An end to ‘easy’ money isn’t always easy

04 August 2022

Jason Todd

Jason Todd is Head of Wealth Management Investment Strategy for Macquarie’s Banking and Financial Services group. Jason is a CFA who began his career in 1996 with JPMorgan New Zealand as its Equity Strategist.

Financial markets have been fed a cocktail of cheap and easy money for more than a decade, as global central banks responded to every shock and/or crisis with ever more money at cheaper rates. With cheap credit finding its way into every crevasse of the economy and in turn pushing up valuations of many interest rate sensitive assets to record levels, it should have come as no surprise that when this liquidity tap was turned off and interest rates began to rise that some market turmoil would ensure.

But regardless of how much time was spent assessing what the economic and interest rate transition phase would look like, it has still managed to surprise all but the very bearish of forecasters. In large part, we think it was the pace at which interest rate expectations changed, but the impact has been brutal for financial markets.

A spike in bond yields drove a rapid de-rating in equities and other interest rate sensitive assets. In fact, if the year was to end now, then first half returns would put equities on track for one of their worst performances in 50 years, while bonds (depending on the type) are close to posting their worst ever half. Impressive statistics but for all the wrong reasons.

What went wrong during 1H22?

Many factors combined to undermine the economic and financial market outlook through the first half of 2022, including a sharp reversal of expectations that markets were impervious to anything and everything thrown at them. Amid ongoing supply chain disruptions and geopolitical conflict, prices continued to rise and the broadening out of inflation pressures drove an unexpected repricing in both the pace and magnitude of central bank policy tightening that then started the ball rolling.

Higher bond yields and expectations of policy tightening then began to undermine equity valuations and other risk assets that had been beneficiaries of cheap and easy liquidity, as valuations were no longer consistent or unsustainable given a new cost of capital outlook.

Unfortunately, this was only the first phase of the sell-off, as inflation fears soon transitioned into recession fears, as central banks began to talk up a ‘whatever it takes’ approach towards containing inflation. As a result, the bear market that started as a valuation correction in highly prized growth assets then spread into more economic sensitive areas of the equity market, ensuring few areas were left unscathed by the end of the first half.

What’s in store for 2H22?

We don’t think the economic and financial market uncertainty that ravaged markets through 1H22 has passed. Economic transition periods take time. They are rarely smooth and can often take many turns, particularly as the risk of policy mistakes increases and/or when economies are being buffeted by exogenous forces that carry significant economic consequences, like the conflict in Ukraine does for global energy and food prices, as well as supply chains.

Global recession is not a certainty, and it is possible that the global economy experiences a soft-landing through 2023, even if several major developed economies find themselves in recession. At this stage, Macquarie expects the global economy to escape recession in 2023. There is a material chance that this view proves optimistic, but it’s unlikely that the economy surprises to the upside and enters a reflationary phase. This suggests that the best outcome for the coming 12-18 months is one where growth slows sharply but where a global recession is avoided.

It is now clear that faced with a once-in-a-generation surge in inflation, most central banks will need to tighten policy until inflation slows back towards target. This is likely to require an uptick in unemployment in many developed economies. Macquarie forecasts that several major advanced economies (U.S., U.K., Europe) will enter recession over the next 12-18 months, as strong inflation weighs on real incomes and sentiment, and as monetary policy moves from being highly accommodative to contractionary. However, China is expected to be the outlier, due to 2H22 stimulus measures, and this should provide enough support for the global economy to avoid recession.

Central banks’ inflation fight has become unconditional…

Central banks have backed themselves into a corner by waiting too long to act. If they fail to do ‘whatever it takes’, we may be faced with a far worse outcome, like a 1970s style stagflation. This seemingly unconditional fight against inflation is why Macquarie’s macro strategy team believe the economic outlook has soured materially, as strong inflation weighs on real incomes and sentiment, and as monetary policy moves from being highly accommodative to contractionary.

Risks to our central case remain skewed to the downside and have the potential to push our soft landing scenario into either a 1970s style stagflation or even a hard landing scenario, should policy makers push too hard. Elevated uncertainty will remain, driven by a multitude of factors, such as the duration of the conflict in Ukraine, which is impacting energy and foods prices, more persistent than expected supply chain disruptions, tightening labour markets, and rising geopolitical risks, as emerging nations struggle with rising cost of living concerns.

…with risks skewed to the downside…

We think it will take time for economic data to show some degree of consistency (either good or bad) and until that happens, markets will remain hostage to the ebbs and flows of data prints. Risks to growth are largely skewed to the downside, as economies are hard to manage via interest rates alone. Once growth begins to slow and unemployment picks up, a self-fulfilling feedback loop can often take hold, as confidence and employment begin to weaken.

