Where’s The Light at The End of This Tunnel?

October 4, 2022

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Aleksey Mironenko

September ended much the way it began – a complete reversal of the summer’s rally. All major financial assets – except the US dollar – generated negative returns last month. The causes were clear-cut: August inflation that surprised to the upside, consistently hawkish central banks (not just the Fed), further escalation of the Russia / Europe energy crisis, and policy missteps in the UK. 

Looking forward, a near-term rally from very oversold levels is possible for the next month or two, but the fundamental problems plaguing the world economy remain unresolved. As such, we will likely see a positive Q4 and perhaps start to 2023, followed by a transition to muted returns and a potential US recession later in 2023/2024.

Jump to an insight:

The Fed’s Job is Largely Done For Now

During September, the market has finally come to believe that the Fed is focused on only one part of its mandate – to slay inflation. The summer rally occurred because the market refused to accept the Fed’s estimates for future rate hikes, believing Chairman Powell would blink when confronted with lower inflation and higher unemployment.

Neither has happened (yet!) and every Fed speaker spent September reminding us that inflation hurts more people than unemployment and as such, the Fed would not quit “until the job is done.” Today, the market expects another 1%-1.25% in hikes by year-end and few, if any, cuts in 2023. This contrasts with August expectations of only 0.5% hikes in Q4 and outright cuts in 2023, explaining the bulk of the equity correction.

The result of all this is that the Fed has contained inflation expectations, which are critical because fears of high future inflation can drive people to buy today, thus creating shortages and actual inflation. On this front, the Fed’s job is done. Consumer inflation expectations are 4.7% one year from now and 2.7% five years from now, down materially from 5.3% and 3.1% in June.

Capital markets agree with this assessment – 10-year inflation breakevens (a measure of expectations) have come down from a 20-year high of 3% in April to 2.24% today. In short, the Fed has convinced both investors and consumers that inflation will be contained, regaining its inflation-fighting credibility for now.

Housing Holds the Inflation Key, Not Wages

August’s inflation print spooked markets and drove the Fed to action, with a three-decade high in shelter inflation being the main surprise. Shelter costs increased 6.2% year on year (0.7% month on month) and are 33% of the Consumer Price Index (CPI). 

Yet real-time inflation data paints a very different picture. For the “inflation is a monetary phenomenon” folks, there is good news: the last six months have seen US money supply growth of precisely 0, which is a 3-decade low. This level is close to the danger zone not for inflation, but financial and economic stress (see next section).

Real-time shipping, gas, agricultural, and car price data has rolled over and some items are in outright freefall. Wages have grown, but increasingly we see telltale signs of weakness in the labor market – most new jobs are part-time, average hours worked are down to April 2020 levels, and average hourly earnings have actually dropped over the last three months. Lastly, base effects matter and Q4 last year saw very strong inflation that will fall out of Q4 numbers this year.

This leaves shelter CPI as the big unknown. By design it is a lagging measure to account for the slow pace of lease renewals, taking ~12 months for shelter CPI to fully reflect a price increase. In our view, that is exactly what we saw in August’s inflation data. Private sector real-time measures from Zillow and Apartment List show a peak in rents exactly a year earlier – in August 2021 – followed by a return to trend the last six months.

In fact, the risk in housing is not inflation but a slowdown. The Case Shiller Home Price Indices came in negative for August, as did the slower Federal Housing Finance Agency Housing Price Index for July. Housing is the most interest rate-sensitive sector of the US economy, and mortgage rates have risen from sub 3% last year to ~7% today. This will, without a doubt, lower housing prices (and thus shelter CPI) and push the economy into a recession as construction slows. 

But not just yet. Most homeowners locked in ~3% mortgages over the last few years, and very few took out home equity revolving lines of credit. Unlike the mid-2000s, home construction remains below population growth, vacancy rates are the lowest on record, and inventories are low. Lenders have been prudent, requiring high FICO scores and keeping loan-to-value ratios low.

Central Bank Induced Recession Fears are Getting Closer

If inflation is showing signs of containment, why did global equities drop 10% in September? In short, the market now believes that the Fed won’t wait to see the effect of its actions but instead will act to “ensure” that inflation is contained.

More than two-thirds of recessions since World War II were caused by the Fed raising interest rates faster than the economy can handle. Soft landings – where rates rise, but economic growth and the job market remain okay – are extremely rare.

In fact, we are getting the opposite message today. Global manufacturing is contracting for the first time since the first half of 2020. Output decreased in 20 of the 30 economies covered. Surveys of US purchasing and supply executives point to slower production and higher inventories going forward, suggesting consumers are holding off on purchases and tightening their belts.

