Equity markets have risen substantially in the last two months. The oil and financials-heavy FTSE100 actually rose during 2022 despite higher inflation, higher interest rates, higher bond yields and much greater geopolitical risk.
At Linchpin we share the consensus view that inflation may be peaking but will not return to anywhere near pre-COVID levels, that the Federal Reserve is likely to continue to try and haul back some of the previous 25 year’s monetary largesse, and that bond yields will stay in a range of 3 to 5% at best. As regular readers are aware, we see a global recession as inevitable and have concerns about the fragility of the financial system, especially its reliance on the repo markets for short-term financing.
We therefore find the resilience of equities surprising and are a little concerned that our views are too close to consensus. One common view is that all bear markets involve at least two down legs. The first came in the first half of 2022, largely comprising valuation contraction in growth stocks. The second is about to hit markets and will be based on earnings compression as the impact of recession hits corporates. We can expect to see the usual gamut of earnings downgraded, emergency financing and companies going bankrupt. On this view, analysts are underestimating the severity of what will happen because they have never seen a recession of this sort before.
We consider this scenario very probable. It would suit all the hoary investors (we include ourselves here) who are fully risk-off and patiently waiting to pounce on distressed assets when they emerge. However, one thing we have learnt after 40 years in the markets is that they rarely pan out in a way which suits the consensus. This article therefore looks at what might justify the current level of equities and make life uncomfortable for risk-off investors like ourselves. In a sentence, what could possibly go right?
The first is that U.S. equity earnings simply do not compress in the way forecasters expect. The headline economic data (employment, etc) in the U.S. is less negative than elsewhere, and the domination of big tech may lead to positive earnings surprises at index level. The passing of the Science and Chips Act makes it more difficult for Chinese companies to compete in western markets, albeit not others, and lead to more oligopolistic behaviour and higher margins among the winners. If this comes to pass, then U.S. equities generally, and big tech specifically, will be the place to invest.
The second is a resurgence of Chinese activity as the country emerges from COVID. There clearly will be an increase in tourism, both inwards and outwards, but we suspect the latter will be muted, if only because the central authorities will not wish to encourage it. The rise in exports is also likely to be muted, partly because of the shortening of supply-lines among western companies, and partly because China is losing relative competitiveness as negative demographics hits it. Domestic consumption will probably have to form the bulk of any uptick. Here we would not rule out better news, but we doubt it will have a major impact on western markets.
A third possibility is that central banks choose, or are forced by politicians, to return to some form of Quantitative Easing. The LDI crisis in the U.K. in September showed that they are not averse to adding to their balance sheets if needed. We think that if a recession really starts to bite, they will do this. It will not be the same as the last 25 years, because it will be more limited and withdrawn more quickly, but it will provide a more supportive background for risk-takers. However, we are also of the view that a second leg in the bear market is almost a pre-condition for central banks to ease the taps, so we do not see this as justifying current equity prices.
The really big move would be a central bank decision to ‘pivot’ and start reducing interest rates again. It is bound to happen one day, but equity markets may be anticipating it happening sooner rather than later. While inflation remains above 5%, we remain sceptical; we believe the Federal Reserve is determined to send a long-term message to politicians and consumers that they are serious. However, we cannot rule out political pressure or a deeper recession forcing central bank hands, perhaps in the U.K. or the Eurozone, where the problems are less tractable.
Could bond yields come down again of their own accord and support valuations? We doubt this very much, because the term premium remains very low, even after this year’s moves. It could only happen if inflation expectations fall further than the current market-derived figure of 3.2% (U.S.) in 2028. That is possible – and certainly counter-consensus.
Except for the last, none of these scenarios really constitute good news. Even U.S. earnings resilience (the first) is dependent on a narrow base of oligopolistic companies, which is not sustainable in the long term. Contrarians (optimists) therefore, have to believe that inflation will come down faster than expected. As our annual inflation survey, published just before Christmas, pointed out, the indicators are moving in the direction of lower inflation. The question is whether the market is already anticipating the move, and we believe it is.
In conclusion, we struggle to find a rational backing for equity market levels, especially when investment grade bonds now offer a return of 4 to 7%. It is always possible that there is something else out there to surprise us, but for once, we are content to find ourselves agreeing with the risk-off consensus.