Tired and Emotional
Markets are exhausting at the moment. Volatility is high and liquidity is poor. The news flow is unpredictable, and the macro outlook has deteriorated. That glorious period between the end of COVID and the outbreak of war was painfully short (or non-existent, depending on your viewpoint). A quiet period of calm doesn’t seem to be anywhere on the horizon with the coming weeks likely to see even worse news on inflation and who knows what from Ukraine. Thankfully spring is on its way so we can all at least go out and enjoy the daffodils.
The US Federal Reserve (Fed) and the Bank of England (BoE) did what everyone expected this week. They raised policy interest rates by 25 basis points (bps). The subsequent market chatter was that the Fed’s message was more hawkish, and the BoE’s was more dovish. Hence market pricing at the moment is for another six or seven 25bps hikes from the Fed this year and just under five additional 25bps hikes from the Bank. But what does the market know? Monetary policy decisions will be data and news dependent and there is an almighty geo-political event unfolding in Ukraine that continues to have the potential to dictate the market narrative and, indeed, the economic profile for 2022 and 2023 across major economies.
I’m slightly obsessed with the yield curve and have written about the shape of the curve and what is implied in forward pricing in the bond market on a number of occasions recently. Curves are flat and forward markets suggest a very modest peak in bond yields in this cycle. Again, a fair bit of tightening is priced in up-front, but the yield curve suggests that inflation will come down or that growth will slow or that central banks won’t be aggressively reducing their balance sheets and selling lots of bonds back to the market. It also means there is not a lot of value in long-term bond yields with the curve being so flat and central banks still having the capacity to surprise with more rate hikes than currently priced in.
Bull market resumes
That message is a benign one, however. If we take, for example, US 10-year bonds 2-years forward we currently get a forward yield of 1.80%. Add on an “equity risk premium” of 3.5% (which has been the average difference between the 10-year Treasury yield and the earnings yield on the S&P500) and we get an implied price earnings ratio of 18.9x. Multiply that by the 2024 consensus earnings per share and you get an index level for the S&P500 of over 5,000. The market message is inflation recedes, growth is not damaged too much, and the bull market can resume over the next two years.
I’m not sure that this is necessarily a conclusion that is robust enough to lead to a huge allocation of capital towards risk right now. It is true that valuations are much more attractive but the news flow in the short term is going to be problematic. Apart from the uncertainty surrounding the war, the biggest concern remains inflation. There is a chance that March will see a huge jump in inflation following the invasion fuelled spike in global oil prices. I’ve heard talk of a 10% year-on-year print for the US consumer price index. That would be astonishing as it would require the monthly change in the index to be around 2.6% which would be the biggest monthly increase in the CPI index since 1947 (which is as far as my data series from Refinitiv Datastream goes back). A 9% y/y rate would require the 4th biggest monthly increase since then. US gasoline prices have risen 21% during March and with a weight in the index of just over 3.7% that alone could contribute up to 0.78% to the monthly change. But a lot of other things have to go up significantly as well. Yet it is possible, and a 4-sigma CPI event would be a negative one for markets.
Landing zone for inflation?
It’s not just about one month’s inflation data either. Markets really need to see inflation peaking to become less nervous about the rate outlook. It is true that the bond market has lower inflation priced in the future – the 10-year US Treasury Inflation Protected Securities (TIPS) break-even inflation rate is 2.94% compared to a 2-year rate of 4.72%, but the spot numbers themselves have to start coming down. That should happen. Even if we get 10% in March and subsequent monthly increases in CPI are twice their two-decade average, the y/y rate will subside. The risk is though that this could still leave 2023 inflation close to 5% which will be too high for the Fed. Under this scenario bond pricing seems way off where it should be. What we really need is energy prices to fall massively and there to be limited second round effects in wage and other costs. That may be wishful thinking at this stage, especially if there is no slowing in the economy to sub-trend growth.
Short coffee, long gasoline
A quick Google suggests that the average price for a gallon of gas in the US is currently $4.70. At a well-known US coffee retailer, a “venti” caffe latte costs $4.15. Not saying that they are substitutes but one less hot beverage would fund enough gasoline for an additional 22 miles of road trip. A facetious point but one which illustrates how other forms of spending could be cut back if energy prices remain high. It’s starting to happen too. The February retail sales data showed a 0.4% decline in sales excluding autos and gas. US consumers are starting to feel the pinch, and this will flow through to the growth data.
It is tricky to invest in this environment of high inflation, rising rates and slowing growth. I finished our regular review of fixed income markets with the team this week and the conclusion was that the macro outlook was negative for most sub-asset classes (with the exception of inflation linked bonds). The only positive light was that things have got cheaper and, as I argue last week, credit asset classes look to offer better value than they have for some time. European and Asian credit markets look better value than in the US, but they face greater headwinds and may suffer more from downward pressure on ratings and possible increased default risk in high yield sectors. That is not our expectation at the moment but is a risk.
Multi-year highs in credit yields
The outright yield on European investment grade credit (at the index level) is now at its highest since 2015 (excluding the COVID spike in March 2020). For European high yield it is roughly the same and for Asian high yield credit, yields are the highest since the 2008 crisis. This sector is still heavily impacted by Chinese property issuers (the real estate component of the JP Morgan Asian credit index yields 17.4%), but recent policy moves to support the economy in China could help yields fall from their current eye-watering levels. Despite the global nature of the energy shock and Asia’s reliance on Russian oil, inflation in the region is low. This could also be a supportive factor for returns from Asian markets.
Arriving versus travelling
In the short term bonds are taking some relief from arriving at the point of the monetary policy tightening cycle rather than just anticipating it. The Fed has set out its stall and rate increases at the next two or three meetings look baked in. By the end of July, however, when the Fed has seen the June inflation data and will have a decent idea how the economy fared in Q2, things might be different. It certainly isn’t a boring year and it certainly isn’t a year in which to easily deliver positive investment returns. So, keep in mind the idea that it is always darkest before the dawn and that when everyone is fearful, you should buy. Are we there yet? Impossible to know but for those readers lucky enough to be able to take a two or three year view, judging when that point has arrived will be very important.
Glory delayed (again)
I haven’t written about Manchester United for a while. However, I thought I would mark the week when their season effectively came to an end with a few words. Much like markets, there is not much good news. Out of all competitions and at huge risk of not finishing in the top four of the premier league describes the obvious state of affairs. Without a permanent manager and with ongoing numerous reports about player dissatisfaction and dressing room unrest are the more worrying off the field aspects of the situation. But, forever optimistic, I look forward to the 2022-23 season, a new world-class manager, the clearing out and refreshing of the squad and going longer into competitions than the 15th of March. Meanwhile, I will concentrate on cricket and the New York Yankees!