Before we get too excited, a few comments. It is likely that we are seeing short covering at the moment, which over the illiquid summer months is driving market direction a lot more than would otherwise be the case. We should always expect bear market rallies during a bear market, and it is likely that this is just one of those periods of time. It is too early to be planning for this to be over. Q2 numbers have been strong on the top line but we are certainly seeing margin pressure. Consumer sentiment has taken a hit, and we have yet to see that flow through to economic activity, or company results. According to a tweet by Congressman Gus Bilirakis, 2/3 of consumers are planning on reducing their spending over the next six months as a result of inflation. Anecdotal, but not surprising.
So what got the markets all excited? Powell’s press conference seems to be fairly hawkish to me, but there was one sentence that precipitated the debate around the Fed pivot. “…As the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy and inflation.” This was taken by some to mean that the Fed will pivot. The market has taken that pivot to be in play as soon as January/February next year, which seems highly unlikely. Inflation will be lower but certainly not at the level to allow a rate cut. It would also mean a severe downturn in the next 4-5 months, which also seem unlikely given the data we have in front of us at present.
Q2
Better than we had been expecting to be honest. We had anticipated a poor Q2, given inventory build and margin compression, and had positioned ourselves for this. In fact, tech results have, on the whole (bar Meta), been good. Amazon and Apple have defied the doom mongers with reports that the consumer is still spending. 75% (by market cap) of the S&P has now reported, and according to data from Goldman Sachs there has been a 9% increase year-over-year. Revenues rose 3.8% in real terms. This is not a recessionary environment just yet. Having said that, forecasts are falling according to Bloomberg Intelligence but not yet fast enough to warrant recessionary fears.
Treasuries
US Treasuries and, for that matter, Bunds have been incredibly volatile. We have seen approx. 85bps moves lower in both 10-year bonds over the past 3-4 weeks. Until we see this volatility dissipate it is unlikely that we will see investors come back to the market. 10-year US Treasuries at 2.65% make little sense. Will inflation be less than that over the next 12 months? It seems unlikely. As we have said before, we should expect a higher level of inflation for longer, but it will be the path of decline that will be an important indicator for market direction. Perhaps we settle at a higher level than the 2% target. Even 3% would be ok. What this is telling us is that investors buying at these levels are not only worried about growth but are also betting that inflation is going to fall dramatically. Both of these elements are somewhat difficult to opine on as we sit here today.
Europe
As you know, we have been cautious on Europe for a while. The ECB raised rates by 50bps, which was a surprise, but a welcome one. As with the Fed, the ECB has been late to the inflationary party, but unlike the Fed, has been somewhat muddled with its messaging. The ECB has to go early given the weaker economic environment, and also has the headwinds of energy costs/Russia and trying to satisfy the entire Bloc. The TPI or anti-fragmentation programme should help alleviate the concern over debt financing for some of the highly indebted peripheral countries like Italy and Greece, but until we see it in action, we do not know what the full effect will be. A weaker Euro is also a concern, and I am sure there was one eye on that with the 50bps move. The Euro appreciated briefly but then fell back. More interesting will be the pressure on the USD as traders begin to price in (rightly or wrongly) less rate hikes. Stagflation is not off the table for Europe.
Activity
We have to be cognisant of the market, and at the moment, the path of least resistance is higher, at least in the short term. We are therefore likely to focus on our hedges into next week’s CPI number with the view that the headline is going to be weaker as a result of lower oil and the market may latch onto that as a positive. We would then look to re-set our hedges at the end of August, when we begin to have more data points and the next Federal Reserve meeting.
In hindsight, we were a bit early in our caution. Q2 is not likely to be the poor quarter we thought it would be – economic activity is still fairly robust – and we thus delay to Q3 or Q4 numbers. This requires a slight positioning tilt in our hedges for a while. Having said that, we do believe that if we continue to rally, risk markets will look vulnerable to a pullback given there is no real justification for markets to be at these levels unless one truly believes that there will be no recession or it will be of very short duration with a rate cut to follow within the next 6-9 months. There will be another opportunity to buy High Yield at 600bps over.
Outlook
The picture has become a little more murky. Neither the Federal Reserve nor the ECB is providing forward guidance. We are back to being data driven, which means we will continue to see heightened volatility into key inflation and economic numbers. For the US, data, employment etc. are still fairly robust, - the latest US July ISM Factory Gauge at 52.8[1] is still in expansionary territory - and with markets rallying post the meeting last week, the Fed will be wanting to dampen down that enthusiasm. Also, it can move rates much higher in this environment, so it seems fairly unlikely that it will take the foot off the brake pedal so quickly. Having said that, let’s not forget inflation is a backward-looking measure and we will need to be patient and see how things unfold over the coming months.
[1] Source: Reuters, 1 August 2022
