In the last month, we have seen a sharp recovery in the stock market that most analysts (including myself) found surprising. Let us briefly go over the reasons for this boom. We see a number of them.
1. The unexpected stock market boom
Holidays mean low trading volumes on the market, oil prices fell sharply and immediately dragged inflation and interest rates lower. The main driver of the boom was probably the subsequent hope of a less aggressive Fed. Quant funds (e.g. trend-followers or volatility-control funds) were very quick to capitalise on the boom and reinforce it. Furthermore, there was still a lot of cash on the sidelines that partly joined, and short positions (speculation à la baisse) were reversed at an accelerated pace. Good labour market figures and strong wage growth also supported the stock market recovery.
We must ask ourselves how many of these elements are structural in nature. Let us go over them.
The good labour market (which helped the stock market recovery) supports consumption (but also inflation). However, today there is a big difference between consumer confidence and spending. Confidence is at an all-time low (index started in 1952). Low unemployment (528,000 jobs were created in July, more than twice as many as expected) and high savings clearly support consumption. The question remains as to how long this will continue.
Regarding oil prices, we wrote two months ago that supply and demand are not in balance. Only a slowing economy (heading for recession) can keep the oil price down. The fact that significantly less was driven during this “driving season” shows that the American consumer is making budget choices. The Chinese slowdown is also pushing the oil price lower. But this week we read that bin Salman, Saudi Arabia’s energy minister, says OPEC is ready to pump less oil to push the price up.
Expectations mismatch
As for hopes of a less aggressive Fed, these were sharply tempered by Ms Daly and Mr Bullard last week. The former was sceptical about whether the central bank would cut rates again next year and the latter backed a third consecutive rate hike of 0.75 percent in September. Both statements pushed the market, especially growth values, lower again.
Both statements should not surprise us. The hope of a slightly less aggressive Fed due to slightly falling inflation pushed US 10-year yields sharply lower, stimulating the economy. Just the opposite of the central bank’s intentions. We have seen a mismatch between market expectations and central bank statements in recent weeks.
But also in our part of the world, inflation remains a concern. The German central bank is talking about the possibility of inflation going above 6 percent in 2023 (yes, you read that correctly - in July it was at a 40-year high of 8.5 percent). The year-on-year increase of 37.2 percent in their producer prices in July is clearly worrying. Nagel, the Bundesbank president, left open whether we will get another 0.5 percent increase in September, but further interest rate rises are necessary, he said. The dilemma for the European central bank is that during its interest rate actions, the economy is cooling down considerably at the same time.
As if this were not enough, Citibank expects UK inflation to peak at 18.6 percent in January (higher than the 17.8 percent during the 1979 oil shock). Again, a major dilemma with household incomes suffering greatly from rising prices and pushing the economy into recession, while at the same time the central bank has to put the brakes on to bring inflation down. A delicate balancing act.
Needless to say, central banks and inflation are chained together. Both will have a major impact on financial markets in the coming months. And we are experiencing a period of synchronised upward interest rate behaviour in several countries, with the exception of China.
2. An additional Fed interest rate fight: quantitative tightening
So far, we have mainly discussed inflation and the impact of interest rates through central banks. But in the United States of America, a second interest rate war is underway, namely the reversal of bond purchases. We will explain this in more detail, because I think it is underexposed and underestimated by the market.
After the banking crisis, the Fed started to buy bonds in the market. This drove bond prices sharply higher and immediately bond yields lower (both are mirror images of each other). These were unlimited purchases on all bond markets, such as government and corporate bonds, MBS paper (Mortgage Backed Securities) or Municipal Bonds (bonds issued by state or local governments).
One consequence of this was that at the height of the Covid-19 crisis (Aug. 2020), the 10-year US Treasury yield was barely 0.55 percent. The result was that investors sought out other, more risky areas in order to obtain a return. In March 2021, for example, the S&P500 reached an annual result of more than 50 percent.
But the interest rate party came to an end at the end of 2021. The higher short-term interest rates threw a spanner in the works. And this interest rate party will be further disrupted by the reverse movement of bond purchases that has recently started. We are clearly at a turning point. Why?
Fed in reverse
The central bank in the United States is now reversing the process. Where purchases were a major boost to markets, this could be reversed in the coming months. Fewer purchases (we are not even talking about selling bonds yet) means a big buyer disappearing, which will push bond prices down and interest rates up.
The central bank remains coherent with itself. It makes no sense to raise short-term rates on the one hand and to lower 5- or 10-year paper rates on the other hand by continuing to buy. So today we are in a phase of broad monetary tightening. The problem is that historically there have been few examples to assess the consequences. Few professional analysts speak out about it. Morgan Stanley did research it, but with mixed results. Most analysts do mention that the 10-year government bond is the beacon on which many markets focus (equities, mortgage and corporate rates, etc). The central bank plays it cautious and tries not to influence market interest rates too much.
