International | Feb 16 2022
Don't automatically assume the only way is up from here for interest rates and inflation, reports Danielle Ecuyer, as the world anno 2022 is not a copy from the 1970s
By Danielle Ecuyer
First Of All: Don’t fight the Fed
“Don’t fight the Fed” has evolved to an investing idiom, meaning investors who chose a contrarian view to the actions of the world’s largest central bank have discovered the hard way that liquidity matters; either by increasing or decreasing the amount of monetary stimulus in the financial system.
You are probably familiar with the terms QE (quantitative easing = pumping money/liquidity into the financial system) and QT (quantitative tightening = removing money/liquidity from the financial system).
The weight of influence the Federal Reserve’s monetary policy has in the global financial system determines what happens in Australia and the rest of the world, due to the hegemony of the US dollar and the scope of influence of the US economy.
Paraphrasing an example cited by the economic editor at the Sydney Morning Herald Ross Gittens, Australia’s Reserve Bank could do little else but join the quantitative easing (QE) party in 2020 at the start of the pandemic, lest Australia suffer an elevated exchange rate that would impact on exports.
Some historical context on interest rates
For almost four decades investors have been beneficiaries of falling interest rates. Lower rates underpin higher asset valuations.
There are many reasons why interest rates have kept falling, not least of which is the response to major stock market crashes, such as the October 1997 mini-crash, the 2008/9 GFC and black swan events such as 9/11 and the 2020 pandemic.
I was recently reminded that Fed Chairman Alan Greenspan, dropped interest rates to a 45-year historic low of 1% in 2003 post the 9/11 attacks in New York and the subsequent recession (albeit brief).
The go to mechanism for the Federal Reserve and other Central Banks was to respond to an economic and financial crisis by lowering interest rates. By the GFC the monetary tools moved to more extreme measures or QE where the Central Banks bought assets such as bonds.
The result is that debt levels have ballooned, and asset prices have ridden a favourable tailwind since the mid-1980’s.
However, Central Banks have been receiving a hefty dollop of criticism that their willingness to shore up the financial system or Wall Street has taken precedent over the real economy.
Notably asset prices have been rising inexorably whilst real wages suffered years of declines.
Debt and the financialisation of the US economy
According to Peter Boockvar, Chief Investment Officer of the Bleakley Advisory Group, the US has US$30trn of federal debt or 136% of GDP (US$22trn). Total business debt is estimated at US$18trn or 78% of US GDP compared to 69% prior to the GFC and 61% at the end of 1999.
David Rosenberg of Rosenberg Research recently cited that US households collectively own US$43trn of equities or double the size of US GDP and ten times the size of their bond holdings.
Ten years ago, the exposure to equities was US$14trn, a tripling of the appetite for equites in a decade. Worth as a share of disposable personal income has grown from around 550% in 2010 to 796% currently.
Whichever statistic you choose, the facts speak starkly of the leverage of the US economy to equities and financial assets.
The picture is repeated to varying degrees around the world where property is swapped for equities as the asset of choice. I often need to pinch myself that the value of Australian housing reached $9.1trn in October 2021, according to CoreLogic. This represents four times the size of Australia’s GDP and 28% higher than the estimated value of superannuation, the ASX and commercial property combined.
In 2020 the global level of debt rose the most since WWII or 28% to 256% (US$226trn) of global GDP.
Viktor Shvets, MD and Head of Asia Pacific and Global Strategy at Macquarie Group, wrote in his 2020 book “The Great Rupture’ that other financial instruments such as derivatives could be worth as much as US$400 to US$500trn.
The bottom line is, by design or policy error over the last four decades, the world’s economies have become intrinsically intertwined with financial markets and assets.
Viktor Shvets refers to the phenomenon as “financialisation” and David Rosenberg describes “The economy (US) has become one giant financial mania”.
All this debt leads us to the next step in understanding the web of interconnectedness between financial markets and our economies and why the rise in inflation to 40-year highs, or 7.5% for the US January CPI reading is creating more than a stir for investors and a headache for Central Banks.
"The debt surge amplifies vulnerabilities, especially as financing conditions tighten", IMF in Global Debt Reaches a Record US$226 trillion.
