THU 23 JUN 2022
It is clearly an understatement to say that the broad selling in equities became extreme last week. From our perch, that sets the stage for an oversold counter-trend rally. However, as we have noted recently, the correction has so far been driven by valuation compression which has taken the global risk proxy (S&P500) back to 15.9 times forward earnings (the long term average is around 16.7). On the negative side, valuation typically overshoots equilibrium to the downside and equities will still have to adjust for the probable earnings downgrades to come.
On a tactical basis, only 2% of the S&P500 are above the 200 day moving average, CBOE Volatility Index closed last week with 4 out of 5 days above 30 and 80% of the S&P500 is down by more than 20% year to date. Investor sentiment in the AAII sand the BofA Fund Manager survey is extremely negative (although that does not always align with actual equity positioning). However, overall the prevailing bias is rather pessimistic.
On a more fundamental basis our estimate of excess liquidity - the difference between US M2 money supply and industrial production - has plunged over the past year and was probably consistent with the sharp correction already experienced in equity prices (chart 1). The good news is that it is also already near trough levels. On the negative side, excess liquidity typically only improves with a pivot by the Fed and softer interest rates. Unfortunately that seems unlikely until after the northern hemisphere summer.
Switching gears, the tightening in broad financial conditions and deterioration in future growth expectations has started to impact commodities. The good news, is that the correction in spot prices has likely been influenced by some easing in supply side constraints. The bad news is that the weakness is also likely a reflection of (at least some) demand destruction. From a pure price perspective, crude oil is around 22% below the March high (chart 2) although it is still above the recent 100 day moving average or trend. The additional positive to note is that China (the largest consumer of most commodities) has started to ease credit and implement infrastructure stimulus.
Rightly (and sometimes wrongly) the change in oil prices tends to be correlated with market based breakeven inflation (chart 3). In turn, 5 year, 5 year forward breakeven is a key input for the Fed’s reaction function. While energy and commodity prices are a relative price (producers win at the expensive of consumers when prices rise) they matter for the prevailing bias on inflation and future short rate expectations. The good news is that a moderation in energy prices would ease pressure on inflation, rates and one of the negative influences on household sentiment.
In conclusion, the extreme weakness in sentiment and tactical indicators suggests that the stage is set for an oversold counter-trend rally. There has also been a non-trivial compression in valuation, albeit only modestly below equilibrium for the global risk proxy (the S&P500). On the negative side, valuation typically overshoots equilibrium to the downside and equities still have to adjust for the probable earnings downgrades to come. It is also the case that excess liquidity typically only improves with a pivot by the Fed and softer interest rates. That is probably necessary for a durable equity market recovery. The good news for Asia is that the valuation and earnings adjustment is further advanced. Moreover, China is easing credit and liquidity.