Week ended April 15th 2022
EQUITIES AND BONDS BOTH WEAKER ON HOT INFLATION DATA
It was a holiday-shortened week in the US, the UK and Europe, probably a good thing given the direction of travel in both the global equity and bond markets. As I discuss in more detail in the section containing market data, returns were negative last week in all of the global equity indices I track aside from Japan. US Treasury bonds also sold off at the intermediate and longer-end of the curve as yields ballooned further, with UK and Eurozone bonds following suit. It is unusual to see weakness in the equity and bond markets at the same time, but this is where we are at the moment.
US CPI for March was a scalding 8.5% (BLS release here), about in line with analysts’ expectations, whilst UK CPI came in at 7.0% (ONS release here). In both cases, energy was the major culprit. In the US, energy prices (fuel oil, electricity, gas) were up 32% (March to March). In the UK where data is presented differently, the major drivers of the highest inflation seen since the early 1990s was “housing and household services” – which includes electricity, gas and other fuels – and “transport”, which includes motor fuel and second-hand cars. At the end of the day, there is simply nowhere for most countries and their economies to hide from higher energy prices. Food prices are also rising, and most economists seem to believe this will worsen because of growing supply-chain disruptions, many related to the war in Ukraine. Plenty of pundits seem to believe we have seen the peak as far as inflation, but personally have doubts regarding this unless – for one reason or another – oil prices were to fall sharply and quickly. To make matters worse in the US, PPI for March was released the day after CPI (here), and the March-to-March figure was an incredible 11.2%. PPI is often believed to be a harbinger for future CPI, so I have a hard time reconciling this sort of double-digit level for PPI with a supposed “peak” CPI number in March.
Investors did not like these inflation figures, but given the shocking absolute levels, it could have been a lot worse. It feels to me like investors are getting accustomed to higher inflation for longer, even as various Federal Reserve governors and regional presidents sing over and over again from the same “hawkish” hymnbook. The shorter end of the US Treasury yield curve actually saw yields decline a few basis points this week in spite of the high March inflation data, which I believe reflects the fact that the Federal Reserve’s path forward is finally aligned with the thoughts of investors. The intermediate and longer end of the curve could find no place to hide though as yields soared, which probably reflects the harsh reality that investors increasingly believe inflation will remain at an elevated level for a rather long period of time. The yield curve steepened, which has been a two-week pattern since the curve inverted for a single day (at the close) on April 1. Is this because recession risk is lower? I don’t think so. Instead, I think it is simply a reflection of higher inflationary expectations for longer, and these concerns are – at the moment – trumping the risk (and high likelihood) of a slowing US economy (caused by tighter monetary policy). Whether or not the Fed – or for that matter the Bank of England or the ECB – can navigate a soft landing remains to be seen, but it is clearly going to be a difficult task the longer central banks wait to aggressively address soaring inflation. As I have said many times, it will take a combination of precision and luck for the US (and other economies) to contain inflation without tipping the economy into recession. Even if a recession can be avoided, we are undoubtedly heading for slower growth and higher unemployment, although the economy remains so near to full employment at this point that it is hard to imagine this happening until 3Q2022 or even later.
What investors also need to consider is the effect of higher mortgage rates on US residential real estate prices. There has undeniably been a positive consumer “wealth effect” resonating from higher stock prices, a topic often mentioned. However, according to this article, around 52% of Americans own stocks but around 63% own real estate. The latter asset class is also more likely to be leveraged (via mortgages), making real estate more vulnerable to slowing demand and falling prices. If the “feel good” from appreciating real estate starts to dissipate, causing prices to fall and foreclosures to increase, it could have dire collateral effects on people’s outlooks for the future. This, in turn, could dampen the main driver of the US economy, which is consumer spending, and create a negative spiral that might prove challenging to halt. According to the S&P/Case-Schiller 20-city price index (via FRED), residential real estate has risen 19.1% just in the last year (Jan-Jan 2021/22), and has increased on average 15.1%/annum over the last two years (Jan-Jan 2020/2022). Meanwhile, the 30-year US mortgage rate (Freddie Mac 30-year fixed rate mortgage average via FRED) increased from 3.11% at the beginning of this year to 5.00% last Thursday, a sharp increase that will almost certainly cool down the over-heated US real estate market. This is the first time the 30-year average US mortgage rate has been above 5% since February 2011.
This coming week the focus will be on 1Q22 earnings releases, Ukraine-Russia conflict, COVID (especially to see how China’s leadership might react and the economic effects of the reaction), and select economic data.
