The Wild Ride Continues
November 7, 2022
Most global markets rebounded in October, following a period of poor performance in August and September. In particular, U.S. equities benefitted from a solid earnings season and oversold conditions and registered the largest gains. Chinese stocks disappointed as the 20th Party Congress did not result in a significant shift away from Beijing’s current macro and regulatory policies. However, Chinese stocks have started to rebound in November. Meanwhile, global government bonds posted a small gain in October. Bond yields are falling as investors price in a slowdown in the pace of rate hikes.
Leading indicators suggest that U.S. inflation is about to roll over, which should allow the Fed to ease its current hawkish tone once rates get above 4% by the end of this year. We believe that we will see inflation drop over the next few quarters without much of an increase in the unemployment rate. This could lead to a stock market rally into mid-2023.
European growth is likely to reaccelerate next year as the energy crisis abates. In our view, Chinese growth could also surprise on the upside as the government relaxes its zero-Covid policy and ramps up stimulus.
Global growth could, however, slow again in 2024 as the lagged effects from higher mortgage rates take their toll on housing markets.
Jump to an insight:
This is Not 1982
The prevailing view these days is that the Fed will have to engineer a recession to bring inflation back down to target. Most investors do not believe that a soft-landing scenario, where inflation could fall significantly with minimal economic pain, is even possible. The current situation is often compared to the early 80s when then Fed chairman Paul Volcker raised interest rates aggressively to 20%, which caused the 1982 recession – at the time the deepest slump in U.S. post-war history.
While there are some similarities between today’s environment and the early 1980s, there are also major differences: back then, long-term inflation expectations were unanchored: most people thought that inflation would average close to 10% over the remainder of that decade. Secondly, the economy at the time had to deal with stubbornly high unemployment. Fed Chairman Paul Volcker had to crush the economy to bring down inflation expectations. Jay Powell does not need to do that because inflation expectations remain well contained, no matter if one looks at TIPS break-evens, CPI swaps, or surveys of households and economists.
Today’s situation is a lot more straightforward than it was 40 years ago: the economy is at full employment, and so the labor supply curve is nearly vertical. Once there is no slack left in the labor market, any additional labor demand will not boost employment since everyone who wants to work already has a job. All that will happen is that job openings will rise, and wage growth will accelerate. This is exactly what happened last year.
Contrary to the consensus view, the U.S. economy could experience rapidly falling inflation with little increase in unemployment in 2023. The latest U.S. nonfarm payroll employment number confirmed the strength of the employment market, rising by 261,000 in October, largely above expectations of 193,000. Moreover, the September increase was revised up from 263,000 to 315,000.
Given that monetary policy affects the economy with a delay of 9 to 18 months, the risk of a recession is much higher in 2024. Fortunately, if a recession does occur, it is likely to be a mild one, thanks to the absence of major economic imbalances in the U.S.
While the U.S. stock market has not priced in a deep recession for 2023, it has discounted a meaningful economic slowdown. As the FOMC explicitly acknowledged in its November meeting, monetary policy operates with substantial lags. You make money in financial markets not by focusing on what central banks are looking at now but what they will be looking at in the future. 2023 could feature a Goldilocks environment where inflation is falling, but unemployment remains low. This would create a constructive environment for equity markets.
A slowing economy will lead to less inflation. The danger is that demand will fall so much that unemployment starts rising quickly. This is not an imminent risk. There are still 1.9 job openings per unemployed worker. However, if the economy were to burn through most of those job openings, then any further decline in labor demand would trigger a vicious cycle where rising unemployment leads to lower aggregate income, decreased spending, and even higher unemployment – the very definition of a recession.
The good news is that the Fed is aware of this risk. The statement accompanying the November FOMC meeting explicitly acknowledged what every economist already knows, which is that monetary policy operates with potentially long delays: “In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”
Forward-looking indicators are pointing to a deceleration in price pressures. The Atlanta Fed Wage Growth Tracker and the employment cost index have rolled over. Measures of wage pressure from regional Fed surveys and the NFIB survey support this signal. That said, the Fed will rely on hard data to guide policy, rather than forecasts. A downshift in the pace of tightening, and eventually a pause, will therefore require clear evidence of decelerating inflation and a slowing labor market, for a few consecutive months, at least. These conditions could materialize in time for a pause to occur in the first half of 2023. Whether it will be followed by a resumption of rate hikes, or a dovish pivot, will ultimately hinge on future labor market conditions.
Globally, the picture should brighten. In Europe, the price of the November 2022 natural gas contract has fallen by 70% from its high in late August thanks to rising natural gas inventories (storage is 95% full, well ahead of the 10-year average) and prospects of a warmer-than-normal winter. The futures market points to stable gas prices over the next two years.
