Bedrock’s Newsletter for Friday 11th November 2022

Friday 11th November 2022

Risk appetite has roared back with a bang and the Thursday just gone was one of the best 24 hours for financial assets in recent memory. The S&P 500 Index and the NASDAQ Composite Index rose +5.5% and +7.4% respectively, while the MSCI All Country World Index (a broad measure of DM and EM equity markets) was up +4.4%. This was the best day for all three indices since the early days of the pandemic and, after a wobbly prior week, the moves were sufficient to bring nearly all major equity indices back into the green on a MTD basis. Moves in fixed income markets were also dramatic. The US 10Y yield fell 29bps on Thursday to 3.81%, leaving it a full 40bps tighter than the 4.21% reached on Monday, while the US 2Y fell 25bps to 4.33%, the largest daily decline since 2008. Rates also moved lower across the pond and credit spreads narrowed. All of the above conspired to push the Bloomberg Global Aggregate Bond Index (Hedged) to a daily return of +1.3%. This does not seem overly impressive in comparison to equities, but it actually represented the best day for this index (and, by proxy, global bond markets) since 26th December 2000! Beyond both equities and bonds, other major movers included USD – the DXY fell -2.12% in its worst daily performance in 7 years – and gold, which rallied +2.9% to $1,755/oz.
 
The cause of all of this was the release of the October CPI print in the US, which came in at +7.7% YoY. Outside of the last 10 months, this was still the highest annual rate of inflation since the 80s. However, it was 0.2% lower than expectations, a pleasant surprise after an extended period of less pleasant ones. Importantly – and in contrast to last month – the slowdown in headline inflation was accompanied by a slowdown in core inflation (which excludes volatile energy and food prices), which fell to +6.3% YoY (0.2% below consensus) from +6.6% YoY in September. Other closely watched measures of inflation, such as the Cleveland Fed Trimmed Mean CPI (which excludes large outliers) and the Atlanta Fed Sticky CPI (which tracks a basket of goods that change price relatively slowly), also inflected, suggesting that there was actually a fairly broad-based deceleration of price pressures in October. In aggregate, this contributed to the overwhelming sense that, just maybe, inflation has actually peaked and that that we might finally see the beginnings of a long-anticipated Fed pivot. For their part, Fed officials held to a reasonably neutral tone, although the collective takeaway was certainly that there is growing support within the Fed to slow the pace of tightening. Financial market participants appear to have thrown the full weight of their convictions behind this narrative, as highlighted by the huge rally in asset prices. We have also seen expectations for a 5th consecutive 75bp hike in December diminish almost completely, with a 50bp hike now fully priced into treasury futures, while the terminal rate for next year has fallen back below 5%.
 
Nonetheless, we would advise caution to those feeling too optimistic at this point. This is certainly not the first time that hopes of a Fed pivot have precipitated a rally this year – we seem to have had this happen in some capacity every couple of months – yet each of the previous rallies has proved short-lived. Could this be the same? We think it is reasonable to assume that we are now past peak inflation and commentary from Fed officials does imply that they are more amenable to (relatively) easier monetary policy than they have been for some time. However, the Fed needs to rebuild credibility after a period of excessively loose monetary conditions and members have repeatedly stressed that the risks of easing policy too soon are greater than the risks of overtightening. While slowing, inflation remains well above the Fed’s long-term target. Moreover, the Fed has often referred to the tight labour market as one of the key drivers of inflationary pressures. As of now, there are few signs of weakness there. Labour shortages are still a very real issue across industries and wage growth continues to come through. October non-farm payrolls (a measure of the number of jobs added to the US economy across several industries) came in at 261,000, well above expectations of c.200k. While this was the lowest reading since December 2020, it pointed to strong labour demand. In a similar vein, the unemployment rate for October came in at 3.7%, creeping up from 3.5% in September but refusing to budge from the narrow (and low by historical standards) range of 3.5%-3.7% that it has held since January. Both those readings suggest a slowing but robust labour market. Now, it is possible that we are starting to see signs of this changing, as highlighted by the latest string of lay-offs at big tech companies. Just yesterday, Amazon announced that they would be launching a deep review of its cost-base in light of the challenging market environment, which came on the heels of a report from the Wall Street Journal highlighting that Amazon employees in certain divisions have already been told to look for work elsewhere and a statement from Amazon that they were pausing “incremental hiring” across certain division. It is not hard to guess what this means for employee headcount. We have also had Meta announce that they will be laying off 11,000 employees (13% of their global workforce!), while Twitter has sacked roughly half of its staff since Musk took over (although some of these have allegedly been asked to return since…). However, we are still not seeing this weakness reflected at the aggregate level and, until we do, we do not expect the Fed to deviate too far from their previous path. In light of this, we think that markets may be getting a little overly enthusiastic based on the available information. More broadly, we also feel that the idea of a sustained rally in equity prices taking hold in the context of such a bleak economic outlook (outside of the labour market) is a little optimistic. Investors might find some comfort in the direction that interest rates have taken over the last 24 hours, but businesses are facing more headwinds than simply a rising cost of capital.
 
We would have expected to spend more time discussing the US midterms in this newsletter, but they have been something of a non-event for markets, particularly in comparison to yesterday’s CPI print. That said, we will give a quick recap of where things stand as of writing. While we are now three days past the closing of polls, control over both the House and the Senate remains unconfirmed. By default, this is a better-than-expected outcome for the Democrats given all the talk of a “red wave”. According to CNN, within the House, the Republicans have currently won 211 seats compared to 198 for the Democrats. Both are shy of the 218 needed for a majority, but the Republicans are favoured to take this given the seats they have already won from the Democrats. The Senate is even more hotly contested, with 49 seats currently for the Republicans and 48 for the Democrats. Three states remain outstanding – Georgia (which is heading for a run-off election in December), Arizona, and Nevada – and both parties need to win 2 more seats to gain control. (In the event of an even split, the Senate would default to the Dems as Vice President Harris’ has the deciding vote). All-in-all, it is looking like the Republicans will claim a narrow majority in the House and the Democrats will retain control of the Senate. Such a divided Congress reduces the chance of any sweeping policy changes being pushed through for either side – a “grid lock” – which is not necessarily a bad thing for investors, as it tends to reduce uncertainty about policy direction (something that markets typically abhor). That said, the result also reduces the likely scale of any upcoming economic stimulus package given the GOP’s focus on the state of the government coffers. Simplistically, this outcome is probably a net benefit for bond markets and a net negative for equity markets, but we would prefer to wait for the remaining seats to be decided before looking into matters too closely.
 
In conclusion, the rally in asset prices that we saw yesterday was certainly welcome, but we have doubts about its durability in the context of such a bleak economic picture and so much uncertainty. We would also caution that, while it is very possible that inflation could have peaked, one data point does not make a pattern and any inflationary surprises to the upside in the months to come could trigger a very violent reaction. We would continue to be wary of taking on excess market beta and stress that security selection will be more important than ever in the coming months.


 

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