By Rob Edel, Chief Investment Officer | Written as of July 15, 2022
Highlights this Month
- Stocks fell further in June, but what about the bond market?
- The old bull market has had a humbling 2022.
- If we are only halfway through this bear market and markets like the S&P 500 have another 20% or so more to fall, what would be the driver?
- The key to determining the likelihood of a recession, and its magnitude, lies in the bond market, and according to credit markets, the news is not good.
- Could central banks turn out to be more hawkish than the market expects?
- Look to inflation when determining how long and severe a bear market will be.
June in Review
As headlined by Bloomberg Businessweek, markets have been seeing a “whole lotta red” lately; last month included. Most asset classes were weaker in June, apart from Chinese equities, as the Shanghai Composite was up 9.1% in Canadian dollar terms. Even commodities finished the month in negative territory, with copper down over 13% and WTI Crude Oil down 8.3%, both in US dollar terms. Despite a correction in June, commodities, along with inflation and cash, were among the few asset classes to remain in the black for the second quarter. Stocks and bonds of all types fell in Q2, with Bitcoin taking the most honest investment award in our opinion, declining nearly 60%.
Stocks fell further in June, but what about the bond market?
While Chinese stocks were positive last month and up 3.0% in Q2, Scotiabank notes that they were still down 12% year-to-date in US dollar terms. With the S&P 500 down 20% (total return in US dollar terms), US stocks suffered their worst first half since 1970. The S&P 500 was down 8.3% in June alone and lost 16.1% in Q2.
Canadian stocks were a little better, down only 9.9% year to date (total return in Canadian dollar terms), but finished the first half of the year under pressure, with the S&P/TSX down 8.7% in June and down 13.2% for Q2. Normally bonds would provide some protection when equities come under such pressure, but this has not been the case so far in 2022. According to Scotiabank, both US and Canadian bonds are in the midst of experiencing their worst price drawdowns ever. The iShares Core US Aggregate Bond Exchange Traded Fund (ETF) has lost over 12% from its August 4, 2020 high and is down 10.2% year-to-date, while the FTSE Canada Universe Bond Index is -12.2% at the end of June, 2022. A “whole lotta red” indeed.
While not down as much in absolute terms, the bond market has been where the action has been. We will, of course, spend some time recapping what equities have been doing and what we can expect in the future, but we expect that the bond market will likely determine the fate of investors over the rest of 2022. As such, inflation, central bank tightening, and the resulting path for bond yields for the rest of the year will be our focus this month.
Unlike bonds, US stocks are not yet suffering their worst drawdown ever, but they did slip into an official bear market on June 13, falling over 20% from their January 4, 2022, high. According to Strategas, roughly $14 trillion in capital has been erased from the US equity market, more than the $11 trillion decline during the financial crisis of 2007 to 2009. If you include losses from both bond and cryptocurrency markets, the wealth destruction has been far greater than the numbers would indicate. As is typical when experiencing a bear market, volatility has been unusually high, with 90% of trading days seeing the S&P 500 up or down more than 1%.
The old bull market has had a humbling 2022.
Also typical of most bear markets, the volatile trading range includes a fair number of rallies, with the old bull market trying desperately to drag itself out of the hole it finds itself in 2022. Unlike past drawdowns, however, S&P 500 rallies are now failing rapidly, with big cap US stocks trading below their 50-, 100-, and 200-day moving averages. While ETF traders bought the dip earlier in the year, they are now tending to sell or fade the rally. With quantitative traders and Hedge Funds also selling, systemic positioning has been pushed two standard deviations below average, as measured by Deutsche Bank AG.
Unsurprisingly, the S&P 500 slipped below 20% in year-to-date losses. While that technically defines a bear market, it is just a number, and many individual stocks had already breached the ominous 20% threshold months ago. What is important is not whether the S&P 500 would enter a bear market or not, but rather what kind of bear market we would experience. Strategas reports that, since 2019, bear markets have lasted 20 months and declined nearly 40% on average. BMO’s Investment Strategy Group believes that bear markets coinciding with a recession have historically been when most of the damage is done. BMO calculates the average bear market since 1945 has declined 35% and lasted 463 days (about one and a half years) when coinciding with a recession, as opposed to only 28% and 168 days (about five and a half months) when there was no recession.
