Three Upcoming Events That Will Transform Perspectives – Tim Toohey
Financial markets saw no respite in the final months of the year, with the losses suffered by bonds and equities in the June quarter reaching historic proportions.
Where financial markets have ended
In the last 160 years of data on Australian bond yields, there have only been 30 that have recorded a negative return and only 2 years that have suffered double-digit declines. Worse was the uncertainty surrounding the Federation, which contributed to the 11.3% decline in Australian bonds in 1900-01. Remarkably, this was nearly eclipsed in 2021-22, when bonds fell 11.0%.
As bad as that sounds, it wasn’t so bad as global bonds which fell 15.3%.
Australian equities have done better in a relative sense, but of course no one is thrilled with Australian annual returns of -6.5%, including a 6-month return of -9.9%. Again, it could have been worse had you not been hedged and were overseas, as global equities fell 14.3% for the year.
But in another lesson in the virtues of the Aussie dollar working as a cushion for local investors, the Aussie dollar’s 8% decline over the year mitigated the damage for an unhedged investor to -7%. Nonetheless, over the past 6 months the Australian Dollar has been less protective and a -16.4% decline for the unhedged investor is an experience they would clearly prefer to avoid.
By far the best place to hide was the goods. The GSCI ended the year with a 47% gain, with oil providing much of the gains, but even here commodity prices have finally started to react to signs of slowing demand and recession fears.
Oil prices are normally a primary catalyst for recession and recessions have a strong habit of resolving lower oil prices.
The process now appears to be underway, with WTI plunging below $100 a barrel on recession fears and the number of rigs in the US rapidly approaching 2018 highs.
The macro backdrop
I want to take a few minutes to frame the discussion and touch on some of the questions that are no doubt on the minds of you as investors and advisors. In Australia, inflation is the highest for 40 years, the unemployment rate is the lowest for almost 50 years. Interest rates are finally rising at home and abroad and financial markets are now looking for an aggressive series of rate hikes which has contributed to a repricing of risky assets. All of this has happened against a backdrop of global financial markets obsessed with the risk of recession in major developed markets, geopolitics in flux, including the first ground war in Europe since World War II, and a global pandemic continues to have material impacts on the real economy on supply chains.
This is of course a very unusual set of circumstances. Some of these were unpredictable – naturally the pandemic falls into this category and arguably the invasion of Ukraine, although even here there were warning signs. Some of them were quite predictable – here I would include the initial surge in US inflation, although few looked at the right indicators. And some of it was made worse by a policy error.
It’s easy to get lost in the noise and lose sight of what matters to financial markets. A mentor of mine once told me that in times of uncertainty, the key thing to remember is that there is always an underlying business cycle that normally follows a predictable path. The trick is to identify where we are currently in this cycle and which of the various recent shocks has changed the impression of what will happen next.
For 90% of the time, the underlying economic cycle is just a variant of this stylized version of an industrial cycle. The remaining 10% is a smarter cycle of debt deflation, which has been the experience of the GFC.
If you look at the first chart for a moment, you can no doubt identify where we are currently in the Australian economic cycle. If your eyes are more drawn to the top right around “wages are rising, interest rates are approaching neutral, and purchasing power is falling,” then you’re probably in the right space. But don’t take the gaps between steps as an indication of time. We can move from one stage to the next quite quickly and occasionally slip back a stage or two due to a shock, but it is rare for a stage in the cycle to be missed.
Graph 1 – Traditional industrial cycle
So, at this benchmark, we are pretty close to a significant slowdown in sales and a spike in demand on this cycle-ready meter. However, there are two very unusual aspects that have skewed this cycle.
The first is the degree of fiscal stimulus deployed (over 11% of GDP in Australia – arguably the largest in the world depending on how you count it) in conjunction with the stop-start nature of the mandatory restrictions. This accelerated demand recovery long before the supply chain could ever respond. So we crossed the sweet spot of the cycle faster and more aggressively than the non-COVID world would have likely delivered.
