The impact of historic coordinated global policy tightening (read: interest rate hikes), continues to ripple across financial markets, although the smoke is clearing;
- Whilst many prognosticators, justified by leading indicators, point towards recession, the odds do seem high that it ultimately transpires. However, as yet the data is not confirming a material slowdown;
- Inflation vs Stagflation vs Deflation: logically after a supply tightness, we should see a supply glut leading to lower prices going forwards;
- Equity market anxiety will then naturally migrate from inflationary concerns to growth worries and falling earnings;
- In the face of extreme pessimism, and very underweight positioning, equities have the potential to surprise on the upside in the first half of 2022;
- The commodity outlook remains mixed, although a weakening US Dollar will provide some support, as well as the China re-opening providing a tail wind to industrial metals;
RECESSION WATCH
Many have it that the seeds for the 2023 recession were sown some time ago, with central banks globally forced to hike interest rates into a slowing economy – something unprecedented in recent times. Indeed the Conference Board’s leading economic indicator index has now fallen for nine consecutive months – something that hasn’t happened since 1959 without presaging a recession beginning with a few months.
Chart 1: Leading Economic Indicator
Source: Haver Analytics, ARIA, Bloomberg, January 2022
Global PMI Indicators, which record real time purchasing managers’ intentions on behalf of businesses, which have historically also had predictive powers for equity market performance have also swooned:
Chart 2: US PMI Indicators & S&P 500 eps growth (historical Z-Score for comparison)
Source: Refinitiv Datastream, ARIA, January 2022
The US Federal Reserve seems very focussed on the labour market and wage growth. Whilst it could be argued that these particular parts of the economy are the last to present a weakening pulse, the logic is that it is wage inflation that is buttressing inflationary pressures. Break the labour market, break wage growth and hence inflation. Of course, that means de facto generating an economic slowdown and whilst economic readings hold up, and credit markets do not show any stress, perhaps there’s no reason not to continue with rate hikes.
Alternatively, perhaps the slowdown is behind us? That would certainly not be a consensus view. Perhaps the asset price falls of last year were sufficient to price in any recessionary conditions, and the ‘recession’ is limited to further deterioration in housing prices globally, but not materially poorer company earnings beyond those already priced in. The chart below suggests that the recession began some months ago.
Chart 3: Leading Indicator to Coincident Indicator Ratio
Moreover, we’re open minded to the potential for a surprise in stock market returns. Recession is a hotly debated topic, and its appearance would certainly not surprise anybody. In fact, stock markets can even make positive returns where earnings growth for companies was negative, even if it was a bumpy ride.
Specifically, the S&P 500 delivered a positive return in 9 of the last 11 times we saw negative earnings growth year over year. That said, within those 9 years, there was a drawdown of -14% along the way. So whilst current sentiment and positioning allow for a surprise to the upside in many markets, we should still expect downside volatility.
Chart 4: Annual S&P 500 Earnings Growth vs. Return
During Years When Earnings Grwoth Is -10% Or Less
Source: ARIA, David Bahnsen, January 2022
ASSET ALLOCATION VIEWS
Equities:
What has been notable year to date, is the relative underperformance of US equities relative to the rest of the world. Given the underperformance of technology shares, and the US’ heavy weighting toward them (compared to European stocks), it is not surprising. In fact, Europe’s outperformance, along with EM markets we feel is set to stay for some time yet.
Chart 5: VPE10: USA vs The World
Source: ARIA, Refinitiv, January 2022
The bear market of 2022 returned many international markets to ‘cheap’ valuations, but did not necessarily take the froth out of US multiples. With German exports very sensitive to Chinese demand, and its re-opening and about turn on its COVID policy having seen Xi secure his lifetime presidency, more cyclical indices could yet continue to outperform. In fact, in the face of such dire headlines, EU and UK economic data has genuinely held up, as has stock market performance.
