22 Jun Coming Off The 2021 Sugar High
- Falling equity and bond markets
- Higher interest rates and stubborn inflation
- Risk of recession rising
- Earnings estimates too high
- Buy the dip?
Risks are rising
“On balance, the risks for investors have risen substantially, so you need to assess what works for you to sleep well at night.” Shareplicity Blog March 7, 2022
In March, Shareplicity painted a downbeat outlook for shares, due to rising interest rates, slowing economic growth and the inflationary pressures from war in Ukraine.
Two months on, and the macro-economic picture has not lifted the spirits of investors.
Long-dated risk assets, such as loss-making technology stocks and crypto currencies, have been in the eye of the storm as higher interest rates punish valuations. Falls of 70% plus are not uncommon.
So much for “this time it’s different”.
Time will tell whether the companies and crypto assets that were beneficiaries of the US$10trn liquidity stimulus post-Covid survive this tightening cycle.
With each passing week, the bond and equity markets are registering new records for falling prices that go back years, if not decades.
Inflation keeps on keeping on
Inflation in the developed markets has continued to march higher.
In Australia, the 5% rate is expected to rise to 7% by year end, according to Philip Lowe, head of the RBA.
The June 8.6% CPI reading in the US (the highest in 41 years) prompted the Federal Reserve to raise the fed funds rate by 75bpts at the June meeting, with talk of another 75bpts rise at the July meeting.
These are the highest rises since 1994 and they echo the rate rises of the early 1980s.
In 2022, the leaders of the global financial systems are prepared to continue to raise interest rates to ensure that the inflation genie is levered back into the bottle with a ‘whatever it takes’ policy stance.
Look no further than Jerome Powell referencing the inflation slayer Paul Volcker in May to appreciate how seriously the world’s most influential Central Banker is taking the inflation challenge.
Just a reminder that Volcker created two back-to-back recessions to crush inflation in the early 1980’s. Not the type of news any of us want, but investing is all about risk management.
Costs, costs, costs
The spike in energy and food prices is being felt across the globe with the less well-off the most impacted. This means less money to spend on all the discretionary and household goods that the consumer could not buy enough of in the lockdowns (with the help of stimulus cheques).
Major US retailers like Walmart, Target and Amazon have announced inventory build ups and the upcoming quarterly earnings reports in the US will provide an update on how the normally robust US consumer is faring.
Making matters worse, interest rate hikes are driving higher mortgage rates (the rate doubling in the US), higher car financing costs and higher credit card charges.
Australian borrowers are also feeling the pinch, particularly those on variable loan rates or coming off fixed rate mortgages.
Despite wage rises in Australia and the US, wages growth is not keeping pace with the rising cost of living.
On balance, this means less disposable income.
In the Australia and the US, the consumer represents around 50-55% of GDP, respectively, so it does not take much of a leap of faith to appreciate how vulnerable economic growth is to the declining spending power of the consumer.
Making matters worse are falling asset prices – stock markets, crypto and, next in line, housing.
Years of financial ‘sugar hits’ from falling interest rates have supported asset price inflation. Americans and Australians have a higher exposure to asset prices through property and shares.
When the asset prices reverse course, the owners feel less well-off.
The asset price falls (wealth destruction) are recognised by Central Banks for having a negative feedback loop into the real economy.
Recession and Profit downgrades on the cards
Despite the denials from Central Bankers the risks are rising that tightening is happening too aggressively at a time when economic growth is slowing.
Two economists who you can follow on YouTube or Twitter, Stephanie Pomboy, and David Rosenberg, are in agreeance; the US economy is already slowing.
Cathie Wood at ARKInvest may be called into question for her stock picking, but her macro-economic observations have been prescient, calling a likely build-up in inventories as early as late 2021 and early 2022.
Wood is also of the view that the Federal Reserve risks tightening into a slowing economy.
In a recent interview for Wealthion (YouTube), Pomboy noted that the University of Michigan Consumer Confidence Survey registered its lowest reading on record.
Since 1998, the movements in the survey were a forward leading indicator to the S&P. The picture isn’t pretty.
Company earnings are the next shoe to drop.
Pomboy highlighted that the deterioration in producer prices (PPI) versus the consumer price index (CPI) has reached a level not seen the early 1970s, meaning company margins will be under pressure from rising costs, slower demand, and the inability to pass on the full cost increases.
Given the macro-economic headwinds, experts and equity strategists are seriously questioning the S&P earnings forecast growth of 10% for 2022 (5% ex the energy sector).
In 2008, analysts started the year expecting expected 17% growth in S&P earnings and they ended up down 72%, according to Bloomberg.
While few strategists are forecasting or expecting another banking crisis like the GFC, the point to stress is that earnings’ estimates across most markets are most likely too high.
Equity valuations also remain elevated despite the falling share prices, compared to the long-term average. The forward multiple on the S&P500 is around 15x but contracted to 12-13x or less in previous cycles.
Strategists are forecasting around 3200 on the S&P500 index, suggesting we haven’t reached the bottom in markets yet.
The Blackrock Investment Institute summed up the proposition well in their latest Weekly offering.
“U.S. stocks have suffered the biggest year-to-date losses since at least the 1960s. That’s ignited calls to “buy the dip.” We pass, for now. Valuations aren’t much cheaper given rising interest rates and a weaker earnings outlook, in our view”
Nothing is set in stone when it comes to forecasting but markets are forward looking.
For now, the risks remain that Central Banks are too zealous in tightening, through interest rate hikes and shrinking the balance sheets (QT or quantitative tightening).
Earnings and valuations remain at risk, particularly those with cyclical exposure – commodities and banks.
Inflation will moderate but maybe not as quickly as the authorities would like, so for now the markets will continue to remain cautious and, on the lookout for both a real and earnings recession.
Typically markets fall 30% in a recession.
With the Australian market down 15% from the August 2021 high and the S&P down 20%, there is good reason to believe more falls are ahead. Should a hedge fund or credit crisis erupt, the falls may be steeper, so best to be aware that tightening in a highly leveraged financial system can lead to black swan events.
The best advice for anyone is patience, with cash on the side lines. Bear markets also bring robust rallies to sell the losers.
When the buy-the-dip mantra disappears and the FOMO trade is gone, then that is time when you and I might want to go bottom fishing.
Disclaimer: Shareplicity offers information that is only general in nature. It does not take into account your personal financial situation, needs or objectives. Nor does it take into account the financial needs of any specific person. You should consider your own personal financial situation and needs or seek financial advice before making any decisions based on this information.
The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. Past performance is not a reliable indicator of future performance. Investment involves risks. The value of an investment and any income from it can go down as well as up.
Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass.