Market Insights Podcast – 3 October 2022
We warned previously that this September would be an extremely challenging month for the capital markets. In fact, the U.S. stock market really suffered its worst September since 2002 and has fallen for three consecutive quarters. In September, the Dow fell 8.8%, the S&P 500 fell 9.3%, and the Nasdaq fell 10.5%. S&P has fallen 25% so far this year, the third-largest drop in history (since 1931). The market capitalization of the S&P 500 has lost about USD10 trillion from its record high in January.
U.S. economic data are mixed: the Fed’s most important indicator of inflation, the core PCE price index, accelerated upward. Excluding food and energy prices, the core PCE index rose 4.9% year-on-year in August, higher than the expected 4.7%, compared with 4.6%, the fastest pace since May. This strengthening investors’ expectations that the Fed would maintain aggressive interest rate hikes, while personal consumer spending rebounded in August, growing unexpectedly faster than expected, thanks in part to falling gasoline prices, showing some resilience in a high inflation environment. After the data released, Fed officials stressed that they would continue to raise interest rates and keep restrictive interest rates for longer, and the market reaction to the economic pain caused by the rate hike still prevailed.
U.S. Stock indexes tumbled, the dollar soared and Treasury yields hit their highest level in more than a decade after investors were hit by new signs of a global economic slowdown and Britain’s plans for massive tax cuts through borrowing. The current losses could accelerate the sell-off by forcing funds to sell more assets to raise cash. The downward spiral on Wall Street, which is snowballing, will lead to forced liquidation of assets.
After raising interest rates by 75 basis points for the third time as scheduled, the bitmap released by the Federal Reserve shows that most officials expect to raise interest rates by another 125 basis points by the end of this year, putting on the table the possibility of raising interest rates by another 75 basis points in November. Around one-third of officials expect rates to stay above 4%. The median interest rate forecast for Fed officials shows that interest rates are expected to be 4.6% next year. The Fed once again sharply lowered its forecast for economic growth this year by more than 1% to 0.2%, and continued to raise its unemployment forecast for the next three years to 4.4% on average.
This round of interest rate hikes will be harder, shorter and more destructive. This will lead to greater downside risks to the market in the future and is expected to fluctuate further. Given the hawkish stance of the Federal Reserve, the likelihood of a recession in the United States in 2023 is increasing. While it is widely believed that earnings expectations are too high given such a large recession risk, the market is unlikely to see through the decline in earnings because valuations are usually compressed too.
Apart from the fact that the federal funds rate was higher than the yield on two-year Treasuries in the 1980s, historically, the yield on two-year Treasuries has peaked above the federal funds rate-an average of about 80 basis points higher. What’s more interesting is that yields on two-year Treasuries usually peak either before the federal funds rate or almost at the same time.
Therefore, a peak in U.S. two-year Treasury yields would be a key sign of a hawkish policy peak and some relief from pressure on various assets. Although we do not think we are close to such a turning point, an analysis of past events can provide a useful reference for a better understanding of the types of cross-portfolio models that investors can expect in the final stages of the Fed’s rate-raising cycle.
As the rate-raising cycle draws to a close, markets are often spooked by the risk of the Fed tightening policy “too aggressively”, eventually triggering a vicious circle between tighter financial conditions and weak economic growth. This is especially true at a time when inflation remains high. The peak of hawkish policy also usually brings about a volatility adjustment in the stock and bond markets. Before the two-year Treasury yield peaked, the dollar tended to be strong, which was consistent with expectations that the dollar would strengthen further in the future, but then the dollar generally weakened and fluctuated more.
The U.S. stock market can hardly bottom out before the “strong dollar” cools down. According to Morgan Stanley research report, every 1% rise in the dollar index had a negative 0.5% impact on S&P 500’s earnings. The recent trend of the dollar has created an unsustainable situation for risky assets, which, historically, ended in the U.S. financial or economic crisis. Although risk events are difficult to predict, the conditions for such an event are in place and will help speed up the end of the current bear market in U.S. stocks.
Investors dumped sterling and gilts to cast a vote of no confidence in the plans of the new prime minister, Liz Truss, after the UK government announced economic growth plans that included big tax cuts. The plunge in sterling shows that investors are worried about Britain’s ability to manage so much extra debt, especially as rising interest rates lead to a sharp rise in borrowing costs. the deterioration in public finances will hurt the long-term growth prospects of the UK economy.
