Today’s CIO Weekly Perspectives comes from guest contributor Robert Surgent.
June saw us hit what I call the “growth concern phase” of this tightening cycle.
As equities declined, credit spreads widened and global yields rose in the first half of the year, it was only a matter of time until conditions tightened enough to slow growth to the point necessary to offset inflation. Sure enough, pretty much every commentator you hear is now calling for a recession and a decline in corporate earnings.
The question for investors, however, is how much inflation, how much tightening and how much of a slowdown is already priced in—and is it enough?
For the first time this year, we in the Multi-Asset group’s Tactical Allocation team believe that it might be. We think we are in the late innings of the tightening cycle and that a further, aggressive directional sell-off from here would require an even worse deterioration in the inflation, growth and earnings outlook than is currently anticipated.
At the very least, while caution may be warranted over the next quarter, we don’t think it makes sense to be gloomier about markets now than we were six months ago.
Our turn to cautious optimism is based on just how far some key indicators have moved in the first half of the year.
First, indices of financial conditions have tightened more rapidly than at any time in the past 20 years.
A big part of that tightening has come from rising real yields—we raised the alarm about that potential move back in December. By the end of June, U.S. real yields were positive by 50 basis points or more from five years outward on the curve, having been deeply negative six months earlier. We think 0.5% real could be considered a long-term “neutral rate”—the rate that is neither accommodative nor restrictive given prevailing economic conditions. Real rates could rise further from here, but it’s not obvious that they need to.
Next, overnight index swaps have already tested a terminal fed funds rate of 4%—that is, the rate in the current cycle at which the U.S. Federal Reserve stops hiking (and therefore the rate that the Fed hopes is neutral). Even if we assume long-run inflation at, say, 3%, that suggests a 1% neutral real fed funds rate.
But the Treasury market’s 10-year inflation expectation is currently 2.3%, and the expectation for five-year inflation starting in five years’ time is just 2.1%. That, together with the impact we’ve already seen on equity markets, suggests to us that a 4% terminal rate would not be neutral, in fact, but restrictive. We may therefore be at or past the peak of market pricing for this tightening cycle.
Looking to equities, when we compare the performance of cyclical versus defensive stocks, or the price of semiconductor stocks relative to projected earnings, we see levels equivalent to the 2012 eurozone sovereign crisis and the 2016 crisis in China and commodities, when Purchasing Managers’ Indices dropped firmly into contraction territory. Similarly, the forward price-to-earnings ratio of the MSCI World Index is at its lowest level since 2014. To push these levels much further, the coming hit to growth and earnings would need to be on the scale of the Great Financial Crisis and COVID-19.
Finally, there is inflation itself. The majority of forecasters, including inflation swap markets, expect U.S. CPI to peak at just over 9% before starting to drop in September. The more confident investors become that inflation is peaking, the more likely they are to remove some tail-risk pricing from financial assets.
So, what makes us cautious?
As mentioned, rates markets have already priced for a 4% terminal fed funds rate that we think is overly restrictive. But to get meaningful relief from that in the shorter term might require a much more precipitous fall in inflation than is anticipated in the fourth quarter or, which would be much worse news, downgrades to growth and earnings that are deeper than currently expected.
What makes us most circumspect, however, is the hugely uncertain outlook for energy prices that is still clouding inflation projections.
We are amazed at how much of the inflation impulse is energy-related and how little this is discussed in inflation forecasts. If supply is as tight as some strategists suspect and oil is heading to $150 per barrel over the next six months, that would be a very different world than if it follows the path mapped out in the futures market, where the December 2022 contract is pricing at $92 and the December 2023 contract is at $81. It’s also worth pointing out the enormous inflationary pressure exerted on European and emerging countries by the unusual rise in both the dollar and the oil price.
In short, energy prices still present a tail risk to the economy and asset prices.
We believe it’s this background, where it is so difficult to forecast long-term equilibria, that is making markets so dynamic, so data-focused—and so jittery when key numbers come out.
But when we look at market pricing, all the dangers we flagged at the end of last year—highly negative real rates, historically loose financial conditions, a very accommodative terminal rate, stretched equity valuation multiples—have corrected substantially.
Day-to-day volatility could be extreme in the third quarter. But big changes to inflation and growth expectations would be required to cause meaningfully sustained market moves, in our view, and there’s a reasonable chance that it turns out to be the first flat or positive quarter for risky assets this year. At that point, it may be time to take stock again, and decide whether we have a foundation to build on.
In Case You Missed It
- Eurozone Producer Price Index: +0.7% in May month-over-month and 36.3% year-over-year
- U.S. Employment Report: Nonfarm payrolls increased 372,000 and the unemployment rate was unchanged at 3.6% in June
What to Watch For
- Wednesday, July 13:
- U.S. Consumer Price Index
- Thursday, July 14:
- U.S. Producer Price Index
- China 2Q 2022 GDP
- Friday, July 15:
- U.S. Retail Sales