The Fed ‘put’ – what is it?
The term the ‘fed put’ is a term used to describe the phenomenon where the US Federal Reserve either reverses its stance on monetary policy (from one of tightening to easing) or intervenes due to a black swan event, at a point when financial markets become dysfunctional or simply stop working and economic erosion is threatening the prosperity of citizens.
The ‘put’ refers to the concept that the Fed is backstopping financial markets from falling further by intervening and becoming an active participant in markets.
The intervention can be in the form of an emergency drop-in interest rates to QE i.e., bond buying programs (including mortgage-backed securities) and even a speculated vehicle that can buy equities.
Japan and Switzerland are extreme cases where the Central Banks are now large owners of stocks.
Contrary to the views of some commentators, I do not believe that the Federal Reserve backstops Wall Street to keep prices elevated, rather the financial markets are so intertwined with real economies, situations necessitate an intervention.
On LinkedIn, Viktor Shvets proffered “one should remember that the Fed is not an arbiter but rather market’s mirror, and the key to watch are signs of rising financial distress.”
Tightening cycles – a challenge for equities
Historically tightening cycles have been a challenge for equity markets. Higher interest rates mean a slowdown in economic activity, eventually, and maybe even a recession with higher financing and borrowing costs and lower valuations for long duration assets such as technology companies.
Commentators on CNBC recently used two examples to highlight that the S&P500 traded sideways in 1994 and then again in 2014 when the Federal Reserve was raising interest rates.
In 2018, the current Chairman, Jerome Powell halted the tightening due in January 2019 after the S&P500 fell -16% in three months. As well as raising interest rates, the Federal Reserve was conducting QT by shrinking the size of its balance sheet i.e., bond holdings. The tightening increasingly caused problems in the money markets through a lack of available liquidity which flowed on to the equities market.
The problem for equity investors in tightening cycles is the question of how far rates will rise and what in turn will be the impact on equity valuations and earnings?
Fintech company Affirm, in the Buy-Now-Pay-Later space fell over -40% in two days after the company downgraded earnings expectations and noted higher bad debts at the same time as the stock market took fright from the possibility of more aggressive interest rate rises from the record January CPI reading.
The bottom line is rising interest rates create volatility in equity prices as investors grapple with the potential for earnings downgrades and compounded by valuation contractions. Not all companies will fall by the -40%-plus that we have witnessed on the Nasdaq in the early part of 2022, but the uncertainty will drive sharp selloffs and sharp rallies.
Looking ahead in 2022
“Policymakers must strike the right balance in the face of high debt and rising inflation.”, IMF in Global Debt Reaches a Record US$226 trillion.
With the Brent oil price now exceeding US$90bbl and 40-year high readings in the US CPI, some experts are comparing the current situation to the 1970s.
According to Cathie Wood, founder, CEO and CIO of ARKinvest, the Federal Reserve was far too slow to react to the oil price shock of the 1970’s which enabled inflation to become embedded in the system.
The same comparison is now being made, even though the makeup of our economies has changed since then, and the fragility of the system heightened due to the debt build up.
A slave to inflation, the economy or financial markets?
Equity markets have started 2022 with a 'shoot now, ask questions later' stance, meaning good news is met with selling and bad news leads to even more selling. Both bond and equity markets are being sold off due to the fears about inflation and a more aggressive tightening cycle.
For those of us trying to navigate the markets, and asking ourselves 'how bad will the correction in stock markets be?' I think it is worthwhile citing the work of some of the more contrarian experts.
Contrarian to the extent that they all share concerns that the US economy is much weaker than most think, risking over-tightening and a recession; that the rate hikes will not be able to rise as much as is currently being discounted (5 to 7 hikes of 25bps in 2022) and that the so-called neutral rate (upper rate) is now much lower due to the indebtedness of the US and other economies.
Morgan Stanley US equities strategist Mike Wilson, along with Cathie Wood and David Rosenberg all highlight the contribution of inventories to the 4Q US GDP. Even though growth registered a 6.9% gain, final sales were 1.9%, meaning inventories grew 5%.
