Good morning. The World Cup final was a great end to a great tournament. Special kudos to Emiliano Martinez, Argentina’s goalkeeper, who looked almost relaxed while smacking down France’s attempts during the final shootout. None of the Unhedged readers who sent in their predictions guessed yesterday’s outcome ahead of time. Did you? Email us: robert.armstrong@ft.com and ethan.wu@ft.com.
One year later, still just talking about the Fed
In a piece written a year ago, called “What we know about markets in 2022”, this was the first item:
Monetary conditions are set to tighten, at least until the market or the economy hits an iceberg; this will put pressure on asset prices. The Federal Reserve is tapering its bond purchases at a faster pace. It looks set to raise rates mid-year (though its fundamental bet is still that inflation will prove transitory).
The striking thing about 2022 in markets was that the most important thing that happened was clearly visible in advance. The year started with the core consumer price index at 6 per cent, the Fed needing to tighten. The Fed did tighten, and that was hard on asset prices, as everyone thought it would be.
Of course, the precise paths of inflation and policy were not predictable, and there were huge surprises, such as the invasion of Ukraine. But a big part of the script was in place at the outset. This goes a long way to explaining why, despite rate increases, geopolitical uncertainty and slowing US and world economies, the damage to asset prices has not been worse. Everyone had some time to prepare for trouble.
There is no comparable north star investors can use to navigate 2023. The Fed has pushed rates to 4.5 per cent, and the market thinks the central bank is almost done. But how long rates will stay at their peak level is uncertain; the Fed has said it will be a while, but the market doesn’t believe it. Still, it is worth trying to map the territory. Here are the most important knowns:
US inflation has peaked. On a long enough timescale everything is transitory, and so it was with goods inflation. The supply chain normalisation sorely hoped for in 2021 arrived this year, delivering a mighty drag on inflation (see below). Bloated inventories at retailers helped, as did a softening car market. If all goes to plan, shelter inflation will come next, as slower rent growth for new leases gradually feeds into the official inflation data. That could come sometime in mid-2023 but even if it takes longer, goods deflation will keep a lid on price growth. With consumers’ excess savings depleting as high rates start to bite, a slowdown in demand is probably due. Anything can happen, of course, but the worst inflation looks to be behind us.
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After a tough year, there is still little sign of capitulation in the US stock market. The forward-year price/earnings ratio on the S&P 500 has fallen from 27 to 18, which sounds like a lot, but only brings the index down to its pre-pandemic valuation level. Meanwhile, earnings estimates for 2023 have fallen, but only by about 10 per cent from their peak. That still implies mid-single digit growth from 2022, a year in which margins have remained near all-time peaks. Middling valuations, high estimates and high margins together mean that a recession — predicted by the yield curve — is not priced into stocks.
There are some bargains in the US, though — and international stocks look relatively cheap. The gap in price between the cheapest and most expensive US stocks is very wide by historical standards, and in the past, that has presaged good returns for the value end of the market. Reversion to a more normal relationship may take time, though: value stocks tend to be cyclical, and a recession could be tough on cyclical companies’ earnings. Look abroad, then: in Europe, the UK and in Japan, stocks are on sale. Our friend Dec Mullarkey, of SLC Management, reckons the gap in p/e ratios between US and European stocks sits at 6 points, the widest it has been in decades.
Credit is attractive, relatively. We often carp about the fact that credit spreads, like stock valuations, do not seem to anticipate a recession. The fact remains, though, that the absolute yields on both Treasuries and corporate debt now appear to reward some risk-taking — on both rates and credit — for the first time in years. Taking duration risk in Treasuries makes some sense for those confident that recession is coming. High-quality corporates pay a percentage point or two over Treasuries with modest credit risk. Junk credit is offering equity-like prospective returns, as it should.
And here are the big unknowns:
How fast will US inflation fall? And how will we tell when it has? For months inflation reports have been free of ambiguity: inflation is very hot! That is changing. As inflation crests, judging its underlying trend is getting harder. Slicing the data wisely is difficult enough now: should we ignore deflation in CPI medical services, partly driven by methodology quirks? Next year will present even tougher questions: should inflation in non-housing core services inspire fear even if rent inflation, the biggest category, starts dropping? Is high wage growth an inflation problem in itself?
How much will the Fed sacrifice to stamp out inflation? As Jay Powell has said, both sides of the Fed’s dual mandate right now point in the same direction — out-of-control inflation undermines sustainable growth and demands higher rates. But as inflation and growth both fall, will the central bank’s calculus shift? Consider the following scenario. It’s July 2023 and core PCE has fallen from 5 per cent to 3.5 per cent, still above the Fed’s target, but unemployment has risen above 4 per cent and recession alarms are blaring. Would such a scenario spell rate cuts? Dovish talk but no policy change? An end to quantitative tightening? Our guess is that the Fed will keep rates high even as recession approaches, but our confidence in this prediction is only moderate.
Will geopolitics deliver another commodity shock? Inflation this year was worsened by Russia’s invasion of Ukraine, causing an ill-timed surge in energy and food prices. Could it happen again? Among the looming risks: an escalation (or settlement) in the Ukraine war, US-Iran nuclear talks breaking down, instability in Iraq and China’s zero-Covid exit (see next bullet). All of this uncertainty hangs over the oil price — which has fallen and diverged, strangely, from the price of oil-producers shares, which remain high.
How will China manage its dual crises? At the start of 2022, we named the China real estate crisis as one of the key unknowns, and it remains one. How much will the government support house prices, which are consumers’ key store of wealth? The question is compounded this year by uncertainty around the end of the zero-Covid policy. This uncertainty is not important because of its effect on China’s own markets, which are not important globally. The question is whether Chinese demand, especially for commodities, rebounds — and whether the Chinese export machine can keep humming as it has, remarkably, through most of 2022.
Will housing drag deliver a shock to the US economy? Medium US existing house prices fell 8 per cent between June and October, according to the National Association of Realtors, but are still about 25 per cent higher than before Covid, despite much higher mortgage rates. We still think that a house price crash is unlikely because most homeowners have a lot of equity in their homes, a fixed-rate mortgage, a decent balance sheet, and no need to move. But a rapid increase in unemployment could change the dynamic. Not a big risk, but one to watch all the same.
Tomorrow, we will do the stupidest thing a markets writers can do: offer some predictions. (Armstrong & Wu)
One good read
From the blog that brought you “Is Alameda Research Insolvent?” a week before FTX’s hedge fund proved to be just that: Is Binance.US a Fake Exchange?
Source: Economy - ft.com