Chinese real GDP increased by 3.9% in Q3. While this was faster than expected, it was still below the government’s growth target of 5.5% for 2022. The Chinese government’s increasingly central economic policies will heavily weigh on growth over the long run. In the short run, however, economic activity could accelerate as Covid policies are relaxed in the coming months, property developers receive additional financing to enable them to complete long-delayed projects, and the authorities ramp up the pace of stimulus.
For the outlook for stock prices, it is important to estimate how much recession risk has the stock market priced in? Since the start of the year, analysts have cut U.S. earnings estimates by 1.4% for 2022 and by 4.8% for 2023. Outside the energy sector – where profits have soared thanks to higher oil prices – earnings estimates are down 7.3% and 9.5% for 2022 and 2023, respectively. In dollar terms, earnings estimates have dropped somewhat more for overseas bourses.
Stock prices have declined significantly more than earnings estimates. Year-to-date, U.S. equities have fallen by 22% in nominal terms and 27% in real terms. Stock markets outside the U.S. have dropped by 25% in nominal terms and 30% in real terms. As a result, the forward PE multiple has declined to 16.7 in the U.S., from 21.5 at the start of the year, and from 14.2 to 11.4 outside the U.S.
Stocks are probably not pricing in a very deep recession. However, we do think that they are currently discounting a proper economic slowdown if not a mild recession.
One key reason for us to be positive on the outlook for equity markets going forward is that companies seem to be able to maintain their earnings within expectations. More than 90% of S&P 500 companies have reported Q3 results so far, with 71.3% of companies beating consensus analyst expectations, above the long-term average of 66%. Furthermore, 69.6% have posted Q3 revenues that exceed expectations.
Importantly, the strength in revenue is broad-based: they are higher in Q3 2023 versus Q3 2022 in all 11 sectors. Sales gains in energy (47.2%), industrials (12.2%) and consumer discretionary (13.7%) are particularly notable. However, the earnings picture is not as positive. Six of the 11 sectors registered year-over-year losses with communication services (-21.5%), financials (-16.3%) and materials (-8.2%) being notable laggards.
The Q3 earnings season highlights that most of the weakness in earnings stems from higher costs, rather than deteriorating sales. But even though margins are compressing, they have not narrowed as much as feared. As highlighted above, a larger share of S&P 500 companies beat earnings expectations versus those that beat revenue estimates. Moreover, signs of decelerating wage growth are positive for the earnings outlook.
Chinese equities are starting November on a positive note. The Hang Seng and CSI 300 are up 10% and 7.4% respectively since the beginning of the month. In particular, tech stocks have been outperforming, with the Hang Seng Tech index up 14.4% over this period. Speculation that authorities could relax the zero-Covid policy, and Friday’s news that U.S. officials completed onsite audit inspections of Chinese companies ahead of schedule boosted investor optimism.
Has the Dollar Peaked?
The U.S. dollar, which has strengthened significantly over the past 15 months is starting to show signs that the technical conditions are ripe for a reversal at a time when the dollar is the most overvalued since the 1970s. Real interest rates, which are an important driver of foreign exchange rates, could also surprise to the upside outside the U.S., specifically in places like the UK, the Eurozone, and Sweden, where most inflation has been supply-side driven. And where central banks are now raising rates rapidly as well. The question remains whether global central banks can engineer a soft landing, and if the worst of the Russia-Ukraine conflict is behind us.
It is very well possible we have seen peak dollar. For example, the Sterling Pound bottomed near 1.035. The Euro also probably bottomed near 0.96. That said, over the next three-to-six months, we could still have a blowout phase where the dollar does well. The historical evidence, however, suggests that the dollar has probably peaked.
After we rebalanced core portfolios late last month by tilting towards Japanese equities and profitable tech companies, we made no changes this month. We have a slight pro-risk tilt in the equity portfolio, while we remain defensive on fixed income. The yield curve is still flat, so it makes little sense to take on longer dated bonds. Our preference remains for shorter-dated public market exposure (~4% yields) or private credit (~8-9% yields), where we can get better credit protection than public bond markets.
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Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.
The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value-weighted index with each stock’s weight in the index proportionate to its market value.
The Hang Seng Index is a free-float-adjusted market capitalization-weighted stock market index in Hong Kong. It is used to record and monitor daily changes of the largest companies of the Hong Kong stock market and is the main indicator of the overall market performance in Hong Kong. These 50 constituent companies represent about 58% of the capitalization of the Hong Kong Stock Exchange.
The CSI 300 is a capitalization-weighted stock market index designed to replicate the performance of the top 300 stocks traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange. It has two sub-indexes: the CSI 100 Index and the CSI 200 Index. Over the years, it has been deemed the Chinese counterpart of the S&P 500 index and a better gauge of the Chinese stock market than the more traditional SSE Composite Index.