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Of the three big negative factors impacting the bond and equity markets this year (Gas, China Covid and the “Fed”) the news flow from two of them deteriorated in August.
During the month there was a deliberate reduction in the supply of gas to Europe. This forced up market electricity prices which, unless there is significant government action, will tip economies on this side of the Atlantic into recession.
In the US, despite inflation seeming to peak and general commodity prices rolling over, the Fed disappointed markets by becoming even more aggressive with its inflation beating rhetoric. Markets had started to believe that US inflation (the key number for global equity markets) had peaked and thus US interest rates would start to fall in the second half of 2023, just in time to stimulate the usual pre Presidential Election boom.
However, at its annual Jackson Hole symposium the Fed appeared to “double down” on its negative guidance, rather than easing it as was widely expected.
We had previously identified in earlier Newsletters that a big risk to markets was the Fed “going too far” and thus precipitating a recession.
The fear is now, with this guidance, that is exactly what they will do. Also, it is just possible that is what they want?
Whilst the Fed Chairman Jay Powell was appointment by the then President Donald Trump he did receive severe criticism from the White House. Thus, to avoid being seen as politically biased in any way, getting the pain out of the way early and quickly and then get interest rates moving down ahead of the election, might well be part of the motivation behind this market surprising move.
Is a US recession, previously priced at 50:50, now inevitable?
US Recession Watch: US Leading Indicators
The US Conference Board publishes various indices designed to signal peaks and troughs in the business cycle for major economies around the world. The US Leading indicator, as shown in the first chart, is historically pretty accurate at predicting a recession.
Worryingly, this indicator (blue line) is rolling over. When it crosses the Coincident Index a recession is usually inevitable. The second chart shows the percentage move (rate of change) in the Leading Economic Indicator. The last reading showed a sharp move lower which brought the indicator down to a critical level.
It needs to hold here otherwise a recession signal will be triggered.
What these indicators can’t predict is how deep the recession will be or its length.
Also, as these are based on real time data they cannot be easily translated into stock market moves.
Share prices have already priced in a recession, the real question is, have they priced in the recovery too early? The correct answer for now is no-one knows. Many markets commentators (most of whom missed out the recent rally) are suggesting that as the Fed is appearing to be more aggressive than was previously thought and thus priced-in, then equity prices need to be reset to take account of the new information.
However, if we simply go back to the three key market drivers, the picture is not quite so clear cut:-
1. Rate of change and direction of US Inflation.
The latest data (still very early days) suggests that US inflation has peaked and may be rolling over. This would be a major positive for both bond and equity markets. At present there is not enough data points to be truly confident that this is the case, but it won’t take much.
2. Rate of change and direction of US Interest Rates.
This driver is presently tricky to assess with any accuracy. The Fed is suggesting that US official interest rates have to go higher than previously thought and stay there for longer.
But the market rates, as represented by US Treasury yields, have remained stable with the 10 year Treasury Bond yielding between 2.8% and 3.2%. Is the market suggesting this is just the central bank “talking tough” and will not follow through with its threats? Perversely, if the Fed does go too far with raising the official Prime Rate the market rates will go down!
Why?
They will assume a recession is inevitable and look for an early cut. However, if the inflation data comes in better than expected, then the Fed will back off and the current negative rate of change and direction of interest rates will reverse and become a positive.
3. Rate of change and direction of Corporate Earnings.
Classically, high inflation means high interest rates and thus a collapse in company profits. That certainly has been true in the past but maybe not this time? The reason is two of the biggest market sectors Banks and Energy (Oil) have made no money for the past 10 years, they are now finally doing so.
Plus, the widely forecast collapse of the dominant tech sector earnings simply hasn’t happened and doesn’t look like it will do so either. So far this remains a market positive especially as valuations have moved from “expensive” to “cheap”.
UK/European Natural Gas Prices (Source: Trading Economics and Charles Schwab)
There is a major energy crisis underway in Europe and the UK which could tip both areas into recession. This is a direct consequence of the war in Ukraine and UK/European military support to the defenders.
We are currently in the period where the Europeans fill gas storage ahead of the winter, Russia initially sought to disrupt this process by reducing supply by 80% and has since shut the main pipeline due to “technical issues”.
Gas prices have therefore shot up as power station buyers and industries have paid up in order to secure supplies.
For the UK we have to pay the same otherwise our own supplies would simply divert to those paying the most. This interestingly came just as Germany and the rest of Europe announced they are very close to the 85% storage target.
Analysis from Goldman Sachs suggests that Germany would have easily coped with Russian supplies at the 20% level as long as they have a “normal” Winter. They could now run out by spring, that’s if Russian gas is totally cut off and a bad winter.
Markets
As we enter the traditionally difficult autumn season for markets, the Fed is living up to our worst fears and being particularly “hawkish”.
Our view is that they want to press ahead with getting US rates to above normal, maybe as high as 4%, as soon as possible.
Why? Firstly, inflation looks as if it is already starting to come down and they will thus soon lose their excuse to do so.
Secondly, they want to engineer a boom in time for the US election, not because they want influence the result but simply to avoid what could be quite aggressive criticism, especially from the Republicans. They have a window to do this, but it will close rapidly. The Fed has now gone from a supporter of the markets since 2009 to post Jackson Hole, a temporary headwind.
The key word is though temporary, markets do work 12 to 18 months ahead of the actual economy, the election is coming and so is a boom, it is just a question of being patient.
In Europe and the UK it is all about gas and electricity prices. The EU and the UK need to work in concert, there is effectively still a single wholesale market for power. The EU apparently will announce structural changes this month. In the UK we now have a new Prime Minister in place with the outline of an energy plan already presented. This appears to be no too dissimilar to the bank bailout of 2009.
Crucially, this might bring headline inflation down to a far more reasonable 4 to 5%.
Also, the Ukrainian counter-offensive has started, how this fairs will have big implications for gas supplies. As summer ends and autumn begins this already complex period looks to become even more so.
September 2022
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This information is not intended to be personal financial advice and is for general information only. Past performance is not a reliable indicator of future results.
