MARKET UPDATE | Looking Beyond the Slowdown | August 2022
Markets are looking past the anticipated slowdown and pricing in a recovery in 2024.
Looking Beyond the Slowdown: Summary
- Companies have fared well despite inflationary pressure: though companies have issued downward guidance and continue to do so, every sector of the S&P 500 posted positive sales growth and 8 of the 11 sectors also posted positive earnings growth despite cost pressures, suggesting healthy pricing power offsetting the prospect of waning demand.
- The U.S. Treasury yield curve is quickly recovering from its inversion: the gloomy outlook for the economy has started to abate as expectations for the Fed are less hawkish and the economy is showing some resilience.
- As oil prices fall, inflation pressures should also fall: expectations for year-end oil prices are finally being revised down to $98 per barrel, suggesting we may see a recovery in oil prices, but not a bounce back to conflict highs which is good news for inflation.
You can read the full Market Update below.
Market Review: Inflation Persists
Markets in July were impacted by higher-than-expected inflation, a second consecutive Fed rate hike, and fluctuating energy supply and demand patterns.
U.S. equity markets posted a strong recovery in July setting pace for the best month of the year. The S&P 500 closed the month up 9.11%, despite inflation worries and the continued hawkish Fed stance. The Consumer Price Index tracking inflation rose by 9.1% year over year, prompting another 75bps hike from the Federal Reserve. However, an upbeat earnings season across the financial and tech sectors helped buoy the first leg of the stock rally as companies showed profits in spite of the high inflation in Q2. Economic data showed a contraction in U.S. GDP for the second consecutive quarter of 0.9% which prompted an expectation that the Federal Reserve would be less aggressive in raising interest rates in the fall and winter. The worst performing sectors for the month included Health Care, Materials, and Utilities. Recessionary fears continue to linger though the National Bureau of Economics Research has not yet declared a recession. The NBER weighed the second quarter of consecutive negative GDP growth against the strength of the labor market to reach this conclusion reflecting the reality that the corporate earnings are not showing significant signs of recession , or at least not yet.
European equities rose steeply in July, gaining 5.1%, reacting to the positive earnings data from U.S. companies and European industrial production outperforming estimates, despite the challenging access to energy, the resulting soaring oil and natural gas prices and the following on economic challenges stemming from the Russo-Ukrainian conflict. In addition, the European Central Bank (ECB) hiked interest rates by 50 bps marking the first increase in over a decade, in efforts to combat inflation that measured at a staggering 8.9% and slowing growth. The euro fell to parity with the U.S. dollar before narrowly edging above towards the end of the month. Europe is anticipating a worrying winter as energy demand is expected to rise above supply which stokes fears of an unprecedented recession as indebted countries will suffer from both higher costs to borrow and potentially increasing energy cost.
Within emerging markets, Chinese markets equities posted the lowest performing month this year. China’s zero COVID policy continued to prevent restrictions from being completely lifted as cases continued to rise. In addition, a tight housing market, rising political tensions with the U.S., and global monetary policy tightening measures have eroded confidence in the near-term growth of the Chinese economy. Decreasing global demand from China has slowed production for the month as measured by the Purchasing Managers’ Index (PMI) which came in below expectations for the second month in a row. The U.S. dollar strength is up 5% compared to China’s yuan and 15% against the Japanese yen. Latin America has recovered from recent energy-related losses, with a gain of close to 4.5% for the regional MSCI Latin America Equity Index.
Economic data showed signs of cooling, with GDP output slowing, however exports for the last quarter surged. Nonfarm payrolls came in higher than expected while Consumer Price Index (CPI) tracking inflation rose by 9.1% for June which was .2% more than expected. With the cooling Industrial Production numbers, the Federal Reserve expressed a willingness to take less aggressive action going forward until 2023. The yield curve inverted this month, a classic signal for recession expectations. However, other factors like unemployment, payroll and Q2 company earnings show positive signs of an economy dealing with unprecedented inflation. As a result, high yield credit spreads compressed dramatically over the month from a high of 583 bps to a month end of 409 bps above Treasuries. In addition, the pace of downgrades fell this month, though downgrades continued to exceed upgrades, which should not be ignored.
Energy based commodities contracted in July. WTI crude oil futures traded near $95-per-barrel during the last ten days of the month and Crude oil prices in Europe have dropped 10% as European political leaders discussed a plan to impose a price cap on Russian oil to prevent future global spikes. Among metals, outflows from gold and silver pushed gold to $1760 per ounce toward the end of the month as markets re-evaluated their expectations on the Federal Reserve’s policy for the second half of the year. Within the crypto universe, Bitcoin has managed to recover 20% of its price closing out the month at around $24,000.
Going Forward: Looking Beyond the Slowdown
For investors in their golden years, the memory of stagflation bubbles to mind as the Fed lamely raises rates against commodity-induced inflation much like Don Quixote waging battle against windmills. Though the reduction of liquidity was necessary for proper risk allocation, the manner in which it is being done is triggering two forms of inflation: energy-driven inflation which it has limited impact on and interest rate inflation which it is directly driving. Interest rate inflation is driving up the cost of debt in all forms from mortgages to autos to credit cards, significantly crimping spending. The reduction of demand can have an impact on energy demand in the medium term, however, supply constraints are the key cause of it. No amount of Fed tightening can make the oil wells pump more supply into the system. That takes time and coordination. In the meantime, inflation readings continue to linger and though they should fall, they are expected to remain higher than the preferred 2% level while the economy slowly cools bringing on a milder form of stagflation.
