Market Insights Podcast – 8 August 2022
As the forward guidance cannot keep up with the changes in inflation data, the Fed has revised its expectations of raising interest rates several times this year. The European Central Bank (ECB) did so last week, when ECB President Christine Lagarde officially suspended the release of forward guidance on interest rates, and the future monetary policy path will be decided month by month “depending on data”. Reducing forward guidance and keeping interest rate policy ambiguous will give Fed officials more flexibility in their future actions.
Inflation in the U.S. is not necessarily due to a tight labour market, but tight employment makes it harder to get out of the inflationary dilemma. Non-farm payrolls remain strong in July, rose by 528,000, way above market forecast 250,000. The average hourly wage increased by 0.5% month-on-month, up 5.2% from a year earlier. The unemployment rate fell to 3.5%, the lowest since 1969. Nevertheless, in financial markets, good news is bad news, and everything goes back to the question of how the Fed intends to fight inflation. The performance of the job market frightened traders, who instinctively realized that the data would encourage the Fed to raise interest rates further, and the yield on the two-year Treasury note surged 20 basis points on the day and seemed to be returning to its June high. Fed Chairman Powell is likely to see the latest report as a green light for further interest rate hikes, including a 75 basis point hike at the September meeting.
Non-farm payrolls “really messed up the market’s narrative of the Fed’s turning point” and was very unfriendly to financial markets. This development seems to marks the end of the recent bear market rally in the U.S. stocks. One of the main drivers of the rally in U.S. stocks has been investors’ hope that the Fed will not be so aggressive in the future, which has pushed growth and technology stocks higher.
So how much pain does the job market have to suffer to keep inflation under control? No one wants to see people lose their jobs, but Fed governors who have a vote on monetary policy seem to admit that curbing inflation requires some sacrifices in terms of unemployment. All participants in the fed’s bitmap predict that the unemployment rate will reach at least 3.9% by the end of 2024, with a median of 4.1%, and these forecasts are likely to be raised in September. The Fed’s interest rate policy is a brutal tool to fight inflation. Higher interest rates make it harder to get money, while plummeting asset prices make people to feel poor. Powell, does not admit this, but he knows it. In any case, the non-farm payrolls report will only encourage the Fed to work harder.
The junk bond market signals that the United States will avoid recession. High-yield bonds rose 5.9% in July, the biggest monthly increase in a decade, and have been rising in August. The risk premium on bonds is at a level that has nothing to do with recessions. Stocks, junk bonds and other risk markets rebounded in the second half of July as investors increasingly hoped that signs of slower growth would translate into a loosening of the Fed’s plan to tighten the money supply. Long-term Treasury yields are in many cases lower than short-term yields, a situation known as upside down, which, if sustained, could herald an impending recession. Commodity prices have also generally fallen this month.
Companies with poor credit ratings are now facing serious challenges. CCC-rated bonds, the lowest-rated companies, rose 4.95% in July, while BB securities, the highest level of high yield, rose 6.1% on the basis of total returns. The recent squeeze in spreads is largely due to energy debt, which has outperformed the broader high-yield market this year as oil prices rise. This could reduce expected default rates in the wider market, which in turn makes investors to be more optimistic about widespread purchases of high-yield bonds.
There was some good news on non-core inflation, superimposed by falling gasoline costs and signs of an economic slowdown, and market was concerned that a slowdown in headline inflation in the upcoming data would prompt the Fed to conclude that its policies were working. Yet in fact, more needed to be done. Now is not the time for the Fed to change its monetary policy. The danger is that we might have a situation like that in the 1970s, in which the Fed did not do enough to curb inflation to make it permanent. Excluding commodities such as food and energy, the core inflation rate is around 5% by all reasonable measures, which is more than when Nixon imposed price controls.
Noted that the former Treasury secretary Lawrence Summers reiterated his criticism of Federal Reserve Chairman Powell last month that the Fed had reached a “neutral” state of neither stimulating nor curbing inflation with the latest rate hike. He stressed that if the Fed doesn’t raise real interest rates significantly, then just creating conditions for stagflation.
The most debatable question is whether the bond and equity markets have fully priced in the worst of the rout in growth and the policy tightening required to curb the inflation. The balance of probabilities suggests that there is more downside to growth assumptions but the rate of inflation is set to decelerate. Earnings estimates are still to be cut, but the bond rally has put a floor on valuations, at least temporarily.
Powell just took a fairly aggressive calculated risk with his credibility and if inflation breakevens or the inflation expectation surveys data start to jump, we will quickly see a change in Powell’s tone. For now, though, with two consecutive quarters of negative growth in place and a dovish dumping of forward guidance, the 2022 bear market in stocks could finally be coming to an end. When the S&P 500 closed at an 18-month low of 3,666 points, as a likely stock market bottom. It’s never easy to pick a bottom in the stock markets. With some investors starting to believe that inflation has peaked and since mid of June, we’ve seen commodity prices coming down and we’ve seen a slowing in the economy, which will help to moderate inflation. Better-than-expected earnings in the second quarter are one cause for the market’s bullishness. We are not expecting the Fed to have to hike interest rates above 3.5%, with quantitative tightening and the dollar’s continuing strength already acting to constrain monetary policy.
It is a tale of two markets: the futures market for oil (controlled by Wall Street) and the physical market, which reflects the real world demand for oil. Both factor in many dynamic inputs, notably whether we’re actually heading into a recession. The price of oil dropped by about USD15 a barrel in a few days in the futures market, thanks to recession worries. That pushed the global benchmark Brent crude oil price below USD90 per barrel for the first time since April. However, in the real world, there is no sign of a slowdown in demand for oil. In fact, it’s quite the opposite.
