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Capital markets are discounting mechanisms, and the current bear market is preparing us for slower economic growth caused by a multitude of economic factors. But could slower growth, or even a mild recession, be beneficial for Equity and Bond markets? What can an investor do in this economic climate, when Equities and Bonds are moving in tandem, while Central Banks are increasing interest rates and reverting to “Quantitative Tightening” to control inflation? Normally safe-haven bonds move inversely to equities but how should one think about their portfolio when they move in sync?
How did we get here?
The years post the Global Financial Crisis have proved to be unique. For the first time, Central Banks, outside of Japan who’d done it before, directly intervened in capital markets by buying securities under their Quantitative Easing (QE) programs. However, despite this, in many countries the economic recovery had been somewhat weak and markets had become hooked on easy money. As a result, Central Banks sustained their historically low interest rates and increased their asset buying programmes. Milton Friedman would have expected all this liquidity to cause inflation. It did, but instead of higher prices for products and services, liquidity found its home in capital markets and real estate. This caused prices to rise meaningfully and resulted in the longest bull market on record.
Before the QE era, Equities and Bonds acted as counterweights in a portfolio. Equities increased in price as the economy and company earnings improved. Bonds moved in the opposite direction. Despite the low interest rates, inflation remained broadly in line with (or below) targets. Yet, as inflation expectations rose causing yields to rise, the risk was the economy would slowdown, as is usually the case with higher rates. But QE broke that relationship as Central Banks bought more Fixed Income assets, suppressing yields. Not only easy money but a confluence of factors including government grants, Covid19 supply chain issues, under investment by many commodity suppliers and finally a war in Ukraine has pushed inflation to levels not seen for decades in many developed countries. Finally, Central Banks are acting by increasing rates to control inflation, yet the global economy was already slowing down.
Most would argue that the Federal Reserve in the USA has done too little, too late, even after the recent 75bps hike, and inflation is now out of control. Others argue that the Fed is doing too much too quickly and is going to cause a major recession. We think the Federal Reserve is more experienced and knowledgeable than many might believe and is most likely to respond to the data in the right way. Most investors use the federal funds target rate to judge the Fed’s hawkishness or dovishness. However, as we’ve mentioned, markets are discounting mechanisms, and the Fed has been skilfully working on market participants’ interest rate expectations by guiding them upwards.
This is evident by the sharp rise in yields mainly on the short to medium-term end of the yield curve. The mere hint at or slight indication of future rate increases is enough for investors to adjust their expectations, and they’ve adjusted upwards quite considerably. The Fed can (and does) cause market yields to increase, effectively tightening monetary policy, without actually increasing the short-term fed funds rate to the same degree. You can see from the above chart that 2-year Treasury yields increased from 0.25% to 1.5% by February 2022 without the Fed actually increasing rates, which now brings us to inflation expectations.
“Bad” news for the economy can be “good” news for markets
During the Covid-19 pandemic, governments effectively shut down their economies (i.e. supply chains, industrial production, many services and concomitantly consumption), while at the same time generously supporting households and corporates with stimulus (cash cheques and tax breaks on the fiscal side and low rates and QE on the monetary side). Consequently, consumers spent less, retailers froze their orders as inventories ballooned and manufacturers shut down factories or halted production due to Covid restrictions. As economies reopened, the reversal was strong and swift, leading to a surge in demand mainly for goods (less so for services). As expected, when one hinders supply and demand returns with a force inflation ensues. It will be interesting to watch in coming months how increasing retail inventory (as a result of retailers restocking/overstocking due to supply concerns) potentially results in deflationary pressures as they offload inventory in a slowing economy.
The Fed argued that supply chain bottlenecks cannot be solved by increasing rates and “Inflation is transitory” became the message. They only recently changed course with consecutive hikes, including a 75bps hike in June, the highest since 1994, with more to be expected. “Expected” is the key verb in the sentence.
The Fed now appears to be spooked by inflation, and may be doing too much, but too late, which is why any positive surprise (lower) in inflation expectations can cause markets to rally. Furthermore bad news about retail sales and consumer confidence, rising inventories and discouraging macroeconomic data can actually be good news for investors because the Fed will not be compelled to be as aggressive in their rate hiking as the market currently expects.
More supply + slowing demand + rising inventories = lower inflation?
Retail giants released 1Q 2022 earnings highlighting increasing inventories, especially in the non-discretionary segments, and slowing sales. As a result, stock prices in the consumer staples/discretionary categories suffered significant losses. However, the combination of cooling retail sales, rising inventories and record high manufacturing orders offers an interesting dynamic that could help alleviate inflationary pressures.
The purchasing power of consumers is diminishing because wages are not growing as fast as inflation. However, US consumers increased their savings during the pandemic and are now sitting on trillions of US Dollars of excess savings. Rational consumers would support their non-discretionary expenses with their savings (if necessary) and delay discretionary purchases of durables, luxury items, and homes, as we have recently started to see.
Rising inventory levels among retailers, combined with high orders and falling sales should lead to discounts, fewer future orders, lower manufacturing output, lower commodity prices etc. This dynamic has the potential to reduce inflation without the Fed increasing rates to uncomfortable levels. Excluding General Merchandise stores, Inventory/Sales ratios are still low in the retail and manufacturing sectors but seem to be rising. We expect 2Q retail sector earnings to shed more light on the matter and we watch with a keen interest.
Healthier valuations
The S&P 500 has now fallen 20% from its all-time-high in January. Naturally, its forward P/E ratio is looking more attractive compared to 2021. The same applies to most major global indices, which are now trading below their historical average P/E ratios. Despite recent earnings downgrades by analysts, we believe that the current bear market has created a plethora of opportunities.
Recession is not a certainty
The Fed in the 80’s and the 90’s increased interest rates to control inflation without causing a recession. In a similar manner, a bear market is not always the warning sign of a recession. The post-Covid era was filled with extravagant valuations, overnight cryptocurrency/NFT millionaires and ample liquidity. Slowly but surely, liquidity is being pulled from the financial system and valuations are reverting to more normal (if not discounted) levels. We doubt whether anyone can call the market bottom, but to the long-term investor, Equities, and in some cases Bonds, are looking much more attractive. As quoted numerous times by many, including our firm, it is time in the market that is most important for your long term returns, not timing the market. We suggest adding to risky assets on meaningful drawdowns if your excess liquidity allows, but certainly not selling into the drawdown.