Global stock indices
The S&P 500 (US) was the worst performing index of the global indices I track, down 2.1% during the holiday-shortened week. Only the Nikkei 225 (Japanese equities) managed to eke out a small gain for the week as all of the other indices lost ground. The FTSE 100 is the only index with a positive return YtD in 2022, and in fact has the best 12-month return amongst these global indices as you can see in the table below.
US stock indices
US equity markets had a disappointing week nearly across the board with the exception of small cap stocks, of which the Russell 2000 is the proxy index. The yield-sensitive tech names got hit the hardest, resulting in the NASDAQ being the poorest performer, whilst the more concentrated and defensive DJIA outperformed the S&P 500. Markets were generally choppy all week, as high CPI and PPI further raised the temperature of the Fed’s likely hawkish response.
Banks did their best to buoy markets, with five of the largest six US banks (JPM, GS, WFS, MS, C) releasing 1Q22 earnings this past week. Generally, I thought the results were fairly decent given the context, but investor response was mixed. Elon Musk also grabbed headlines for the second week running, by declining an offer to join TWTR’s Board and instead making a hostile offer to buy the company for $43 bln. At the very least, this will provide entertainment value for the market in the coming weeks. I suspect TWTR will eventually be sold now because the company is in play.
It should perhaps come as no surprise given the poor performance of US Treasuries this year, exacerbated by mid-week inflation data releases for March, that bonds got hammered once again. The ICE US Treasury 7-10 year bond index is now down 9.87% YtD, which is a very poor performance for an asset class that is normally significantly more stable than (and negatively correlated with) equities. The ICE US Treasury 20-year bond index has a negative return YtD of 18.22%, a significant loss on longer-dated US Treasury bonds in only 3.5 months. These are significantly worse losses than investors have experienced on equities YtD, an asset class that is almost always much more volatile. Focusing on yields for a moment across the curve, the damage last week from hot inflation data was at the intermediate and long-term end of the curve. Yields actually fell at the shorter end meaning that the yield curve to (re)steepened. What might be the messages here? Perhaps the Fed’s plans as far as its well-telegraphed hawkish next steps, especially increases in the Federal Funds rate, has finally caught up with what the bond market has been indicating needed to be done for several months. Whilst this might have settled the shorter-end of the curve, intermediate and longer-maturity UST bonds are sending a different message. I suppose you could optimistically argue that the curve is signalling robust economic growth ahead. I would argue though the curve is increasingly signalling the likelihood of a longer period of high inflation, an economy characterised by sluggish growth, rising unemployment and stubbornly high inflation.
Corporate bonds (credit)
Corporate bonds also had a poor week after finding some stability in early April, as yields and spreads on USD-denominated BBB (investment grade) and high yield bonds drifted 10-12 bps higher across the credit curve. The pain was greater in the European high yield market, as spreads gapped out 17bps and yields ended the week 22bps higher. Investment grade corporate bonds have had a negative total return YtD of nearly 11%, whilst high yield (both USD and EUR) has had a negative total return YtD of around 6%. Again, there seems to be nowhere to hide. The tables below illustrate the migration of corporate bond yields and spreads.
From the perspective of new issues (i.e, primary volumes), Moody’s Analytics reports that USD-denominated investment grade issuance totalled $540 billion and high yield issuance totalled $65 billion through April 8th, significantly down from volumes in 2020 and 2021, but more or less in line with YtD volumes in 2018 and 2019.
Safe haven and other assets
Gold was stronger on the week, as was the US Dollar, perhaps in both cases not surprising given the continuous flow of hot inflation data and hawkish comments from the Federal Reserve. The Dollar is also strengthening against the Pound and the Euro, less surprising vis-à-vis the Euro since the ECB is making more hawkish comments but has to simultaneously deal with hotter inflation and collateral effects of the (closer) Ukraine-Russia conflict. In spite of it safe haven status as a currency, the Yen weakened again against the US Dollar – and probably will continue to do so – as the monetary policy of the Bank of Japan is so divergent with that of the Federal Reserve and most other developed markets’ central banks.
Oil was up sharply on the week, as WTI went back above $100/bbl on Tuesday, following its lowest close on Monday since the Russian invasion of Ukraine in late February, and the price continued to steadily increase the rest of the week. Bitcoin drifted lower on the week as the cryptocurrency approached the $40,000 level to end the week (at the time I am writing this).