Market fundamentals have passed peak tightness as headwinds increased from the deteriorating economic backdrop, the bank noted. Signs have emerged that high prices have taken the edge off gasoline and distillate demand, despite robust global air travel on the reopening of international borders, these signs include a 7% year-over-year drop in U.S. gasoline demand and a delay in recovery in China due to its zero-COVID strategy. Persistently, high inflation is expected to keep central banks on a tightening basis, while energy shortages could push some economies into contraction. Still, the risks of supply shortages remain high as European sanctions have yet to be fully implemented and fears of limited spare capacity remain, with the supply of Organization of the Petroleum Exporting Countries plus members (OPEC+) hike only 100,000 barrels a day highlighting this concern.
The International Monetary Fund (IMF) has downgraded to China’s 2022 economic growth to 3.3% and 2023 economic growth to 4.6%.The Gross domestic product (GDP) forecast of IMF came just after the Chinese authorities abandoned their own 5.5% estimate. It is hard to recall a time when economic growth is so poor and employment growth is so weak ahead of a The Central Committee of the Chinese Communist Party (CCPC). The political timetable will inhibit major initiatives suggesting the economy will drift into 2023.
While the IMF’s change in Chinese economic forecasts for this year were related to further lockdowns and the deepening real estate crisis and will have not come as too much of a surprise. Perhaps, more pertinently for investors, there seems to have also been a temporary decline in earnings estimates being cut. In terms of ‘reopening’ passenger and commercial car sales have turned around, and hotel revenue is also gaining traction.
Growth and revisions areas were the best performers in July. The 7-day reverse repo rate closed at 1.3% last week while government bond yields rallied through the month. The Shanghai Shenzhen CSI 300 Index (CSI 300) has struggled under the weight of bad economic news. Short-term financial conditions have moved into “easy” while sentiment indicator is marginally negative.
Venture Smart Asia Limited (“VSAL”) is a company incorporated in Hong Kong and whose registered office is at 23/F, Lee Garden Five, 18 Hysan Avenue, Causeway Bay, Hong Kong, and is a licensed corporation regulated by the Securities and Futures Commission of Hong Kong for types 1 (dealing in securities), 4 (advising on securities) and 9 (asset management) regulated activities pursuant to the Securities and Futures Ordinance. VSAL is a member of Venture Smart Financial Holdings Limited (“VSFG”).
This document is for information only and is not intended to be construed as an invitation or offer of any securities or other investment products or as an invitation or offer to conclude a contract or to buy and sell any securities or other investments products. Any such invitation or offer will only be made by means of a confidential offering memorandum.
All information contained in this document is confidential and intended solely for the information of the person to whom it has been delivered and may not be distributed to any person in any jurisdiction where distribution to such a person would constitute a violation of any applicable law or regulation. Recipients may not reproduce or transmit it, in whole or in part, to third parties.
This document is only intended for professional investors (as defined in the Securities and Futures Ordinance (Cap. 571)) and is not to be distributed to, or relied on, in any circumstances by any person who is not a professional investor. This document and any securities or other investment products referred to in it have not been registered with, authorized, approved or disapproved, by the Securities and Futures Commission or any other authority, whether in Hong Kong or in any other jurisdiction. No authority has passed upon or endorsed upon the merits of any such securities or other investment products or the accuracy or adequacy of this document.
The information contained in this document does not constitute investment advice and has not taken into consideration any person’s investment objectives, legal, financial and tax situation or particular needs in any respect. Investors should seek professional advice as to the suitability of any securities or other investment products mentioned in this document.
Information contained in this document, unless otherwise specified, is obtained from sources which are believed to be reliable but no representation or guarantee is made by us as to the accuracy or completeness of any such information. If this document contains any information relating to the past performance of any securities or other investment products, you should note that past performance is not indicative of future results. If the base currency of any securities or other investment products mentioned in this document does not match your reference currency, the return may be affected by currency fluctuations. Potential for profit is accompanied by possibility of loss. This document may contain certain statements that may be deemed forward-looking statements. While forward-looking statements represent judgments and future expectations concerning any securities or other investment products mentioned in this document, a number of risks, uncertainties and other important factors may cause actual results to substantially differ from such judgments and expectations in a material way. Any market or investment view mentioned in this document is not intended to be investment research. Information contained in this document is subject to change without any obligation on our part to notify you of any change.
If this document forms part of a presentation or is presented to you together with other documents and materials, this document should not be read in isolation and may not provide a full explanation of all of the topics presented and discussed.
Investors should note that investment involves risk. The price of any securities or other investment product may go down as well as up. Investors should read the confidential offering memorandum for details and risk factors affecting the investment. If conflicts exist between this document and the confidential offering memorandum, the confidential offering memorandum shall prevail.
VSFG does not accept any liability whatsoever for any decisions taken based upon the material. No representation or warranty, express or implied, is made with respect to this document or views herein as to its fairness, accuracy or completeness. Neither VSFG nor any of its subsidiaries, affiliates, controlling persons, directors, officers or employees, or advisers shall be in any way liable or responsible, directly or indirectly, whether expressly or by implication, in contract, tort, by statue or otherwise for the contents hereof or any loss howsoever arising. Risks are involved in any investment. It is the investor’s responsibility to independently verify any data relied upon for an investment using qualified legal, financial, and operations advisors. Prior to investing, investors should also carefully consider possible tax consequences and legal requirements.