Dominos de la banque centrale

They are all getting in on the act. Interest rates might even be going up in Europe as the domino effect from the Fed plays out. You never know, Japan might also start to ponder whether its endless monetary largesse is still appropriate. Markets are responding with higher market rates and yields, wider credit risk premiums and equity market de-rating. There is more to come in the short-term so brace yourselves. Financial assets are getting cheaper and while the Fed put has expired, central banks will ultimately be mindful of the downside to economic growth. Peak inflation and lower energy prices in the Spring might bring a more positive outlook for market returns.

Sick and tired

January was brutal in markets – even worse for those trying to go “dry”. Everything was down. I have tracked thirteen fixed income total return indices for the last ten years in support of one of our total return strategies. January was only the fifth month since 2012 that all of them had a negative return. There has not been two consecutive negative months for all thirteen indices – representing government and inflation-linked bonds, investment grade and high yield credit and emerging market fixed income. That might be good news and typically when it has happened, longer duration fixed income does well in the following month. But I am not so sure today. If January was about anticipating just how hawkish the US Federal Reserve was going to be, February seems to be about the European Central Bank and the Bank of England taking away their punch-bowls as well.

20% bingo

Meanwhile the equity market correction continues with the Nasdaq composite now 13.5% below its peak. There have been near-bear market corrections in emerging market equities and US small cap as well, while broader markets are down anywhere from 5.8% for the EuroStoxx market to 11.2% for the Nikkei. All of this is consistent with two things – stock markets tend to go through a period of de-rating when interest rates are going up and monetary tightening brings in greater uncertainty about what will happen to growth and earnings.    

Long-term view

The good news for investors is that throughout tightening cycles, returns tend to be positive. Equity markets have gone up during the period between the trough and the peak in the Fed Funds rate in every cycle since the early 1970s, except for in 1973-74 when the global economy was hit by the oil crisis. The dynamics are usually that ratings come down (valuation adjustment) but earnings recover through the cycle to allow total equity performance to be positive. Of course, not all cycles are the same. Typically the biggest drawdown relative to market levels at the time of the first hike come quite quickly – after all that is when central banks are at their most hawkish. However, when cycles are long and provoke an aggressive slowdown in economic growth prospects, equity market performance can weaken again. That was the case in 2015-2018 when the combination of higher US rates and trade concerns hit markets.

Reversing the COVID era bounce in multiples

Defensiveness around equity exposure should probably be already in place. Monetary cycles result in de-ratings and that hits performance of markets up-front. In the last two cycles, the biggest drawdowns from the levels in place at the time of the first hike came from the Nasdaq, Japan, US small cap-stocks and China. The markets that held up better were the UK and value stocks. Yet through the cycle, the US tends to outperform – probably because expectations of a peak and subsequent cut in rates come through first in the US. Today, looking at price-earnings ratios based on 12-month forward forecasts for EPS, the US markets are the most expensive with the Nasdaq at 1.6 standard deviations to its long-term average and the S&P500 at 1.3x. The cheapest and – arguably – least at risk from a global de-rating are China, the UK and Japan with Europe fairly valued close to long-term averages. The massive pandemic related injections of liquidity and fiscal stimulus pushed US equity PE ratios higher by several points and the unwinding of that is they key story as the Fed normalises.

When doves cry

The short-term outlook is difficult with the market now expecting the ECB to be in play at some point in 2022. Mdme Lagarde did not do a great job on communicating the ECB’s stance and the market has taken away a view that could see rates being increased this year. Some commentators think the first move could come as soon as March. There is a widespread on the timing of the first move. There is also incredulity amongst economists that the ECB is even contemplating a rate hike. But why not? Rates are negative and arguably don’t need to be anymore, especially as Europe is also experiencing inflation well above the ECB’s target. Exchange rates don’t and shouldn’t be that important in determining central bank decisions, but the recent weakness of the euro combined with higher energy prices will have added to the argument of the hawks to tighten policy.

In London town

Meanwhile, the Bank of England is adding to the socio-political soap-opera that is the UK. Boris Johnson’s “credibility – ahem” as prime minister is unravelling quickly. The Bank nudged its base rate up to 0.5% on the same day that it was announced domestic energy bills could rise by more than 50% for the majority of households. National insurance contributions are also set to go up in April adding to the squeeze on household incomes. If there were a general election in the UK anytime soon we would all have to start incorporating the Labour Party’s economic policies into the outlook. In the meantime, the stress might fall on sterling and small and mid-cap UK equities at some point. The Bank suggested that inflation will fall quickly from the second half of this year – although it didn’t acknowledge that this might be because of the risk that the UK is heading into a recession before any other G7 economy.

Tough road ahead

Developed market central bank tightening and the absence of any real political leadership makes investing tough. My “expectations” markers are a 10-year Treasury yield at 2.5% (real yields heading to zero and inflation priced in at 2 ¼ to2 ½ per cent; the S&P500 touching 4,000 (with a risk it goes lower) as a 20% correction from the record highs is seen and growth stocks continuing to suffer from their supposed “long-duration” characteristics. That possibly means a print on the Nasdaq of between below 13,000. Not to mention the more fundamental impact on equity performance and earnings from the possibility of margin squeezes as the inflation wave flows through the global economy this year.

Looking for turning points

In the absence of going “short” investors need to focus on where the downside is less and what needs to happen to trigger a turnaround. On the equity side the de-rating risk is lowest in markets like the UK, Europe and Japan relative to the US. More value driven strategies should continue to outperform but that is subject to any margin squeeze in the industrials and an eventual peak in the energy cycle. On the bond side, short-term rates are rising, and this is likely to generate higher bond yields, even if curves flatten. Thus, downside risk to total returns is more limited in short-duration strategies. I still like short-duration high yield and credit as the fundamentals are still relatively good. However, this last week or so has started to see credit crack a little with spreads widening and the risk is that further equity volatility will extend those moves. The shift in the ECB’s stance is key here. If markets get a sense that QE is over in Europe as well, then the obvious risk is wider sovereign spreads impact bank spreads and confidence in the broader corporate market. A 60-100 bps widening in investment grade spreads is likely during the tightening cycle with high yield moving higher, depending on the growth and implied default outlook. But that will mean good buying opportunities in credit at some point.

Any chance of a quiet year soon?

Markets will get used to the tightening regime at some point. Through most cycles, both bonds and equities deliver positive returns. But volatility will be higher. The medium term view i.e. looking into 2023, depends what happens to growth expectations and corporate earnings. So far, what we are likely to see from interest rate increases is probably not enough by itself to trigger a major growth meltdown (ECB repo just back to zero percent by year-end). Even with markets more skittish, the terminal levels for rates being priced in are low by historical standards. But the growth and earnings forecast revisions in the next few months will be key. So far, they are holding up. Short-term, a peak in inflation in Q1 is imperative as is some rolling over of energy prices. It would also be helpful if the current crop of central bank heads did a bit of research into the Alan Greenspan approach to market communications.