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Is the sell-off overdone?
Markets continue to be highly volatile and whilst some have made numerous attempts at a bounce, fragility is the dominant theme.
Despite a few days of buoyancy through the earlier part of the week, US markets took another tumble on Wednesday (18th May), giving back the vast majority of the gains made since Friday 12th. Once again, higher growth areas of the market, such as Technology stocks bore the brunt of the selling although, notably, Target Corporation a “big box” department store and the 8th largest retailer in the US lost over a quarter of its market value on Wednesday night.
For now, the UK market appears to be holding up much better and the most visible and reporting index, the FTSE 100 remain in positive territory (just) year to date. However, our clients’ portfolios are not invested in just the largest 100 UK companies and so trying to compare returns to the FTSE 100 is akin to comparing a fruit cake to a victoria sponge. Both are cakes and both are edible, but they are very different in terms of their ingredients and the way they taste.
Some clients might be wondering whether now is a good time to buy into the market. Honestly, no one knows and, as regular readers will be aware, we are not advocates of attempting to time the market. Attempting to call the bottom of a market is extremely difficult. However, to paraphrase the renowned investor, Howard Marks, now might not be the time to buy but it is a time to buy.
So, could the heavy selling we have seen so far this year be overdone? Honestly, we don’t know but let’s briefly look at the arguments both for and against a less fraught second half of the year.
Many strategists and investors are expecting/hoping that the sky-high inflation numbers we are seeing in the UK and the US will start to ease through the second half of the year.
As I am writing, UK annual inflation numbers (CPI) came in at 9%, a 40-year high. According to reports, the Chancellor, Rishi Sunak, stated during a speech to the Confederation of British Industry (CBI) that there is nothing any government can do to tame inflation. He has a point. Much of the inflationary pressures are due to energy and food prices which have been driven up by pandemic induced lockdowns and the war in Ukraine. Raising interest rates will not bring prices down. The Bank of England Governor Andrew Bailey has also said he felt “helpless” to stop inflation.
At the same time, new car registrations in Europe have fallen by 21% year-on-year as supply chain issues caused by Covid lockdowns and the war in Ukraine linger on. As we have discussed before, supply chain bottlenecks are inflationary. Last week, US core inflation came in higher than the market had hoped although the rate of the increase had slowed.
Given this data, the risk is clearly that inflation will remain very high as energy, commodity, and food prices are all affected by the war in Europe. Should China continue to pursue its zero-Covid policy, rolling lockdowns will exacerbate the inflationary problem.
However, there are a few reasons to be hopeful. Covid cases in China appear to be falling which should bode well for the cost of shipping around the world. As the 2nd chart below shows, shipping costs appear to have peaked. The black line shows the cost of 40ft shipping containers in US Dollars. Whilst there is a long way for prices to fall to their pre-pandemic levels, indications are promising:
Over in the US, the price of used cars appears to be peaking out as well:
It is important to note that, as human beings, we are prone to certain biases. One of which is the tendency to look for data/evidence which supports our own hypothesis. Therefore, it is important to note that none of these charts are conclusive.
Nonetheless, it is the rate of change in the inflation data which matters most to markets, not necessarily the absolute level. Should inflation simply stop accelerating then mathematics dictates that the headline inflation number will start to fall. This could bode well for risky assets such as bonds and equities, should it transpire.
We, and many other investors, are worried that a recession might be on the horizon. The Bank of England has warned that the risk of recession in the UK is high and the US Federal Reserve (Fed) is trying to bring down inflation without killing off economic growth.
Whether the Fed will be able to engineer this “soft landing” or not is debatable and, to be blunt, it doesn’t have a great track record. A recent academic paper showed that, since 1955, on each of the three occasions when inflation was above 5% and unemployment below 4% (as is the case now), recession followed within a year. This does not bode well.
Again, there might be reasons to be optimistic. Some of the inflationary pressures have been caused by consumers switching from spending on services to durable goods. As the world locked down during the pandemic, we couldn’t spend on eating out, holidays, or going to the cinema and so many spent on home improvements instead.
As consumption switches back to services from durables, and the supply side hopefully succeeds in increasing production, the price of manufactured goods could fall. There were signs of this happening already in March when US durables prices fell by 0.9% month-on-month. The problem, however, is that because of rising energy costs and lockdowns in China, the supply-side response might be further delayed thus mitigating any downward pressure on prices.
There is a school of thought that excess savings could support the economy, even if wage growth is more than offset by inflation. In the US, estimates suggest that there is over $2 trillion of excess savings, which is equal to about 10% of US GDP. Therefore, should consumers decide to spend this, it could support the economy for a few years:
Bearing in mind a tight labour market, rapidly increasing wages, and the factors discussed above, the outlook for the US economy is highly uncertain. Many strategists expect a recession (after all expansion cannot last forever) but the expected timing varies.
Should the economy avoid a recession in the short term, this could support risk taking and equity and bond prices from here.
Investor positioning & valuations
One could argue that global equities are now more attractively priced following the recent sell-off. That is true but it doesn’t get away from the fact that some markets are still expensive relative to their own history. The chart below shows the valuation of global equities on one measure and we can see that the US is by no means “cheap”:
However, investors appear to be very pessimistic. In the chart below, when the line is moving down, investors are more pessimistic. We can see that pessimism is worse even than in the depths of the Global Financial Crisis in 2008:
This very bearish sentiment could be a contrarian indicator and draw people back into the market in search of bargains.
However, positioning across US investors suggests that, despite the bearishness, investors haven’t actually repositioned their portfolios very much. The chart below shows that equity holdings have barely fallen, and cash has only risen at the margin:
Perhaps then investors are as concerned as we are over the risks of recession but are mindful of the finely balanced arguments both for and against a more benign environment going forward.
How we are navigating these markets
It is fair to say that markets have been very difficult to navigate since the onset of the pandemic, just over 2 years ago. This is particularly true of 2022 so far.
In environments such as this we suggest:
Until next time stay well.
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