Monthly Market and Economic Update – October 2022

“If you have one economist on your team,
it’s likely that you have one more than you’ll need.” 

Warren Buffett

Key Points: 

• Inflation still looks strong.
• Is recession coming to the US economy?
• What about the global economy?
• When will interest rates peak?

THE MARKETS

Markets slowly closing on the downtrend floor

The above graph tracks the Bloomberg US Bond Index (the light blue line) and the S&P 500 Index along with the US Federal Reserve Funds Rate (the dark blue line).

Interest rates rise … trading prices decline.  Generally across the markets, trading price valuations are moving closer to acceptable fundamental levels as the overall market moves closer to the market downtrend floor.  It won’t be next month or even possibly this year, although the further down trading prices decline the closer we move to that point.

The Fed Dot Plot

The above table tracks the US Federal Reserve consensus view on the Funds Rate over the next few years.

As the Fed Dot Plot table above shows, further interest rate hikes look reasonably certain – take a close look at the graph (and the year of the red circled dots).

On the one hand, we might think that the market knows this and therefore has priced in those interest rate rises.  However, on the other hand, the evidence over the last several months shows this is not the case.

Each time the Fed raises rates, even though the market knows it’s going to happen, trading prices decline.  Part of the reason of course is the short-term trading that’s going on which is significant.  That’s why prices move so strongly, up and down from one day to the next.  It has nothing to do with the fundamentals of each business.

The most recent 75 basis point interest rate increase, for the third time since June, has brought the Fed Funds Rate closer to the target range of 3% to 3.5%, the highest since 2008.  Based on Federal Reserve projections, it looks as though the Central Bank will continue to take that rate above 4.5% in the months ahead.

The Fab Four

As I outlined last month these are

• Spiking inflation
• Rising interest rates
• Worry about recession
• Earnings revisions

On that last point (earnings revisions) I see limited expectation across the markets about earnings revisions currently, however when we look at the math, it would seem that markets remain somewhat expensive.

The Math

Talking generally, bear markets can end with a price to earnings ratio of 13 to 15 multiples although they can go as low as 9.

With the current forward PE ratio for the S&P 500 sitting at around 17, there could be further downside for markets generally but as I said, we are closing in.  This ratio is down from 17.4 last quarter and down from 19.11 twelve months ago.

The Market Is Not The Business Though

The point here is that individual trading prices in the short term generally move in line with market indexes. However when we look more closely, there is divergence and opportunity for us investing in individual businesses to take advantage of better pricing.  Some trading prices decline much more than the market.

For example, Adobe has seen its trading price decline sharply because of the recent announcement of the take-over of Figma.  There are risks attached with the deal and the market believes Adobe is paying too much, hence the re-rating of the trading price.  That said, Adobe is a highly profitable business that will be further enhanced if they can get the Figma deal across the line without too much disruption.

The point here is that it’s one thing to look at market indexes to gauge where things are at.  It’s a very different thing to consider the merits of an individual business and its trading price.

The Global Economy

The above graph tracks economic contraction and expansion in the US from 1950 up to 2022.

Recession is coming.  I say that because we still have inflation tracking at an elevated level (in the US and other countries) well ahead of the US Federal Reserve’s 2% benchmark.  That means not only further interest rate increases but probably rising unemployment along with an earnings revision for some companies as they report each quarter.

By the way, I’m not trying to be doom and gloom, just simply stating what I see ahead.  We are investors rather than economists.  We invest (in businesses directly, not the economy).

Interestingly, recessions have been relatively small compared to economic expansion.  In the US for the last 70 years for example, the US has been in official recession less than 15% of all the months over that time.  Also, their net economic impact has been relatively minor.  The average recession reduced GDP by 2.5% whereas the average expansion increased economic output by 25%.

Interestingly, equity returns sometimes are positive over the full length of a contraction.  That’s because some of the strongest stock market rallies have occurred during the late stages of a recession.

TIP:  Markets are forward looking and can change direction within hours.

It’s good to know where things are economically however it’s a shame for those who get caught up in the noise of short-term economic data and then miss out on the inevitable rally that emerges.

We seem to be heading for recession

The above graph tracks the New York Federal Reserve model for probability of recession.

Unfortunately, it’s difficult to nail down the exact timing.  That would depend on the pace and also the magnitude of the Federal Reserve rate hikes.

Getting inflation back to 2% currently looks reasonably daunting.  It’s difficult to see how that can be achieved without pushing the economy into recession.  For example, by some estimates, unemployment in the US may need to rise to around 5 or 6% before wage growth starts to moderate.

US Fed increasing interest rates faster than expected

The above graph shows the difference between June projections for interest rates and September projections.

It almost seems as though the US Federal Reserve underestimated inflation!  The interest rate projection graph above tells an interesting story.  As you can see, September projections are materially above June projects.

It appears that personal consumption continues to drive inflation and also the demand for workers in the area of services continues to push wages up.  Those two items are working directly against the US Fed and may mean another upward revision of interest rates. 

China

GDP (Economic Growth)

The above graph tracks economic activity in China.

It’s not difficult to see when looking to the right of the above graph that China is feeling the impact of lockdowns.  It’s not surprising that economic growth has slowed right down.  Ironically, this is helping them to manage inflation.