US financial conditions have tightened materially this year and are on par with levels from the height of COVID in March 2020, the 2016 hiking cycle, and the Global Financial Crisis. While higher rates filter through to stock and bond prices right away, they take time to filter through to the underlying economy.

Even prior data couldn’t escape growth concerns, with last week’s US Gross Domestic Income revisions pointing to much slower overall growth so far in 2022, as well as a materially lower savings rate. The average of Gross Domestic Product and Gross Domestic Income – a joint measure that adjusts for statistical differences in calculation – is now negative for the first half of the year, reinforcing the lack of growth in the US economy.

Quite simply, because of a belief in transitory inflation (including from yours truly earlier in the year), the Fed fell behind the inflation ball and is now trying to catch up by creating the second fastest hiking cycle on record. The risks of driving the economy through a rear-view mirror are material and warrant a slowdown in hikes in our view.

Europe’s Energy Woes are Overestimated

The story outside the US couldn’t be more different. Europe is already in recession, and most investors do not expect the growth outlook to improve anytime soon. There will no doubt be pain this winter, but we are more optimistic three to six months out.

Despite nearly 0 Russian natural gas imports, EU gas inventories are at 89% of capacity and in line with 5-year averages prior to 2021. France is raising nuclear energy production, Germany is delaying its nuclear plant shutdowns, restoring coal-fired power plants, and building two new LNG terminals, while Spain should have a new gas pipeline to the rest of Europe operational by spring.

Rationing may still be required depending on weather, and costs will, of course, eat into consumer wallets, but the tail risk of nationwide industrial shutdowns is likely to be averted. In fact, in a case study for flexible market-based economies, Germany has so far adjusted miraculously, using 20% less gas with only a 2% fall in industrial production.

On the policy front, European governments have announced nearly 600 billion euros in support measures to buttress households through the winter. While it has weighed on equities and European currencies so far, we would not be surprised to see a V-shaped recovery in European markets in 2023.

The UK Pounding – A Case Study of What Not to Do

Of course, not all government policies are equal. If you’re a new government on a wartime footing against a slowing economy, rising inflation, high energy prices, and continued BREXIT repercussions, it might be a good idea to hold an inter-departmental meeting to align on next steps.

Instead, on Sep 22, the Bank of England (BoE) announced a 0.5% rate and further quantitative tightening. They cited more to come in a commitment to fighting double-digit inflation. But on Sep 23, the newly formed government announced a multi-billion energy subsidy and the second biggest tax cut in UK history, without any spending cuts to pay for either. The BoE clearly had no clue.

Our economic system’s main tool to fight inflation is withdrawing, and raising the price of, money. The BoE’s actions amount to a ~100 billion pound withdrawal of liquidity, while the government’s plans amount to a broadly similar amount of liquidity support. The net effect? No change in growth and inflation, but vastly higher debt.

The market reaction was swift. The British Pound collapsed from 1.13 to 1.05 to the dollar, and UK 10-year government yields spiked from 3.5% to 4.5%. Such a large market move is a systemic risk to the UK pension system, requiring action from the BoE. Instead of withdrawing liquidity, they were forced to add it, reducing their ability to fight inflation.

In recent days, Prime Minister Truss made her case, pointed fingers, but eventually canceled the planned tax cut with her government’s reputation and market perception in shambles. The Pound has recovered fully, currently at 1.13. But yields settled at 3.95% at the time of this note, nearly 0.5% higher for no good reason. Ironically, higher yields will raise borrowing costs and accelerate the recession, potentially helping inflation down the road after all.

Dollar Wrecking Ball

The UK experience is likely an isolated incident, but policymakers are taking note. With the Fed only a few moves away from reaching their forecast peak, and the dollar at a 2-decade high, official views are starting to diverge.

Vice Chair Lael Brainard spoke on Friday about policy needing “to be restrictive for some time,” but questioned the speed of further rate hikes and discussed ways the global rate-hiking cycle could spill over to the US. Her speech showed a clear concern for and awareness of the need for financial stability.

We can’t forget that the Fed is now shrinking its balance sheet by $95 billion a month, withdrawing liquidity on top of rate hikes. The combination of quantitative tightening and higher rates, as well as a soaring dollar, create financial stability risks that the Fed will need to pay attention to.

Higher rates increase borrowing costs of US corporates while a stronger dollar reduces their international revenues. The combination pressures margins at home, but it is even more painful abroad. Commodities are primarily priced in dollars and are now more expensive for many countries. Many emerging markets fund themselves in dollars and will now struggle to service their debt.

We observe initial signs of stress in the trading of credit and other critical markets around the world. As John Connally (Nixon’s Treasury Secretary) said in 1971 – “the dollar is our currency, but it’s your problem.”