Given that we are already down 20%, determining whether we are headed for a recession could go a long way to concluding if equity markets have already bottomed out. According to BMO, if we are headed down the recession path or already in a recession, it is only halftime for this bear market. Alternatively, a soft-landing scenario would mean we are close to full-time. According to Strategas, simply buying the market every time the market has corrected 20% has been a bit of a coin toss, yielding returns six months later of less than 4% on average. Markets are at a crossroads.
If we are only halfway through this bear market and markets like the S&P 500 have another 20% or so more to fall, what would be the driver?
Valuations have already experienced a large correction. According to Bloomberg, earnings multiples reached extreme levels last year but are now back near their 21st-century average. BMO calculates that the S&P 500’s P/E multiple has contracted 6.4 points this year already, which is about average for historical bear markets, not that it cannot correct more. While a recent Bloomberg graph highlights valuations for the S&P 500 have contracted 26% in the current bear market, they corrected 29% during the pandemic bear market of 2020, 42% during the US financial crisis bear market in 2007, and 49% after the tech bubble bear market. Also, while P/E multiples are currently corrected back to their historical average, many other valuation measures remain elevated.
Wall Street analysts have generally been giving markets the thumbs up. The average consensus recommendation for individual S&P 500 stocks stands at their highest level since 2002. While the average year-end target for the market has declined about 7% from January to 4,617, it is still nearly 22% higher than the closing level of 3,785 on June 30th for the S&P 500. Conversely, the spread is wide, with Morgan Stanley forecasting 3,900, a 3% gain from Q2’s closing level, and Oppenheimer at 5,330, which translates to a nearly 41% gain. The key variable is earnings. While valuations have dropped significantly, Strategas reports consensus earnings estimates for the S&P 500 index have only fallen from $231 per share in December 2021 to $227 in Q2, or about 2%. A more material drop in earnings, likely due to a recession, will cause year-end target levels to adjust downward, to say nothing of a thumbs up from traders. Morgan Stanley’s forecast, for example, drops to 3,000 (down 23% from the Q2 close) in the event of a recession.
Strategas, in fact, reports that earnings have historically fallen an average of over 30% during recessions, and according to the Financial Times, many macro models are already pointing to double-digit declines in earnings. Piper Sandler believes that the recent decline in leading indicators like ISM Manufacturing point to a rough earnings season for Q2. According to Morgan Stanley, the strength in the US dollar alone could be an 8% headwind for S&P 500 earnings.
The key to determining the likelihood of a recession, and its magnitude, lies in the bond market, and according to credit markets, the news is not good.
Spreads have continued to widen, particularly for riskier credits. Earlier in the year, spread widening was due to higher rates, as evidenced by investment grade issues performing worse than non-investment grade issues. However, with the recent underperformance of non-investment grade issues, credit concerns have become more prominent as markets begin to price in a recession. Regarding fund flows, while positive flows into stocks indicate equity markets have not yet capitulated, outflows from credit are more ominous as fixed income traders start to position for a recession.
The direction of government bond yields has been less clear in their signal to markets. 10-year US Treasury yields hit 3.47% on June 14th, breaking above a downward trend in rates that have been in place for roughly 40 years. But then yields stalled and turned lower again, ending the second quarter just above 3%. Higher rates are a sign that economic growth is strong with inflation remaining high, while lower rates indicate the opposite. Elevated volatility in the bond market indicates that traders are having difficulty deciding.
Bond market volatility has remained more elevated than equity volatility. Historically, rates tend to converge and peak in line with the Federal Funds Rate. Strategas notes that the peak in 10-year yields has historically been an average of 17 basis points below Fed Funds Rates. If 3.48% turns out to be the peak in 10-year yields this cycle, then Fed Funds should peak around the same level. Currently, Fed Funds are 1.5% to 1.75%, meaning an additional 1.75% in tightening may be in the cards. Is this reasonable?
