For markets, April was a month to forget whether one was investing in bonds and/or stocks. The Bloomberg Global Aggregate Total Return Index declined by 5.5% in April - the biggest drop in any month since the index was created in 1990 – bringing the year to date drop to -11.3%. The NASDAQ in April fell by 13.3%, the biggest one month decline since October 2008 right after Lehman Brothers announced its bankruptcy. The S&P 500 fell by 8.8% while the 10 yr US Treasury yield jumped to 2.94% from 2.34%. According to Deutsche Bank, April brought something we’ve only seen three other times since 1973 and that was a more than 5% drop in the S&P 500 and a drop in US Treasuries by more than 2% in the same month.
Overseas markets fell in April as well, but without such steep declines. The Euro STOXX 600 index was weaker by just 1.2% while the Shanghai composite was down by 6.3% and the Nikkei by 3.5%. Just as we saw higher US interest rates, the same occurred in most Asian and in all European bond markets. The German 10 yr bund yield for example almost doubled to .94% from .55%. Its 2 yr yield went above zero for the 1st time since August 2014, a few months after the European Central Bank began its experiment with negative interest rates. The Australian 10 yr yield rose to 3.13% from 2.84% and the South Korean 10 yr yield was higher by 26 bps to 3.21% to name a few notable moves in Asia. The only bond market to hold was in Japan but that was due to the Bank of Japan’s reiterated commitment to yield curve control.
The catalysts for this weakness in equities and rise in interest rates is something we’ve been talking about for a while - higher inflation, rising interest rates and tightened monetary policy response. By the time you read this, the Federal Reserve will most likely have hiked interest rates by 50 basis points after the initial 25 bps increase in March. They will also begin the process of shrinking their balance sheet at a pace that in three months will reach $95b per month. Also, the Bank of Canada raised interest rates by 50 basis points in April to 1.00%. The European Central Bank reiterated that QE will end in July and rate hikes could soon follow. Higher interest rates tends to lower multiples paid for assets and also reduces economic activity in interest rate sensitive parts of the economy.
The other big news of the month was the aggressive Covid driven shutdowns seen in Shanghai, a mega city of about 25mm people and known as the most cosmopolitan city in China. This is the largest city in the 2nd largest economy globally and thus has major implications not just for consumer spending in China, but also global supply chains that were only just beginning to rebound after two years of turmoil.
Lastly, the US dollar has accelerated its year to date gains, mostly against the major currencies of the euro, yen, and British pound. This is predominantly due to the rising interest rate differentials between the US and others as the Fed has shifted into a more aggressive monetary stance, especially when compared to the ECB and BoJ. The weakness in the yen was particular noteworthy in April, down 6.2% and is lower by 11.3% year to date vs the dollar. For a G10 country and the world’s 3rd largest economy, that is a rather sharp move. I’ll get into the implications later in this letter.
The Federal Reserve
Following the 50 basis point rate hike at the May meeting, the fed funds futures market is expecting more 50 basis point rate hikes in the meetings to come. As for when this will stop, that market is looking at something around 3.25% in the middle of 2023. This at the same time the Fed will begin letting its balance sheet roll off to the eventual tune of $95b per month or a $1.14T annualized pace. Of this, $60b will be US Treasuries and $35b will be agency mortgage backed securities. The US Treasury run off will be easy as the Fed holds hundreds of billions that mature this year. The MBS side won’t be easy as mortgage pre-payments are slowing dramatically in response to higher interest rates and thus the Fed might have to sell these securities outright at some point.
For perspective, the last time the Fed started to reduce the size of its balance sheet in October 2017, the initial pace was $10b per month that in 12 months progressed to a pace of $50b per month. The last time the Fed hiked rates by 50 basis points was in May 2000 and in early 1995 before then. Thus, this will easily be the most aggressive monetary tightening we have experienced the post Paul Volcker world of US central banking.
Years of easy money policy has created an economy very dependent on debt. This permitted financial markets to build up higher levels of valuation and credit spread tightness on a very low discount rate. We need to understand that the era of easy money in this cycle is over and thus will continue to have ripple effects on business activity and market pricing.
What’s Been Priced In?
