The Thunder from Down Under
FRI 20 MAY 2022
Over the past few weeks your humble student of the markets has been on the road Down Under. Clearly cross asset volatility has remained elevated. However, there has been a notable shift in consensus beliefs from inflation fear to growth. Of course, phases of elevated inflation or economic volatility often lead to a regime of higher market volatility as that typically causes short term interest rate expectations to rise and central banks to withdraw liquidity. Put another way, volatility moves inversely to liquidity and financial conditions.
While some market participants have argued that the drawdown in equities has priced a recession, our sense is that most of the correction (so far) has been attributed to valuation multiple de-rating given earnings on the S&P500 (the global risk proxy) is still well above January levels (chart 1).
To be fair, earnings expectations have moderated in sectors like technology which have been exposed to lower global demand expectations and ongoing supply disruptions in China. Moreover, there has clearly been a re-calibration in sectors such as retail which have been exposed to input cost margin pressure. As we often note, the valuation multiple is also pro-cyclical or has a reflexive relationship with earnings. That is, the de-rating represents a rise in risk perceptions (risk premia) related to future earnings growth prospects. While, earnings expectations still have some way to adjust, the tightening in financial conditions (rate of change) is already consistent with a material (recession-like) slowdown in growth and profits (chart 2).
The good news, as we noted in early May, is that short term
interest rate markets have already largely priced the plausible tightening cycle with more than 300 basis points of tightening by mid-2023. The bad news is that while inflation remains elevated and persistent, the Fed will continue to hike rates over the coming months despite the correction in equity prices. Perversely, labour market strength and resilient household consumption are the key reasons why the Fed does not see the economy slowing, although we would argue that contradicts the trends in household sentiment, real income and consumption caused by inflation.
From a pure price perspective, the shift in beliefs from inflation fear to growth is evident in the recent pause in nominal Treasury yields and the US dollar (chart 3). Of course, as policy rates rise and financial conditions tighten, real Treasury yields will continue to rise as inflation expectations (breakeven rates) start to fall.
On the positive side, a moderation in the US dollar and rates would be positive for Asia, especially in the context of easing liquidity and credit conditions in China. The improvement in China’s credit impulse (rate of change in credit growth) and infrastructure-led stimulus is a positive for growth in the region. There has also been a notable shift in the rhetoric on regulation of China’s major technology companies. On the negative side, the persistent lockdowns until the November CCP Congress will likely retard the effectiveness of policy easing and continue to exacerbate supply-side constraints.
In conclusion, there has been a notable shift from inflation fear toward growth over the past few weeks. The good news is that the former risk is now relatively well priced. However, our sense is that the downside risk to profits is still not fully priced although that is clearly a key reason why the valuation multiple has de-rated. The good news for Asia is that US dollar strength and rates might have peaked and the credit impulse has improved in China. The valuation multiples in this region are also much closer to trough levels. The bad news is that China’s policy makers could persist with rolling lockdowns of major cities until at least November and retard the cyclical recovery. In short, sifting through the drivers of volatility, the worst probably isn’t over.