Peak rates, massive relief
Markets are resilient. Negative returns last year reflected the end of quantitative easing and the normalisation of interest rates. Of course, inflation created uncertainty and higher rates have led to forecasts of recession. But firms are, generally, in good shape and people are, mostly, working. There are things to worry about – the technology sector is having a bit of a wobble, the US government may shut down, China might create a new energy price spike – but growth might not be that bad and inflation is coming down. Investors clearly like higher bond yields and equity markets are looking through this year’s earnings decline to future growth opportunities. It won’t be plain sailing and volatility has not gone away, but for now, the bear market has moved on.
Markets are rallying because this period of monetary tightening is almost over. Central banks have one job to do and that is to achieve price stability. They raise interest rates when inflation is rising and when it is too high - and cut when inflation is falling or too low. There were no surprises in the latest round of policy moves but the veil of super-hawkishness has started to slip. Inflation is much too high for policymakers to be complacent and the medium-term outlook for inflation is uncertain. However, across economies headline inflation is falling quickly and could even get back to target levels before the end of this year. Even if there are final moves higher in policy rates in March, the market pricing of where terminal rates will be has been consistent in recent months and there is no need for that to change. The game going forward will be central bankers justifying why rates will stay high and markets second-guessing them by pricing in cuts. That game is already well underway in the US and UK with rate cuts priced before the end of 2023.
Markets like it
Market returns in 2022 were hit by rising inflation and the aggressive hawkishness of monetary policy. The gap between one-year interest rates and the Federal Funds Rate in the US rose rapidly in the first half of 2022 as future rate hikes were consistently priced in. This gap quickly widened and stayed wide for some months during which returns from equity markets were at their most negative. Since October, with the end of the tightening cycle coming into sight, that gap has narrowed almost back to zero, and markets have recovered. Not raising rates anymore is, by itself, bullish for stocks (and bonds, but you know I am bond bullish).
Lower yields tell the story
As always, there is scepticism about the positive market reaction. Bears will argue that rates in restrictive territory will hit economic growth. This should be reflected in weaker equity and credit markets. It is easier to defend the rates market’s reaction. Long-term interest rates are supposed to reflect the expected average of short-term interest rates in future periods. It is a very difficult argument to make that short rates will remain at current levels over the next decade. Yield curves are inverted, meaning that rates are expected to fall over the medium term. So, another 25 basis points (bp) or 50bp on today’s overnight rate is not necessarily going to have an impact on longer-term yields when the consensus view is that inflation will fall further, and growth is slowing.
It is not in central bankers’ nature to declare victory because they are obsessed – rightly – with risks. But they’ve done their main job. At some point, they will have to decide what to do about inflation being too low, or what level of rates is appropriate when inflation gets back to the circa 2% global target. In both cases, rates will be lower than today. The retreat of inflation and interest rate risk premiums in global bond markets since early in the fourth quarter has delivered very strong returns to bond investors. Since last October’s lows, a typical global aggregate bond index is up around 12%. Returns are likely to moderate going forward, especially given the move we have already seen in medium to longer-term yields. As noted before, shorter-dated fixed income could provide a nice yield in today’s market for investors who are now able to follow income-oriented strategies. Generally, there is positive momentum in fixed income markets, flows are positive, and investors are still demanding yield after being underweight for many years.
Not just rates for equities
For these reasons it seems investors are increasing their allocations to bonds. That does not seem to be the same for equities. Sure, performance has been great since October, but it is not clear how widespread the participation in the rally has been. Some Wall Street equity analysts continue to call for new bear market lows. The core driver of a bearish view on stocks is the risk of a more significant decline in earnings than seen so far. The reasoning is that if the central banks have done enough to bring inflation down, then they have probably done enough to cause growth to slow sufficiently to hit business sales and profit margins. This view rules out a ‘soft landing’ or the idea that inflation can come down only if unemployment goes up. The notion that the 2022 inflation surge was a function of the massive stop-start the global economy went through in 2020-2021 does not sit comfortably with Phillips Curve purists.
