We are perhaps approaching the peak of hawkishness, or in other words, the point where central banks will be obliged to either slow down the path of interest rate increases or stop them altogether. We have seen this already in the UK where the first signs of stress in financial stability obliged the BoE to actually start buying (!) long-term bonds to keep yields in check. As the macroeconomic data continue to deteriorate, with the labor market usually the "last shoe to drop", central banks will soon face the dilemma to either continue being aggressive and risk a big policy mistake throwing the world in a deep recession or press on the brakes before the accident (ie a global major recession) happens. When the markets start discounting this "peak-hawkishness" scenario, there will be significant implications on the direction of various assets (long-term bonds will rally, equities will stabilize, the USD will weaken, Gold will creep higher).
We saw such a first, tiny example from the Australian Central Bank (RBA) , which raised interest rates by only 0.25%, vs expectations for 0.50%. In the text accompanying the decision, the RBA mentioned that although the top priority right now is to attack inflation, it should also ensure that the economy is operating in a balanced way. The New Zealand Central Bank also chose to raise interest rates by less than widely discussed, namely by 0.50% vs. some expectations for 0.75%. Of course central bank officials in the US and in Europe will, for now, stick to their plans to aggressively raise interest rates in the coming two months. But early next year, they might have to change views and eventually their path.
Equities moved higher for the week, despite Friday's sell-off. The strength of the equity markets at the start of the week was enough to make them finish on a positive note, on a weekly basis. Japan's Nikkei was the out-performer with a 4.5% gain while the rest of the world rose by about 1.5% on average. Chinese markets were closed the whole week for holidays. In terms of sectors, Energy powered ahead by 10%, as oil prices rebounded strongly and the most defensive sector, Consumer Staples, actually posted minor losses for the week.
The US labor market's growth slowed down in September. The non-farm payrolls were announced at +263'000 vs expectations for 250'000 and 315'000 in August. Actually, the +263k number is the slowest monthly increase since April 2021 ! Even more importantly, the annual average wage increase slowed down to 5%, after several months of 5.2%-5.3%. Admitedly, the labor market remains tight, which gives the FED officials reason to publicly claim that they will not deviate from their recently communicated strategy to push interest rates to almost 4.50% in the next 3-4 months. However, numbers can change fast, especially if one takes into account the number of public companies which have announced personnel reductions or hire freezes during the last three months, including some high-growth companies in the Technology sector.
The US September ISM Manufacturing dropped much more than expected. It was announced at 50.9 vs expectations of 52.2 and 52.8 in August. Even more pronounced was the drop in the New Orders sub-index which fell to 47.1 from 51.3 while the employment sub-index also showed signs of deterioration. On the positive side (for inflation), the Prices Paid sub-index dropped further, to 51.3. As a comparison this index had reached a high of 85+ in May of this year and it was in the 40-50s during the pandemic. If one adds the big jump in unsold inventories across many goods, including semiconductors (the revenues' warning by AMD on Thursday did not come as a surprise) a rosier picture for inflation can be painted for as early as in March or April of 2023.
Bonds moved in a dramatic way last week. The news from Australia and the bad macroeconomic data at the start of the week made bond prices rally (yields to fall) significantly. The US 10-year yield reached a low of 3.60% from 4.00% the previous week, which represents about a 3% rally in prices. The German equivalent fell to 1.80% from 2.30%. But these moves were reversed towards the end of the week, as FED officials pushed against the market's perception that there will be a slowdown in interest rate hikes and as the labor market data were in-line with expectations. The 10-year closed at 3.88% and the 2-year at 4.30%.
Gold fell towards the 1700$ level again, while Oil prices shot up by almost 15%. The rise of yields at the end of the week, which lead also to a rise in the USD did not help Gold. WTI Crude finished the week at 93$, pushing it above its recent technical resistance, as the market is becoming again nervous about the Russia/OPEC/West tensions.
OPEC+ announced a production cut of 2mn barrels per day, although the devil is in the detail. The production cut is calculated vs their existing production targets (quotas) which remained unchanged. However many countries, including Russia, as producing far less barrels a day anyway, not meeting their targets. Hence the real production cut is estimated at less than 1mn and closer to 500k, which still leaves oil priced vulnerable to an upswing.
The Q3 corporate reporting season starts this week, in the US. As usual, it is the major financial companies/banks which commence with JP Morgan, Citigroup, Morgan Stanley and Blackrock among the ones who are set to report on Wednesday and Thursday of this week. The bulk of the earnings will come towards the end of this month and will play an important role for the final direction of equity prices until year end. Most market participants expect a significant downward revision of 2023 estimates which should take place in the next one or two months. The market has already discounted a downward revision, with the S&P500 trading at just 15 times forward earnings. What will matter is the magnitude of the fall in expected earnings. If, by any chance, the company news do not show a sizable revision for next year, the market could further rally to a short-term target of 4050/4100 for the S&P500, almost 8% higher from current levels.
Chart of the Week :
How long-term bonds protected investors in 2000-2003.
This is the chart of the S&P500 during the bear market of 2000-2003, in blue line. The green line is the yield of the 10-year US Treasury in the same period. We see that the S&P500 dropped about 50% from its peak in March of 2000 to the bottom in March 2003. At the same time, the yield of the 10-year dropped from 6.5% to a low of almost 3.5%. This drop in yields represents is estimated to have generated a total return of about 45%, which includes the interest earned and the capital gains because of the bond prices moving significantly higher. Put together, this means that a very basic balanced portfolio of 50% equities and 50% government bonds was very well protected in this very bad period, thanks to the long-term bonds. Looking forward to what happens next and primarily in 2023, one could definitely argue that the current levels of high quality bonds could similarly protect an investment portfolio if we were to see equities drop significantly next year too, based on the premise of a possible recession and corporate earnings downgrade. Although the starting level of yields is not the same as back then, which lowers the potential interest earned in 12-18 months from now, the capital gains on long-term bonds could be significant.
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• Sources: Chart of the Week : Factset