Market Insights Podcast – 11 July 2022
The Fed’s 75 basis point rate hike in June was a key step in a rapid shift from a very loose monetary policy stance at the beginning of the epidemic. In determining the speed and magnitude of future interest rate increases, the Fed will closely monitor the economic situation and explore the impact of tighter financial conditions on the economy, as well as changes in inflation, inflation expectations and economic prospects. It will rely on data and remain flexibility.
Latest data released by the Labour Department showed that non-farm payrolls rose by 372,000 in June and jobs grew faster than expected, further boosting expectations that the Fed would raise interest rates by 75 basis points in July. Supply in the labour market was “very tight” and the Fed had achieved its target of full employment of 3.6%. Tightening monetary policy, aimed at curbing inflation, will push up unemployment to some extent. Wage growth has slowed, but the Fed’s inflationary pressure has not abated and if CPI (Consumer Price Index) exceeds expectations again in June, the market may reprice the July FOMC rate hike and could reignite volatility in the global capital markets.
The Atlanta Fed’s GDPNow model predicts a 2.1% GDP (Gross Domestic Product) decline in the second quarter. Fears of a sharp slowdown are getting the blame for the stock market’s renewed slide while also driving a retreat in Treasury yields. If the forecast is on track, it would mark the second consecutive fall in GDP after a 1.6% contraction in the first three months of 2022. Stocks have taken no comfort from the recent decline in yields because they see the same issue portrayed in the GDP, a U.S. economy is rapidly cooling.
The three central bank governors of the U.S., Europe and the U.K. all said that inflation was the top priority at this stage and did not rule out a bigger increase in interest rates in the summer. Powell pointed out that there was a risk that higher interest rates would lead to a sharp slowdown in the economy. The greater risk is high inflation persists and the process of reducing inflation is likely to produce “some pain”, admitting that a soft landing in recent months is more challenging and cannot guarantee success. At present, financial conditions have tightened sharply and market conditions in the stock market, the dollar and corporate credit are tightening, unlike in the past interest rate hike cycle. While slowing demand may be good news for the Fed, which has raised interest rates aggressively to curb the highest inflation in decades, fears of a recession continue to rise.
Recently, bond yields have shown a downward trend, which may reflect investors’ bets that inflation will peak in the second half of the year, while the Fed’s hawkish stance is likely to weaken. The S&P 500 performed the worst in more than 50 years in the first half of this year as investors worried that the Fed’s tough attitude and soaring inflation would exacerbate the economic contraction. However, any sign of slowing down in interest rates hike or even rate cut should be interpreted as concerns about economic growth, rather than a possible Fed easing. If the macro data doesn’t point to a recession, stocks could rise further, but if the economy does shrink, the S&P 500 could be down even more than it is now.
The stock market is likely to be driven by second-quarter results from now on as interest rates and equity risk premiums begin to reflect slowing economic growth more accurately. At the same time, earnings for the S&P 500 and Nasdaq 100 are expected to be more than 20% higher than the normal trend in the wake of the global financial crisis, suggesting that earnings expectations will be lowered in the coming months. Unless earnings expectations fall to a more reasonable level or valuations reflect this risk, the bear market is not over. In addition, defensive industries such as telecoms, utilities, insurance, real estate, some essential consumer goods and healthcare look more advantageous in assessing risks. The technology hardware and semiconductor industries face greater risks.
Just as earnings momentum fades and growth disappointments loom, the market has begun to test the solvency and balance sheet health of companies. This is intuitive – as credit spreads widen and inflation expectations roll over, the risk of over-tightening also grows. Financial conditions have squeezed on a par with the March 2020 pandemic. Treasuries are beginning to rally. Investors could have these option to get defensive in the volatile market due to the uncertainty ahead: 1) Hold large proportion of cash; 2) Switch from individual technology holdings into related Index ETFs; 3)Switch technology ETFs into defensive ETFs such as Healthcare (XLF), Insurance (KIE), Consumer Staple (XLP).
We believe that the “technology bubble” had not yet burst and there were two certainties in an uncertain world: profit growth would continue to slow and liquidity would continue to tighten. Starting investing in no earnings and low quality technology stocks at the moment is still very risky despite they were correcting largely from their peak.
However, from short term trading perspective, the total short selling rose by only USD20 billion in June, the lowest monthly increase in 2022, down from a USD61 billion increase in May. It seems that short sellers withdraw their bets on stocks, a slowdown in bears could be a sign that investors see the stock market near its short-term lows and are bracing for a market rally.
Despite a rebound in U.S. stocks last week, the S&P 500 fell nearly 14% in the second quarter and is still likely to record its worst quarterly performance since the COVID-19 outbreak in the first quarter of 2020. Investors are still looking for the bottom of the market and hope that last week’s rally will continue, but there seems to be no obvious catalyst for a meaningful rebound. One of the thornier issues now is to assess the difference between a bear market rally and the start of a more lasting rally. The current rebound is ostensibly impressive, but there is still no obvious fundamental improvement. Question of when the market hits bottom, when there is an inflection point, this does not necessarily happen immediately. If the stock market is to maintain its upward momentum in the second half of the year, we need to see inflation peak and data stabilise.
