House View: July 2022

July 8, 2022

Financial markets do not like sudden change, but what we have experienced in the past half year are the most seismic changes we have seen in several decades. It’s not ‘only’ in the geopolitical sphere and the related interruptions in the global trade in energy as well as agricultural commodities, but in monetary policy settings that are also experiencing dramatic shifts – compared to past decades of mollifying waves of cheap central bank liquidity. Equity markets are into their worst first half-year since the days of Richard Nixon’s presidency, while bond market “fear gauges” such as the ICE BofA MOVE Index (the bond market analogue to the CBOE Volatility Index (VIX)) have reached 13-year highs, that is to levels unseen since the Global Financial Crisis.

ICE BofA MOVE Index

War in Ukraine: cause or catalyst?

The military conflict at the borders of the European Union now is in its fourth month, with no clear indication of any truce, let alone peace talks. The situation appears to be dragging on for a long time, considering the frozen conflicts in which Russia also plays a significant role, be it in Georgia or Moldova. The final outcome is impossible to even sketch, as so many imponderables are in play, among them the West’s stamina in terms of supporting Ukraine in the military domain, but also in terms of sticking to the economic sanctions that exact a price by pushing up prices for energy (gas, oil) and foodstuffs (grains, oilseeds), among other commodities.

There are many who attribute the spike in inflation rates over recent moths to the horrifying events in Ukraine. Most certainly, the naval blockade by Russia blocking commodity exports from Ukraine via the Black Sea has played an important part in the steep surge in grain prices, as Ukraine ranks among the top exporters in several agricultural commodities, and is known as the ‘bread basket of the world’. Also, the energy embargo by the EU, if even only a partial one, has driven energy prices by close to 60% higher than before the invasion took place in the early hours of February 24, with some correction only taking place in recent weeks.

But considering the already strong price pressures in many economies before war broke out in Eastern Europe, we do not see the war to be the root cause of the price surge, but more as a catalyst that speeded up the processes already underway. Looking at different countries’ January 2022 inflation rates, they had already reached record levels, for instance in the US (7.5%), the Eurozone (5.1%) or the UK (7.8%). Thus the Russian invasion of Ukraine supercharged the inflation that already existed, but was not in itself the main reason for higher prices.

Bloomberg commodity subindices: energy & agriculture

The new trend has only just begun

A new monetary policy era has resulted, as the signals from the world’s major central banks have changed markedly – from a benign neglect of initial signs of rising inflation, calling it “temporary”, to a message that “we will not let inflation get out of control”. Market expectations for the Fed Funds Rate at the end of December 2023 only 18 months ago stood at 0.2%. 6 months ago, i.e. at the end of 2021, market expectations regarding the December 2023 Fed Funds Rate had moved to 1.4%, and since then doubled to 2.8%. Such steep changes in market expectations typically lead to volatility on markets. There appears to be some relative calming in interest rate expectations, as the chart shows: the expected 12-month rate change has dropped from +200 basis points (2.00%) to a little above 70, reflecting heightened slowdown risks.

3-month change in expected interest 12 months out

We doubt whether we have reached this cycle’s end of the flagpole in terms of central bank rates, even after the FOMC’s hawkish turn at its latest meeting. Much depends on the future path of inflation, of course. The cyclical forces in the economy, after much pandemic-related disruption, certainly played their role in the sudden spike in consumer (and production) prices, after a period of back and forth, with lockdowns and “freedom days” in different countries and at different points in time. The structural forces driving up inflation however cannot be overestimated: demographics and de-globalization are the key factors making central bankers’ price stability goal a lot more complicated than in previous years. Wages and salaries will be key in the coming quarters as we expect a significant rise to materialize due to the imbalance of open positions and number of unemployed persons. The Atlanta Fed Wage Growth Tracker, to name one important indicator, has already reached the highest level since it was first published in January 1997, a good 25 years ago.

Atlanta Fed wage growth tracker

Zombies, beware

Add in the enormous monetary largesse of the past two decades by major central banks, and things get even more complicated. So-called zombie companies which have survived only thanks to the very low interest levels of the past years are being squeezed. Out of the 2000 companies that are constituents of the US small- and mid-cap Russell 2000 Index, about 20% did not generate enough operating cash flow to cover their interest expenses in the past 4 quarters, while having less than 12 months of operating expenses in liquid assets. Now, with interest rates on the rise – and more so in high yield bonds than in central bank rates such as the Federal Funds Rate – and cost pressures rising (leading to lower operating cash flows), these companies will struggle badly.

US high yield ex energy: spreads over treasury

The high yield bond market has started to display stress as the yield premia over Treasuries (the so-called spreads) has basically doubled in 2022 to a level that exceeds those of the turbulent fourth quarter of 2018 when the Fed was last time aggressively hiking rates only to pivot and reverse course. Consumer price inflation then stood at 2.5% (October 2018) and 2.2% (November 2018), i.e. at less than a third of today’s rate. Later in 2019, the US central bank started cutting rates again, saving many a distressed borrower at the time.