Pessimism is Everywhere

The Fed has made no indication of a policy pivot, but if weakness in leading indicators translates to weakness in real data, their tune may change quickly. 

The one resilient data set so far has been employment, but labor “hoarding” to avoid having to rehire may soon turn into labor “disgorging,” which should awaken the Fed to the tightening taking place. FedEx withdrew their full-year guidance on weak shipments, Nike earnings disappointed on dollar strength, and used-car dealer CarMax saw a collapse in car-buying due to affordability issues. It is unlikely that these companies will continue to keep their payrolls at current levels.

US earnings downgrades have consistently outnumbered upgrades since early June as analysts lowered earnings estimates for Q3 by 6.6%. That number would have been closer to -10% with energy stocks excluded as they were the only ones to see upgrades. Pressure will likely continue to mount for 2023 earnings in the coming months.

Investor surveys also point to extremely negative sentiment, with 61% of investors bearish and only 20% bullish, according to the American Association of Individual Investors surveys. Institutional data tell the same story – professional investors are accumulating cash after the drop, indicative of overall market capitulation.

In our view, such negative sentiment and consistent pessimism set up an opportunity for a rally into year-end. 

Closer to The End or The Beginning?

Multiple measures of market breadth and trends clearly show the S&P as being oversold. Valuations, while not outright cheap, are now reasonable. The long-term investor should be compensated with reasonable equity returns from this point forward.

Now that the bar for good earnings is lower, we may even see some pleasant surprises. After all, earnings are nominal and inflation is still here. In aggregate, consumers are still employed, have plenty of pent-up savings, and continue to spend them.

Oversold conditions, low expectations for US and European growth, a down-wave in inflation, and likely Fed attention to financial risks suggest a short-term rally from current levels.

The question is how long it will last. It is hard for us to see a continued rally through 2023. The Fed is not yet ready to consider a pivot to easing and will likely pause to monitor instead. The down-wave in inflation will be viewed positively but is also likely to result in higher real wages and lower corporate earnings down the road. If inflation settles at a ~4-5% rate, or if a second wave of inflation does appear, the Fed will increase rates again. This will almost certainly cause a recession in mid to late 2023.

Portfolio Positioning

In the short-term, we are marginally positive on equities and are increasing exposure slightly. Our preference is for sectors that have fallen the most and for non-US exposure, where the combination of low stock and currency valuations makes for attractive risk/reward. 

Specifically, we are topping up NASDAQ exposure slightly (down -32% YTD) and adding a tilt to Japan (the Yen is down -26% YTD), which stands to benefit from continued easy monetary policy, a weak but defended currency, and proximity to Asian consumption as economies in the region reopen post-COVID. It is too early for Europe, but it is an allocation we are monitoring in the coming months. 

However, this is a near-term view. If a rally in global equities develops, we might look for opportunities to position the portfolio more defensively overall into 2023. Only when we see inflation trending below 4% will we be comfortable that the long-term bottom is in. 

In fixed income, we believe rates are likely to trade sideways in coming months as continued Fed fears are countered by future growth concerns. With short-term yields of 3%+, fixed income is no longer a dirty set of words for investors. The yield curve is still flat, so it makes little sense to take material interest rate via long-dated debt. 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.

We continue to believe that the US dollar is overvalued, presenting an opportunity for non-US assets and currencies over the long term. Currency valuation may overshoot in the short term, but it is the best leading indicator of long-term currency performance. The Yen, Euro, and even the Pound look attractive on a long-term basis.

DISCLAIMERS & DEFINITIONS

This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. 

Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices does not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.

The Consumer Price Index (CPI) is a measure of inflation compiled by the US Bureau of Labor Studies

The Nasdaq Composite Index is a market-capitalization weighted index of the more than 3,000 common equities listed on the Nasdaq stock exchange. The types of securities in the index include American depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks. The index includes all Nasdaq listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debentures.

The S&P CoreLogic Case–Shiller Home Price Indices are repeat-sales house price indices for the United States. There are multiple Case–Shiller home price indices: A national home price index, a 20-city composite index, a 10-city composite index, and twenty individual metro area indices. These indices were first produced commercially by Case Shiller Weiss. They are now calculated and kept monthly by Standard & Poor’s, with data calculated for January 1987 to present. The indices kept by Standard & Poor are normalized to a value of 100 in January 2000

The FHFA House Price Index (FHFA HPI®) is the nation’s only collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s.  The FHFA HPI incorporates tens of millions of home sales and offers insights about house price fluctuations at the national, census division, state, metro area, county, ZIP code, and census tract levels.  FHFA uses a fully transparent methodology based upon a weighted, repeat-sales statistical technique to analyze house price transaction data.

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