The rollercoaster ride that has been 2022 so far has showed no signs of slowing down as we have moved into the final quarter of the year. Indeed, the S&P 500 rallied an impressive +5.7% over the first couple of days of October – its largest two-day rally since the sharp rebound in April 2020 – as a weaker than expected ISM Manufacturing PMI print in the US drove expectations (or maybe simply hope) of a Fed pivot. However, the rally was short lived as stronger economic data from the US trickled through over the next few days and members of the Fed firmly pushed back on the idea that a moderation of the anticipated hiking cycle was needed. This led to a strong back up in yields and 6 consecutive down days for the S&P 500 – and global equity markets more broadly – which more than offset the earlier gains. We then had a higher-than-expected US CPI print yesterday and somewhat inexplicably managed to finish Thursday with both bond yields and equities strongly up (despite some more expected downwards moves for equities in the immediate wake of the print). We will do our best to make sense of this over the following paragraphs, but we do not make any guarantees.
We will start with the economic data from the US. October kicked off with the US manufacturing PMI for September coming in at 50.9, compared to the expected 52.0. While still in expansionary territory, this was the lowest reading since mid-2020 when the US was still wrestling with the impact of strict covid-related lockdowns. The print notably included several indications of weaker demand (such as a contraction in new orders), as well as softening price pressures and hiring freezes in places. In short, it seemed to imply a cooling of the US economy and investors were quick to infer that it could well be the excuse that the Fed needed to take its foot off the interest rate pedal, potentially reducing the risk of a hard landing (i.e., an interest rate driven recession) in 2023. This led to a retreat in yields – at one point on Tuesday last week, the US 2Y yield had come down nearly 30bps from its end of September levels, briefly dipping below 4% – and a corresponding rally in equity markets. However, subsequent data releases pointed to a much more robust US economy. In particular, the ISM services PMI came in ahead of expectations at 56.7 on Wednesday last week. While still representing a deceleration from previous months, it suggested that activity in the services sector remained vigorous and that the weaker manufacturing print might just be a reflection of demand shifting from goods to services (a reversal of the shift towards goods seen throughout lockdowns) rather than a broad-based weakening of economic activity. Strong US employment data – encompassing non-farm payrolls increasing by +263k and the unemployment rate creeping down to 3.5% in September – further supported the idea that the US economy could well be in good enough condition to support further interest rate hikes (at least in the Fed’s eyes). This sentiment was echoed by Fed officials and interest rates gradually increased throughout last week and early this week. As would be expected in the current context, this drove equity prices down. So far, so good.
With the above in mind, all eyes were on yesterday’s CPI number and it would have been perfectly rational to expect a higher-than-expected US CPI print to push yields up further and equity performance for the month firmly into the red. Initially it did just that but, for reasons still unclear, there was an astonishingly strong equity rally into yesterday’s close (a 5%+ intraday swing) and the S&P 500 finished the day up +2.6%! It is not as though there were any particularly redeeming features of this CPI number either. The headline figure was +0.4% MoM (vs +0.2% expected), resulting in YoY inflation also being slightly ahead of expectations at +8.2%. Falling energy prices dragged the headline figure down, but core inflation actually accelerated to +6.6% YoY (annualised), the highest reading in 40 years. Various other measures of core inflation that remove outliers and focus on changes in sticky consumer prices were no more flattering. The market obviously took this inflation print seriously as interest rates moved upwards in response; the US 2Y yield spiked from 4.27% to 4.51% on the day and Treasury futures began fully pricing in a 75bp hike for November for the first time, as well as a high likelihood of another 75bp hike in December. At the same time, the terminal rate expected for next year moved very close to 5%, having been at just 4.5% at the start of the month. This makes the rally in equity markets all the more baffling, and the only seemingly logical explanation is related to excessively bearish positioning across market participants in the run-up to the reading. We expect it is just that and see this more as a brief bear market rally rather than any fundamental shift in direction or sentiment.
It would also be remiss of us not to spend some time discussing developments in the UK over the last two weeks, even though we spent the majority of our last newsletter discussing the impact of Kwarteng’s ‘mini-budget’ on Gilt markets. At the time of our last newsletter’s publishing, it had appeared that the Bank of England’s (BoE) promised intervention in Gilt markets had been sufficient to put the worst of it behind us, but volatility has returned this month with a vengeance… Truss’ reversal of plans to scrap the 45% income tax bracket was well received early on in the month – even if it was only a relatively minor portion of the £45bn of tax cuts proposed – and we saw Cable climb to just shy of 1.15, as well as a gradual drift downwards in Gilt yields (the 30Y fell from nearly 3.8% to 3.6% last Tuesday). However, Gilt yields were then dragged upwards by global pressures in the latter half of the week, with the rise exacerbated by news that the BoE had barely been making any purchases through its emergency intervention programme, and the UK 30Y yield ended at 4.4% last Friday. This week, we then had the BoE announce that they would expand both the breadth (to include index linkers) and the volume of its bond purchases. While designed to steady markets, this announcement fuelled concerns that the BoE were seeing increasingly serious signs of instability within the UK financial system. Governor Bailey’s firm reiteration on Tuesday evening that the BoE’s bond buying programme would end on Friday regardless of the status of Gilt markets or LDI funds (contrary to speculation that it could be extended if necessary) did little to reassure investors. From Bailey’s perspective, this stance could well have been aimed at ‘scaring’ LDI managers into actually raising liquidity (i.e., selling Gilts), which seems to have worked somewhat as the BoE’s auction volumes surged the following day. However, fears of growing financial instability in combination with the promise of a swift removal of a Central Bank backstop proved too much for bond markets to handle and 30Y Gilt yields shot to back above 5% on Wednesday, just shy of their post ‘mini-budget’ highs. The impact was not contained only to the UK either, as Bailey’s comments coincided with a notable increase in Treasury yields… The drama continued into today, as Kwarteng was sacked as Chancellor of the Exchequer (his 38-day tenure has been the shortest on record, excluding appointments ended by death) and Truss committed to proceeding with the corporate tax increase as opposed to scrapping it, representing a monumental and somewhat embarrassing U-turn in policy. While this was initially viewed in a positive light (i.e., as a return to a more fiscally responsible approach), concerns about broader political and financial stability in the UK have gathered pace in the late afternoon and Gilt yields are once again surging as we go to print…
If asked to describe the current financial landscape in a word, “unstable” would be hard to beat. October has not historically been a gentle one for markets, being home to three of the largest equity market crashes in history (the Wall Street Crash of 1929, Black Monday in 1987, and the post-Lehman Brothers collapse in 2008), and the upcoming earnings season could well be the catalyst for another steep leg down should it disappoint… In light of these concerns, we have maintained our equity protection across portfolios, although we have also been monetising it gradually as volatility has risen to levels that make it difficult to hedge efficiently. That said, we do also believe that we are entering a stock-picker’s market and that we are likely to see a meaningful divergence in company performance over the coming months, which should present opportunities for diligent investors.
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