Week ended June 24, 2022
MARKETS REBOUND, THE FED COMES CLEAN
[SKIP THE COMMENTARY AND GO STRAIGHT TO THE TABLES]
SUMMARY OF MARKETS
Markets rebounded this week as risk sentiment improved, a reprieve after a series of challenging (down) weeks. Perhaps the Monday holiday in the States provided investors with an extra day to recalibrate valuations more precisely. Or perhaps it was the fact that – at last – Jerome Powell uttered the word “recession”, finally putting reality on the table as far as “Fed think.” Whatever the reason, the outcome is that sentiment shifted to a more constructive tone, improving as the week wore on and pushing all of the global indices I track into positive territory. However, to pour a bit of cold water on the week and return us to reality, keep in mind that the S&P 500 remains down nearly 18% YtD, and the best performing global equity index I track – the FTSE 100 – is up a mere 1.8% YtD (and is fading). As equities improved, US Treasury bond prices also rose this week in the ongoing battle of countervailing forces between longer-term inflation (arguing for lower bond prices/higher yields) and a slowing economy (arguing for higher bond prices/lower yields). Cryptocurrencies stabilised. Gold, the US Dollar and the Yen were all modestly weaker. Corporate credit spreads are exhibiting a flight-to-quality pattern in my view, with investment grade spreads stable/slightly improving, and high yield spreads widening, more perversely as you migrate down the credit spectrum to weaker ratings categories. This is a red flag worth monitoring. Oil prices came under pressure this week, with the price of WTI crude decreasing 1.8% (close $107.62 /bbl), although a sharp rebound on Friday pushed the price back up from its lowest close on Thursday since early May. All in all, the week was a resounding success and welcome reprieve for investors holding risk assets. My advice though is to not get used to it because there is plenty of uncertainty on the horizon.
Economically, I had tweeted early in the week following the UK inflation read of May (9.1%/annum) that at least the Bank of England is serving up reality to its citizens, unlike the Federal Reserve. The UK is probably already in a recession or very close, and the BoE readily admits that the circumstances will probably lead to UK inflation topping out at 11% in the autumn. Boris Johnson and his merry men remain under severe pressure, the country had a series of crippling rail strikes this week, the Pound is slumping and that old chestnut BREXIT just won’t go away. However, at least the BoE is willing to paint a realistic albeit dire picture of the UK economy in the coming quarters. Meanwhile, the Federal Reserve had until this week continued to see the US economy through rose-tinted glasses, an outlook to which it is hard to subscribe based on the hawkish rhetoric / policy actions and a rather broad array of economic indicators. However, this charade finally ended mid-week with Chairman Powell coming relatively clean in testimony before the Senate Banking Committee, finally admitting that a recession might be a possible outcome. Duh! I realise that it is a hyper-sensitive topic politically because the pain of bringing down inflation through tighter monetary policy (meaning higher interest rates) is a difficult pill to swallow, and the hangover afterwards is every politicians’ nightmare. However, I suspect a recession will materialise in the US, and now the talk has finally turned from not “if” but to “when” and “how severe.” I find this encouraging for investors because it provides a more realistic context for fair price discovery.
I suspect equity markets will find levels in the +/-5% area in the US the remainder of this year, with the risk skewed towards the downside based on forthcoming earnings. 2Q22 earnings, which kick-off in mid-July, remain a real risk to stock prices. I feel slightly better about Asian equities. I am bullish on Japanese equities, less perhaps because they have been battered this year and more because the weak Yen and on-going dovish policies of the Bank of Japan should eventually give a boost to stocks. Similarly, I believe the Bank of China will remain dovish to offset the periodic shutdowns there caused by COVID outbreaks. I am not comfortable at all with UK and European equities, the former most bothersome and the latter facing some potentially unpredictable monetary policy moves by the ECB. I was admittedly wrong – at least for a few days – in predicting that the yield on the10y UST would not go above 3-1/4%, but this suddenly looks OK at the moment. I continue to believe the 10y UST yield will stay in the low 3s, and that the USD will eventually weaken as the US economy slows. I am also bearish on oil in the intermediate term (post-summer perhaps) as the global economy slows, but this does not solve the supply issue we are currently facing. For this reason, I would not be surprised to see oil prices pop again. Of course, the great unknown remains the Ukraine-Russia war and its implications for global oil supply.
ECONOMIC AND GEOPOLITICAL NEWS THAT MATTERED THIS WEEK
The Office of National Statistics (ONS) released UK inflation data for May this week (here), and CPI came in at a scorching 9.1%/annum for the month. The Bank of England is signalling that inflation could go as high as 11% in the UK in the autumn, and that the economy is headed for a recession. It’s fully on the table as far as I am concerned and will influence UK government bond yields and equities going forward (and not positively for the latter).
The Fed comes clean….sort of
Jerome Powell testified before Congress this week in two sessions (one before the Senate and the other before the House), and you can find his official opening statement from the Semi-annual Monetary Policy Report to the Congress here. I listened to some of the session on the first day in front of the Senate, and I would largely characterise the session as political theatre. There were one or two senators that seemed to understand monetary policy and the implications of inflation, but most of the questions from others had a political slant, lacked any understanding of economics, or were just plain stupid. I wasn’t really expecting much anyhow. I suppose the one thing that came up during the questioning is that Mr Powell for the first time to my knowledge suggested that the US economy might be at risk of a recession as monetary policy is tightened to address high inflation. As silly as it might sound, I think this restores a sliver of credibility to the Fed which has largely seen confidence in its policy actions fall sharply as inflation has risen and remained consistently high. And even more bizarrely, I think this provides a much more realistic backdrop for valuing risk assets.
There is a lot of economic data coming this week as June and the first half of a challenging 2022 draw to a close. I think the second half of the year could be equally challenging, although I think most risk markets that can be underpinned by valuations (meaning not cryptocurrencies) will find support at or around current levels. This being said, investors need to be selective and defensive rather than jumping into recovery rallies that ultimately prove to be nothing more than dead cat bounces. The biggest risk on the horizon in my opinion is 2Q2022 earnings. Most companies that are struggling with costs have said as much to investors, so now this can be calibrated into prices. However, if these downward revisions prove not to be sufficient, things could go south again quickly. Recall how the FAMAG earnings for the 1Q22 rattled markets. Let’s hope we don’t go there again!
We also have Chairman Powell and BoE Governor Andrew Bailey speaking this week, and the words coming out of these talking heads could further stoke volatility.
Corporate bonds (credit)
Safe haven and other assets
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