As some head off for summer breaks, investor sentiment and portfolio positioning are at record bearish levels with many investors nursing historic losses across both bonds and stocks. Recent fiscal and monetary support is being unwound the world over at a rapid pace as economies have rebounded sharply following the pandemic and, together with the sequential supply shock of war in Ukraine, inflation has surged.
The Federal Reserve has done an industrious job of managing financial conditions – flagging the rate hiking path, the withdrawal of emergency QE, driving a stronger dollar and a lower stock market with associated wealth effects. The sum of all this appears to have worked harder and faster on confidence and activity levels than traditional policy tools with an almost instant negative transmission to the real economy. At Tellsons, we believe the power and efficiency of this network effect today marks a key difference from the policy pivots of the past, certainly the 1970’s, when monetarist theory was literally academic, still under wraps in Milton Friedman’s study.
Retail sales in real terms have contracted, inventory overhangs are being discounted, goods orders have declined, oil is off from heady spikes on reduced demand expectations, and many other industrial and agricultural commodity prices are sharply off their peaks too. Services and manufacturing PMIs and confidence indicators have moved lower, perilously close to, if not already, indicating contraction. It would not be surprising then if core CPI components may soon start rolling over on this weakening demand picture, perhaps even enough to start offsetting some of the more persistent food and fuel elements for the headline numbers.
In the coming quarter, investors may be looking back at Q2 GDP in contraction again, following the technical contraction in Q1 where surging trade imbalances on clearing import backlogs tipped the US negative. The Atlanta Fed Now index has been pointing to just zero growth in Q2 for a while and just recently indicated negative. The same external trade balances as in Q1 risk that tilt lower and higher inventories: supply chain bottlenecks have continued to clear record volumes of goods through Q2 from anecdotes at container terminals in Long Beach California and Shanghai and the intermodal volumes at Union Pacific Railroad. The stronger dollar will have sucked in further imports piling up all that inventory sitting around in warehouses now.
With possibly two consecutive quarters of negative GDP in the US, we would already be in recession, however technical in nature, with a lot of heat taken out of confidence and activity across the board. If, and it is indeed a big ‘If’, employment, wages and core CPI show any softening in the summer months, then the bond markets will put some slack into the forward rates curve, as they have already started to do in recent weeks. Fears of ever-higher inflation may recede as one and two year inflation break-evens are suggesting. In that scenario, real purchasing power in consumers’ pockets should start to improve, and stock markets can focus on how corporate profit margins and consumer confidence may recover in the second half of the year, albeit against many headwinds not least the European energy crisis.
That backdrop could be characterised as the shallow recession many are predicting for the US even if more acute risks overseas, with strong household finances and corporate balance sheets too, albeit somewhat sooner than currently expected. US 10-year Treasury yields, and forward policy rates, would be just below the long-term average, one year inflation expectations just above the long-term average but declining, stock market valuations just around the long-term average, and QE on the way out.
It’s a lot of ‘Ifs’ admittedly, and it would be too early to call as a base case. But in this context, we could envisage that we are already entering the soft landing. There would still be a big wall of worry ahead, not least energy supply, war or peace, food security and housing bubbles, and maybe another leg lower in stock valuations on profit margins and earnings revisions between the second and third quarter results. But stock markets need those walls to climb and at some point not too far away, they may just start getting on with it.
The 60:40 portfolio and its variants offer balance for the binary outcomes of this landscape, a crucial utility to investors’ allocations once again on bonds that actually yield something, and by consensus something actually ‘real’ too over the coming years. Giving back some of those supra-normal gains in bonds from over a decade of financial repression doesn’t seem too unreasonable a price to have given back this year for a substantial move towards normalisation, surely a hallowed land if a little scary arriving!
This admittedly optimistic scenario may well not play out entirely in the holiday quarter ahead but given the heightened levels of uncertainty around so much in the landscape, it is not entirely without the realms of possibility – risk is a double-sided coin. Perhaps a reasonable base case would be that most of it plays out over the second half, while that is no guarantee stocks won’t have one further leg down before it does, maybe on persistent inflation or earnings downgrades. One eye on inflation this week and the other on the earnings season coming then.
This article was originally published as an OpEd in Investment Week – July 2022.
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