- After a partial recovery at the end of Q2 2022, markets fell as risky assets remain heavily impacted by persistent inflation and rising interest rates.
- Inflation rose 8.3% year-on-year (YoY) in August, more than expected, as rising shelter and food costs offset lower energy prices.
- Constant hawkish central banks continue to send mixed signals to global economies, affecting consumer and investor sentiment. The Federal Reserve (the “Fed”) increased its policy rate by 0.75% for the third consecutive time and projects rates to reach 5.0% by Q1 2023.
- US 30-Year mortgage rates surged to 6.7% for the first time since the 2008 Global Financial Crisis (GFC), while house affordability and rampant inflation are exacerbating pressure on households and the housing market.
- Markets may fall further considering that:
- Inflation and interest rates are expected to rise,
- - Economic growth may weaken further, and
- Stocks are still trading above their average long-term valuation multiples.
- Markets may fall further considering that:
- S&P 500 earnings are still growing in most sectors, especially energy. Without the energy sector, S&P500 earnings are revised downward significantly.
- The overall economic environment is increasing fears of recession. The JPMorgan Chase & Co. trading model is showing a 92% probability of US recession, compared to 51% in August. Market sentiment is at levels not seen since the COVID-19 pandemic.
Main indices year-to-September 30, 2022 performance
(*)Basket of 59 non profitable tech companies
Markets remains in Bear market territory
Equity markets suffered a 10% correction in Q1, but rallied strongly in the last two weeks of March, despite Russia's invasion of Ukraine and the first rate hike by the Fed in March. But the relief was short-lived as both equity and fixed income markets trending lower in Q2 and stocks falling into a bear market (correction of 20% or more). Bonds and equities recovered slightly in Q3 but are returning to bear market territory.
Anatomy of Bear markets
(*) Dow Jones Industrial Average Return from December 31, 2021, to September 30, 2022 (-19.72% loss, 194 days)
US Bear markets & recoveries since the 1800s
Bear markets are divided into three categories: structural, cyclical and event-driven. Structural bear markets are initiated by structural imbalances and financial bubbles (e.g., the Dotcom bubble, GFC). Cyclical bear markets are typically prompted by rising interest rates, an impending recession and falling earnings (e.g., 2022 bear market). Event-driven bear markets are triggered by a one-time shock (e.g., the 1990 oil price shock, Covid-19). We are in a cyclical bear market correction.
Source: Goldman Sachs Research, data from 1835 to 2022
Data based on MCSI World
U.S. economy is contracting
Global financial conditions have tightened sharply as central banks moved to tame inflation and the US composite Purchasing Managers’ Index (PMI) fell below 45, increasing fears of a potential recession.
Inflation is still high
Despite the 5% drop in energy prices and 10.6% drop in gasoline prices in August, YoY inflation was higher than expected at 8.3%. Shelter and healthcare costs rose 0.7%, while prices of durable and non-durable goods increased 0.5% and 1.4%, respectively, in August.
Pushing Fed rates to 4.25%-4.50% by year end
The Fed hiked rate by 0.75% for the third consecutive time in September. The Fed is expected to raise its policy rate by 0.75% in November and 0.50% in December, followed by two 0.25% rate hikes in February and March 2023. This would bring the fed funds rate to 4.25-4.5% by year end and 4.75-5.0% by Q1 2023.
Source: Federal Reserve, BofA Global Research
A tightening policy is matched by rising yields
Rising yields reduce the valuations of risk assets as investors demand higher returns. Assets with longer duration (i.e. high sensitivity to interest rates) are the most affected.
Data is as of September 30, 2022
But real estate haven’t repriced yet
The six-month US Treasury yield is getting closer to the average US capitalization rate (net operating income to value) which provides little incentive to invest in real estate. The spread of 2.7% is below the 20-year average of 5.9%.
Mortgage rates put additional weight on household
U.S. 30-year mortgage rates reached 6.7% in September, the highest level since 2008 and more than double the level a year ago. US real estate affordability dropped significantly to levels not seen since the 1980s.
In August, housing starts dropped -2.5% YoY for a fourth consecutive month, while building permits declined to the slowest pace since mid-2020. After falling for six consecutive weeks, US mortgage applications rose 3.8% in the week ending September 16th, the biggest increase in three months.
The correction has not yet factored lower anticipated earnings
Lower earnings are expected due to higher labor and raw material cost amidst supply chain bottlenecks.
S&P 500 earnings growth led by energy sector
Of the 498 companies in the S&P 500 that have reported earnings as of September 23, 2022, 78% reported better-than-expected earnings in Q2 2022 (vs. a long-term average of 66%). Energy sector earnings comprise 13% of S&P 500 earnings and have increased 295.5% YoY, boosting the index earnings growth. Without the energy sector, earnings growth for the S&P 500 would be significantly lower. Also, energy sector YoY earnings growth is expected to slow to 118% in Q3 2022 (1,798% in Q3 2021) and 64.4% in Q4 2022 (12,611% in Q4 2021). The expected S&P 500 earnings growth of 7.7% in 2022 is 0.7% below January expectations.
Source: I/B/E/S data by Refinitiv as of September 23, 2022
(*) Blend of Reported & Estimated Earnings
While stocks are still trading above historical averages of high interest rate environment
Public market valuations, notably the S&P 500, may drop further with earnings revisions. In previous inflationary environments when the consumer price index (CPI) exceeded 3%, the median and average correction in price to earnings (P/E) were 20% and 30%, respectively. The S&P P/E was around 22.0x when the Fed started hiking rates in March 2022, indicating further downside as earnings are revised.
Source: Bloomberg, data Between January 2007 and September 2022
Low Interest rate < 1%
Moderate Interest Rate Between 1-3%
High interest rate > 3%
Weak sentiment across CEOs and consumers
The CEO confidence level dropped to 34 from 42 at the end of Q2 2022. The measure has fallen to levels not seen since the start of the COVID-19 pandemic in 2020. The Consumer Sentiment Index has declined significantly since the beginning of the year as fears of a recession mount. JPMorgan Chase & Co. trading model shows a 92% probability of a US recession, compared to 51% in August.
Watch labor and housing market
Source: Yield Curve: 10 2Yr differential: US Personal Consumer Expenditure YoY . Labor: U.S. Unemployment %. Credit Performance: U.S. High yield spreads. ISM MFG: U.S. PMI. Earnings: S&P YoY Earnings growth. Housing: U.S. House Price Index.
What this mean to your portfolio
Given the inflation & growth regimes
Favor quality credit over equities
Business activity is slowing amid persistently high inflation, which drives high market volatility. Moreover, as central banks around the world hike rates to tame inflation, growth could reduce further. As a result, credit is favored over equities.
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