The quick answer is yes. According to the Morgan Stanley Market Implied Terminal Fed Funds Rate, financial markets expect Fed Funds to peak at 3.5%. This expectation is down from about 4% in mid-June, but still higher than the 3% level markets pegged Fed Funds to peak during most of April and May. Like bond yields, the market-implied terminal Fed Funds Rate has been volatile, with the market now starting to discount a decline back to 3% by November of next year after the Fed Funds peak in early 2023. It is a moving market, but if we assume 10-year rates should converge and eventually line up with the terminal Fed Funds rates, bond yields could gravitate back up to the 3.5% level, though estimating this is not an exact science. Even Strategas shared that their historical negative 17 basis point differential between peak 10-year yields and terminal Fed Funds rates came with a range of negative 1.23% to positive 0.56%. Using a 3.5% terminal Fed Funds rate and the negative 1.23% to positive 0.56% range means peak 10-year yields could theoretically range between 2.25% and 4.06%. 10-year rates can go higher, but there is a limit, and 4% appears to be as good a level as any. In a sell-side survey, Strategas found most analysts believe the 10-year yield in Q4, 2022 will range between 2.5% and 3.5%. Six out of 52 participants saw 10-year yields between 3.5% and 4.0%. No one is forecasting rates will be above 4%!
Could central banks turn out to be more hawkish than the market expects?
How could they be wrong? This is the key question for investors. Central banks know they flubbed the whole transitory inflation thing, they waited too long before starting to tighten financial conditions and let inflation run too hot. Even now, with Fed Funds at only 1.75% (upper end of the range) and inflation in May at 8.6%, the real (inflation-adjusted) Fed Funds rate is still a wildly stimulative negative 6.85%!
Some believe monetary policy does not become restrictive until Fed Funds rise above inflation, which means either inflation must drop a lot, or the Fed Funds rate needs to move higher, quicker. As Chairman of the Federal Reserve, Jerome “Jay” Powell does not want to go down in history as the guy who let inflation get out of control like it did between 1965 to 1982, when multiple inflationary waves ultimately resulted in inflationary expectations permanently adjusting higher. Rather than being associated with the much-maligned Fed Chair of the time, Arthur Burns (Chairman of the Federal Reserve between 1970 and 1978), Powell wants his picture to hang alongside the legendary Paul Volcker, Chairman of the Federal Reserve between 1979 and 1987, and largely credited with breaking the back of inflation, and the economy, in the early 1980’s.
It’s not an easy task that both Powell and the Federal Reserve have been charged with. Not only do they have to oversee an increase in overnight interest rates, but they also plan to simultaneously shrink the central bank’s balance sheet, which exploded from just over $4 trillion before the pandemic to nearly $9 trillion. According to Bridgewater, US Government Debt has increased by more than $11.6 trillion over the past decade, which, thanks to quantitative easing and the resulting expansion in the Fed’s balance sheet, was bought almost entirely by the Government itself, or more precisely, the Fed.
While the private sector has bought very little of the government debt issued over the past decade, it will be counted on to carry most of the buying load as the Fed trims its holdings. Ultimately, Bridgewater claims that the private sector will need to purchase government debt equivalent to 8.5% of GDP by the end of this year. Outside of the war years (World War I and World War II) and 2010, when high unemployment drove large government deficits, this is expected to be the most significant draw of private capital in liquidity on record. With liquidity already under pressure, capital markets are likely to remain strained until liquidity turns higher, a point highlighted in a recent Bloomberg chart examining the tight correlation between excess liquidity and the declining MSCI World Equity Index.