Earnings growth has fallen
There is uncertainty about growth and earnings, that is clear. The International Monetary Fund recently revised up its global GDP growth forecasts but many are still anticipating recessions. Consensus earnings forecasts from equity analysts have been falling for months. For the S&P 500, the 12-month expected growth rate for earnings per share (EPS) is 4% but the range of expectations is very wide – the standard deviation of 12-month EPS forecasts was only higher in April 2020 just as lockdown started. For Europe – for the EURO STOXX universe – the expected growth rate of earnings is just 2.1%. Interestingly, the variance of European forecasts is a lot lower than it is for the US market. Analysts are more aligned that European earnings growth will be weak while the uncertainty over the outlook for big US sectors like technology and energy provides more scope for surprise. Either way, earnings expectations have come down a lot and long-term growth estimates for most equity markets are lower today than a year ago (although for both the US and Europe, long-term growth rates are now back at their historical average – which may ultimately help provide a more realistic foundation for valuations).
Market up despite weakness in reports
For the current earnings season, with around half of S&P 500 companies having reported, the aggregate shows little in the way of surprises for sales or earnings. Weaker expectations are being borne out in the actual data. Earnings growth is flat to slightly negative so far and there have been enough examples of downbeat outlooks to keep the bears grumbling. Yet, it is hard to say that what we are seeing now or what companies are saying is a severe earnings recession. In Europe, the current earnings season seems better with reports so far pointing to positive sales and earnings growth. With lower valuations, some modest decline in growth risks and the potential for the European Central Bank to signal that it is done after March, the strong performance of European equities can continue.
Previous recessions have seen deeper troughs in earnings while periods of systemic shocks – like during the global financial crisis or the pandemic – have seen year-on-year growth rates as bad as -65% for the S&P 500. In the 2017-2018 cycle, when US rates went up only half as much as they have so far in this cycle, the economy avoided recession but even with a soft landing earnings growth for the S&P 500 was flat during 2019. That appears to be kind of what we have now.
Interestingly, during 2019 when there was essentially no growth in earnings for the US large-cap stock market, the price-earnings ratio on the S&P index was about where it is today. Earnings were flat but the Federal Reserve pivoted on rates at the end of 2018 and cut in the second half of 2019. The market was up 29% that year. You can have a growth slowdown and weak earnings growth, but if the rates environment changes, returns from equities can be very positive.
Markets are forward-looking. Market commentators not always. Much time and effort is wasted trying to make direct links between difficult-to-understand complexities in the global economy and what levels the stock market or long-term bond yields should be at. The bond market has known for a while that rate hikes would come to an end and that rates wouldn’t stay at their peak indefinitely. Stock markets de-rated when bond yields were rising (remember how low they were in 2020?) but that process has stopped and may be partially reversing. The US market may still seem expensive, but the current price-earnings ratio is only at the 22nd percentile of observations since 2015 and is bang in the middle of the valuation range that has been in place since 1993.
The historical volatility of stock returns is high. An average annualised price return of 9% for the S&P 500 since 1993 has been associated with the risk that for two-thirds of the time returns could be in a range of -7% to +25%, and even beyond that for the other third of the time. So, predicting them is hard. My sense is that the combination of the peak in inflation and rates, the valuation adjustments already made, and a more optimistic global growth outlook should provide enough to keep returns biased towards the positive side. The consensus is that the rest of the world is cheaper and that appears very much to be the case. But is the downside worse for the US? I don’t think so. The death of the US equity market is much exaggerated, as a 6% total return in January served to remind us. And if the US market is positive, potentially that bodes well for equities in general.
Is the fundamental story improving?
The mix of global growth between real output and inflation should improve in the next couple of years. Higher global interest rates have impacted the outlook and what is in the pipe could continue to damage growth for quarters to come. But the surprise may be just how resilient the global economy is. Policies designed to invigorate industrial investment in the US are widely seen as something that could improve long-term growth prospects. There is a global battle, being fought between the US, China and the European Union, to gain competitive advantage in green technologies and renewable energy, as well as in technology more broadly. Some of this may keep inflation at levels higher than what prevailed in the last 20 years or so, but it will also provide growth opportunities and potentially spur productivity – so benefitting jobs and incomes. I have not really got on the ChatGPT bandwagon yet, but it is another example of how technology – in this case artificial intelligence – can contribute to increased output in a labour-scarce world. There is no reason to think that green, clean, and digital can’t deliver us a world of 10% equity returns.
Prepare the cabinet
Erik ten Hag has secured his first Cup Final for Manchester United. A tie against the Saudi Arabian-funded Newcastle United awaits on 28 February. The Carabao Cup (English League Cup to give it its non-sponsored name) is the least glamourous of the English competitions but United are also alive and kicking in the FA Cup, the Premier League, and the Europa League. Who would have thought after losing to Brighton and Brentford in the first two games of the year? Onwards and upwards.