Friday 20th May, 2022
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Financial markets have certainly not settled down over the last 2 weeks. If possible, things seem to have become even more frenzied, with major moves (e.g., daily equity swings of 4%+) seemingly catalysed by nothing more than whichever side of the bed markets decided to wake up on. Indeed, we experienced the largest 1 day fall for the Nasdaq (-5.0%) since June 2020 seemingly off the back of generic concerns about rising inflation and slowing growth. This should not be news to market participants! The pendulum has swung both ways at times, but the net effect has been another challenging 2 weeks for equity investors. This follows 5 prior weeks in the red and, unless something very unexpected happens during today’s trading session, both the S&P 500 and NASDAQ are on track to complete their 7th consecutive weekly decline. This will be the first time this has happened for both since 2001 (the bursting of the dot com bubble), when these indices fell -16% and -32% respectively between January and March. Now, the sell-off has not been quite as extreme in the tech sector this time round, but the NASDAQ has still declined c.-20% since the start of April, while also closing in on a -30% drawdown from the highs reached in November. Given broad risk-off sentiment, credit spreads have also continued to widen (both IG and HY spreads in the US are approaching the wides reached during the liquidity crunch in Q4 2018), but rates have stabilised somewhat, falling from their peaks. We will go into more detail on the moves in equity markets later on in this newsletter, but we will start with the latest pieces of economic data.
Firstly, we had the closely watched release of the April CPI in the US on Wednesday last week. While the annual inflation rate declined to +8.3% (from +8.6% in March) – the first deceleration since August last year – the headline print was still above expectations (+8.1%). Importantly, a decomposition of contributors showed a fairly broad-based increase in prices across food, shelter, and new vehicles, as well as energy. Now, it is not as if the idea of “transitory” inflation has been anywhere near as fashionable over the last few months as it was throughout 2021. However, there is certainly a lingering sense of (slightly desperate) optimism that inflation will return to its previous run-rate once the near-term supply shocks in the energy sector have worked themselves through. The likelihood of energy markets normalising anytime soon is itself much debated but, regardless of your thoughts on this, we find a return to 2% inflation any time soon unlikely and April’s CPI reading certainly suggests that price increases are becoming increasingly entrenched across all sectors of the economy. The gradual recognition of this, and the recognition that central banks will have to move much further and faster than initially expected to combat it, has been responsible for the rapid rise in interest rates seen this year. In this context, the overall impact of April’s reading on rate markets was fairly interesting. As expected, the initial response was a move upwards across the curve, with the US 2Y yield spiking from 2.57% to 2.73% and the US 10Y from 2.99% to 3.07%. Short end yields remained at elevated levels afterwards, with treasury futures pricing in a longer run of 50bp hikes as well as a higher chance of a 75bp hike in June (despite multiple Fed members saying this would not be the case). However, longer end yields gave back all the gains and more, with the 10Y actually finishing the day at 2.92%. As of yesterday’s close, the 10Y yield was sitting at 2.84%, well below the intraday high of 3.20% reached on Monday last week. This is a manifestation of one of the market’s key concerns at the moment; namely, that the Fed will be unable to orchestrate a soft landing without triggering a recession. On a more positive note, we also had the release of US retail sales. April retail sales did disappoint slightly, growing +0.9% MoM compared to +1.0% expected. However, it was still a robust figure (even adjusted for inflation) and, given worries about the longer-term impact of rising prices on consumer balance sheets, the suggestion that US consumers were holding up well provided some much-needed relief. This was reinforced by a significant revision upwards to March retail sales (+0.5% to +1.4%).
Now, onto equity markets. As mentioned in the opening paragraph, the sell-off seen this year has been brutal by most metrics. However, it has truly been a crisis of valuations as opposed to fundamentals so far. Fundamentals have actually held up more than well. FactSet published their latest “Earnings Insight” on Friday last week with 91% of S&P 500 companies having reported their quarterly results. Of these companies, 77% had reported a positive Q1 EPS surprise, while 74% had reported a positive revenue surprise. Forward looking data was also positive, with 10 of the 11 sectors having their growth rates revised upwards after earnings (only Consumer Discretionary declined) and, as of Friday 13th, forward EPS for the S&P 500 was 6.1% higher than it was at the start of the year. Despite this, share prices have fallen across the board and the S&P 500 is down -18% YTD. There was a particularly interesting stat in FactSet’s report that analysed stock price movements from 2 days prior to a company’s Q1 earnings call to 2 days after. It highlighted that a company was required to beat earnings by 20% or more to see any price appreciation, while modest earnings beats were rewarded with modest declines and, as you can imagine, earnings disappointments were severely punished. A tough backdrop for a fundamental equity investor. With earnings still strong, it is easy to see that the fall in equities is due to a drastic readjustment of valuations. From the start of 2022, we have seen the 12m forward PE of the S&P 500 fall from 23 to 17 (having peaked at 27 last year!) and cross below its 10Y average for the first time in 2 years. As we have discussed many times, rising interest rates have been a key contributor to this given their role in valuation models. Indeed, an inverted plot of the US 2Y yield tracks the devolution of the S&P 500’s forward PE since November incredibly closely. However, the decline could also well reflect uncertainty about the longer-term outlook. A record number of companies are citing inflation as a key concern, yet they have largely been successful in passing costs through to customers so far (i.e., margins remain healthy). That said, it is only rational to question how long they will be able to keep this up if inflation becomes increasingly entrenched and consumer demand starts to weaken. We are already seeing demand slow in the consumer discretionary sector; how long until we see this feed through to other sectors and bottom lines are squeezed? Of course, this is greatly dependent on what actually happens in the economy, particularly with respect to inflation. We are simply trying to highlight that, while the current fundamental picture is robust, there are many confounding factors to the outlook and we are wary of being overly optimistic. With that in mind, we will remain diversified, continue to look for opportunities in areas of the market that we believe are genuinely oversold, and pay close attention to economic data related to both price movements and consumer demand.
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