The UK government’s response to this situation is to borrow, which will further strain UK revenue and increase government spending as a result of energy subsidies. What worries the market even more is that the Bank of England is dealing with high inflation by continuously raising interest rates. Borrowing will lead to a rise in the cost of government debt, tax cuts and tax breaks for the rich, inflationary pressures will intensify and interest rates will have to rise further. The market fears that this will make the British economy irreparable. Without sufficient funds, there is little “catalyst” to boost sterling, and even if the central bank adopts more aggressive policies, it may be difficult to reverse the decline.
Apart from the dollar, few assets are traded constructively and the market is very pessimistic. Most investors choose to wait and see.
The bond market and the UK crisis are the most serious problems right now, and it will be hard for U.S. stocks to calm down until they are resolved. The Fed will have to strike a balance between its inflation control target and the risk of unintended consequences that disrupt bond market flows. In fact, the yield on 10-year Treasuries has risen 50 basis points, hitting 4.0%, the highest level since 2008. These figures highlight the current sharp tightening of the credit environment in the U.S. and will put additional pressure on companies.
The rise in U.S. Treasury yields basically coincided with the collapse of UK assets. Yields on 10-year gilts have widened by 130 basis points since last Thursday. The UK’s apparent market failure reached a certain extent, and the Bank of England was forced to announce emergency policy action and buy longer-dated gilts without restrictions in order to stabilize the market. The Bank of England is not the direct catalyst behind the market turmoil, but the tax cuts introduced by the new British government. But if central banks such as the Fed and the Bank of England had not made financial conditions so tense before then, the market reaction might not have been so severe. Rising nominal and real interest rates, a stronger dollar as a reserve currency, slowing credit flows and rising volatility all contributed to the collapse of UK financial markets. In other words, the crisis in the UK could have been avoided if market credit conditions had been relatively loose.
Worth-noting that Standard & Poor and Moody’s Corporation, two of the world’s top three rating agencies, will re-evaluate the UK government’s credit rating. Credit rating downgrade would put pressure on Britain’s foreign debt and could affect the economic outlook. If fiscal conditions remain tight, Britain’s sovereign credit rating could be downgraded. IMF said in a statement: Given that many countries, including the UK, are facing rising inflationary pressures, we do not recommend large-scale and untargeted fiscal plans at this critical moment. The point is that fiscal policy cannot run counter to monetary policy.
A special meeting of EU energy ministers held in Brussels, Belgium on September 30 reached a political agreement on emergency intervention to lower energy prices, but failed to agree on a cap on natural gas prices. Since the outbreak of the crisis in Ukraine, due to the counter-phagocytosis effect of EU sanctions on Russia, European energy supplies have been tight and natural gas and electricity prices have soared, leading to high overall inflation and putting pressure on the European economy. Euro zone inflation climbed to 10%.
Saudi Arabia expects Brent crude to be about USD76 a barrel in 2023, in line with current forward prices but far more pessimistic than analysts’ expectations. According to the median forecast by Bloomberg analysts. Brent crude will hit USD94.63 a barrel next year. OPEC+, with Saudi Arabia as a key member, is facing increasing calls to curb the decline in oil prices through further production cuts.
The Monetary Policy Committee of the People’s Bank of China held its regular meeting in the third quarter of 2022. The meeting pointed out that we should deepen the market-oriented reform of the exchange rate, enhance the flexibility of the RMB exchange rate, guide enterprises and financial institutions to adhere to the concept of “risk-neutral”, strengthen expectation management, and keep the RMB exchange rate basically stable at a reasonable and balanced level. They aim to build an institutional mechanism for finance to effectively support the real economy, improve the innovation system of financial support, guide financial institutions to increase medium-and long-term loans to the manufacturing industry, and strive to stabilize the supply chain of the industrial chain.
The good news is that the real estate market is embracing credit easing again. The People’s Bank of China and the Banking and Insurance Regulatory Commission jointly issued a circular to decide to adjust the differential housing credit policy in stages, and the city government that meets the requirements may decide to maintain, lower or cancel the interest rate floor of the local first housing loan by the end of 2022.
Affected by multiple factors since the beginning of this year, China’s economic growth has declined to a large extent, but it began to recover gradually in the third quarter. From the performance point of view, the fourth quarter can focus on the performance of consumer stocks. The lower growth rate of consumption in the first three quarters, a lot of consumer demand has been suppressed, and there may be opportunities to resume growth in the fourth quarter. Coupled with the National Day, New Year’s Day, Spring Festival and other seasonal factors, it is often the traditional peak season of consumption, which is expected to boost the fourth-quarter performance of consumer stocks. Industries such as liquor, food and beverage, tourism, and tax exemption, may have the opportunity to rebound in performance in the fourth quarter. On the other hand, some industries with declining earnings growth or weak sustainability of earnings growth should be avoided.
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