Bedrock’s Newsletter for Friday 5th August, 2022



“He will win who knows when to fight and when not to fight.”

Sun Tzu

Friday 5th August, 2022

Equity markets staged a powerful rally in July after a bruising first half of the year (the worst for the S&P 500 Index since 1970) – and the positive momentum has continued into August so far. The recovery is being driven in large part by a steep decline in sovereign bond yields amid signs that inflation may soon peak and as the global economy slows sharply. That inflation pressures are likely to moderate at least somewhat in the months ahead – due to softening commodity prices, tighter financial conditions, and deteriorating consumer spending and confidence – has convinced many investors that the Fed and ECB will choose to slow (or even reverse) interest rate hikes if a meaningful recession arrives in their respective regions before the end of the year or early next year. Central bank policy plays a critical role in driving investor sentiment and thus equity multiples; and a more dovish outlook for short- and long-end sovereign rates – and discount rates on future cash flows – explains the rally in multiples across stocks in recent weeks, particularly in fast growing sectors (which have the highest sensitivity to interest rate policy). For example, in July, while the S&P 500 Index rose +9.1% and the Euro Stoxx 600 Index rose +7.6%, the technology-heavy NASDAQ Composite Index was up a mighty +12.4%! This is despite the shift in monetary policy expectations being driven by a deteriorating economic outlook. Liquidity is still king when it comes to investor sentiment!
 
Still, as we discussed in our last newsletter, we do not forecast a sustainable recovery for equity markets until there is more clarity over when, where, and how deep any recession will be in Europe, Asia, and/or North America even if central banks adopt a less aggressive monetary policy stance due to an economic downturn. Fundamentals count for something, and just because the equity sell-off year-to-date has been driven (almost entirely) by multiple de-rating, that does not mean that the next leg lower might not come from sinking earnings instead. Indeed, the worst impact of high prices was always going to lag the initial rise because consumers and businesses had healthy balance sheets post-lockdown and could rely on excess savings to smooth consumption when inflation first began to take off in 2021. The disappointing results from US financial institutions during the current quarterly earnings seasons and news that many tech companies are looking to cut headcount and/or slow hiring in the months ahead may be a harbinger of things to come. Still, on the flipside, the latest payroll data (which came out today) suggest that the US jobs market overall is much stronger than two quarters of negative GDP growth suggest it ought to be: non-farm payrolls were up +528K vs +258K expected in July.
 
Uncertainty over the outlook for inflation and the real economy are why many central banks are adopting self-described ‘data-dependent’, ‘step-by-step’ approaches to monetary policymaking (i.e., putting less emphasis on forward guidance) at the moment. But this does not mean that they are becoming more relaxed about inflation, as some investors have interpreted the most recent raft of announcements to imply; the latest headline CPI prints (i.e., those for June) in the US (+9.1%), UK (+9.4%), and Eurozone (+8.6%) make for uncomfortable reading for policymakers, too. And we do not doubt their commitment to take action to prevent inflation from becoming embedded in the economy, even if households face greater short-term economic pain as a result. Fed Chair Jerome Powell has been clear that the US central bank could hike policy rates another 75bps as soon as September, while ECB President Christine Lagarde chose to surprise everyone mid-July by beginning the ECB’s tightening cycle with an aggressive 50bps interest rates move. In addition, reaching ‘peak inflation’ soon is by no means certain given multiple tail risks from ‘Zero Covid’ Taiwan-taunting China and the war in Ukraine… nor will all of us hit that peak at the same time. For example, on Thursday this week the Bank of England (‘BoE’) hiked the UK policy rate by 50bps to 175bps (in the single largest move in 27 years) and warned that UK inflation was set to rise above 13% by year-end due to the lifting of the energy price cap! (That is 4% more than the current rate of inflation and represents a huge further increase from here.) As explained in our last newsletter, however, we do think that there is an opportunity to add duration whenever the US 10Y treasury yield hits 3% because of risks to the economy and the skew in the distribution of possible futures that favours rates failing to rise as far as markets expect. But we make that call with our eyes wide-open.
 
Beyond the inflation-rates-recession nexus, investors were also transfixed this week by the US Speaker of the House Nancy Pelosi’s visit to Taiwan where she expressed congressional support for Taiwanese democracy in the face of Chinese military and economic threats. President Biden (initially) said that he did not support the trip and that the US military had cautioned against it. However, he has since fallen in behind his Democratic colleague. China, meanwhile, had suggested in advance of her arrival that a massive (and potentially kinetic) response would be justified; and the Chinese government has since announced sanctions on Taiwan and Speaker Pelosi, cancelled climate change talks with the US, and initiated the largest ever military drills off the Taiwanese coastline, which include live-fire exercises all around Taiwan, effectively blockading the island for several days. Taiwan has said that it is combat ready should the exercises turn into an invasion, but we do not think that a direct attack is imminent: the mobilisation required would take many weeks and be highly detectable (whereas the deliberately visible movement of Chinese military assets on the Fujian coast, across from Taiwan, during Pelosi’s visit was clearly meant for show) and weather patterns give an October deadline for any seaborne-invasion across the Strait – just as the CCP will be gathering for its National Congress, which Xi is unlikely to disrupt with an enormously risky military venture. That said, we continue to monitor the situation closely. With communication between the Chinese and American militaries largely having broken down, the danger of miscalculations and mistakes is high – as the news that Chinese missiles had overshot Taiwan to crash into Japanese exclusive economic zone waters has demonstrated.


 

______________________________________