen as a technical rebound at best.
- In a most hated market rally, we increased equities to 50% from 40% with a focus on US equities where corporate fundamentals look stronger. We keep an Underweight in Europe (more cyclical and sensitive to a global economic slowdown and energy disruption), Emerging Markets and Japan.
- Upside potential however looks limited from here as equity markets are not cheap. The S&P500 is now trading at a forward PE ratio of 17.5X, below the 5 year average of 18.6x but above the 10 year average of 17,0x, and well above the 15.8 PE ratio registered at the end of Q2 while earnings expectations have been revised down slightly (-1%). While some moderation in prices may be awaited in the second half of the year due to favourable comparison basis, we believe inflation will remain elevated for the next two years, leaving little room for multiples expansion.
- We think markets will remain highly volatile until we have a clear view of the end of the tightening cycle, probably at the end of the year. Economic data however remain noisy, paving the ground for boom and bust sentiment. A Fed tightening above market expectations has still the potential to further disrupt financial markets over a 6-12 months horizon. A reverse “wealth effect” could then kick in, slowing consumer spending, lowering corporate earnings and eventually leading to recession.
- We maintain an Underweight in bonds as we think markets underestimate the Fed tightening cycle. We prefer short duration High Yield and inflation linked. We restarted a small position in Emerging Market Debt but refrain from a more constructive view as the asset class remain vulnerable to further US rate hikes and a stronger dollar. High Yield markets offer some value but still face the risk of a deterioration of in credit fundamentals in the second half of the year.
- We remain flexible enough to adapt our strategy to incoming data.