The second major distortion was the perverse decision by many of the world’s most important central banks, including the RBA, to engage in unprecedented monetary expansion and switch to a new retrospective targeting framework for the inflation rather than the proven and reliable forward-looking strategy. inflation targeting. Why is this important? Although economics is not an immutable science, there are rock foundations that over the past 40 years have remained largely unchallenged.
One of the most important was that if you desire stable price growth, you must increase the money supply in line with the growth of the economy – a concept called money market equilibrium.
I apologize for using such an obtuse economic concept, but it’s the best way I can think of to illustrate the challenge ahead. The RBA likes to talk about its willingness to “insure” against the COVID pandemic.
The second chart shows the difference between buying insurance and fueling a currency bubble. Much of the credit created came from the expansion of central bank balance sheets and much of that excess contributed to both excess demand elements and valuation stupidity. The problem for financial markets is that the distortion is so large that the late-cycle rate hikes now imposed on us risk more than a slight slowdown in economic activity.
Graph 2 – Money stock surplus
This brings me to the prospect of a recession.
Since the beginning of the year, we have warned that signs of recession in the United States and Europe are steadily increasing. Collapsing consumer confidence, soaring oil prices and flattening yield curves all flashed red. The invasion of Ukraine cemented the case that parts of Europe would likely slide into recession through 2023 and by April we were confident enough that the odds of a US recession emerging by the end by 2023 had exceeded 50%.
It sounded like a brave call at the time and enough to grab headlines, but it’s now coming very close to a consensus view, at least as far as stock markets are concerned.
Indeed, it is rare for stock market sentiment to be as weak as it is right now. This translates into a series of measures. We are currently in the third wave of risk aversion since the start of the war in Ukraine and the following chart shows both our own measure of risk aversion and the sentiment of investors polled in the United States.
The fact is that while cross-asset risk aversion is high, it pales in comparison to equity risk aversion which is currently above GFC levels.
Chart 3 – US AAI Investor Sentiment – Bullish minus Bearish: Net % who believe the equity market will rise over the next six months
It is curious that despite the fact that the financial infrastructure was on the verge of collapse in 2008, investor sentiment is worse today. This is for investors knowing that much of the growth in the post-COVID era was about building castles on sand, backed by excessive fiscal and monetary stimulus.
Our financial conditions framework suggests the US is heading into a recession before the end of the year and our nowcast for real-time growth suggests the US is flirting with a recession now, not in 2023.
Chart 4 – MSCI USA: EPS dynamics and financial conditions
So we know, and the market knows, that a wave of EPS downgrades is ahead of us. It’s just a matter of how much and when does the market look past the risk of negative earnings. If we use forward 2-year EPS growth as a benchmark, the current +18% consensus growth will likely need to be revised down to 15% to adequately reflect a recession.
Much of these revisions are expected to hit the markets in the next quarter.
From my point of view, I prefer not to stand in front of this wave. As we discussed last quarter, we moved overweight bonds into our multi-asset strategies in May and June and expect bonds to continue to rally significantly in the September quarter. The time to buy stocks is approaching, and I have said publicly that September-October should be the time to come back and take advantage of some relatively indiscriminate selling in quality stocks.
We are not there yet, but we are getting closer to three likely events.
- The Fed will likely pivot on growth fears around September.
- We believe that US inflation will start to surprise the consensus on the downside through Q422 and into 2023. Not least because commodity markets are now pulling back and excess inventories in the US will demand a reduction in price leading to a slowdown in sales.
- The prospects for the RBA to reach the 3.5% currently implied by IB futures are slim at best. We believe the RBA will end the year with a cash rate of 2.35% and this will likely complete the local rate tightening cycle. Australia will likely avoid a recession, but growth will be weak in 2023. The silver lining for markets is that interest rates will likely be lower than what the market is currently pricing. The dark line is that we still have to work through the excesses of the previous period of monetary and fiscal excesses that preclude a return to above-trend economic growth for the next few years.
The first quarter was difficult for the financial markets, the second quarter was much worse and the third remains a challenge.
The good news is that Q4 is my line in the sand where I expect stocks to start a more genuine bounce.
I hope we will discuss the first signs of this when we start again in three months. Good luck and see you next term.
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