Oil prices have fluctuated sharply last week and while there are still signs of tight supply in the market, West Texas Intermediate (WTI) crude fell more than 10% last week and rebounded on Thursday as investors worried that a potential global economic slowdown would dampen energy demand. Over the past month, there has been growing concern that the coming recession will erode consumption, driving down crude oil futures prices. As for the recent sell-off, there was not much rational assessment and that it was a panic sell-off. Economic worries may not end, but they are likely to abate when supply tensions re-emerge.
The crude oil market remains tight. The physical market is still strong. OPEC + (Organization of the Petroleum Exporting Countries) has pushed production close to its limit and only Saudi Arabia and the United Arab Emirates can increase production further. At the same time, China’s oil demand is rapidly recovering from the April-May blockade. The sale of large amounts of crude oil from its strategic oil reserves by the United States does help to ease the supply crunch. After all, its release of about 1 million barrels a day exceeds the production of some OPEC countries. Yet, such releases will either end in October or be scaled down. One detail of last Tuesday’s plunge in oil prices, the main reason why oil prices have tumbled so much in a single day last week is that oil market futures are very illiquid and are vulnerable to the unwinding of positions or the sale of forward contracts. Such liquidations and sales took place last week.
Some analysts think that talks of a recession in the oil market has been exaggerated, the global economy is not slowing enough to trigger a collapse in crude oil prices. Under these bearish conditions, it makes sense for oil prices to fall, but the slowdown must be more severe to keep Brent crude below USD80 to USD90 a barrel, let alone the USD65 forecast by some banks as an extreme scenario. We believe that crude oil performed very well in the first half of the year, so many investors chose to cash out at the beginning of the second half of the year and use the profits from crude oil investments to make up for losses in the stock and bond markets.
U.S. weighs capping Russian oil at USD40 to USD60 to cut war financing. Biden administration officials are having multiple meetings each week on a price cap, an effort that will intensify in the coming weeks. The U.S. reportedly is concerned that the European ban as is, which begins to come into force at the end of the year, could contribute to oil prices spiking even further and potentially leading to a global recession. J.P. Morgan warned recently that crude prices could skyrocket to as high as USD380 a barrel if Russia retaliates to price caps by imposing deep cuts in oil production. That is another extreme anticipated scenario. J.P. Morgan is taking a more realistic base case scenario – sees Brent crude averaging USD90 a barrel under mild recession, USD78 a barrel under more severe downturn.
The first half of 2022 is shaping up to be a very bi-polar world: inflation pervading the Western economies while China has been desperately fighting a deflation battle as the household savings rate has surged. The Western yield curves are by and largely flat while China’s has steepened. But it is the divergence in monetary conditions that is making the most difference. After the first half of 2022, in which real money supply had collapsed into negative territory in China, the latest data shows that the mainland’s has now returned to the black. In contrast, the U.S. is experiencing a more painful period of contracting money supply. The two major economies and equity markets are parting company. The U.S. needs to raise rates to cool the economy. Meanwhile, China needs to ease policy. The respective credit spreads are also diverging suggesting different levels of risk appetite.
The Chinese authorities have ramped up their stimulus and both money supply and lending data have improved dramatically since April. The negative factors of corporate profits, supply disruptions and outbreaks might have passed in the second quarter. Valuations are relatively attractive and China’s policy tends to be loose at a time when global monetary policy is tightening. While the risk of the epidemic still raises concerns, re-opening up and policy support could provide more catalysts for the Chinese market. In contrast, the rest of the world has not experienced the slew of downgrades that would have been expected. China could probably provide a “safe haven” for global stock markets.
China’s move last week to set up a RMB reserve pool with four neighboring countries and Chile at the Bank for International Settlements is seen as a latest step towards erecting a system that helps reduce the U.S. dollar’s global dominance. Beijing is eager for the Renminbi to play a bigger role in the Asia-Pacific because of concern about the U.S. dollar hegemony, as well as impacts from U.S. rate hikes to tame high inflation.
Banking authorities in China signed an agreement with the Bank for International Settlements (BIS) to set up a liquidity arrangement for the Chinese currency (Renminbi) to support to other central banks during times of market fluctuations. The People’s Bank of China (PBOC) said that the first five participants in the new set-up would include Bank Indonesia, the Central Bank of Malaysia, the Hong Kong Monetary Authority, the Monetary Authority of Singapore and the Central Bank of Chile. Each participant will contribute a minimum of RMB15 billion (USD2.2 billion) or the U.S. dollar equivalent. The BIS said in a separate statement that the funds could be contributed either in RMB or U.S. dollars and that they would be placed with the BIS, creating a reserve pool. The People’s Bank of China said that the renminbi liquidity arrangement would help to meet reasonable global demand for the RMB and contribute to regional financial security.
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