Market Insights Podcast – 5 September 2022
Muted investor sentiment carried on after the Fed Chair at the Jackson Hole symposium indicated that policymakers were committed to raising rates in order to combat inflation. A trend of “good-news-is-bad-news” trading also weighed on the S&P 500. The U.S. economy has been giving off mixed signals this year, with Gross domestic product (GDP) falling for two straight quarters, while demand for workers outstrips supply. Fed Chair Jerome Powell has repeatedly called the labor market unusually strong in recent months, while his comments at Jackson Hole sent markets into a tailspin.
Non-farm payrolls in the U.S. increased by 315,000 in August, with an unemployment rate of 3.7%, a labor force participation rate of 62.4%, and an average hourly wage of 5.2% compared with the same period last year. These data exceeded expectations for the fifth time this year, but fell sharply from the previous month. Combined with the higher-than-expected rise in unemployment and labour force participation, there are signs of cooling in the U.S. labor market this month. However, the gap between supply and demand of labour is still at an all-time high, which are still some ways from achieving the Fed’s goal. Considering that the average hourly wage is still high at 5.2% year-over-year (yoy) , the upward pressure on inflation caused by employment has not been eliminated, and core Consumer Price Index (CPI) is expected to stay high in August.
The equity markets are trying to second guess the depth of the slowdown but also the degree of tightening in financial conditions that is warranted to choke inflation. While the U.S. economy has hit its output gap with overheating concerns as its top priority, the rest of the world is fighting stagflation (U.K. & Europe) and deflation (China). We expect a profit recession and not a credit / balance sheet one. The curve inversion may be prolonged causing the S&P 500 to consolidate.
Powell quelled loose expectations that the Fed would suspend tightening and cut interest rates next year. The result is that the market needs to correct too many loose expectations, especially high-value growth stocks, led the decline. Cleveland Fed chairman Loretta Mester said that she supported raising the federal funds rate to more than 4% from the current 2.25% and mentioned that she did not expect to cut rates next year.
For now, traders think the Fed raising interest rates to a 15-year high of 4%. Of course, this is not the most important thing, the most important thing is how long will such a high interest rate last? According to some economists, it is about two years. The 4% federal funds rate by the end of the year will hurt asset markets for some time until inflation comes down and returns to normal. The problem now is that no one knows for sure how long it will take for inflation to return to the Fed’s 2% target. Inflation will remain high because of “unprecedented growth” in the money supply and that the U.S. is heading for a deeper recession next year, although not necessarily because of higher interest rates.
U.S. stocks may have a difficult journey before the next The Federal Open Market Committee (FOMC) meeting. What really worries the market now is not the scale of the Fed’s interest rate hike at its next meeting. It is exactly when the Fed will stop raising interest rates and how long they will last. We don’t think that the central bank is ready to turn. We suspect that the central bank will remain a headwind in the market for some time to come. The goal for this year is to be stable and strive for progress in the midst of stability. More emphasis should be placed on the quality of economic growth rather than the speed of economic growth. U.S. inflation may get out of control, former Fed governor predicts that interest rates will not be cut before 2024.
The FOMC meeting scheduled for Sept 20 and 21 will likely drive market volatility during the month, prompting the S&P 500 to fall near its June lows. Ahead of that will be critical economic data, such as a reading on consumer prices that will give investors more insight into whether inflation has peaked. The strong rally since June, however, suggests that the index will continue to rebound through December. While we might end up retesting the June low, history says that we might not set a new low within this year. While fund managers as a whole remain bearish, the ratio of bulls to bears has improved since July, reducing the likelihood of outsized gains in the months ahead. At the same time, the use of leverage by hedge funds, a proxy for their willingness to take risk, has stabilized since June and is now near the lowest level since March 2020.
Investors may continue to rotate out of cyclical, value-oriented stocks that benefit from rising inflation and into technology and other growth stocks that can take market share despite an economic slowdown as the Fed continues to emphasize that it will maintain rates until they see signs of the labor market cooling.
As the fallout from Jackson Hole continues to ripple through markets, investors have their eyes on more drama stemming from the central bank. The Federal Reserve this week is set to raise the throttle of its quantitative tightening (QT) program by picking up the pace at which it unwinds its balance sheet. The move is a stark reversal of pandemic-era bond buying, which saw the central bank nearly double its balance sheet to nearly USD 9 trillion from USD 4.2 trillion over the past two years.
