29 August, 2022 - September is beautiful (but tricky for markets).



September has historically been the worst month for equities, but this is no reason on which to base an investment decision to sell. We enter this tricky month, coming from a hot July with indices up 10-15% from the lows, so things can get nasty fast. There are three main reasons which make us nervous: a) The famous QT, i.e. quantitative tightening by the FED is expected to double in September. In other words, liquidity is going to be withdrawn from the system much quicker than before, b) corporate buybacks, ie the ability of companies to buy back their own shares is going to stop on the 15th of the month, entering the "black-out" period ahead of the corporate results. A significant buyer of equities (corporations) will be out of the market. And finally c) earnings revisions for the end of the year but most importantly for 2023 will start to happen in the next two months. All in all, it is worth being cautious, but looking out for buying opportunities in the coming weeks until mid- or end-October. Our strategy would be to stay in high quality stocks with low leverage, significant cash flow and some pricing power. Some places to (temporarily) hide would be Healthcare and large cap Technology as well as the Communications sector (for example Google) which have already partly discounted a recession.


The FED's Chairman, J. Powell, delivered a clear message at the Jackson Hole symposium. Inflation is the number one enemy, and it has to come down almost at any cost. He warned about "pain" , as he mentioned that they are prepared to "bring demand down forcefully". It is very rare for a central banker to so publicly admit that a recession is not only possible but a "welcome" side-effect of their efforts to bring inflation down. With respect to interest rates he repeated their desire to push them into "sufficiently restrictive territory" and leaving them there for a "considerable amount of time". He specifically said that it would be premature to start reducing rates any time soon, making reference to the 1970s where the FED made several mistakes that led to the well-known turmoil of the time. It seems that lessons have been learned. If we wish to draw the most likely scenario for rates, this would be that after reaching about 3.75% by the end of 2022, the FED will stop and wait for several months to see the effects on the real economy and inflation. Rates could stay at these levels for most part of 2023, creating thus issues for companies with weak balance sheets and high debt levels.


US equities dropped 3-4% on Friday, as the previous rally was based on wrong foundations and boosted by a lot of short covering. As already mentioned, the 4300 level for the S&P500 would be very hard to overcome at this stage. But it seems that the June low might have been the bottom of this cycle and we should be looking soon again at oportunities. On a more positive note, the S&P500 already moved quickly close to a significant support zone of 3980-4000, down 6% from its peak two weeks ago.


Short-term bonds dropped and their yields moved higher, with the 2-year US Treasury touching 3.45% again. The longer-term bonds moved slightly higher (yields dropped) as that part of the market chose to focus on the risk of a recession in the next 12 months, which will eventually force the FED start reducing rates perhaps in late 2023.


The Purchasing Managers Indices (PMI) dropped further in July. The PMIs, both in the US and in Europe continued to move south in July, as per the preliminary readings announced last week. The Manufacturing sector in the Eurozone managed to increase vs June but remained below 50, which signals recession. The Services sector dropped further to a new cycle low of 50.2 and remained slightly above 50, but the trend looks down. Germany was the worst contributor in the Services PMI with a drop to 48.1. The US numbers were even worse. The Services PMI dropped to 44.1, the lowest since May 2020, while Manufacturing fell but remained above 50, at 51.3. Overall, these data show again an increased probability for a recession. But on the positive side, they point to lower consumer goods prices ahead which will help keep inflation from reaching new highs.


The "peak inflation" theme gained some further ground last week. The Fed's favorite inflation metric, the Personal Consumption Expenditure (PCE) Deflator dropped on a monthly basis (albeit for a mere 0.07%) for the first time since 2020. On an annual basis the PCE was announced at 6.3% vs 6.8% in June. There is no doubt that the most likely scenario is that we have seen the worst of inflation, unless a world war explodes. The scenario of "peak inflation" is taken positively by the markets as it puts less pressure on the FED. However, we must once again note that the reason behind the "peak inflation" is the dramatic slowdown of the economy, at the edge of a recession.


China continues its "drop-by-drop" offer of stimulus to the economy. They cut the 5-year mortgage rates by more than expected, bringing the actual rate to 4.3%, down from 4.45%. They also cut the 1-year lending rate by 5bps. These continue to be rather small steps towards stimulating the economy, as China has done for most part of this year. Those who wait for a "bazooka-type" of stimulus, like the US ocherstrated in 2020 amidst the pandemic recession will be very disappointed. China is not willing to have volatility in its economy. Having seen the side-effects of massive monetary easing in the US the last 12 months and the struggle to curb inflation, they want to maintain a much more controlled and slow pace of boosting the economy. No surprise that the phrase "chinese torture" is widely used metaphorically in the western world.


US and China signed agreement for the Chinese stocks listed in US exchanges. U.S. regulators have for long been demanding access to audit papers of Chinese companies listed in the United States, but Beijing has been reluctant to let overseas regulators inspect accounting firms, citing security concerns. According to the agreement the US could at its "sole discretion to select the firms, audit engagements and potential violations it inspects and investigates – without consultation with, nor input from, Chinese authorities." China's Securities Regulatory Commission said the agreement was an important step towards addressing the auditing issue. This is an important development that lifts a significant weight that had been hanging over Chinese stocks for more than a year and outright positive for the region's equity market to try to recover again.


In other corporate news, semiconductor powerhouse, Nvidia warned for lower revenues for the next quarter, again. The supply issues of the 2020/2021 period led to an overinvestment and as inflation and higher interest rates hurt demand, semiconductor companies seem to have entered a down cycle. However this should be viewed as a cyclical, short-term pause within a structural, longer term, ever increasing need for semiconductors, making the shares of the leading companies attractive again in the next 3-6 months. On the contrary, the cloud migration business looks to be unaffected for now, , as another company (Snowflake) posted very solid results and guided for superb growth in the near future.


 

Chart of the Week : The US housing market already in recession


This is the chart of the New Home Sales in the US on a seasonally adjusted annual basis for the last 10 years. In July they fell to 511'000, much lower than forecasted and at the lowest level since 2016. This figure represents a staggering 13% drop from the previous month's rate. At the same time, inventory of homes has risen dramatically as measured by the amount of time it would take to clear the market. This now stands at 11 months, the highest since April 2009, right in the middle of the financial crisis. July also marked the first time in three years that home prices declined vs the previous month. The monthly decline was 0.8%, which seems too small, but it is the largest monthly decline since 2011. The housing market is the first "shoe to drop", the first victim of the FED's tightening campaign. This is normal as mortgage rates reached almost 6% a few weeks ago, double the 3% rate of last year which fuelled the pandemic boom in sales, as clearly shown in the chart in 2020. From boom to bust in just a few months, and the FED would love to see also rents coming down, as this is a big (and sticky) component of the inflation calculation.


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• Sources: Chart of the Week : Factset