Global Macro & Strategy

It’s 2022, and the outlook is nothing like the past 20 months

In the current world of constant ‘clickbait’, the headline to this article could have been vastly different. In fact, insert any type of doomsday headline you like, and we could have run with it, and justified it with any number of scary charts and analysis to back up such a dire warning. Lets face it, fear gets the clicks.

To be sure, there are a number of challenges that investors face this year (and we’ll get to those in a minute) however the doomsday scenario is not where we are at. Not yet anyway. As investors, we need a calm, rational approach to what is in front of us – according to the weight of evidence –  to give us the best chance to navigate what we think will be a challenging year ahead. The emotion driven prognostications of click baiting doomsayers don’t help. It only adds to the noise.

It boils down to this

Like every month, there are a ton of data points that come out and just as many charts to explore. The thing is, most of them are useless in terms of having any real value to investors. Again, they just add to the noise in your head. Right now, the big picture strategy conditions investors are facing are actually not that hard to understand, and we can sum it all up quite neatly with the following bullet points. Re-read this list a number of times if you need to. It’ll help cement it in your head.

  • Inflation around the world is at multi decade peaks. The latest US inflation rate is 7%.
  • Hence, the Fed is now wide eye’d about the inflation threat (so much for “transitory”), and is now hawkish and looking to do the treble tightening – end QE, raise rates, and even start Quantitative tightening (reducing their balance sheet). In other words, we are entering the OPPOSITE phase that we were in after the initial COVID shock, which involved PMIs coming off of low points and massive monetary policy easing / stimulus that propelled stocks to record highs in quick time. We are now moving in the opposite direction – PMIs rolling down off highs and into monetary tightening. You do the math.
  • Ok, so what? The Fed say they can do it because economic growth is going so good. That’s true, it is for now. HOWEVER………
  • The probability is high that growth has peaked and is slowing (see the ISM model chart below). We are now in the phase of the business cycle where the PMIs are decelerating. This is generally the phase where risks rise, market corrections are more commonplace, and the probability of earnings disappointments start to rise. And remember, stock market valuations are priced such that any earnings disappointments will be harshly dealt with.
  • So in a nutshell, its all about this – the Fed is tightening into a slowdown – which is NOT GOOD. Our members will know we flagged this late last year as a risk for 2022, so this is nothing new.
  • On top of this, the rate of change of fiscal stimulus is negative. Yes, that may change as the year goes on, and we’ll take that as it comes.

Just two charts

We love charts, and I could fill this page with a bunch of them, but lets keep this as simple as possible, as most investors need less noise, and more concentration on what actually matters. I’m going to boil this down to just two charts for you. Both these charts appear in the weekly Portfolio Strategy Update for members, as they form an important part of the macro section of our RISK MONITOR (note the 2nd one below has only just started appearing in the RISK MONITOR).

Exhibit A

First up here (above) is the US business cycle (the ISM, orange line), and our multi-factor forward model (blue line) which represents past tightening or stimulus in the system, that acts on a lag to the real economy. As you can see, the model is suggesting that the peak in the cycle is just about in (the ISM actually decelerated last month), and that for the rest of 2022 the pressure is to the downside. This is the phase of the cycle we call “RISK RISING”. At the top here, things are still OK. The economy is still humming along, just not as good as before. For investors, it means stock markets get more susceptible to corrections and volatility, and it’s generally time to start building more defensive positions and the focus on asset quality comes more into focus. When the business cycle is accelerating, just about anything goes up. Not now. The market now becomes much more discerning, and the rubbish is left by the wayside. Quality and stability of earnings growth now becomes paramount.

Exhibit B

The chart above is the ASX200 vs a multi factor model that represents the importance of the US monetary policy on the rest of the world, including Australia. The orange line is the ASX200, and the blue line is a forward model based on the rate-of-change of US liquidity and cost of money. As you can see, the circles highlight times where the blue line has fallen precipitously, and represents points in time of high risk for the share market. Look at the final circle on the chart (i.e. where we are NOW). Draw your own conclusion on the risk situation this year.

Looming “risk off” probability in Q2 for growth and inflation combo

The 3rd leg to the risk table, which is not a chart but is a very important part of the RISK MONITOR, is the outlook for the change in growth and inflation. As Ray Dalio has taught us, one of the most important risk signals for investors to monitor is the combination of DECELERATING growth and inflation data in the US. This includes both the current data as it comes in, and the forecast data based on base effects and data trends. Quantitative macro modelling, which aggregates a large range of both growth and inflation data, is currently anticipating inflation data starts to peak out soon here (mostly due to high base effects) while growth data (such as the PMIs) are already starting to decelerate here. So no “risk off” signal just YET in the aggregated expected growth & inflation data (and hence why markets have not yet pivoted that way), however it does start to look highly likely when getting closer to the end of Q1 / start of Q2 2022.

And make no mistake, the market will start to sniff that out and front run the macro transition, hence why we have it on orange lights now so you can prepare. Our best guess is nearer the end of Q1, but the reality is the market will signal that when its ready to do so. This is also why you don’t anchor on just one thing (macro conditions or market signals). You use both in tandem.

The bottom line

The headline really says it all. When you look at all of the evidence above, and treat it with no emotion, it is clear that the underlying fundamentals in 2022 look nothing like 2021 or the 2nd half of 2020 (i.e. the past 20 months). It’s a different part of the cycle now. Risks are rising. The Fed is tightening and focussed on fighting inflation, a foe it has not really had to contend with for decades, just as growth is beginning to slow. It wont be a straight line (or straightforward) in either direction, and investors need to have their wits about them. Defence will likely become increasingly important, as will investment quality. This is not the time for high beta (risk) positions. On the other side of the weighing machine, markets are still OK at the moment, and trading with a slight ‘reflation’ bent. The Omicron variant of COVID may also crowd out the other less virulent strains, and we may get to mass immunity quicker resulting in a bounce back in the data as economic activity bounces. Again, it wont be straight line. As always, keep an eye each week on the Portfolio Strategy Update where we’ll keep members up to date on the latest developments.

 

Author: Graham Parkes
Macro analyst & editor of The SMSF Investor

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