One of the positive aspects of Fed action has been a significant compression of forward price to earnings multiples, making equities more attractive on the whole. However, overall forward P/E multiples range from as low as 6x for energy companies to as high as 28 for consumer discretionary companies with the S&P 500 sitting at 18x overall. Though economists are expecting a recession, it is likely to be mild based on the performance of corporate profitability and labor markets so far. European companies look quite a bit cheaper at 12x, but the outlook for the economy is a bit more dire given their proximity to the Russo-Ukrainian conflict and energy dependence. Between now and winter, European policy makers will have to create some economic insulation from the conflict in order to make investing in the region look attractive. Japanese equities are at nearly the same valuation but could be subject to a repricing if U.S.-Sino tensions continue to rise. Overall, despite the fears of a mild recession, investors are continuing to test the waters in growth stocks and favoring growth outlooks.
Now that the bond bloodbath looks to be behind us for now and ten-year yields have settled back to the upper 2% range, currently trading at 2.8% with an upward trajectory and high yield bond yields offering reasonably attractive 7.5% yields, we anticipate some support in the bond markets as investors step back in to the markets. Credit markets have fared well as corporates benefitted from the inflationary environment. Despite a rise in the cost of capital, corporations pushed margins by raising prices and ensured reasonably healthy balance sheets at the higher end of the high yield quality spectrum. That said, the lower end of the quality curve, like unprofitable company stocks are likely still going to find it hard to attract capital until we are through the recession. Quality matters across the corporate bond spectrum.
While the Fed is determined to control inflation, we remain convinced that energy will be more determinant for the inflation outlook than the Fed. And, though many are concerned that the Fed could induce a recession by crimping demand, so far, the data does not yet show it. We have now seen a technical recession with two subsequent quarters of negative GDP growth; however, the National Bureau of Economic Research has not yet declared a recession. The labor markets are still robust and corporate earnings have done well in the recession. Though wages also grew, they grew less than inflation, suggesting that incremental earnings are buying less. We fully expect a mild recession, but we don’t anticipate further impact to multiples unless the Fed suddenly returns to their aggressive hawkish stance. The Fed Funds futures curve is anticipating the Fed Fund rate to peak out at roughly 3.5% at the February 2023 meeting after which it will go on hold briefly and then begin cutting rates back down to 3% by year end. This could support the search for growth in anticipation of a 2023 rally.
We are going back to neutral on value vs growth as we believe that the opportunity has largely played out.
Past performance is not an indication of future performance. The information provided in this newsletter is for informational purposes only and should not be considered investment advice or a recommendation to buy or sell any types of securities. There is a risk of loss from investments in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses.
The information contained herein reflects Lido’s views as of the date of this newsletter. Such views are subject to change at any time without notice due to changes in market or economic conditions and may not necessarily come to pass. Lido has obtained the information provided herein from various third-party sources believed to be reliable but such information is not guaranteed. Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. Lido is not responsible for the consequences of any decisions or actions taken as a result of information provided in this newsletter and does not warrant or guarantee the accuracy or completeness of this information.
MSCI ACWI covers approximately 85% of the global investable equity opportunity set. The index is based on the MSCI Global Investable Market Indexes (GIMI) Methodology—a comprehensive and consistent approach to index construction that allows for meaningful global views across all market capitalization size, sector and style segments and combinations.
MSCI EAFE Index measures international equity performance and is comprised of the developed markets outside of North America: Europe, Australasia, and the Far East. (Source: MSCI)
MSCI Emerging Markets Index is a free float Adjusted market capitalization designed to measure equity performance in global emerging markets and covers 800+ securities across 23 markets and represents about 13% of world market cap. (Source: MSCI)
The Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency). (Source: Barclay’s)
The BofA Merrill Lynch U.S. High Yield Master II Index value, which tracks the performance of U.S. dollar denominated below investment grade rated corporate debt publicly issued in the U.S. domestic market. (Source: BofA Merrill Lynch)
The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market. (Source Russell)
The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. (Source Russell)
The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market. (Source: Russell)
The S&P 500® is a market value weighted index that includes the 500 leading U.S. based companies and captures approximately 80% coverage of available market capitalization. (Source: S&P Dow Jones)
Dow Jones Industrial Average™ was introduced in May 1896, is a price-weighted measure of 30 U.S. blue-chip companies. (Source: S&P Dow Jones)
MSCI AC World Ex U.S.: A market-capitalization-weighted index maintained by Morgan Stanley Capital International (MSCI) and designed to provide a broad measure of stock performance throughout the world, with the exception of U.S.-based companies. The MSCI All Country World Index Ex-U.S. includes both developed and emerging markets. (Source: MSCI)
Barclays U.S. Universal: Unmanaged index comprising U.S. dollar-denominated, taxable bonds that are rated investment grade or below investment grade. (Source: Barclay’s)
HFRX Global Hedge Fund: The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is comprised of all eligible hedge fund strategies falling within four principal strategies: equity hedge, event driven, macro/CTA, and relative value arbitrage. (Source: HFRX)
The Alerian MLP Infrastructure Index is a composite of energy infrastructure Master Limited Partnerships (MLPs). The capped, float-adjusted, capitalization-weighted index has 25 constituents that earn the majority of their cash flow from the transportation, storage, and processing of energy commodities. (Source: Alerian)