Will spring bring light?
Over the last 20 years, monthly increases in consumer prices in the US averaged 0.2%. For 94% of the time, they were below 0.6%. The CPI rose by 0.6% in January. Can that be sustained? Are we into the 6% probability range? That kind of monthly increase would sustain annual rates above 7% for the rest of the year, meaning more aggressive hikes by the Fed and bringing the next recession closer. If we move to monthly increases somewhere between 0.6% and 0.4%, annual inflation will fall, but not by as much as previously hoped. The risk of a 20% correction in US equity markets and reaching at least a 2.5% yield in 10-year Treasuries is very much alive.
Inflation is continuing to come in higher than anyone expected. This means higher interest rates need to be priced in with the potential negative implications for the economic outlook and for risky assets. Investors are wary of fixed income markets because yields and – now credit spreads - are rising and that means negative returns. They are wary of equity markets because valuations are still higher than where they were before the pandemic. The hardest thing for investors is judging when to override negative sentiment, take a contrarian view to the current narrative, and buy. It’s not going to be easy. And we might have to wait some time.
Peak inflation? Not yet
I have been thinking about triggers to turn more positive on markets. The most important trigger to make that call is inflation peaking. The 7.5% y/y CPI print in the US for January might be it – but it might not. The details of the report showed persistent inflationary pressures in sectors that are not going to see a reversal anytime soon – like rent. As noted in the introduction, monthly inflation increases of 0.6% are fairly unusual so the probability is that we will see some easing that allows the y/y rate to moderate. But in the short-term that is looking like more hope than expectation. And what goes for the US probably goes for Europe and elsewhere.
Lower energy prices
The second trigger, related to the first, is that energy prices need to fall as well. Although crude oil prices are down a little from the recent peak, it is not yet a convincing move. The same is true for natural gas prices. If oil was to fall into the $70-$80 per barrel price range it would help year on year comparisons, but there is not likely to be a negative impact from energy on overall inflation numbers for some time.
The third trigger I had in mind was greater clarity from the Fed and other central banks on the rate outlook. The outlook has been made less clear by the January inflation data. Some observers are talking about a 50bps hike by the Fed in March and market expectations are now for the Fed Funds rate to rise above 2.0% next year. The anticipated rate hike cycle is starting to look at lot more like 2004-2006 than 2015-2018 with seven hikes priced by January of next year. The Fed moved sixteen times in that 2004-2006 period, tightening financial conditions so much that we had a Global Financial Crisis. If the Fed sticks to 25bps moves and can point to some easing in the inflation rate in the months ahead, we can be more optimistic. But, to be honest, I think markets don’t bottom for a while now. Sentiment is poor and investors need clarity on the path of inflation, energy prices and rates. Sentiment is swinging towards too much tightening and an earlier end to the expansion than was the case a few weeks ago.
Minimum bearish expectations
Investors want to have a rosier outlook based on the view that eventually the Fed won’t have to do as much as is now priced. The ECB and BoE have rowed back on some of their hawkishness, but inflation is not as high and labour markets are not as tight as in the US. A such there is still a need to have some MBE (minimum bearish expectations). I’ve set mine out several times – US Treasury yields to 2.5%, Bund yields climbing towards 50-75bps, credit spreads another 50-100bps wider, and a further de-rating of equity markets, especially in the US. If all this happens, then subsequent risk-adjusted returns will improve significantly. But we might have a long and difficult wait to make that proclamation.
Some downward momentum
I don’t subscribe to the ‘policy mistake’ argument (it’s there in every cycle) because we know that the Fed can pivot if the growth data does start to seriously deteriorate. At the moment the economy is too hot. Moreover, deep down the Fed understands that most of the inflation has come from supply side issues which are starting to ease. For equity investors, the Q4 earnings season has been relatively positive with reports beating estimates on the whole and EPS growth above 25% y/y. Of course, it’s important what happens to earnings going forward. The bottom-up consensus of EPS forecasts for both the US and European markets has started to deteriorate a little. Earnings revisions are less positive and the balance between upward and downward revisions to EPS expectations has tended to be a good indicator of performance. At the moment those revisions look like they are just about to enter negative territory coincident with the 6-month rolling percentage returns from stock markets also turning negative. Typical deep corrections usually register a 20% drop in market valuations but not all cycles are the same. Market PE ratios are already down from their pandemic highs. They are likely to fall further and I don’t think we can rule out levels below 4,000 on the S&P and below 13,000 on the Nasdaq. These are the markets where valuations are more than one standard deviation above their long-term averages.
Medium term bull
Unless one believes that all of the positive impact of the accumulated QE of the last decade is going to be undone through 2022-23 then the medium term expectations for most asset classes is to get positive returns. It seems that getting positive nominal – let alone – real returns right now seems something quite distant. But it will happen even if they might be lower than in most of the QE era. Markets do go up over time because returns are driven by economic growth. On the bond side I would repeat it is extremely unusual to get two consecutive years of negative returns. Duration is a pretty self-correcting risk factor (if real yields go too high, economic growth falters and yields fall again). The likelihood of overall US inflation staying above 7% and core above 6% for an extended period is low in my opinion. But the Fed has to act, and it may act aggressively at first for credibility reasons. Spring should be a rebirth but this time around the winter might extend.