The liquidity tide of ultra-low interest rates and asset buying (aka quantitative easing) reached its peak for this cycle a short while ago and has started to turn as western central banks begin to react to the rising inflation data. This is important as ultra-low interest rates encouraged investors to re-allocate cash (which has been making negative returns when adjusted for inflation) to riskier assets such as corporate bonds and equities in order to generate acceptable returns. Central banks further encouraged this dynamic by conjuring huge amounts of money out of thin air and buying assets which they then held on their balance sheets.
Despite the economic shock of the Russian invasion of Ukraine, central banks are continuing to flag a likely acceleration in the rate of interest rates rises as inflationary pressures continue to exceed expectations. After adjusting for inflation expectations, interest rates remain negative which central banks judge to be too low given strong labour markets.
It is uncomfortable that these dynamics are revealing themselves at a time when equity prices remain elevated. At the end of April 2022, the MSCI World Net Total Return Index was just 7.1% below its highest ever level which was recorded earlier this year (4 January), in Sterling terms. The index has returned more than 62.4% over the past five years which means investors are sitting on a lot of profit which they may start to book given a challenged outlook for earnings.
Companies are facing a triple whammy of potential slowing of demand, higher input costs and higher refinancing costs.
The Office for Budget Responsibility (OBR) has stated that it believes UK real household income will see the sharpest contraction since records began in the 1950s. This dynamic is not confined to the UK.
The events in Ukraine are amplifying these trends as global energy and food prices respond to the risks of reduced supply. Volatility in commodity prices and uncertain supply chains leads to companies holding more stock, which is a drag on cash generation.
The globalisation theme of the past two decades, which helped economic growth decouple from inflation is under threat as supply chain security and near shoring become strategic imperatives for company management teams as well as politicians. President Biden has recently said that the US needs to end their long term reliance on China and other countries for ‘inputs that will power the future’.
In the past, Chinese policy makers have come to the rescue when global economic growth was threatened and, indeed, we expect further measures will be announced to stimulate domestic economic growth. However, the outsized Chinese property sector continues to struggle under an unsustainable weight of debt which will take time to work out. This will hinder the transmission of falling interest rates to the real economy. The recent Covid related strict lockdowns in mainland China have had tangible negative impacts on the economy. China needs to escape from its ‘zero covid’ policy but in doing so opens their economy up to further disruption.
Our concern is that inflation shocks are often followed by negative interest rate surprises which can lead to recessions and elevated risks to asset prices. Some investors point to strong labour markets as proof positive that all will be fine, however we view labour market health to be a lagging, not a leading, indicator. We place more emphasis on negative real wage growth which has, in the past, led recessions.
As a result of all of the above, global GDP growth forecasts are beginning to be revised down and earnings downgrades may well follow. Equity markets do often make headway as earnings forecasts are revised down, so negative earnings revisions in themselves do not indicate the future direction of the market. More problematic this time round is that bond yields are rising at the same time and central bank asset purchase programs are coming to an end.
Perversely, a reason not to be too fearful about the future direction of markets is that a recession narrative is likely to build over the coming months and inflation is likely to peak and start coming down (given base effects). As a result, current elevated interest rate expectations are likely to fall. This means that central banks may well capitulate earlier in the interest rate cycle than expected. In other words, the rising interest rate cycle in the west may be considerably shorter than many fear and if this came about it would be a positive surprise.
Market Outlook – June 22
15 Jun 2022