Market rally fizzled as the Federal Reserve squashed hopes of a near-term policy pivot
During the first half of August, domestic equity markets continued gaining off mid-June lows, but swiftly reversed course to finish the month in negative territory following Federal Reserve (Fed) Chair Jerome Powell’s speech at the Jackson Hole Economic Summit.
Leading up to the speech, softening economic data and improving inflation stoked optimism of a slowdown in the pace of Fed interest rate increases. Those hopes dissolved as Chair Powell instead warned against premature policy loosening and reiterated the Fed’s resolve to achieve price stability through restrictive monetary policy.
In our view, the key driver of equity market volatility this year has been forward guidance from the Fed. We continue to expect volatility to remain elevated until markets get a clear signal that inflation is moving in the right direction and aggressive Fed action can begin to pause. Notably, while equity markets reacted negatively to Chair Powell’s speech, expectations for future rate hikes remained virtually unchanged, keeping to the previous 50-75 basis points (bps) range (Figure 1). In our view, this suggests fixed income markets are already positioned for a steep rate hike in September.
Figure 1. Market-implied Probability of a 25 bps Rate Hike, bps
Rate hike expectations largely remained unchanged after Chair Powell’s August 26 speech
As of 8/31/2022. Source: Bloomberg, L.P
View accessible version of this chart.
The S&P 500® ended August down 4.1% after gaining more than 4.2% by mid-month. In addition to disappointment from the Fed, the equity rally was interrupted by macro headwinds surrounding intensifying energy inflation across Europe, softening economic data in China and expectations for tighter global monetary policy. S&P 500 sectors, aside from Energy and Utilities, finished lower for the month, as signs of a slowdown pressured the global economic outlook. While energy prices have declined 28% since peaking in early March, elevated inflation and rising interest rates have increased the probability of lower earnings revisions. Large-cap growth stocks faced the most pressure during August as valuations compressed, while value-oriented and small- and mid-cap indices outperformed on a relative basis.
Softening economic data continues to suggest we are in the slowing expansion phase of the business cycle. Despite improving consumer sentiment and strong labor markets and manufacturing activity, recent data indicate tightening financial conditions are negatively impacting retail sales and housing markets. For example, the July report for new home sales showed a 12.6% decline during the month as elevated prices combined with 30-year mortgage rates above 6.0% to impact affordability.
The July reading for the Consumer Price Index (CPI) moderated to an annualized rate of 8.5%, showing a decline for the first time since May 2020. Inflation remains elevated as pandemic-related supply disruptions and the ongoing Russia-Ukraine war continue to impact prices. Recent declines in crude oil and gasoline prices helped to offset the increases in services, food and goods inflation. While it is possible inflation has peaked, we believe the Fed will need to see more significant declines in inflation to change course with monetary policy.
Equity volatility, as measured by the CBOE Volatility Index, increased throughout August, with the largest spike occurring after Fed Chair Powell’s speech at Jackson Hole. We believe volatility was likely exacerbated by a lack of market liquidity as August had the lowest monthly trading volume for the year. Given the lack of market liquidity, we are less concerned about the potential implications of the market’s move lower during the month.
The U.S. Treasury (UST) yield curve moved higher in August as markets repriced rates based on Chair Powell’s unwavering fight against inflation. The short end of the curve, which is the most sensitive to monetary policy decisions, saw the biggest increase, with the 2-year and 5-year tenors jumping 61 and 68 bps, respectively. Notably, the move in the 2-year yield, which ended the month at 3.49%, was 7 bps above the high set in June and is now at its highest level in 15 years. The increase in rates kept the yield curve, as measured by the spread between the 2- and 10-year UST yields, inverted for a second consecutive month, the longest streak since 2007.
Continued uncertainty regarding the path of monetary policy, lack of new issuance and record outflows of more than $9.5 billion from bond funds contributed to spread widening in high yield (HY) bonds.
The Bloomberg High Yield Index option-adjusted spread ended the month at 484 bps, representing a 15 bp increase from last month. On the other hand, investment grade bonds, which represent the most creditworthy borrowers, saw spreads move lower by 4 bps to 140 bps. Thus far, the largest moves in spreads have been concentrated in the lowest-quality HY bonds (CCC-rated). Tightening financial conditions, substantial increases in yields and widening spreads all put pressure on the market’s least-creditworthy companies, raising concerns of the potential for financial distress and defaults.
Valuations compressed across the market-cap spectrum in August, although they remained above mid-June lows. The S&P 500 forward price-to-earnings ratio of 16.6 times is back to pre-pandemic levels. While large-cap valuations are trading above their 10-year averages, both the S&P 400 MidCap® and Russell® 2000 continue to experience valuation compression below their long-term averages. This may be due in part to the composition of those indices as they lean toward lower-valuation, lower-growth sectors. Going forward, we do not expect meaningful multiple expansion without a material decline in inflation rates from 40-year highs.
