Inflation has been bad news all year. So the unexpected decline in US inflation in October was nice. Markets might have overreacted to what was, let’s face it, just one data point, but it strengthens a particular narrative. That is that most of the monetary tightening is behind us. Rates will go up a bit more and might stay high for some time. But once we get to a position where the expected next move has a high probability of being a cut, the risk-return in markets will become more favourable. There may still be bad news ahead, but fourth quarters are generally positive for stocks and bonds. This one doesn’t seem to be bucking that trend. The tone in the new year might also reflect that, but keep in mind inflation is still too high and growth is slowing. It could be another challenging year ahead.
Investors got a nice surprise on 10 November. The release of the October inflation report for the US showed an unexpected slowing of the pace of price increases. The headline index rose by 0.4% rather than the forecast 0.6%, and the core inflation index rose by 0.3% rather than the forecast 0.5%. Both headline and core annual inflation rates slowed to 7.7% and 6.3% respectively. This was good news. It was a vodka shot to an already slightly inebriated market that had got all giddy in the wake of the most recent round of central bank meetings. Rightly or wrongly, markets had concluded that central banks were ready to call an end to phase one of the tightening cycle – what I am amusing myself by calling the Hawkish Hiking phase – by preparing to dial down any further rate hikes from the 75 basis points (bps) per meeting that have been de rigueur since the summer.
Markets responded very positively. Inflation has been the core concern for markets for months. It has been unexpectedly strong and has resulted in an aggressive rise in global interest rates which, in turn, has threatened to create a global recession. One month’s worth of better data might not allay these concerns completely, but it does strengthen the “inflation has peaked” narrative. If you also throw in the blow that Trumpian politics took in the US mid-term elections and the retreat of Russian forces from Kherson, you can’t fault the markets from having a bit of a risk-on party.
Many will read that and think “it can’t last, inflation is still high, central banks are still raising rates, and a recession is still coming”. I agree. But these things are known and priced in. Before the release of the consumer price index (CPI) data, the market had a 5% peak in the Fed Funds priced in for the end of Q1 2023. It’s now a little lower but it is not like the market has priced no further rate hikes. Similarly, in the equity market, earnings forecasts have been more meaningfully revised down in recent weeks. I suspect that will continue but maybe the extent to which they are revised down might be less aggressive. The year will still see higher bond yields, wider credit spreads and lower equity prices than anyone expected at the beginning of 2022.
Having said that, the news supports my positive view on fixed income which has been building since early summer – but suffered a set-back post-Jackson Hole when the Fed ramped up its anti-inflationary rhetoric. The highest conviction has been on short-duration strategies because yields already more than reflect the expected peak in central bank rates. Longer duration strategies, that seek total return from both higher yields and some anticipation of capital gains as interest rates fall, have so far been less attractive. This has been because of the sensitivity to further policy hawkishness. However, the long end moved on the inflation data on the view that inflation is now on the down-path, the peak in rates might be lower, and we should look forward to both the Hawkish Hold and the Dovish Easing periods of the monetary cycle getting underway in the next 12-18 months. The 7 year-10 year US Treasury bond index still trades on an average dollar price of roughly $82.60, close to its lowest level since the index was launched. Most of the fixed income world offers very attractive entry points viewed through this lens.
Long duration relief
For months there has been this tension in markets between valuations and macro factors. Valuation has got so extreme that a little bit of better (and unexpected news) was all it needed to allow markets to punch higher. Duration in bonds and equities has been the worst performing factor this year, with the highest volatility. Long duration government bonds and highly valued, growth equities were the main victims of the interest rate reset. If that is over, they can bounce. They bounced pretty hard on Thursday. If we are genuinely close to the peak in rates, the worst of the negative returns might be behind us for assets like long government bonds and NASDAQ-like equities.
For credit and equities, the issue is still about corporate sector cash-flow and earnings. Credit is attractive across the curve. Both the level of yield and the size of the credit spread (risk premium) are at their highest combined levels since the global financial crisis. The bond market has just enjoyed a healthy couple of weeks of issuance. Despite challenging liquidity, the market continues to function and demand for fixed income appears to be strong and, potentially, growing. In my opinion today’s levels represent good entry points and an opportunity to rebuild exposure to bonds, creating a better income stream for portfolios than has been the case for many years.
Still an inflation level that is not acceptable
The Fed will welcome the October inflation data but is still likely to push rates to close to 5% and keep them there until it is clear that inflation is heading lower. The Bloomberg consensus of economic forecasts is for CPI in the US to average 4.2% next year and for the inflation rate to come down only slowly. The length of time that the Fed will keep rates at the peak will be governed by this as well as the growth and labour market data. If inflation and the economy remain resilient, the Fed might keep rates at the peak for a long time – it has done in the past. Inflation today is a function of the combined impact of COVID on supply chains, demand stimulus in 2020-2021, additional supply disruption caused by Russia’s invasion of Ukraine, insufficient investment in traditional energy production during COVID but related to energy transition reasons, and the behaviour of corporates and households seeking to maintain profit margins and real purchasing power. Complex reasons forcing inflation up and a complex challenge to get it back down again.
This relies a lot on reversing the demand stimulus and influencing behaviour. That is why we expect a mild recession in the US. At last this is starting to impact on corporate earnings expectations. Compared to the beginning of the year, the consensus for earnings per share for the Consumer Discretionary sector of the S&P500 has been slashed by 27%; Communications Services by 16%. The forecasts for 2023 have been reduced by similar amounts. At the global equity level, earnings revisions for 12-months forward earnings have been negative since Q2. The question for equity investors is whether a 17% total return decline for the MSCI World index this year (16% for the S&P, 10% for EuroStoxx) is enough to compensate for an earnings recession.
There may be trouble ahead
My hunch is that the macro environment could get worse as the true cost of bringing inflation down is felt. That will keep investor sentiment depressed as we get bad news from housing markets, possibly on the unemployment front and from corporate sales. So I can’t help feeling wary of the November bounce in stock markets. Seasonally, Q4 is generally good for equity returns but yesterday’s move alone was more than the average for Q4 returns over the last 10 years (for the S&P500). All the more reason to be overweight fixed income at this stage. The flags for investors are things like Black Friday and holiday sales, the extent of the labour shedding that has started in some sectors (big tech) and what happens with energy over the crucial December-February period. I think equity market do better in 2023, but there might still be trouble ahead.
The beautiful game
Like many of you I suspect, I have mixed feelings about the upcoming FIFA World Cup. It’s just feels wrong to be having the tournament at this time of year. Wrong for those of us staying at home to watch the games and even more so for the players out in the heat of Qatar. There will be a lot of slow, possession based passages of play I bet. Brazil are my favourites for the title (a few Man Utd players in that squad) and I really don’t see England being able to match the heights reached in the last two international tournaments. Still, it will be good entertainment on these dark northern European winter days. And it will only be 3 ½ years to the next one, jointly held in Canada, the US and Mexico. Now that will be a trip worth making (carbon offsets permitting of course!).
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