Economy & Markets

Market Thoughts: Today’s key investor question is, “What’s in the price?”

Sep 13, 2022

A hard landing isn’t reflected in market pricing, the rally is fragile and global inflation is still too high. We expect the Fed to keep fighting.

Market Thoughts: Today’s key investor question is, “What’s in the price?”

 

  • The operative question for investors right now is: “What’s in the price?” A hard economic landing and deep recession are not priced into current markets.
  • The Fed isn’t ready to quickly pull back and end policy rate hikes. Abandoning forward policy rate guidance is pragmatic, not dovish. They’re too late in the inflation taming game to be hesitant.
  • Risk assets have rallied from the recent June bottom. While markets feel ahead of themselves, I hope we’ve seen the low. It remains a fragile market rally.
  • The challenge for central banks is how much is too much tightening. Markets are giving policymakers, for the moment, the benefit of the doubt.

 

A relentless obsession. With a relentless ‘recession obsession’ racing through the headlines, investors are stuck waiting for the next series of economic data to determine if the demand decline we’re seeing is healthy – helping to bring down the trajectory of inflation. The waiting is the hardest part.

The global economy is unwinding excess stimulus. There is a real problem with inflation that central banks need to get in front of (Figure 1). The ‘leader of the pack’ in this call to action is the Federal Reserve (Fed). The risk of a U.S. recession over the next year is effectively a coin toss. Recession is inevitable. Every cycle ends in recession. What matters most is how mild or severe the recession is, how long it lasts and how much damage it does to the economy and markets.

Figure 1: Global inflation remains elevated

Source: National statistics agencies, Haver Analytics. Data as of July 2022. Calculated by averaging the relevant CPIs of 22 advanced economies weighted by each country's share of total nominal GDP in 2015. 
Line chart of Advanced Economies headline and core consumer price indices (CPI) shown on a year-over-year (yoy) percentage change basis (y-axis) through July 2022. Monthly data points are displayed since 2011 (x-axis). Prior to 2021, inflation as shown was hovering in a range roughly around 2%, depending on the series; but starting in 2021 to date, a marked increase occurred to current elevated levels of inflation for both with the headline CPI slightly below 8% and core CPI slightly above 4.5% most recently. A footnote explains that both headline and core CPI information as shown were calculated by averaging the relevant CPIs of 22 advanced economies, weighted by each country's share of total nominal GDP in 2015.

Investors expect the Fed to punch above its traditional rate of tightening for a few more policy meetings, then slow down the pace of rate hikes. The European Central Bank (ECB) finds itself in a more precarious position. With war in Ukraine enduring and Russia throttling back its supply of gas to Europe, the ECB has to tread lightly. Both the Fed and ECB are likely to lean into front-loading rate hikes. With the Fed able to be more assertive, the dollar should remain well supported. European growth is under pressure.

There is a bit of emotional anchoring happening currently. Why can’t this be over? Investors wistfully recall how quickly markets sold off as the global economy went into Covid lockdown and then recovered. But markets bounced back because of the force put behind both fiscal and monetary stimulus. Each of those catalysts is being unwound.

As recessionists crescendo, the key question to ask is whether inflation has peaked. We won’t know that for a few months, at the very least. The same with regard to whether central banks can regain equal- if not front-footing in managing inflation. That’s critical. The difference in whether they do or don’t will determine if we get a hard landing. Our current portfolio positioning reflects a base case view that we’re not going to see a hard landing.

What’s in the price? “What’s in the market price?” is the operative question for investors, in particular as readings for U.S. and European purchasing manager index data show contraction at a composite level (Figure 2). While the bar is higher for slowing growth to weigh on risk assets given the derating in valuations we’ve seen, a hard landing isn’t priced into markets.

Figure 2: Composite PMIs have slipped into contraction

Source: J.P. Morgan, S&P Global, Haver Analytics. Data as of August 2022. Line at 50 separates expansion and contraction. 
Line chart of Global, Euro Area and U.S. Composite Purchasing Managers (PMI) Index time series with monthly data points displayed on the y-axis and since August 2020 on the x-axis. A horizontal dashed line is shown at 50 to demarcate economic expansion or contraction, with above that value representing the former and below it the latter. In late 2020, we see that both global and U.S. Composite PMIs were in expansion with the Euro area in contraction then. In early 2021, the Euro area regained expansion and all of the Composite PMIs shown remained above 50 coming into 2022, but have decelerated in recent months, slipping into contraction territory.

Equity markets are back to long-term average valuation levels… cheaper, not cheap. If we see earnings markedly move lower, to state the obvious, we’ll give back some of the multiple rerating we’ve seen. That would put pressure again on risk assets. The key is going to be that inflation expectations remain contained and that we don’t see an earnings recession ahead.

We’re seeing a meaningful slowdown in global economic data. Manufacturing and service sector data are signaling a pullback in demand. Like the slowdown we’ve begun to see in the housing market, less demand is ‘good news’ for both the Fed and ECB. Labor market strength is key, allowing central banks to continue to lean into front-loading rate hikes.

If the narrative for consumers is that inflation is too high and expectations are that it’s going to stay that way, the Fed knows it’s losing the battle. They are too late in the inflation taming game to be hesitant. They need to move quickly to contain rising inflation expectations.

I don’t believe the narrative that the Fed is getting ready to pull back and end policy rate hikes. We’re still a long way from the Fed declaring mission accomplished. The Fed abandoning forward policy rate guidance isn’t dovish, it’s pragmatic. It provides optionality for the Fed to take each policy rate decision meeting-by-meeting. The ECB and Bank of England have each done the same. With central banks across developed markets still a long way from pivoting, policymakers need to see labor markets cool. Labor income is going to be as closely watched as inflation.  