As stated above, the market has priced in a very sharp rise in short term interest rates when we see the 2 yr Treasury yield at 2.73% as of this writing, up 200 basis points year to date. What I don’t believe we’ve fully priced in yet are the shrinking of the Fed’s balance sheet, both from a liquidity standpoint and what it means for interest rates and the economic impact of higher inflation and the rapid rise in rates.
The last time the Fed was both raising rates and conducting QT was in 2018 and we know it culminated in the sharp and rapid correction in Q4 2018 which was then followed by an eventual pivot from Powell in 2019. Because of higher inflation this time around however, it limits the Fed’s ability to back away from tightening. I think the only question from here is - what is the Fed’s tolerance for an economic slowdown and level of market weakness before they pivot and back off from tightening.
After listening to a slew of Q1 earnings conference calls, the US consumer has mostly kept up its pace of spending, especially in leisure travel, hospitality and dining as they break free from the grip of covid. There is growing uncertainty though as to what more they can take in terms of higher prices that they’ve absorbed well so far. With prices rising faster than wage growth, there is inevitably going to be a point where consumers moderate their pace of spending and we are close to reaching that point.
The Global Economy
Even before the Russian invasion of Ukraine, Europe was experiencing a sharp increase in the price of both natural gas and oil. One year ago, the price of natural gas in Europe was about $8 per mm BTU when compared on an apples to apples basis to the price of US natural gas. At its peak in December 2021, that price had spiked to $60 and as of this writing it’s currently priced around $33. This all compares with the price of US natural gas at around $7.50 vs $2.50 one year ago. The war created another spike in prices in Europe but they’ve since fallen off in response to the end of winter and a sharp pick up in exports of natural gas from the US, Qatar and Australia.
As of the April read, CPI in the Eurozone is running at a 7.5% y/o/y pace with a core rate up by 3.5% while the ECB still has rates below zero. As wages are not keeping up, the European consumer is getting hurt but so are industrial companies that rely on energy prices as feedstock. We should not be surprised if the Eurozone economy enters into a recession in Q2 or Q3 after a slight increase in Q1.
China as mentioned is the other big economic story as they won’t back off yet from their strict covid control stance. As the 2nd biggest economy, the ripple effects are broad based, whether directly or indirectly. Also, this really mucks up the major supply chains emanating out of China. I’m hopeful though that the Chinese government realizes soon that this is an unsustainable approach and things will reopen again quickly.
The US economy contracted in Q1 by 1.4% q/o/q annualized but we can fully blame the record trade deficit, a drag from inventories and a reduction in government spending. Capital spending and consumer spending were both pretty good. However, not much of a rebound is expected in Q2 as estimated by the Atlanta Fed which is currently forecasting only 1.6% growth.
I want to quickly mention the behavior of the yen specifically as the Japanese are reaching an important inflection point and one that has global repercussions as a result. The Japanese government and Bank of Japan have increasingly conflicting policies where choices are going to have to be made. Japan is experiencing higher inflation just like the rest of us, mostly on the wholesale side, but consumer prices are rising to the point where government officials are becoming more concerned. This higher inflation though is something the Bank of Japan has been shooting for over the last 10 years and have pinned the 10 yr JGB yield to a range of 25 basis points around the zero level to help achieve this. Well, because of rising inflation pressures and artificially suppressed interest rates, the yen has weakened dramatically in a short period of time where the Japanese government has expressed its displeasure with.
So the Bank of Japan will soon have a choice of either tolerating more yen weakness which will raise the cost of imports and inflation even more, particularly energy which Japan imports most of their needs or decide to let long term interest rates rise by expand its tolerance for higher rates. If the latter were to occur, there would be a big risk of another sharp rise in global interest rates as we all are so highly correlated.
I want to end this letter on a positive note by saying outside of China, the world has kissed covid goodbye in being such a strong force in our lives. Hopefully we are finally liberated from this scourge on our lives over the past two years and the services sector of the world economy can enjoy the benefits. This said and for all the reasons stated above, the investing environment is much more challenging and the economic outlook much more tenuous.
Either way, whatever the outcome will be, it remains vital that investors have a plan that suits their short term liquidity needs over the next 2-3 years. Knowing that period of time is covered can help separate the balance of one’s portfolio from what I believe will continue to be a choppy time for the economy and markets. Time horizon is really key right now. Please do not hesitate to reach out at any time with questions or for any discussion on the economy and these markets.
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