Sally Auld's thoughts on recent market and macro-economic developments
Market and macro-economic developments have been significant over the past few days. In this brief note, we recap what happened and implications for the outlook.
There were four key developments of note:
- Both the RBA (Tuesday) and ECB (Thursday) delivered hawkish surprises relative to market expectations at their respective policy meetings.
- The US headline and core CPI data for May printed stronger than expected on Friday. Price pressures were broad (food, energy, rent, airfares, auto prices etc.)
- The 5-10Y inflation expectation series in the University of Michigan consumer sentiment reading for June (also released on Friday) jumped 30bp to 3.3%, feeding fears that inflationary expectations are starting to de-anchor.
- A well-sourced Wall Street Journal article (Monday) suggested that the FOMC will not go into this week’s policy meeting constrained by their previous guidance that a 50bp rate hike “would likely be appropriate.”
Markets have reacted to these developments by (once again) significantly repricing the outlook for the Federal Reserve policy rate. Current market pricing expects the Fed to hike by 75bp this week, 75bp in July, 50bp in September and 25bp in each of the November and December FOMC meetings. If realised, the Fed funds rate would reach 3.5% by year end.
Since Thursday’s (US) close, UST 2Y yields have risen ~55bp and 10Y yields have risen ~30bp. The 2s/10s yield curve is flat (a yield spread of zero). The S&P500 has fallen ~7% over the same period.
What does it mean?
If the Federal Reserve delivers what is priced into markets, our view is that it is no longer correct to be ambivalent about the possibility of recession in 2023. If market pricing is realised, the Fed will have delivered 325bp of rate hikes in just 9 months. For comparison, the prior tightening cycle delivered 225bp of hikes in 36 months.
Importantly, the Fed is being forced to assert its inflation-fighting credentials. This implies little scope to manage the trade-off between bringing inflation lower and keeping the economy close to trend growth rates (that is, the chances of a soft landing are small). Economic growth will be sacrificed as financial conditions tighten further, meaning that the unemployment rate has likely troughed for the cycle. Accordingly, we think it reasonable to expect the Fed’s updated set of forecasts (released later this week) to show an upward revision to the unemployment rate forecast in 2023 and a downgrade to the GDP forecast in 2023.
For markets, recent developments suggest that there is more downside for equities. Earnings forecasts continue to look too optimistic, in our view, relative to the likely path of economic growth. And relief in the form of a dovish pivot from the US central bank isn’t an option until there are better atmospherics around the inflation trajectory and inflation expectations. A defensive stance in equity portfolios is thus recommended.
Government bond yields remain attractive and we continue to recommend investors add duration to multi-asset portfolios. If we are correct in our view on the growth outlook, the positive correlation between bond and equity market performance of recent days will not sustain.
We also recommend increasing exposure to gold; typically, this asset class performs well in periods of uncertainty (and high inflation). The prospect of a structural shift in demand for gold due to recent geo-political events should also support this asset.
These recommendations are effectively those that were made in our recent Strategic Asset Allocation changes. With the benefit of hindsight, while the broader call to shift portfolios in a more defensive direction was correct, the magnitude of changes we articulated were probably not large enough.
Sally Auld is Chief Investment Officer at JBWere. Analysis as at 14 June 2022. This information has been provided by JBWere Ltd ABN 68 137 978 360 AFSL 341162, for WealthHub Securities Ltd ABN 83 089 718 249 AFSL No. 230704 (WealthHub Securities, we), a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL 230686 (NAB). Whilst all reasonable care has been taken by WealthHub Securities in reviewing this material, this content does not represent the view or opinions of WealthHub Securities. Any statements as to past performance do not represent future performance. Any advice contained in the Information has been prepared by WealthHub Securities without taking into account your objectives, financial situation or needs. Before acting on any such advice, we recommend that you consider whether it is appropriate for your circumstances.