MON 13 JUN 2022
An important question investors should always ask is; “what is your quarrel with price?” From our perch, the reaction to the US data on Friday was probably warranted. Inflation remains a significant problem, the Fed is behind the curve and we are suddenly back to pricing a new cycle peak in the funds rate of around 3.5%. Indeed, the June 2023 Eurodollar implied yield increased to 3.92% on Friday (chart 1).
That was clearly not helpful for risk assets on Friday and on the Monday morning here in Asia. Terminal rate pricing has been a key driver of equities through this episode and has also been a key driver of US dollar strength relative to other fiat currencies. Dollar strength is clearly challenging for entities with dollar liabilities and emerging/Asian market assets.
The good news is that although the Fed is behind the curve, the actions and promises so far have already achieved a material tightening in financial conditions. While inflation remains a significant problem, the tightening in financial conditions (shown in the light blue line moving down in the chart below) tends to lead the annual change in the consumer price index (dark blue line in the chart below). That is consistent with a slowing in other leading indicators such as new orders relative to inventory and some elements of the commodity markets.
On the negative side, the last major episode of rapid tightening in financial conditions of similar magnitude was ahead of the great financial crisis (not the divergence between the CPI and financial conditions in 2007-2008 – recall that oil prices rallied sharply in the first half of 2008). While there has clearly already been a meaningful tightening in broad financial conditions, the challenge for risk assets (equities and credit) is that the Fed is committed to keep hiking rates until inflation comes down in a convincing way. Put another way, do not anticipate a market friendly Fed pivot anytime soon even if some of the leading indicators of the cycle deteriorate. In turn, that suggests ongoing cross asset volatility is likely to continue as rates rise and liquidity is withdrawn.
The good news is that the tightening in financial conditions is happening fairly rapidly or the correction in equities has already been material and the de-rating in valuation has already taken multiples back to around neutral. The bad news as we noted last week is that valuation tends to overshoot and will be reflexive with the probable earnings downgrades in the second half of this year. The additional positive in this region is that China has tended to be a FIFO market (first-in-and first-out). The bear market in MSCI China started in February 2021 not long after the credit impulse peaked in late 2020. Credit and liquidity has started to improve again and is consistent with early-stage recovery ahead of the trough in global markets.