Weekly market update - 20th of June 2022

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 the year at 3.4%. Three months ago, this figure was 1.9%. Elsewhere the Swiss National Bank delivered a surprise 50bp hike — the first in 15 years. The Bank of England increased rates 25bp and signalled they might add another 50bp in August.

There have been some decisive shifts in the way the market is behaving. Looking across asset classes:

• Equities were weak across the board last week: S&P 500 -5.8% (-22.3% CYTD), NASDAQ -4.8% (-30.7% CYTD), Euro STOXX 50 -4.5% (-18.9% CYTD) and the ASX 300 -6.6% (-11.7% CYTD)
• US 10-year bond yields rose to 3.5% — their highest level in 11 years — before falling late in the week to 3.23%
• Credit spreads — particularly sub-investment grade — widened
• Commodities sold off: iron ore -14.3%, copper -4.4%
• Crypto crashed. BTC was -28.1% for the week

The market is now fearing a recession leading to two trends:

1. Liquidated positions, ie selling becomes more indiscriminate as correlations rise
2. Value is underperforming (led by energy and materials) for the first real-time this year on the basis of cyclical risk. This is why we are now seeing the ASX underperform other markets

The core issue is whether the US ends up in a recession. Investor surveys suggest an 80% probability. CEOs are suggesting 70%.

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 primarily driven 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 may find some protection in this scenario, given lower valuations in a historical context and support from a weaker Australian dollar and index composition.

Central bank policy

It was a busy week for central bank watchers:

Monday – The Wall Street Journal ran a story that the Fed planned to hike 75bps
Tuesday – The European Central Bank announced an emergency meeting to address the issue of fragmentation amid concern about Italian bond spreads widening too far.
Wednesday – The Fed hiked 75bp, and signalled the rate would peak at 3.8% (the market is pricing in 4%).
Thursday – The Swiss National Bank unexpectedly hiked 50bp and removed its currency intervention. The BOE hiked 25bp and signalled they might need to go 50bp in August regardless of the economic state.

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.

Australia

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.

Europe

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 by 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.

Switzerland

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.

Japan

The Bank of Japan continues to dig in and remains 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.

US economy

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:

• The “rule of ten” (which looks at the historical correlation of mortgage rates plus petrol prices on consumer spending) has a good track record of predicting slowdowns and recessions  It is now above the crucial “ten” mark.
• Housing looks like it is about to roll over as affordability deteriorates at an unprecedented rate  The only thing propping it up, for now, is low inventories  Falling house prices flow through into other areas of consumption.
• Consumption has benefitted from a material tailwind of credit growth and home equity withdrawal, which is likely to slow down  Even if this stabilises at current levels it removes an impulse to consumer spending.

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 that could see a better outcome include:

• Inflation momentum slows more quickly than expected  There are signs of hope with the higher inventory at US retailers and evidence of discounting appearing  The fall in the oil price is a very important lead if sustained.
• Labour markets loosen up sooner  We have seen announcements from the tech sector on layoffs, but collectively this is not sufficient  On the supply side perhaps inflation and the crypto bust help drive participation higher.
• Supply chains begin to ease up as China re-opens and demand softens.

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.

Markets

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.

• We saw the first sign of an extreme in sentiment in this bear market with the 10-day average of advancing volumes falling to its first percentile (ie the number of stocks falling on a short-term basis is at extreme levels)
• Another flag was Monday’s 46:1 decline/advance ratio in the market  On Thursday it was 17:1.
• Both are among the worst ratios for years
• We saw a spike in flows into short-dated treasuries
• Investor sentiment is pretty bleak

However, we do not see 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 when the market had to consolidate near its lows for a number of months before sentiment improved – unlike the sharp policy-driven bounce of 2020. 

Australian equities

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.

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