Developed International Markets
Earnings resilience expected to fade as macro headwinds intensify
There were few pockets of opportunity in developed international equity markets in August as inflation, energy concerns and central bank rate hikes weighed on returns. The MSCI World ex US Index fell 4.7%, lagging the S&P 500, largely due to continued U.S. dollar appreciation. The euro ended the month at parity with the dollar, its weakest level in nearly 20 years. Germany, along with the rest of Europe outside the U.K., underperformed noticeably as energy supply fears and rising costs pressured risk assets.
Economic data continued to paint a gloomy outlook for the region in August. Inflation in Germany, the Eurozone’s largest economy, hit a 40-year high, leading to a more aggressive stance by the European Central Bank (ECB). Purchasing Manager Index figures remain below the 50-point mark — the inflection point that separates economic expansion from contraction — for a second consecutive month, suggesting activity in the area is slowing rapidly.
Energy costs in Europe remain a major headwind and contributor to inflation. The front-month benchmark European natural gas contract hit $249 per megawatt hour by month end, the equivalent of $418 for a barrel of oil. Natural gas prices are now more than 10-times higher in Europe than in the U.S., which we believe will push the energy component of CPI in European countries higher.
Due to the impact of extreme energy prices, we expect the ECB may continue tightening policy to combat spiking inflation despite faltering economic growth.
Likewise, in the U.K., rising inflation led the Bank of England to raise short-term rates by 50 bps in August, the sixth consecutive rate hike in eight months. The combination of high inflation, tighter policy and low household savings may be strong headwinds for consumer spending, which represents more than 60% of U.K. GDP.
Despite the significant macroeconomic influences confronting developed international markets, earnings growth was resilient in the second quarter, aided by strong earnings from the Energy sector. However, we believe profit growth will slow sharply in the second half of the year as the ongoing surge in energy prices and dwindling household savings and real incomes will significantly curtail spending. As a result, we expect Eurozone equities may struggle to make further headway in the near term as earnings estimates remain high while the ratings downgrade cycle is accelerating (Figure 2).
Figure 2. EU Earnings Estimates and Sentiment
Earnings estimates have yet to reflect the weakening economic backdrop
As of 8/31/2022. Source: Bloomberg, L.P.
View accessible version of this chart.
In contrast to western economies, Japan may have finally achieved its long-desired goal: inflation. However, August CPI only rose 2.6%, still very low relative to most developed market economies. Recent economic data for July point to signs of a recovery, as retail sales and industrial production rose more than consensus estimates, which again contrasts with the slowdown in Europe.
Regional divergences continue to characterize emerging market equities
Emerging markets (EM) ended the month up 0.4%, supported by gains in India and Brazil. However, U.S. dollar strength risks pushing up inflation and debt service costs in certain countries in the near term. We believe a combination of fiscal and monetary support along with continued easing of pandemic restrictions will be enough to drive an earnings rebound in China and a rerating higher from still very depressed valuation multiples.
Investor sentiment remains subdued in EM, driven primarily by China, as evidenced by the steep decline in earnings revisions over the last 12 months (Figure 3). However, headwinds such as China’s zero-Covid policy, regulatory risk and weakness in the property market are already reflected in earnings revisions, in our view. As China continues to loosen its pandemic policies, provides fiscal and monetary support and seeks to stabilize its property market, we believe earnings should start to reflect this trend and revisions should begin to recalibrate accordingly.
Figure 3. EM Earnings Per Share Estimates
EM earnings estimates ex-China remain resilient
As of 8/31/2022 | Source: FactSet®. FactSet is a registered trademark of FactSet Systems Inc., affiliated.
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Together with local governments, China’s banking and banking and housing authorities have stepped in to contain a weak property market and ease the burden on mortgage borrowers. During August, the Chinese central bank cut the 5-year loan prime rate by 15 bps, 10 bps more than consensus expectations. We continue to expect further policy easing during the remainder of the year to support real estate construction and infrastructure spending.
Efforts by both the People’s Bank of China (PBOC) and the Chinese government to prop up the economy helped Chinese HY dollar bonds deliver their best monthly performance in more than 10 years, snapping an 11-month losing streak.
In addition to the PBOC’s policy rate cut, the support pledged by government authorities to help property developers issue onshore bonds with full state guarantees as well as offer reductions in both loan prime rates and mortgage rates boosted risk assets.
TEXT VERSION OF CHARTS
Figure 1: Market-implied Probability of a 25 bps Rate Hike, bps
Rate hike expectations largely remained unchanged after Chair Powell’s August 26 speech (view image)
|Date||Probability of a 25bp Fed Rate Hike|
Figure 2: EU Earnings Estimates and Sentiment
Earnings estimates have yet to reflect the weakening economic backdrop (view image)
Figure 3: EM Earnings Per Share Growth Estimates
EM earnings estimates ex-China remain resilient (view image)
|Date||MSCI EM Earnings Estimates||MSCI China Earnings Estimates||MSCI EM ex-China Earnings Estimates|