Unlike the large rate hikes being broadcast by the Fed, which have been quick to capture investor attention. QT is a more opaque way of tightening financial conditions. Note that the central bank is not selling its Treasury holdings outright, but is rather letting them mature to shrink its balance sheet. After an initial few months at a slower pace, monthly caps for offloading Treasuries and mortgage-backed securities are set to double to USD 60 billion and USD 35 billion, respectively, compared to the peak combined rate of USD 50 billion the last time that the Fed trimmed its balance sheet in 2017 to 2019.
The whole thing is somewhat of a complicated accounting process, involving settlement windows and redemption caps, but at a basic level, it ultimately reduces the supply of bank reserves and drains money from the financial system. Some safety valves have been implemented this time around, like the Standing Repo Facility, after chaos in the repo market prompted an early end to the last QT program in 2019. The new facility will allow primary dealers to borrow more reserves from the Fed against high-quality collateral, but some caution it might not be enough to stave off liquidity issues, and could complicate Chair Powell’s plan to raise rates and bring inflation under control.
In the end, investors need to be alert if QE mattered, so will QT? It might not be totally symmetrical, but there will be a meaningful impact to the market
The world’s largest oil producer stepped up imports of Russian oil in the second quarter despite sanctions aimed at choking Moscow’s energy flows. The increased willingness to grow its reliance on Russian oil is at odds with global powers which are trying to condemn the Kremlin and cut off its exports in response to its invasion of Ukraine in February. President Biden’s trip to Saudi Arabia isn’t likely to yield a deal on oil, further straining price pressures in the U.S.. The imports also allow the Kingdom to free up their own oil exports to reap in profits from the record-high prices on the international market. Saudi Arabia’s game is simple: its recent warning that OPEC+ could cut production sparked a rally in oil prices, as threats to the kingdom’s revenue loom.
On the other hand, India cut its purchases of Russian crude for the first time in 5 months and switched to Saudi Arabia’s cheaper oil. Its purchases of Russian oil dropped about 7.3% but increased its imports of Saudi crude by 25.6%. Appetite for Russian crude appears to be waning as robust demand and tight supply push up prices.
The fundamental reason for the strengthening exchange rate of the U.S. dollar since the beginning of this year is that the U.S. economy has remained relatively resilient in the energy crisis. On the one hand, the U.S. economy is far less dependent on energy than most developed economies such as Europe and Japan; on the other hand, the U.S. economy is still resilient and the Federal Reserve has more strength to tighten.
In the short term, unless there is a substantial easing in the international “energy crisis”, the dollar index may not have “peaked” given the rising energy demand in winter, the impending recession in Europe, and the fragility and tension of non-U.S. financial markets. In the medium term, the “energy crisis” will eventually threaten the outlook of the U.S. economy, and the realization of the risk of a U.S. recession may be the day when the dollar index reaches its peak.
China’s State Council said it will increase domestic stimulus efforts by RMB 1 trillion (USD 146 billion) through 19 policies, making that move as the world’s second-largest economy fights its slowest growth in decades. China’s latest interest rate cuts have further widened the policy gap between Beijing’s approach and that of the U.S. Federal Reserve, which may further challenge efforts to stabilise the Chinese economy. A managed Chinese depreciation is underway as U.S. nominal rates rise to combat inflation while The People’s Bank of China (PBOC) is cutting as it realizes the economy is facing deflation.
In terms of corporate news flows, Tencent proposed a soft target of reducing RMB 100 billion (USD 14.5 billion) in investment in shares of listed companies this year. As part of a major strategic shift, depending on market conditions and internal profit targets. Tencent’s stock portfolio of listed companies amounts to USD 88 billion. Hang Seng Technology Index plunged again on back of this large overhang news.
It seems that no serious economist thinks that Chinese economy will get anywhere near this year’s 5.5% growth target. In fact, the 0.4% expansion that China eked out in the Q2 2022 suggests that it will be lucky to get even halfway there. For Chinese economy’s abrupt downshift, the biggest and most immediate headwind is the massive “zero Covid” lockdowns, which is still ongoing across the country. The policy is wildly out of sync with global efforts to adjust to more transmissible, but less deadly, coronavirus strains.
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