Recession fears

Judging from the violent volatility in all asset classes, the markets are adjusting to a much higher probability of an impending recession, something that had appeared very unlikely only six months ago. Certainly, the geopolitical events since late February have played their role in this development, but the divergence between leading interest and inflation rates had started very long before.

In the 32 years since 1990, the average Fed Funds Rate stood 0.15 percentage points above the inflation rate, in the 12 years since 2010, the real Fed Funds rate (that is, after subtracting inflation) on average was minus 1.5 percentage points. Such an environment of negative real rates leads to capital misallocation and according to the monetarist theory in economics will lead to inflation.

Now, the reckoning has come. The projected interest rate hiking pace is unseen since the days of Paul Volcker (FOMC Chairman 1979-1987), and the announcement of quantitative tightening (QT, reducing the Fed‘s balance sheet by running down its Treasuries and Mortgage-Backed Securities), means that the financial system is being weaned off the abundant liquidity that had led to very low to negative real bond yields for too long a period. Considering the announced start of the QT process during the month of June at a pace of USD 47.5bn per month, one may be surprised to see the Fed balance sheet not to have shrunk, but rather stayed unchanged. Are the current market woes, with global equity markets in June dropping almost 9%, already taking their toll on the FOMC‘s determination? Its communicated plan of stepping up the QT process to USD 95bn per month in September already seems highly questionable.

NFIB small business survey: actual earnings changes

The labor market remains strong but many economists consider it a lagging indicator, i.e. not producing much of any forecasting value. Surveys among businesses tend to have a better value, but are more erratic on a month-to-month basis. The NFIB earnings trends survey for instance has fallen to a level close to the height of the pandemic.

This lack of optimism in the small business segment is echoed by anecdotal statements of business leaders such as JPMorgan’s long-standing head Jamie Dimon relating to a deterioration in business activity. Much depends on the actual pace of interest rate hikes, however the risk is growing that the sudden shift in financial conditions will produce victims in the corporate world, with the threat of a major bankruptcy likely to loom at some point. Risk behavior in board rooms naturally had been boosted by a record-long period of rock-bottom interest rates plus some feeling that the government may be relied upon during times of distress, as was proven by the various fiscal stimulus programs in many countries during the pandemic. It comes as no surprise then that the Treasury-Eurodollar (TED) spread which depicts the difference between 3-month interbank rates and 3-month T-bill yields has started to creep higher from already elevated levels as of late.

Stress in interbank lending in financial markets is often compared to the smell of smoke: there must be a fire somewhere. The recent move to new 2-year highs (i.e. to levels last seen during the pandemic) is an ominous sign for further stress in the banking sector.

Treasury-eurodollar (TED) spread

When will the Fed cave?

To us, the question is when, not if the Fed will change its hawkish stance or at least meaningfully tone it down. The coming CPI prints (usually released just before mid-month) will be instructive, as will be the pace of slowdown in the real economy over the summer. From the experience of previous QT attempts by the Fed, such as in 2012 and 2018-19, the market reacted rather viciously to its punch bowl being taken away from them. Back in 2019, despite decent annualized economic growth in the order of 2%, a crisis in the overnight liquidity market forced the central bank to end the reduction of its balance sheet that had amounted to about 15% of its previous peak in January 2018. In 2012, this reduction amounted to a mere 4% and was stopped by the European debt crisis as the global financial system once again stood by the abyss.

How high are the odds that the announced pace of almost USD 50bn of monthly tightening for the first three months (June-August) and of USD 95bn monthly thereafter will not be met? We would not be overly surprised that we will see quite soon a modification of the plan that had originally been published at the FOMC’s May 2022 meeting.

FOMC projection: end of next year federal funds rate

Plotting the dots

The next dot plot will be published at the FOMC’s September meeting. According to the latest one, FOMC members’ median expectation of where the Federal Funds Rate will be at the end of this year stands at 3.4%, seven quarter-point hikes above the current level.

Over the coming quarter, it will be instructive to follow the Fed Funds Futures December 2023 contracts which currently mirror the dot plot – depending on the degree of weakness in the real economy to show in the next months, our expectation clearly tilts towards a toning down of the hawkish message and some reduction of the anticipated leading interest rate towards year end.

We expect the consequences of such a pivot towards a less hawkish stance to be highly bullish for precious metals. Lower market expectations of interest rates without any meaningful change in the inflation outlook leads to again lower real (inflation-adjusted) rate expectations, thus strongly supporting gold and other precious metals. Positioning in futures markets would support our bullish view: both commercials’ and non-commercials’ futures positioning are within reach of 3-year lows – signaling a trend change highly likely in the near future.