There is debate on what we’ll see from the Fed at the next few policy meetings. Markets expect the Fed’s policy rate to end this year somewhere between 3.5-4%, its highest level since 2008. The Fed may have to go higher if we don’t see inflation moving lower next year.

How policymakers reconcile slowing growth and declining consumer sentiment against high inflation is key. There has been enough divergence in macro data to please both market bulls and bears over the past few months. There was something for everyone, except clarity that central banks can soon slow their pace of tightening.

Time will tell. Risk assets have rallied since their mid-June bottom. While markets in general feel ahead of themselves, I hope we’ve seen the low. Markets were well-primed to bounce. That said, it’s been a fragile rally. Time will tell.

This summer felt like we hit peak pessimism. Positioning and sentiment were due for a squeeze higher. A confluence of things provided a contrarian setup for markets to rebound. The fact that supply chains appear to be improving is helping. Also, that we’ve seen oil prices revert back to levels we were at before Russia invaded Ukraine.

In June, we held onto risk positions believing markets were oversold. We took advantage of late summer market strength to reduce our equity overweight, moving underweight European equity markets. Proceeds went into core bonds. We are neutral duration and overweight the U.S. dollar across multi-asset portfolios.

A lot of bad news is priced into European equity markets, so why did we sell? I believe markets aren’t focusing enough on an already weak economic environment that can get worse, as Russia holds back energy exports. Winter is coming and it’s geopolitically empowering for Putin to continue to put economic pressure on Europe.

Europe faces the obvious challenges the war in Ukraine puts on its economy, in particular as it relates to higher-for-longer energy and food prices. It faces a drag on its exports to China, given zero-Covid lockdowns and weaker Chinese consumer demand and growth. And a weak euro is adding to EU inflation. It costs more to import things that are dollar denominated, like commodities.

Natural gas prices have risen dramatically in Europe this year. Russia is the world’s largest exporter of natural gas. They supply about 25% of global gas exports, with 75% of that going to Europe. About 40% of Europe’s gas supply came from Russia prior to the war.

The EU hit their goal of reaching 80% of existing natural gas storage capacity coming into the fall months. That’s the good news. The bad news is that 100% of Europe’s gas storage capacity represents about 25% of annual consumption. It’s going to be a challenging winter.

Best case, I believe European markets tread water and continue to move in line with risk assets. However, the tail risk for Europe is larger than what I expect for the U.S. in the months ahead. We pulled back equity risk given how far and quickly risk assets had risen since June. We’re playing for less upside, with more potential for downside in Europe than the U.S. We’ve right sized our risk positioning accordingly.

Good enough. Recent U.S. and European earnings announcements were good enough. They were what we expected, surprising modestly to the upside. They haven’t been what hard-landing recessionists feared. However, better than feared earnings positively surprised thanks to energy companies, both in the U.S. as well as Europe. Everything else has been ‘OK.’ And OK earnings – like inflation cooling – are what investors need to see.

I’m using labor market strength and wages as a compass to guide the pace of future rate hikes. We’ve seen this year the fastest year-over-year increase in U.S. unit labor costs since 1982. Recent productivity declines were the weakest two quarter pace we’ve seen in the post-war period. With productivity gains significantly below wage increases, I expect we will hear about companies increasingly guiding down earnings as margins come under pressure.

For the S&P 500, analyst earnings per share estimates have been revised down to about $245 for 2023, from over $250. Our base case expects 2023 earnings to come in right around $240. This year, S&P earnings should be close to $225. To keep it simple, the mental proxy I’m using for ‘fair value’ on multiples is a range of 15-18x, on a forward looking basis.

Taking central banks at their word that they intend to forcefully address inflation, those valuation reference points reflect where S&P multiples have traded historically. I’m a big believer in mean reversion. That said, the pragmatist in me recognizes markets rarely trade for long at historic averages.

A process, not an event. Policy rate normalization is a process, not an event (Figure 3). There is a reason every major central bank has moved to meeting-by-meeting policy rate guidance. We’ve begun to see what I’ll call the easy rollover in inflation we’d expected a quarter earlier. Russia’s war on Ukraine played a large part in extending inflationary pressure globally. That war continues to run at full-throttle.

Figure 3: Central bank policy rate tightening to continue

Source: National Central Banks, Haver Analytics. Data as of September 8th, 2022. *For the Euro area, the deposit facility rate is shown. 
Line chart of U.S. and Euro area central bank policy rates time series data shown in percentage terms on the y-axis and displayed with monthly data points since 2010 through September 8th, 2022 on the x-axis. While divergent in both level and trajectory over the better part of the period shown, and after hovering around or below zero since early 2020, both U.S. and Euro area policy rates are trending higher this year as their central bank’s continue to tighten policy. A footnote details that for the Euro area, the deposit facility rate is shown.

The challenge for policymakers and investors is how much is too much tightening. Markets are giving policymakers, on the margin, the benefit of the doubt. The Fed in particular has said inflation remains too high and that they need to see “compelling evidence” it’s moderating. Inflation seems to be peaking. We haven’t seen compelling evidence it’s truly rolling over.

The Fed is in play for a 75bps rate hike this month. The ECB just hiked by 75bps. There is still far too much noise in the market and macro outlook. Humility comes in knowing what you can’t know and positioning for what comes next, with a distribution of market risks and outcomes clearly in mind. You learn from life and markets looking back. You live life and invest, always looking ahead…

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