In mid-June, markets were shaken – but also somewhat reassured – by the Federal Reserve’s decision to raise interest rates by 75 basis points, more than previously expected, in response to CPI inflation overshooting expectations.
The move generated some confusion among investors, as the Fed’s frontloading of rate hikes was broadly seen as more likely to cause a hard landing – a more pronounced economic slowdown, or potentially a recession. That would, in turn, potentially trigger a pause or a slowdown in the Fed’s rates normalization path going forward.
Inflation and recession usually have opposite effects – the former tends to push long-term interest rates up, the latter down – and they cannot coexist unless the expectation is for a period of stagflation, during which high rates of (mostly supply-side) inflation persist in a stagnant economy. While some analysts still expect a stagflation, others are less pessimistic as circumstances are very different compared to the 1970s.
While some of the month-end equity market moves may be technical – related to rebalancing – a marginal shift in market sentiment has already happened last week. We would not go as far as to say that public markets have bottomed, but some positive catalysts – China’s reduced travel quarantine, some respite in food and energy inflation – have emerged alongside more reasonable valuations that may have started to look attractive to some buyers.
We are tentatively optimistic that the big selloff is behind us, and believe the next few months will feature a “fat and flat” market. Several indicators point in that direction, in our view.
For once, some food inflation has subsided, or is likely to do so as crops appear likely to replenish food reserves that had been suffering since the Russia-Ukraine war started. In addition, China reduced quarantine times for inbound travelers, while its equity market is now a positive performer this year – mostly due to the end of politically-driven tech bashing. While economic fundamentals in China may remain shaky and we believe the country has not yet dealt with its structural issues, these marginal improvements have contributed to removing some uncertainty.
At the same time, US exceptionalism continues to be a dominating theme. We think the US is still very well placed to attract investments – as it is likely to be the first economy to go through a slowdown, with the potential for an equity market rebound as it usually happens during recessions. As both Europe and China – two export-oriented economies – are more dependent on global growth, they are – in our view – going to be slower to recover. Europe in particular is still grappling with the energy shock caused by the Russia-Ukraine war, and by the European Central Bank’s (ECB) conundrum – as policymakers are forced to raise rates, but have to do so while trying to limit the widening of peripheral spread, a monumental task from both a policy and a legal perspective.
Further down the road, we believe 2-year rates – now hovering around 3.5% – are underpricing the risk of a recession/economic slowdown. Indeed, the increasing likelihood of a slowdown or of a recession is likely to force a Fed pause, which would then point to a lower neutral rate. A recent tweet by hedge fund manager Michael Burry, suggesting retailers have been building up excess inventories, which will have to be corrected via lower retail prices soon, has caught some attention. Commodities are also on a slight downward trend – the Bloomberg commodity index is down 10% since June 9. The June CPI reading – to be released on July 13 – will give some more clarity as to where we are heading, but our expectation is that inflation is likely to decrease compared to the May reading.
We believe markets are likely to have priced in all existing negative news, and that further negative surprises are unlikely in the near future as things stand. Inflation seems to have at the very least peaked, and even if it does not subside as swiftly as we expect, it is likely to do so eventually.
On the other hand, there do not seem to be positive catalysts down the road that suggest a potential radical shift in market sentiment, which suggests to us that equities are likely to continue to tread water in the short term. Importantly, we still have to go through a potentially mediocre earnings season. Potential positive game changers could be a negotiated end to the war in Ukraine, which we believe is the only way to end the war, inflation decreasing faster than expected – proving its temporary nature – and the end of global supply chain woes.
We believe tech stocks, which happen to be more sensitive to higher rates and had experienced record inflows due to increased demand from retail investors during the heights of the pandemic, are unlikely to recover their recent losses, and may continue to trade at these levels that reflect less abnormal valuations. And as commodity prices stabilize, the recent rally in commodity-related equities appeared – in our view – to have run its course.
Instead, in this fat and flat environment, investor attention should be focused on alternative investment opportunities that can provide positive returns – with private credit opportunities at the forefront.
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