June 2022 - Monthly House Views
FED's Balancing Act
Repeatedly in 2021, central banks told markets not to worry about inflation – and investors gleefully did as told. Even as inflation kept rising in 2022, markets were relatively sanguine – many thought it had peaked in March as it was being driven by relatively small-weighted items in the inflation basket surging due to the War in Ukraine and covid-related supply issues in China. The expectation was that such pressures – while acute – would eventually dissipate. The belief that inflation would subside naturally further solidified when the April inflation figure, while still high, was lower than the previous month. However, US inflation data released on Friday shattered that belief. The inflation figure hit 8.6%, a 40-year high. Moreover, many of the of the sub-components appear to be gaining momentum.
What is different this time?
As of May, motor fuel, gas and electricity in the US were 49%, 30% and 12% more expensive, respectively, compared to the year before. The price of meats, poultry, fish, and eggs collectively rose by over 14%. Flights became nearly 40% more expensive. All of this contributed to a year-on-year inflation reading of 8.5% in March, the highest the US has seen in four decades. Such pressures are even more pronounced in the UK. The good news is that the items mentioned have had huge percentage increases often because their prices were deeply depressed in the early post-pandemic recovery. They should eventually begin contributing less to the overall inflation calculation as such huge percentage gains are unlikely to persist. The bad news, however, is that these items account for relatively small weight in the basket making up the Consumer Price Index. Far more important is the cost of shelter, which alone makes up one-third of the inflation basket. And here there is clear evidence of inflationary pressures that are likely to be more long-term.
In developed economies, the biggest expenditure for consumers tends to be housing: the average Briton or American spends about 33% of their monthly pay cheque on rent. Cost of shelter did not rise as fast as other components of the CPI – 5.5% in the US in the twelve months to May– but given its prominent weighting likely provided the most painful squeeze to consumers’ finances. Worse yet, compared to other components of the index, rent prices tend to be “sticky”. Whereas the cost of, say, used cars tends to fluctuate with supply and demand, and patient buyers could hold out for a better deal, tenants signing a new, pricier lease will be locked in with the higher cost for years. Further, rent prices tend to not be correlated with real estate prices on the downside: even if house prices fell, tenants are unlikely to benefit from a downward revision of their equivalent rent.
This move from transitory to more systemic inflation has – more than anything else – spurred central banks to action and uncertainty has crept into economic expectations for consumers, corporates, and ultimately financial markets. The S&P 500, a global bellwether, has fallen into a bear market. Sentiment has come down markedly, in some asset classes verging on over-sold territory. Crucially, bond markets suggest that central banks will be able to control inflation in the medium term: 10-year breakeven yields are pricing in an average inflation rate of 2.7% over the next decade. This is important, and signals central banks have not lost the critical battle against long-run inflation expectations becoming unanchored. Nonetheless, many markets participants believe policymakers to be behind the “rate-hike curve”, and now making up for it by aggressive action – with 200 basis points of tightening being priced in over the rest of 2022. That aggressive pace of monetary tightening is at root of the angst in markets today and has clearly increased the possibility of recession.
Stay calm and carry on
Much of Western monetary policy – and indeed the fate of global financial markets - rests on inflation numbers over the course of this year. Fortunately, some evidence suggests that price pressures have already begun to subside. Firstly, many of the smaller CPI items that drove inflation throughout and immediately following the pandemic, such as homewares or used cars, have already started to retract. Even those items impacted by the war in the Ukraine, such as oil, energy, and other commodities, are unlikely to experience further significant price pressures from today’s high bases.
Secondly, house prices, which tend to lead rent prices by about a year, are one of the few factors central banks can target more effectively to combat inflation. Even in anticipation of monetary tightening, 10-year fixed mortgage rates in the US began have shot up to 5.5% from 2.5% at the start of the year, causing house price growth to retract. This development is not restricted to the US - in the UK, house price growth has dropped to single digits for the first time this year, easing from a high of 13.3% year-on-year in 2021.
The balance of probabilities is currently not pointing towards a recession this year. Monetary policy remains loose by historical standards, and there is no evidence of significant degrading of financial conditions: access to loans, whether private or corporate, is still easy. Corporate earnings continue to climb to new record highs. Household savings are unusually high following the past few years of fiscal stimulus, and financial regulation has greatly improved the robustness of both banks’ balance sheets as well as their credit approval processes over the past decade, backstopping another potential Great Financial Crisis. Indeed, a record-low housing stock will likely provide a bottom to prices even in the case of a Fed-sponsored contraction of the housing market.
In uncertain times like these it pays to not panic, stay disciplined, and trust the process. It is currently telling us the following:
The economic outlook remains in slowdown judging by the forward-looking indicators we measure. This is favourable for risk assets. Recession does not appear on the horizon. While financial conditions are tightening, it remains relatively easy and cheap for most households and companies to borrow money. Jobs are plentiful. Corporate earnings are at (or near) record territory.
Valuations had been our biggest source of concern coming into this year but have moderated, as prices for equities have fallen this year while earnings expectations have remained anchored or even risen, leading to affordable if not cheap assets compared to their own recent history.
Momentum for equities remains negative by the 10-month moving-average metric that we favour. This is cause for caution.
Sentiment in markets is neutral but has deteriorated sharply over the past weeks, mainly impacted by negative equity outflows and a strong dollar. Over-bearishness would provide a strong buying signal; however, we are not there yet.
A robust economic outlook paired with fair(er) valuations support the case for risk-taking. On the other hand, momentum of equity prices remains negative for the time being: a signal to seek a conservative stance in the near-term. We prefer a neutral allocation to risk assets supplemented by a range of diversifiers, including cash, government bonds, gold, hedge funds and a Tail Risk Protection Note. This provides a resilient positioning in the wake of rising volatility and sufficient flexibility to adjust our views should conditions change: to further cut risk in case of deteriorating economic environment or add to it should momentum turn or if rate hike cycles prove to be drastically overestimated.
Process and Convictions
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Unless otherwise specified, all statistics and figures in this report were taken from Bloomberg and Macrobond on 05/20/2022.