Lockdowns along with a declining property sector are also keeping the lid on economic growth and inflation in China.

It will be interesting to see how this flows through to the global economy in due course.  Not a cause for alarm however it may well have some impact on global economic growth.

The United Kingdom

The top graph tracks the interest rate on UK Government Bonds.  The bottom graph compares the British Sterling against the US Dollar.

Liz Truss and the new Chancellor Kwasi Kwarteng decided to initiate tax cuts and to borrow the money to do it.  This was met with mixed reviews and in just a few hours, the UK five-year government bond yield rose 1.2% to 4.7%.

At the same time the British Pound dropped by 6% against the US Dollar.  Long story short, they did a u-turn and decided on another plan – extraordinary.

It appears that the harsh market reaction signals how far the market has moved on from the Covid era whereby debt driven stimulus was considered normal.  In the current environment, fighting inflation and more prudent fiscal policy seem to be coming back into fashion – thank goodness.

The UK is a large economy and so will be able to withstand the current market fracas. However, they have a real challenge getting ahead of inflation like other economies, as well as making sure the market doesn’t become overly beaten up and unemployment skyrocket.

It’s difficult for politicians to be voted back in if they’re seen to be responsible for everyday citizens losing their jobs.  However, rising unemployment is part of the recipe for getting ahead of the inflation curve, not only in the UK but elsewhere too.

Australia

Residential Property Prices – Australia

The above graph tracks property prices in the main centres across Australia.

Rising interest rates and a troubled global economy are not making it easy for Australia.

That said, they’re probably in a better place than a number of other countries.

For example, they don’t need to raise interest rates at the same pace as some other countries.  So far anyway, consumer spending has held up.  The Reserve Bank of Australia possibly has at least another 1% to go on interest rates (increasing them).  Right now though, they can moderate the pace of interest rate rises hoping that wages and inflation stay under control.

New Zealand

The Official Cash Rate – New Zealand

The above graph tracks the official cash rate (OCR) in New Zealand.

As expected, Adrian Orr the Governor of the Reserve Bank in New Zealand raised the official cash rate (OCR) by 50 basis points to 3.5% in light of ongoing inflation.  Tight employment conditions (low unemployment) is also forcing the Reserve Bank to raise interest rates.

Market expectations are suggesting an official cash rate of around 4.5% by mid 2023 as the New Zealand Reserve Bank heads down the path to get in front of the inflation curve.  The reality is they have no option because the pain of runaway inflation is much more severe than the pain of high levels of unemployment and interest rates.

Inflation in New Zealand by the way reached 7.3% in July, driven by fuel costs and construction.  New Zealand’s declining currency against other currencies won’t be helping.  Simply, that means that we effectively import some inflation with the low New Zealand Dollar against, for example, the US Dollar.

Interestingly, Adrian Orr said that he was thinking about a 75-basis point increase but opted for the 50 basis point increase instead.  That suggests that he’ll be looking to potentially raise rates by another 50 basis points (at least?) at the next update later this year.

The above table outlines five indicators of property risk.

I know we’ve been hearing that property prices in New Zealand have been declining.  Yet, New Zealand is still ranking highly in terms of expensive property prices.

We can expect New Zealand to slip down those rankings as property prices continue to decline although it will be interesting to see how far down New Zealand property prices can go.

Something tells me that Kiwis’ love affair with residential property is far from over.  That said, rising interest rates and tighter monetary conditions making obtaining loans much more difficult will impact on property prices moving forward.

The New Zealand economy is doing reasonably well all things considered with the backdrop of spiking inflation, rising interest rates, and the ongoing shift in the credit cycle.

It will be interesting to see where interest rates are at when the next election rolls around here in New Zealand.  That might mean the current government could be less popular than is currently the case.

In Summary

The Ukraine/Russia situation continues with no end in sight.  Threats by Vladimir Putin to use tactical nuclear weapons is worrying and yet it would seem a significant step, even for Putin.  For example, would China and India continue to support Russia in the same way as they are now?

To me, the “Fab Four” continue to dominate.  That’s spiking inflation, rising interest rates, earnings revisions and the market worrying about recession.

When all is said and done, economic recessions help to “cleanse” excesses in an economy and are a natural process, albeit with pain exacted on those who unfortunately need it the least.  Everyday citizens and small business owners generally bear the brunt of those types of economic shocks.

As investors what matters is that we keep your eye on the ball so to speak.  That is, ensuring that we invest in quality businesses at favourable prices.

To that end, markets may have lower to go, but are moving closer to the end of the downward trend for trading prices.  I’m not suggesting it’s in the near future.  Trading prices only ever decline so far though.  Then the inevitable happens.  Markets look through the current noise, ahead into the future, see the growth to be had and trading prices reverse direction.

Sometimes that happens quite sharply.  On other occasions it is more of an iterative approach over a period of a year or so.  It’s not uncommon to see some of the best returns for investors emanating from the very loud noise of economic recession and the depths of market volatility.

That’s why you may have heard me suggest recently that I’ll be looking to recommend you ‘nibble’ on opportunities that offer favourable pricing so that we are invested where possible when trading prices reverse from the current downward trend.

Funnily enough, lower trading prices actually reduce risk for investors and set the scene for a better return on investment.

To be clear, it is a folly to wait until the newspapers and the popular media are talking about share market booms for investing.