Week ended August 19th 2022
US EQUITIES, BONDS LOSE MOJO
SUMMARY OF MARKETS
Until Friday, August was increasingly feeling like a typical, low liquidity summer month with prices drifting sideways. Indeed, it felt like Bulls and Bears were at a standstill. Bulls believe that the worst is behind us and stock prices reflect fair value at these new, higher levels. Bears believe that as central banks continue to tighten, raising interest rates and shrinking their balance sheets, economic growth will slow sharply and unemployment will rise, pushing earnings down and stock prices lower. Bulls retort by saying that should the economic pain become too severe, central banks would relent and move back to a neutral or dovish stance, the so-called “Fed put” in the US.
If you follow this narrative, you might be wondering exactly what could make central banks relent? Would it be:
a sharp increase in unemployment and negative economic growth (i.e., a recession), and / or
a rapid deterioration in the still-lofty prices of risk assets like stocks or real estate prices, and / or
liquidity drying up in the funding markets, which could lead to systemic risk in the banking system?
I hope that the answers to the first two questions are “no” since both are an inevitable consequence of tighter monetary policy as central banks need to contain inflation. The Fed, BoE and ECB at times acknowledge that their tightening policies will likely lead to slower economic growth and an increase in unemployment, with the BoE being by far the most transparent and open in this respect. However, central banks cannot afford to back off of their tightening regime until a tolerable level of inflation is in sight, even if economies weaken, unemployment rises, and risk assets like stocks, corporate junk bonds and real estate sell off. It would certainly be a mistake were central banks to back down solely because the prices of risk assets weakened, although – as I mentioned earlier – there are investors that believe this could occur. All bets would be off in the event of the third scenario – funding markets locking-up – although there are other policy tools that central banks could use which could address this without necessarily reintroducing broad liquidity to the market in the form of nil interest rates and / or the resumption of bond purchases (QE). As we have seen during the last two recessions in the US, these unconventional monetary policy steps promote too much risk-taking and propel the prices of risk assets well above fair value.
Following a robust run in risk asset prices since mid-June, Bears retook the high ground on Friday, with both stocks and bonds plummeting. Whether this is a one-day anomaly or the beginning of a new downturn remains to be seen, although one could argue that the writing was on the wall because:
Stocks were getting more expensive again. Through Thursday, the S&P 500 had increased nearly 17% since its low on June 16th.
2Q22 earnings of S&P 500 companies were slightly better than analysts’ consensus expectations, but far from outstanding. According to Refinitiv, revenues of S&P 500 companies excluding energy companies increased 8.5% YoY (following 2Q22 releases), the same as CPI for July 2022 YoY.
Another risk asset category – cryptocurrencies – reached their upper limit following the May/June crypto winter and were again falling in price. BTC was down over 14% this week.
The US Dollar, which had weakened off of its mid-July highs, started to reassert itself and strengthen once again this week (+2.4% WoW). This is relevant because the US Dollar is the ultimate risk-off currency, and a stronger Dollar reverberates into US corporate earnings and emerging markets economies. Also, the Pound sunk back below $1.20/£1.00, and the Euro is again on the cusp of breaking through parity.
Although I only have data through Thursday, credit spreads in the corporate high yield bond market widened this week, after tightening rather significantly off of post-pandemic highs reached in early July.
Memes are back, and that’s just scary!
Friday was also a huge day for options on indices and individual stocks, with around $2 trillion expiring, as you can see in the table below from Bloomberg, in a relatively illiquid market (summer/August).
Government bonds also provided investors with a wild ride this week, especially in the UK. Yields spiked at the short-end of the UK government bond market mid-week following the release of July CPI (10.1% YoY for July), and this sell-off drifted into shorter-dated Eurozone government bonds. Yields on the 2-year Gilt and the 2-year German bund increased 36bps and 17bps, respectively, WoW as bonds sold off following higher-than-expected UK CPI (see section below). Yields in the US Treasury bond market were also wider at intermediate and longer maturities, with the yield on the 10-year UST increasing 14bps WoW and the 2-10 year curve inversion decreasing to –27bps. As an aside, the 2-10 year yield differential in the UK Gilt market is also now negative (i.e., the yield curve is inverted).
Friday might be a day that is forgotten if things get back on track next week. However, I have my doubts given how far and how quickly we have come since mid-June, with no discernible reasons that justify an improvement of this magnitude.
The table below summarises changes week-over-week and year-to-date of the indices and assets that I track in E-MorningCoffee, with more detailed tables in the section “The Tables”.
The major economic news this week involved the release of the minutes from the July FOMC meeting, July CPI for the UK, and US retail sales, all discussed further in the section below.
The focus this coming week is likely to largely be on the Economic Policy Symposium that will be held in Jackson Hole from August 25-27. You can find the press information regarding this event prepared by the sponsor, the Kansas City Federal Reserve Bank, here. Investors and the media will be paying very close attention to what is said by the various central bankers at this meeting.
ECONOMIC AND GEOPOLITICAL NEWS THAT MATTERED THIS WEEK
The minutes from the July 26-27 FOMC meeting were released this week. As is usually the case, the minutes were scrutinised by investors and the main stream financial media although there was nothing I read in the minutes that suggested a more hawkish or dovish tilt by the Fed. Rather, the Fed has committed to remain on a data-dependent track acknowledging that inflation is its number one priority. The question now will be the magnitude of the increase in the Federal Funds rate at the next FOMC meeting on September 20-21, which will certainly grab investors’ attention as we move into September. You can find the minutes from the July FOMC meeting here.
UK CPI was released on Wednesday (here), with month-over-month inflation for July coming in at 0.6%, and YoY CPI running at 10.1%. This was well above economists’ expectations. Government bonds in the UK reacted accordingly, as the yield on the 2-year Gilt increased 24bps on Wednesday following the release of CPI (and 36bps WoW). The bond market is telling the Bank of England that it will need to remain on course to raise the Bank Borrowing rate for the foreseeable future.
US retail sales / earnings of US retailers
US retail sales were flat in July compared to June, according to the advanced sales report (here) from the US Commerce Department that was released on Wednesday. Retail sales were up 10.3% compared to July 2021. Pundits pointed to the resiliency of the US consumer, with non-gasoline retail sales increasing as gasoline sales fell (due to declining prices). This week also had several prominent US retailers release results which were mixed. HD delivered good earnings, WMT slightly better-than-expected, LOW in line and TGT disappointing. All together the news was at best mixed.
Corporate bonds (credit)
Safe haven and other assets