Bedrock’s Newsletter for Friday 9th December 2022

Friday 9th December 2022

With temperatures plummeting, snow falling, and Christmas carols echoing in the air, it feels like the festive season is now well and truly upon us. Unfortunately, financial markets appear to have missed their invite to the Yuletide merrymaking and the much-anticipated “Santa rally” has been conspicuously absent in December so far. Indeed, as of writing, nearly all major equity indices are in the red for the month, with the notable exception of Hong Kong’s Hang Seng Index, which managed to maintain its momentum following its best month since 1998 in November (+27.3%!) on the back of easing covid restrictions, both in the Special Administrative Region and in Mainland China (onshore Chinese shares, too, are continuing to mount higher). As much as it pains us to play the Grinch, we do think that the decidedly un-Christmassy start to December elsewhere is somewhat rational, coming as it does on the back of two bumper months for equities. We do not want to dwell too long on the more distant past (two months feels like a lifetime in these markets) but we have repeatedly highlighted that some rebound in risk assets was to be expected in the context of the excessively bearish positioning that developed in September – but that such gains may not extend further. Having now had this bounce, it certainly does not mean that we believe we are at the start of another bull run. Myriad risks remain and equity performance over the last two weeks has seemed to reflect our view that a more cautious outlook is warranted.
 
Indeed, the S&P 500 has been down for 7 out of the 9 trading days since our last newsletter, though it only finds itself down -1.6% over that period given one of those 2 positive days (+3.1% on last Wednesday) was the second-best day for the index since May 2020. That 1-day rally was catalysed by Fed Chair Powell’s speech – his last communication before the blackout period ahead of next week’s FOMC meeting – stating that “the time for moderating the pace of rate increases may come as soon as the December meeting”. While markets were already heavily leaning towards a 50bp rather than a 75bp hike in December, this comment reinforced this view and we saw expectations for the pace of rate hikes throughout 2023 temper. The terminal rate priced in for 2023 dipped back below 5% on the day, while expectations for the Fed Funds Rate at the end of 2023 fell from 4.64% to 4.43%. In turn, the entire US equity market rallied strongly across the board, with gains largest in tech-orientated companies; the NASDAQ rose over +5%.
 
However, we have since seen equities steadily pare back those gains as they have been confronted with mixed economic data and rising uncertainty about where interest rates will go from here. The ISM Manufacturing print for November came in at 49.0 on Thursday last week, representing a contraction in the US manufacturing sector for the first time since 2020 and providing a sharp reminder of some of the challenges facing the US economy. Lending credence to the potential for a Fed pivot (as it suggested that previous hikes had already done their work, lessening the need for a further ratchet up), this reading caused bond yields to move lower on the day but, interestingly, did not drive equities higher. It seems that market participants are finally starting to stomach the understanding that lower interest rates are not sufficient to support equity prices alone, particularly not in the event that those interest rates are falling because the economic outlook is deteriorating meaningfully. Other worrying signs for the economy include the continued decline in the oil price on demand concerns, with WTI now around $72/barrel, well below the peak of $117/barrel it reached in June. However, we have also had a very strong ISM Services print (56.4) this week, which came in well ahead of expectations and suggested that there was pretty robust domestic demand in the US. At the same time, the US labour market remains stubbornly strong. Non-farm payrolls (NFP) for November came in at 263,000 (well above consensus), the JOLTS report showed that there are still 1.7 job openings per unemployed person, and the unemployment rate held firm at 3.7%. It is possible to see signs of an inflection point in these numbers – the NFP and JOLTS figures both represented a deceleration from October, while the unemployment rate only remained steady because the labour participation rate fell in the month (186,000 people left the workforce) – but it would certainly be a stretch to say that they show meaningful signs of weakness. Indeed, all of the above figures are well above historical averages. Compounding on this, average hourly earnings in the US actually grew by +0.6% YoY in November, equating to an acceleration of wage growth from the prior month. With concerns about a wage-price spiral at the forefront of the Fed’s mind, it is hard to see them taking any lead from the labour market when considering whether to reduce the pace of tightening.
 
Trying to build a coherent view on the likely path that interest rates will take in light of the mixed bag of economic indicators available is certainly challenging. At this point, we think it makes sense to simply hold steady and look towards the all-important US CPI print next week, which will be closely followed by the Fed and ECB meetings. However, we do think that it is important to highlight that, regardless of where yields go from here, the bond market is pricing in a fairly bleak economic outlook right now. While the 2Y US Treasury yield has been oscillating around the 4.5% mark since October, the US 10Y yield has fallen from a peak of 4.24% on 24th October down to 3.51% as of yesterday. This has further accentuated a massively inverted yield curve; a negative 2s10s spread is widely considered a pretty reliable indicator of an upcoming recession and this measure reached -84bps on Tuesday this week, the largest inversion since the 1980s. We feel that bond markets generally have a better handle on these things than equities, which we do not believe are fully pricing in risks for 2023. As markets’ frostily un-festive winter draws in, we take some comfort from the fact that we have recently seen the return to the more typical patterns of a risk-off environment – equities and credit have sold off, while traditional safe havens such as Treasuries and gold have rallied – which should make portfolio construction more straightforward. Indeed, in light of our concerns about the outlook, we see increasing value to be had in holding interest rate duration in portfolios to hedge against downward moves in equities.


 

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