Inventory growth is good for GDP but it is coinciding at a time when the consumer is feeling less confident and higher food, rental and gas prices are eroding purchasing power, particularly the lower income consumers.
The Michigan University’s bi-monthly index of US consumer sentiment fell to 61.7 at the start of February from 67.2 (100-neutral) in January to mark the lowest level since October 2011, with inflation cited as the major concern.
Even though hourly wages are rising at an annualised rate of 5.7%, this still lags headline inflation.
Recent retail sales numbers as provided by Amazon shows weakness and around a third of the US economy is durable consumption and the other third services.
If the US consumer and households are not as robust as thought by some, as supply chains ease, the economy and corporate earnings could start to surprise on the downside, just at a time when the Federal Reserve, under political and media scrutiny, is feeling the pressure to tighten more aggressively.
“Periods of policy shifts are always volatile and episodic, and we expect this time to be especially so given the distance between current policy settings and the reality of economic growth and inflation”, says Lisa Shalett, Chief Investment Officer Wealth Management, Morgan Stanley.
Viktor Shvets also highlights the movement in the bond markets with a flattening in the yield curve. Higher rates at the short end versus the long end. In Shvets opinion “Financialization is unstoppable, and if conditions tighten too much, reversal of policies is as inevitable as a rising sun in the morning”.
Cathie Wood in her February YouTube update and economic round up, also believes the Fed will only hike two to three times, as inflation readings decline year-on-year, the economy softens and the supply chain constraints ease. Ultimately an economic slowdown would favour more secular themes and technology names in the stock market according to the growth investor.
A further brake is an unwanted spike in the oil price above US$100bbl. Due to the sensitivity of demand to higher fuel prices, such a rise would lead to demand destruction and increase the likelihood of an economic recession.
Clearly the spectre or reality of war in the Ukraine is not going to help ease financial markets jittery and volatile disposition. Russia is a major oil and gas producer, increasing the likelihood of elevated oil prices for longer, until the situation is resolved.
Other soft commodities such as wheat could also be impacted, as the Ukraine is a major grain producer.
Three possible scenarios
Post the January US CPI reading, Goldman Sachs has raised the forecast for seven 25bp rate rises in 2022. It would appear they don’t consider the US midterm elections in November as a deterrent to the Fed hiking, contrary to Cathie Wood’s view that the central bank doesn’t want to appear political around elections.
The year-end S&P500 target has been lowered to 4900 from 5100, a 10% rise from the current 4400 level, but only 2% above the end of 2021 level.
Most interesting are the three possible scenarios which offer investors a good insight into the impact of the macro environment on equity markets:
- A US recession – typically the US stock market will fall -24% peak-to-trough with a recession, meaning a further -18% downside to the S&%500 to 3600 (earnings & valuation contraction)
- Inflation remains stubborn and the Fed hikes more than current expectations. This could result in a -12% fall in the S&P500 to 3900 (valuation contraction)
- Inflation recedes and there are fewer hikes which could lead to a 24% rally by year end to 5500 (lower-for-longer interest rates, better earnings & higher valuations)
The main point is the equity valuations will be driven by either valuation contractions (from higher-than-expected rates) or earnings downgrades because of a recession. Hence why so many traders and commentators will be discussing earnings data.
And what about Australia?
The focus of this piece is clearly on the US macro-economic outlook and Australia is not the US. However, the Australian share market will move relatively speaking in tune with the US, so don’t be surprised when you see movements in stock prices that are more aligned with the US sectoral price moves than the operational reality of those companies in Australia.
Until there is more clarity about the outlook for the US economy, inflation and corporate earnings, the mighty US stock markets will remain vulnerable to bear market selloffs and rallies.
After years of investing, picking the bottom is a mug’s game but buying quality companies with strong balance sheets, pricing power, great brands and exposure to secular trends, I believe will be a longer-term winning strategy to play equity markets in 2022.
Danielle Ecuyer has been involved in share investing in Australia and Internationally for over three decades, both professionally and personally and is the successful author of Shareplicity. A simple approach to investing and Shareplicity 2. A guide to investing in US stock markets.
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