By Jan Faure
Global markets declined sharply in September as recession fears deepened on aggressive central bank action to combat decade high inflation. Adding to bearish sentiment was concern over company earnings from margin headwinds, European growth risk from surging energy prices, escalating tensions between Russia and the West, and China growth risk from an unrelenting zero-Covid policy.
US headline inflation (CPI) slowed slightly in August to 8.3% year-on-year but rose 0.1% on a month-on-month basis. US core inflation, which excludes food and energy prices, increased 6.3% year-on-year in August, from a 5.9% increase in July. The news shook equity markets which had been expecting inflation to decline compared with July. It shattered any hopes that the US Federal Reserve (Fed) would moderate the pace of interest rates hikes to combat inflation.
Technology stocks again bore the brunt of the sell-off due to their higher sensitivity to interest rates changes. In the US, the tech-heavy Nasdaq Composite index sank 10.5% for the month (-32.4% YTD) while the S&P 500 index fell 9.3% (-24.8% YTD) in another highly volatile month of trading. In Europe, the Euro Stoxx 50 index declined by 5.7% (-22.8% YTD) while the UK’s FTSE 100 index dropped 5.4% for the month (-6.6% YTD). In Asia, Japan’s Nikkei 225 index fell 7.7% (-9.9% YTD) while Hong Kong’s Hang Seng index slumped 13.7% (-26.4% YTD).
The Fed raised interested rates by another 75 basis points in September. Fed Chair Jerome Powell stated that the bank “is strongly resolved to bring inflation down to 2%, and we will keep at it until the job is done.” Powell said rate rises were necessary to slow demand and ease price pressures to avoid long-term damage to the economy. It is now clear the Fed is willing to rather push the economy towards a recession than allow inflation to remain high for a sustained period.
The US yield curve inverted further (shorter-dated yields rose above longer-dated yields), advancing recession fears in the US. US Treasuries are now offering yields above 4%, the highest in almost 15 years, boosting international demand (safe-haven appeal) and playing towards dollar strength. A strong dollar is welcomed by the Fed as it undermines US inflation, although it is a drag on US corporate earnings when converting revenue and profits made outside the country.
The discoordination of monetary policy between major central banks has also been a prominent factor behind the dollar’s strength. The US Federal reserve leads the way in policy tightening followed by the Bank of England (BOE) and the European Central Bank (ECB), while Bank of Japan (BOJ) is yet to tighten monetary policy. This discoordination implies that we can expect to see this inflation cycle to play out differently across different regions.
Japan intervened in currency markets to support the yen as it tumbled to its weakest level in over 20 years. The euro was also under pressure, dropping to a 20-year low against the dollar. The British pound fell to its weakest level against the dollar in almost 40 years. This came as currency markets judged the new Chancellor of the Exchequer’s “Growth Plan” as reckless and out of touch with current economic reality. The new Conservative government’s mini-budget outlined £45bn in tax cuts and £60bn in energy subsidies. The announcement sparked mayhem in currency and bond markets as investors ditched the pound and UK bonds.
In a time of conservative fiscal and monetary policy, where inflation-fighting is the only game in town, PM Liza Truss’s party defied its name with a budget plan that would boost demand-side inflation and stretch UK government finances. There are clearly political motivations at play with an election 2 years out and the party lagging (by a wide margin) in opinion polls. It raised concerns that the BOE and UK Treasury are not singing from the same hymn sheet when it comes to managing the inflation cycle.
The announcement drew criticism from the International Monetary Fund, warning that the measures are likely to fuel price pressures. The BOE responded by announcing it would carry out temporary purchases of long-dated UK gilts (quantitative easing) and delay the sale of gilts. The BOE’s action emphasised the modern role of central banks as economic fire fighters, cushioning political policy actions that conflict with prudent economic policy. A huge political backlash ensued that has led the UK government to abandon the tax-cut part of the plan.
Commodity prices were under pressure due to the surging US dollar with gold hitting a two and a half year low ($1,685/oz) at end-September. Since gold is a zero-yielding dollar asset, it as has a negative return correlation with a strengthening dollar and rising interest rates. Copper, regarded by many as an economic bellwether, has declined by 23% year-to-date, while iron ore prices have retreated as a slowing Chinese economy and recession fears hurt sentiment.
Brent crude oil declined 11% in September to $85/bbl as pessimism over the global economic outlook outweighed tight oil markets. This brings crude prices back in line with levels last seen in January this year. Crude’s sell-off since June is expected to result in a large production cut by OPEC+ at its October meeting. The energy crisis in Europe took a fresh turn as EU ministers agreed on windfall taxes on certain energy companies as well as mandatory cuts in electricity use. This followed sabotage to the key Nord Stream undersea gas pipeline which runs from Russia to Europe under the Baltic Sea.
World equity and bond markets have sent a clear signal that a global recession is a matter of when not if. The pendulum, however, swings quickly and we are already seeing a rapid adjustment to inflation expectations as commodity prices drop, home building and home buying activity falls, shipping rates normalise and consumer spending contracts.
“Be fearful when others are greedy and be greedy when others are fearful.” Warren Buffet
We are certainly in fearful and pessimistic times. The extreme market volatility that we have been experiencing, as painful as it is, provides an opportunity to capitalise on dislocations between the price and intrinsic value of many securities. Corporate headlines of late have played into negative market sentiment (notably FX and logistics headwinds), however there has been a marked easing in supply chain disruptions. This will allow companies to normalise much of their operations. Company valuations have adjusted, providing downside support, with the 12-month outlook from such a weakened base looking less daunting.
As negative headlines pile up it is easy to get caught up in the bearish sentiment, especially when looking at global markets from a macro perspective (top-down approach). From a bottom-up approach (the security level) however, the outlook seems far more optimistic over the next 12-months. This highlights the opportunity for astute investors and should encourage investors to stay calm during these uneasy times.
Table 1: Global Indicators – Local reporting currencies