After a rebound in stocks off the mid-June lows that carried through July, the S&P 500 sold off by 4.2% in August. The NASDAQ lost a similar amount while the small cap Russell 2000 was lower by 2.2%. Europe was under pressure too, with the STOXX 600 down by 5.3%. Asian markets were more mixed with the Nikkei and Kospi higher but the Shanghai composite index lower, to name a few. I’ll get into more details below but the main catalyst for the US weakness was the reality check that Jay Powell gave us on August 26th in Jackson Hole that he’s really serious about lowering inflation via rate hikes. In Europe, they are suffocating from skyrocketing energy prices.
Bonds across the board sold off in August and highlights the difficult investing year we’ve seen so far where bonds have not been the ballast to one’s portfolio that they’ve been over the past few decades. This of course is because we have inflation running at 40 yr highs at the same time the Federal Reserve is responding with its most aggressive rate hiking campaign since Paul Volcker was in the Chair seat. To add to those rate hikes, on September 1st the Fed is increasing the caps on its quantitative tightening program to $95b per month which annualizes to $1.14t per year, a rather notable amount of balance sheet reduction.
On the tough talk by a variety of central bankers at the Fed on inflation and their desire to keep on hiking, culminating with the Powell Jackson Hole speech, the US 2 yr Treasury yield rose to 3.50% by the end of August, up from 2.89% at the beginning of the month. That 61 basis point increase was almost matched by a 55 basis point rise in the 10 yr yield. Sovereign bonds also sold off sharply in Europe as some European Central Bankers are laying the ground work for a possible 75 basis point increase in their deposit rate at their September meeting at the same time inflation has become a major problem there.
Corporate credit, both investment grade and high yield, was weaker as economic growth concerns continue to spread. There is currently a heated debate over whether the US economy is in a recession or not but I think it’s a game of semantics. The trajectory of growth is slower and we are likely heading to one if not in one already. We’ve already seen two quarters in a row of GDP contraction. Europe is struggling with extraordinarily high energy prices and China is challenged by its strict covid policy and a sharp slowdown in its residential real estate sector.
The Stock Market Rally and the Federal Reserve
On August 25th, the day before Powell gave his monetary policy speech where he reminded the market that he’s going to keep on keeping on with tightening in order to quell high inflation, the S&P 500 was actually up on the month and had retraced exactly half of the drop from the high of around 4800 to the June low of around 3600 as markets up to that point thought the Fed was about to slow the pace of rate hikes. The next day however the S&P 500 fell 3.4% in response to the speech as markets realized that the noose of monetary policy was going to continue to tighten.
At the Jackson Hole annual gathering this year, it wasn’t just Powell that was firm in his conviction on getting the rate of inflation down, he was joined by many of his colleagues. After making the mistake of prioritizing the labor market in 2021 over growing inflationary pressures, they’ve now realized that you can’t have a healthy economy and firm labor market without first having stable prices.
The stock market is still expensive when measured on a variety of market multiples and thus it makes it vulnerable to a rising cost of capital and now worries about the direction of the economy and earnings. The positive is that we still have a good labor market with an unemployment rate of just 3.7% after the August read was released. That though is typically a lagging economic indicator and we’ll be watching closely for a further rise in the quarters to come. Our other key area of focus right now is on corporate profit margins and who has pricing power and who doesn’t.
As mentioned, bonds also sold off in August and it wasn’t just in response to a hawkish Fed but also to a growing hawkish European Central Bank. The ECB is presiding over an August CPI print of up 9.1% at the same time they have their deposit rate at zero (but will rise on September 8th). Yes, zero and that is after a 50 basis point raise at their last meeting. They are not just behind the curve ball, they are not even in the same stadium as their inflation opponent.
As August progressed and ending with the Jackson Hole central bank confab, here and there ECB members echoed more concern with inflation at the same time the price of natural gas in Europe along with power prices were skyrocketing higher. The German 2 yr yield, highly sensitive to ECB rate changes, started August at just .28% and ended the month at 1.20%. In the UK, where energy prices are up sharply too as the government just raised rather notably the energy caps that households will pay, the 2 yr Gilt yield rose by 130 basis points and its 10 yr yield by almost 100 basis points.
The monetary tightening that is taking place is the necessary response to higher inflation but lunch is not free as it comes after a period of high levels of debt borrowing in response to a period of very low interest rates, where negative rates was introduced as a new concept about 10 years ago. A bad idea by the way.
The Global Economy
There is an ongoing debate right now over the state of the US economy and whether we’re in a recession or not in one. I would classify it currently as there is a recession for some and not for others. For those lower income consumers who have seen a sharp rise in their cost of living relative to their wages and they are purposely trading down and limiting spending, they are more challenged. For a higher end consumer, the rise in inflation is not changing their spending habits too much yet. The US housing industry is in a recession, that I’m confident enough to say, as a 40% two year rise in the price of the average home according to S&P CoreLogic combined with the sharp rise in interest rates has sharply reduced the pace of housing transactions. The National Association of Home Builders estimates that housing in totality makes up between 15-18% of the US GDP. US capital spending is hanging in there but the direction of earnings from here will dictate if that is sustainable. As for international trade, US exports are being inhibited by the sharp economic slowing in Europe and tough growth in China.
With respect to Europe, it’s rather shocking to see the price level of natural gas and electricity prices and how much they’ve risen. To make an apples to apples comparison to the price of natural gas in the US, currently around $9 per million BTU, the equivalent price in Europe is about $72 as of this writing, 8x higher. The price of German power that feeds into electricity is higher by almost 500% over the past year and that is after a 48% drop off its late August spike high of almost 1000 euro per megawatt hour. Some households have some protection via government subsidies but many European factories are literally shutting down in response because they can’t be profitable with energy prices this high. Small and medium sized businesses are really getting hurt.
In the US we’ve seen a lot of relief at the gas pump over the past few months. According to AAA, the average gallon of gasoline has fallen below $4, currently at $3.81 as of this writing. This price has declined every day since mid-June when it got as high as $5.00. I highlight gasoline here because it is a price that most of us see each day and its direction does directly impact people’s spending decisions. The July consumer price index reported in the 2nd week of August, was up 8.5% y/o/y but that was below the estimate of 8.7% and down from 9.1% in June. The core rate was unchanged m/o/m at 5.9%. The price of goods, ex food and energy, saw its 5th straight month of slowing rates of gains, although service price inflation continues to accelerate. As stated for the past few months, we believe that inflation has peaked which is great news if the case. The question though is how much and how quickly does it moderate from here. We still believe it will be a while before it settles out at the 1-2% trend that we saw pre covid and we’ll have to get used to 3-4% instead.
Markets got a central bank reality check in late August and that broke the bounce we’ve seen since mid-June. Also QT has now ramped up to its max pace of $95b per month. This at the same time the global economy is on much more fragile ground. While inflation has topped out, as it seems, we still expect the investing environment to remain challenging.
This said, it is important to remember that recessions and market pullbacks are a natural part of the business cycle. As we continue to navigate through this, 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 crucial right now and the best friend of any investor. 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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