As higher rates continue to put pressure on the economy and tighter liquidity puts pressure on asset prices, Jay Powell will also be under a lot of pressure if he wants to see his picture hung next to Paul Volcker. As a recent Bloomberg article noted, aggressive Fed tightening often ends in recession. In fact, research by Strategas uncovered that it took two recessions to stop inflation in the 1980s. Some believe Powell does not have the same fortitude as Paul Volcker and will pivot back towards an easing cycle before the job of vanquishing inflation is done; their view is that he is too political and will blink once the unemployment rate starts to turn materially higher. Therefore, stagflation remains a popular economic backdrop expectation as the economy could again suffer from multiple waves of inflation in the future. If the Fed does not finish the job of fighting inflation, prices could turn higher, prompting the Fed to reverse course once again by raising rates and further slowing growth. While easing before inflation reaches the Fed’s 2% target may grant markets a temporary reprieve, it would present a greater challenge to policy markets and markets longer term.
Decision time may be closing in sooner than initially anticipated for Mr. Powell and his friends. Even though the Fed has just started its tightening cycle, the economy is already experiencing a Wile E. Coyote moment with the ground disappearing beneath it. Deutsche Bank’s second quarter client survey showed 90% of respondents predict that a US recession will occur in 2023 or earlier. A recession was not even on Bloomberg Economics’ radar earlier in the year, and now they peg the odds of a recession before Q1 2023 at 72%. As reported by the Financial Times, economists have become progressively more pessimistic about the US outlook for 2023 while at the same time believing inflation should continue to move higher.
Forecasts of higher inflation and weaker economic growth may make sense. Not just because of the negative impact of tighter financial conditions on the economy but also due to the adverse effects of high inflation on the consumer. Higher wages feel good until we realize prices are going up even more. University of Michigan consumer confidence has fallen to its lowest on record, largely in response to the higher prices’ impact on consumers. The decline in consumer sentiment is also reflected in the fall of the Conference Board’s Consumer Confidence Index, though the decline has not been as dramatic. The Federal Reserve is very aware of the impact of inflation on consumer spending and is one of the reasons the Fed Funds rate increased 75 basis points last month. The Fed was on track to raise only 50 basis points until the University of Michigan inflationary Expectations over the next 5 to 10 years hit a 14-year high of 3.3%. While this preliminary release was later revised back down to 3.1%, the damage had been done. The Fed keeps a close eye on inflationary expectations and will do everything they can to ensure they do not get re-set higher.
Have we reached peak inflation? Not yet, but we may be close.
While we have likely not seen peak inflation yet, we expect we are probably awfully close, especially given signs the economy is rolling over. Commodity prices, in fact, have already turned lower, with oil, natural gas, soybeans, wheat, corn, copper, cotton, and lumber prices all coming under pressure. Also showing some relief from inflationary expectations have been financial markets, with 5-year breakeven rates below their pre-pandemic highs.
On the other hand, service inflation has continued to gain strength. A recent Wall Street Journal article used the price of haircuts to exemplify the impact of inflation on everyday services. Because the two primary cost inputs in running a barber shop or hair salon are rent and labour, they represent a good benchmark for the service industry. According to the Bureau of Labor Statistics, the price of haircuts increased 6.2% year over year in May, the largest annual increase since 1982. No supply chain issues to be resolved here.
Look to inflation when determining how long and severe a bear market will be.
However, the Central Bank’s reaction to this inflation is even more important in gauging the length of the bear market. Will they stick to their word and ensure inflation is soundly beaten before easing financial conditions, or will they blink and pivot towards more easing if financial markets and the economy come under pressure?
The bond market can provide a useful window into what the market is discounting. Peak 10-year yields can provide a reasonable estimate for the level the markets expect the Fed Funds to peak, while credit spreads are a good barometer for the severity of a potential downturn. We are currently seeing a market that is starting to discount a mild recession, with the potential of lower earnings leading the next leg down in equity prices. When looking at the downside tail risk, a scenario where the Fed is too aggressive in its quest to fight inflation and tight financial conditions causes economic growth to suffer a more material contraction, potentially leading to a longer and more severe recession. As pointed out by Rosenberg Research, bad things tend to happen when the Fed tightens, and the more they tighten, the greater the chances of investors feeling unwell.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required provincial securities commissions. All values sourced through Bloomberg.