Please Note: This report was created and provided by VanEck.
The halcyon days of Goldilocks are well and truly over for markets and they now resemble an aimless vagabond. Investors are deep in the inflation era. The question is, how deep? Are we up to our knees, our waist or our necks? And is the depth subsiding?
Central banks around the world are united in their purpose, to suppress inflation induced by supply constraints, war and ultra-loose fiscal policy that was in response to the COVID global pandemic crisis. Every data point and indicator is being scrutinised by market participants in the hope that they can find some semblance of either a way in or out.
Equity markets seem to be waking up to the reality of persistently rising rates. The hope for a Fed pivot has been all but squashed. Bond markets had already accepted this reality and fixed income investors felt the pain earlier this year. However, bonds now offer a ray of shimmering light among the gloom, with nominal yields looking attractive again.
Fixed income will undoubtedly be back in vogue. There are segments of the bond market that offer value, emerging markets (EM) for example. EM central banks hiked earlier and larger than their developed markets (DM) counterparts. Notwithstanding, the dogged US dollar has been the ultimate headwind, although now it could be overvalued, especially on a Purchasing Power Parity (PPP) basis.
The challenge for investors is that the start of a Fed easing cycle is typically a warning of major equity market losses. The only thing worse than waiting for the pivot is what comes after, the concession being when the Fed is able to navigate a soft landing. Soft landings are rare. A tight labour market does not help and the Fed has never lifted the unemployment rate by one percent without a recession. Not that you could tell from the last quarter’s returns.
If there was any doubt that the last quarter was not a bear market rally, one should observe what happened. In July, the long-end of the US yield curve, specifically the 10-year, came off almost 100 basis points and risk assets zipped. August and September yields are well past the June highs. Risk assets zagged.
At a sector level, bond proxies such as real estate and utilities, which have typically been inversely correlated to long-end bond yield rates, have borne the brunt of the sell-off. During August and September no sector was left unscathed, even energy which has been 2022’s darling, was caught up in the sell-off and re-rating.
There are clouds in the short-term. The Fed’s narrative is unambiguous. The Powell pain is coming and the question of a soft or hard landing is now ‘soft-ish’ or hard. That is, it is going to be harder than soft. Market commentators are now debating the type of probable global recession. During a recession, earnings compress. To date, earnings revisions have been soft-ish. Price to earnings ratios need to therefore re-rate. To get inflation down, the Fed needs to loosen the labour market to get wage growth down. Unemployment invariably will rise. If a recession for 2023 is the base case, be prepared for a plethora of opportunities to surface. It is in these times that astute investors buy from the pessimists.
There and back again…but without hobbits
This time last quarter it seemed markets were finally starting to get their heads around what the near future for investors would look like. ‘Transitory’ was assigned to myth and the understanding was that central banks had plenty of work to do. It all pointed to a weak environment for risk assets.
The path through to the other side was going to be bumpy, with glimmers of light such as US inflation topping out, triggering temporary rallies, especially after more than a decade of ‘buy the dip’ being the best investment strategy. The market’s optimism is typically hard to keep down, but the July rally was hard to believe.
Of course, the rule is: if something is unsustainable – it won’t be. The Goldilocks optimism was misplaced for three reasons:
Although year-on-year inflation will see some unwind in the second half of 2022, as last year’s soaring goods prices ease on the back of supply chains healing and inventories turning, the biggest and stickiest chunk of inflation relates to services. These, in turn, are driven by wages. With labour markets running well through capacity, wages won’t come down enough to get inflation sustainably back to target without the Fed generating a solid chunk of slack in the economy.The idea that the Fed could generate this slack without a return to above neutral interest rates did not make sense. The economy is still awash with COVID dollars, even now cash rates are far below actual inflation, so borrow now, pay later makes sense. To be fair, real interest rates, as measured by TIPS (Treasury Inflation-Protected Securities) vs nominal bonds have normalised. And while households’ real earnings are currently falling, they will, at least temporarily, rebound as goods prices slow.Corporate earnings are not usually sustained in the face of a recession. There’s no reason to expect earnings in this recession will be different. And, if there is no recession, the alternative is a long, dragged-out process of attrition, where the economy grows so slowly that the labour market gradually eases through population growth. But that would see inflation retreat so slowly that expectations would become entrenched, aka, the dreaded stagflation.