Since the beginning of 2022, we have been outlining to our members how the big picture conditions that investors were facing this year were quite different to the past year and a half, and that we had entered into a different (higher) risk scenario given the multi-decade highs in inflation, central banks starting a tightening cycle, the peak and roll of the business cycle, and the outlook of our forward models. (CLICK HERE for the January article, and see how things have panned out with the benefit of hindsight).
Fast forward 4 months later to today, and we have seen this scenario play out in an almost textbook fashion, with risk assets (especially high PE US growth equities) certainly responding to the rising risk regime we warned about back in January. As at time of writing, for the year to date:
Long term bond yields have risen a lot in a short space of time due to the multi-decade high inflation prints that have come through this year.
Rising bond yields are negative for the valuation of high PE, long duration stocks like the big technology stocks. These stocks make up a larger proportion of the US markets (especially the Nasdaq), while tech makes up comparatively little of the Aussie market. Add to this the fact that higher bond yields are actually good for bank stocks, and that commodities tend to like higher inflation, and you can see why the Aussie market, with its higher proportion of bank and resource stocks, is well out in front of its US counterparts this year. For example, BHP is up +15.18%, Westpac is up +10.26%, and CBA is up +4.05%.
The key takeaway here is that the reaction of the share markets to the rise in inflation and bond yields has thus far been mostly a PE contraction story, which affects the various sectors differently. In other words, given the higher risk free rate, investors are less willing to pay higher prices for the cashflow of companies, while analysts earnings growth estimates have not moved much. Note in the chart below how the lagged effect of the change in bond yields (the blue line) correlates with the forward PE of the ASX200. PE expansion is one of the reasons why share markets love falling interest rates / bond yields. The opposite of course is also true.
So we’ve had this PE compression due to those rising bond yields. What about the growth cycle ? Leading economic indicators of growth of both the Aussie and US economies thus far have been hanging in there. Although they have peaked and are decelerating, the nominal levels have still been OK. PMIs in the mid to high 50’s still indicates an economy that is growing pretty well, just not as good as before. This is what we call the “Risk Rising” phase of the cycle, where the inexorable rise of the stock market changes and starts to get more choppy, less certain, more volatile, and corrections are more prevalent as earnings growth (particularly at cyclical companies) starts to become more variable. According to our forward model that we use to help forecast the US business cycle and the key risk points (the blue line in the chart below), the slowdown is well underway, but more importantly, still appears to have a significant ways to go.
The next phase of risk is all about market fears transitioning from high inflation over to the slower growth that the chart above is pointing to. High inflation, oil price spikes, and tightening rates cycles have historically almost always led to significant growth slowdowns and/or a recession as the consumer gets squeezed. For example, the US consumer has had six straight months of Y/Y declines in real disposable income, punctuated by a -20% Y/Y drop in March. That is some serious contraction as inflation bites into consumer buying decisions. As growth slows, earnings growth also slows. If growth actually contracts (think PMIs under 50 – well and truly in the RISK OFF phase) and earnings growth actually contracts, that’s where things get really nasty and the bear market does some serious damage. And that is not a scenario that the Australian market will magically escape from.
And in case you think the bottom in economic data or corporate earnings is just around the corner, just consider that we are just getting into the most challenging comparisons we’ve literally ever seen on both the top down and bottom-up data. In other words, the probability is high that the data continues to deteriorate from here for at least a little while yet.
Having said that, bear market rallies occur when “bad news” gets “less bad”. Right now that means lower CPI prints or lower rates could easily be the catalyst, where in that scenario it could well be the Nasdaq that benefits the most short term. But as the next earnings season rolls around, that is where attention to growth and earnings will re-assert.
History tells us that a durable bottom in risk assets generally coincides with an inflection in the liquidity cycle, growth cycle, or both. Most of this year’s risks have been all about rates and inflation thus far. The consequences of that inflation (and the lagged effect of previous financial tightening) are starting to be felt (see the recent poor earnings misses by US retailers) as they weigh on economic momentum through the rest of 2022 and possibly even into 2023. Until those recession risks peak and recede or we get a major pivot from the Fed / other central banks, markets are unlikely to bottom in a sustainable way. Yes, it will be uneven, and yes, there will be rallies in between that promise a new dawn (especially likely when inflation / rates peak and roll) , but overall economic gravity will still be weighing on markets. There will be a time to get aggressive again, but that time is when we have earnings and economic data in the part of the cycle where they are reaccelerating again with macro tailwinds, and generally a pivot in the liquidity cycle. Until then, the prudent course of action hasn’t changed – stay defensive, don’t get overextended in terms of position sizing, and keep risk exposure under control (especially avoiding “pipedream growth”). As always, members can keep track of the latest developments and the trends across all asset classes (not just equities) in the weekly Portfolio Strategy Update.
Author: Graham Parkes
Macro analyst & editor of The SMSF Investor
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