As equity markets, particularly growth stocks and consumer cyclicals, have rallied, the economy has slipped into the condition previously referred to as recession while the earnings of the biggest companies by market value have weakened. Equities are forward looking and are suggesting we can now see past the worst, this week we look at the evidence for both positive and negative scenarios from here.
The growth heavy Nasdaq 100 index has rallied over 16% from its lows in early June, a considerable move, although it remains 20% below its highs at the end of 2021. After that kind of move it might be tempting to call the end of the current bear phase in markets.
On the positive side we have come through the current earnings season without any major damage. US jobs growth continues to be exceptionally strong and wage growth still lags final goods price inflation. Weakness in commodities suggests input price pressure may be subsiding. Markets are taking this as evidence that the Fed will start reducing interest rates earlier than planned as inflationary pressures subside.
Less positive is the fact that many of the largest companies reported declining year on year earnings for the second quarter. Expectations are that earnings are likely to grow rapidly from here, hence there is considerable room for disappointment, particularly as margins are at historic highs.
There is plenty of evidence from various leading indicators that the economy continues to decline, while inflation remains stubbornly high. Politics in the US dictates that the definition of a recession must be set aside for now, but two quarters of declining GDP have already passed (subject to revisions). US consumer spending is rightly regarded as one of the most important drivers of the world economy but a number of indicators of the health of the US consumer are looking unsettling, despite the apparent strength of the employment market.
The chart below shows the University of Michigan Consumer Sentiment Index, which has been declining rapidly.
University of Michigan Consumer Sentiment Index
Source: Bloomberg 31.08.2016 to 31.07.2022
Anecdotal evidence suggests that the recent rises in interest rates are having a material impact on homebuyers; US buyers typically take 30-year fixed rate mortgages and the cost of these has increased materially since the lows of 2021. Combined with house price rises over the same period, the cost of moving home has increased materially. The housing market has often led the overall economy in the US.
We are faced with a situation where lagging economic indicators are still strong, but leading indicators are declining rapidly. Interest rates are likely to continue rising until there is clear evidence that inflation is back under control, but the impact of interest rate rises is believed to be a lagged, so the risk of policy error is clear.
Governmental intervention in the US and elsewhere, looks very likely to be inflationary. While marketed as disinflationary, the US Inflation Reduction Act is a case in point. In practice, all politically acceptable interventions are likely to also be inflationary.
As a consequence, we are very cautious of this rally. Tightening interest rates, high inflation and a deteriorating economy makes for a poor outlook for both valuations and profitability. While we have taken advantage of a few opportunities to build positions in some of our preferred long-term themes we still remain well below our typical equity exposure. Obviously, momentum is a key part of our process and further strength from here will begin to evidence that the broader market is in an uptrend, in which case we reserve the right to change our stance.