So on the subject of QT (quantitative tightening or a contractionary monetary policy), the market is riding in the fog. It will probably be a game of many years and the future will have to show what the result was on the bond and equity markets.
3. Is the Chinese slowdown pushing inflation down?
The sharply slowing housing market has a downward impact on prices of iron ore, copper, coal or oil. For instance, Chinese oil processors refined 10 percent less oil since April compared to the spring of last year. According to the Netherlands Bureau of Economic Policy Analysis, Chinese imports, measured after inflation, are 8 percent lower since the lockdown. Less demand for raw materials also means lower prices on the world market. For example, the price of copper fell by more than 25 percent since its peak in March this year.
As described in previous issues, I continue to believe in the Chinese stock market. Some analysts are sceptical. Real estate is no longer the big economic boost, the lockdown affects the retail sector and the many unexpected regulatory interventions make investors lose confidence in the Chinese market. But China has the long term in mind. It wants to give its people a decent life. After the period when China acted as the world’s factory, the immo market was an ideal means of creating growth. Now one has to focus more and more on the consumer. Even if Covid-19 temporarily halts business. But through strategic investments, one builds for the long term from which the economy and the consumer must be able to benefit. In the short term, we make adjustments.
According to Henry Kaufman (“Dr Doom” because of his sometimes negative predictions), the Fed is not making the same effort as Volcker did back then. Today he says inflation is higher than interest rates. In Volcker’s time, interest rates were higher than inflation. I quote: “We have a long way to go. Inflation has to come down or interest rates will go higher”.
5. What about growth stocks?
In the equity market, we see today a very large valuation gap between cheap and expensive shares. Research by AQR - a quantitative asset manager - shows that this gap is back at the level of March 2000 (the internet bubble). To calculate this gap, one looks at the book - on price value, price on (expected) earnings, sales on enterprise value and cash flow on enterprise value.
Anyone who pays dearly for a share today must have great certainty about the company’s expected profits. The question is whether this is realistic in today’s uncertain environment. Recent Fed rate fears, together with the 10-year US interest rate at 3 percent, are again taking their toll and pushing down growth values. Meanwhile, we read that some chip makers are seeing an unexpected slowdown in PC sales and weaker smartphone demand. Industrial companies and car manufacturers have also reportedly reduced their chip purchases in recent weeks. For now, it remains unclear whether the slower sales are due to supply problems or reduced demand.
Spreading out across all sectors remains the message more than ever.
To conclude
There is great economic uncertainty today, particularly in Europe. This is reflected in a high level of consumer pessimism. The German ZEW indicator sank to its lowest level since 2011. Energy prices, job uncertainty (some factories are shutting down) and higher ECB interest rates are not helping consumer confidence. Carsten Brzeski (ING economist) puts it this way: “We are approaching a perfect storm due to high inflation, energy disruption and a supply friction”.
Much pessimism is already in the stock prices. The price on expected profits for the Eurozone is at 11.6, barely above the low point of the Covid-19 crisis. Germany is quoted at 10.2, about the level of the Covid-19 depth. Exit is therefore not an option. At the bottom of the Covid-19 crisis, the economic world came to a standstill. Today the world is not standing still, but we are in a kind of “energy war mode”. This could be very painful in the short term for companies and consumers, especially in Europe. Can the German stock market go deeper? Yes, if the economy were to grind to a halt and estimated corporate profits proved too rosy. Let us hope that we avoid the worst, thanks to the many preparatory actions that Europe is taking, in concert with all countries and companies.
Italy, with its upcoming elections, is trading at an expected profit of 7.9! Can it go lower? Yes, at the time of the euro crisis it fell to 6.5, in full turmoil. Remember the lessons of Papic about “material constraints”. The many billions from the European pot should force every Italian politician to be reasonable.
US not immune
The United States is quoted at 18.4. Even though the risk of a sharp slowdown is much smaller than with us, they are not immune. Those with large positions in the US could consider a partial arbitrage towards Europe (spread over time).
The Japanese stock exchange is also relatively cheap at 12.6, not to mention the UK, which at 9.9 is among the cheapest exchanges. The expected (long) recession is therefore to a large extent translated into the share price.
Do not exit now. Even though there may still be tough stock market days ahead, historically we are looking at relatively cheap markets (with the exception of the US). Buy further, spread out over time. Those who have a long horizon in front of them and accept the possible coming price falls should be able to look back on a nice return later on.
Jan Vergote is a former chief strategist at Belfius Bank and set up the Investment Talks initiative. He is an Investment Officer knowledge expert.
This column originally appeared on Investment Officer Belgium.