Bonds:
On current valuations, government bonds, (particularly those in the US), are very attractive – in fact cheap. Should recession set in at some point this year, then bonds should deliver very attractive returns, after their annus horribilis in 2022. Moreover, emerging market bonds may even offer a generational buying opportunity should the US Dollar continue to weaken.
Chart 6: Emerging Markets Valuations (Relative to USA)
Source: ARIA, Refinitiv, January 2023
Commodities:
China is definitively transitioning away from a zero covid to a zero cares mentality, and the implications should not be underestimated as an additional source of liquidity to offset tighter conditions elsewhere. Chinese authorities have been very clear in their intention to support property markets, and the PBoC stimulus could be an important bright spot for global markets if they do continue to prime the pump.
Precious Metals:
During any contractionary environment, precious metals typically perform well. We expect 2023 to be no different, with Gold perhaps likely to set new highs in price this year. The fundamentals are certainly shifting in Gold’s favour, and typically, gold advances before, or anticipates, easier monetary policy and interest rate cuts.
Currencies:
The US Dollar has rolled over from its overbought conditions, and unwound its stretched sentiment and positioning. The weakness we are seeing many well foretell of a markedly disinflationary US economy, and the surprise maybe further downside in the greenback. Of course a weaker Dollar leads to strength in EM currencies, but with the European Central Bank with some work to do to catch up with the US Federal Reserve in interest rate terms, the EUR may continue to gain ground in the coming months.
TURNING OF THE US TIDE
The outperformance of US markets relative to their international peers in the last decade has been marked. In a low growth environment, investors were drawn to the ‘FANGMAN’s stocks that still offered growth prices. With a stronger US Dollar, international investors could benefit from a currency appreciation too.
Well that trend appears to be breaking. European and Emerging markets have clearly stolen a march on their US peers year to date, and there are reasons to believe it will likely continue.
European markets are more ‘value orientated’ than US stock markets, with greater exposure to banks, manufacturing and financials. These are all sectors which fare better in higher interest rate environments, (and higher inflationary environments), than tech stocks do.
Chart 7: Germany’s outperformance of the US Tech shares likely to continue
Source: ARIA, Bloomberg, January 2023
Moreover, emerging market indices are more sensitive to Chinese fortunes, commodity prices and the US Dollar. As China reopens and likely continues to stimulate its economy, commodity prices are generally higher than they’ve been in years, and the US Dollar weakens, emerging markets should continue to outperform the US. We believe any rotation in asset allocation from the US to international markets is still in its early innings after such a pronounced period of outperformance.
Chart 8: Emerging Market’s prospects have turned relative to US markets
Source: ARIA, Bloomberg, January 2023
CONCLUSION
Once more, financial conditions or interest rates policy will drive asset market performance in 2023. In hindsight, with the quantum of interest rate hikes touching 600 basis points in 2023, (as reflected in the ‘Shadow Policy Rate’ below), the precipitous falls are hardly surprising. The big question going forwards is the degree to which stock markets have priced in a global slowdown, or simply at this point reflect lower valuations responding to higher interest rates, and the impact of poorer earnings still lies ahead.
Chart 9: DM Policy Rates vs MSCI ACWI
Source: ARIA, Bloomberg, January 2023
The Federal Reserve have made it that the new pace of tightening for 2023 will be 25 basis points, save for a material deterioration in the macro data. Given that diesel prices have risen over 30% since the last inflation print, it seems unlikely that we’ll see large negative surprises in the first quarter of 2022, more likely core will be ‘in line’ with expectations.
Central banks, and specifically the US seem to be operating on a framework that below trend growth will lead to slower wage growth which means falling core inflation. In that respect, they will sit at a 5% Fed funds rate, until wage growth is at or below 5% too. So the question for market participants now is less how many more rate hikes, but rather ‘how long’ will the Fed sit at 5% before cutting again. The answer to that question seems to be how quickly wage inflation falls away, and by extension the potential for positive returns in 2023.