Gold priced in EUR

The strong US dollar of the past 6 months of the order of about 10% has clearly weighed on precious metals prices. In order to filter out the USD impact, it may be instructive to look at gold priced for instance in euros, where about a 10% correction started in early March and which to us appears highly likely to end soon and we expect new highs will be recorded.

What to do with equities?

After global equities’ drop of 20%, has the time now come to add? We remain on the cautious side, as we do see headwinds on several fronts: first, earnings’ estimates in our view have to be significantly cut, especially considering the combined pressure from rising input costs (labor, commodities, capital) and a difficult economic outlook in the coming quarters. Second, longer-term valuations remain elevated; in order to match economically difficult periods of the past 10 years, another drop in the order of 25% would bring valuations in-line, while applying the valuation levels of the early 1980s, another 50% (!) fall in global equities would be called for.

These however are long-term valuation levels, and we do not think it likely that we will reach any of these valuation lows in 2022, as they will only be reached whenever monetary policy has driven any inflation threat out of the system – and such a point may be years away. Therefore, considerable bear market rallies must be expected every once in a while.

CBOE Volatility Index (VIX)

Over the summer, such a bear market rally may be unfolding, potentially on the back of a (temporarily) less hawkish central bank stance. As we lack a full capitulation mood at this point, another down-leg could be on the cards. We would therefore not yet use our dry powder, but rather wait for another spike in risk-off sentiment to do so. Another (shorter-term) buying trigger for equities we would see is the Fed backing off its aggressive balance sheet reduction plans, which we would estimate may happen after the summer.

A very cold crypto winter

Critics of the emerging asset class of cryptos or digital assets are feeling strongly reaffirmed in their view that the whole complex will eventually go to zero. While the year-to-date drop in many currencies exceeds 60%, and in the case of bitcoin amounts to 73% from the highs in November 2021, we would strongly fight the notion that the end has come – to the contrary, the current crypto winter is no new phenomenon, but has already happened three times already. In each downcycle, bitcoin’s drop was more than 80%, in one case even more than 85%. Applying this measure to the current cycle, the price target for bitcoin amounts to USD 10K, some 50% below current prices.

Bitcoin’s (and other coins’) drop in a time when inflation rates are soaring was taken by many observers as proof that digital assets are no inflation hedge. We would not take the rather short history of the past 6 months as final evidence for this claim, but rather note the increasing stress on financial markets which lead to strongly rising correlations among the different asset classes. A famous example is the gold price during the height of the Global Financial Crisis in the fall of 2008 which dropped by a whopping 25%, despite gold being called the portfolio investment insurance in times of crises.

We continue to see a growing potential for the emerging asset class and would add into further weakness. To recapitulate the last cycle, for those who bought in the crypto winter of 2018 (after the strong drops in Q1 that followed after the then all-time highs at 20K) and never sold: these are still at least 100% to 500% up, depending on the entry level. Therefore, albeit a truism, we suggest to buy digital assets not at all-time highs but during those times that their critics are howling victory.

Conclusion

  • Financial markets are undergoing a brutal structural change – from a laid-back posture of all will be well thanks to the support of easy central bank money to a world filled with uncertainty and sorrow due to strong economic headwinds at a time central banks signaling a hiking path unseen in decades.
  • The chances of an outright recession to take place over the coming quarters have risen strongly in the past weeks. Economic data over the summer months will be key, especially with regards to the labor market outlook, because growing demand for rising wages is coming at the worst possible time: if we do witness a further acceleration in wage inflation, central banks will be coerced into further interest rate hikes, adding to the headwinds for the economy.
  • Equity markets, despite a fall of more than 20% in the past 6 months, still appear poised for further losses since longer-term valuations remain unattractive plus the fact that we deem consensus earnings estimates still far too high. A bear market rally could be triggered by the Fed strongly toning down its hawkish message, but also by signals that the labor market is getting softer, thus dampening the markets’ futures interest rate expectations at the short end of the curve.
  • Bond markets remain unattractive, in our view. Although yields (especially in USD) have risen significantly, the further potential losses due to rising credit spreads as well as base rates are not yet compensated by today’s yield level.
  • The USD has risen strongly in 2022 thanks to the Fed’s first mover advantage and the resulting yield difference to other currency areas, weighing on precious metals prices. If we see the Fed reducing its hawkish stance, we expect a strong rebound in gold and other precious metals, likely with new highs to follow.
  • There are a number of reasons the Fed could give as a justification for taking a break in hiking rates (to potentially even cutting, if the economy stutters too much), such as negative payroll figures in early fall or important survey data like the purchasing managers index plunging to new lows.
  • We strongly doubt that the inflationary period will be already over next year, as the underlying causes of the current elevated inflation rates will linger on for some time. These include demographics, de-globalization and increasing supply chain resilience, not to mention too much monetary stimulus for too long a time, which will not have been neutralized by a Federal Funds Rate of somewhere below 4%, but will most likely require more painful levels of interest rates.

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