Therefore, the risk of a policy mistake by central banks intent on bringing inflation down remains high but ultimately, it will depend on how willing they are to live with inflation above their desired target ranges.

If central banks are prepared to allow inflation to run hot for several years, then a sharp economic downturn (potentially recession) may be avoided. But at this stage, we do not know what central banks are prepared to live with, and this includes the RBA. Therefore, the next 3-6 months remain highly uncertain, as we learn how aggressive and unconditional the fight against inflation will be and at what economic cost.

…but structural overhangs that prolong recessions are generally absent

However, underlying economic conditions are relatively robust with limited signs of structural excesses that would deepen and/or prolong an economic downturn, such as excess inventories or an overleveraged consumer and/or corporate sector. In fact, consumer balance sheets are solid, with excess savings accumulated over the pandemic period available to support spending patterns for some time.

In addition, there are few signs of credit stress at a corporate level and/or that the plumbing of the financial system is vulnerable to tightening liquidity conditions. This should lessen the drag from higher borrowing rates and an uptick in unemployment, even if it is not enough to avoid a short and shallow recession for many economies.

Australia to escape economic recession

Overall, Australia’s growth should remain solid relative to other economies, such as Europe and the U.S., as stimulus continues to wash through the economy for two key reasons: 1) Monetary policy is not expected to tighten as much as the other economies, given inflation pressures are less intense; and 2) Australia has more direct exposure to China, which should provide some support to growth over the next couple of years.

Despite the need for a rapid reversal of accommodative monetary conditions and the expectation of a significant economic growth slowdown, Macquarie is not forecasting Australia to fall into recession. However, many sectors within the economy will experience recession-like conditions (consumer spending, housing), with others likely to remain reasonably well supported and offsets to a weaker household sector (business investment, corporate profits and unemployment).

Like the rest of the world, Australia has an inflation problem. Despite already elevated levels, Macquarie expects inflation to rise further, hitting approximately 7 per cent by the end of 2022. Thereafter, we expect quite a rapid decline to between 3-5 per cent over the following 12-18 months, but it is not likely to get back down to the RBA’s 2-3 per cent target band before 2024.

Like other central banks, the RBA is now playing catch-up, with recent back-to-back 50bp hikes. Macquarie is forecasting the cash rate to reach 2.60 per cent by year end, before peaking at 3.10 per cent in the first half of 2023. Thereafter, Macquarie thinks the RBA will be forced to reverse its policy tightening with cuts of 100bps by year end 2024 to reduce recession risks, as an overleveraged household sector begins to buckle under the weight of rising borrowing costs, decelerating house prices and a weakening labour market.

Financial market risks remain elevated

We think financial markets will remain volatile and largely rangebound until there is greater transparency around key uncertainties, as we move into the second half of 2022 and beyond. It is likely that fears around inflation are reaching a crescendo, suggesting we are nearing peak hawkishness on interest rates. But the question then shifts to how quickly inflation decelerates and how comfortable central banks are with the pace of decline. If inflation drops off quickly and expectations stabilise or fall, then economic growth fears will also ease. If inflation proves to be stickier than expected, then it is likely equities will begin to price in a greater risk of recession.

It will take some time to see how the path of inflation and monetary policy is tracking, and this will keep investors and markets reactive to positive and negative data surprises. This does not mean markets are on a path lower, but it does mean that equities and other risk assets are unlikely to trade sustainably higher for now. The concern is an accumulation of policy errors (excessive tightening) that tip us into a deeper and potentially more prolonged global recession.

Equity markets have not priced in a recession

While equity markets have experienced a challenging start to the year, we do not think they are priced for recession, with earnings expectations still optimistic and valuations above trough levels.

At this stage, earnings are still forecast to grow strongly in 2023 for both global and Australia markets. This is at odds with an average earnings decline of similar to 15-20 per cent during recession periods and/or when economic growth slows sharply. Similarly, while equity valuations are now more appealing, they are not yet ‘outright cheap’. Market bottoms usually correspond with trough multiples and both global (14.8x) and Australian (12.8x) equities remain some way above these levels.

Encouragingly, the starting point for fundamentals is strong and capital shortfalls have been largely replenished. Similarly, equities have a long history of quickly recovering from recessions, which means any further weakness may not be prolonged. But stubborn inflation may mean central banks are unwilling to provide a large degree of stimulus to fight off recession, and this means any recovery period for equities and growth assets may be more muted than we have become accustomed to.

The fixed income correction is nearly complete

We think bond yields will be largely range-bound out through the second half of 2022, as they battle competing forces. On the downside, bond yields will be capped by slowing global growth momentum and rising recession risks. On the upside, they will continue to battle high inflation and ongoing policy tightening.

The good news is that the higher reset in bond yields has probably already occurred, which does limit the scope for further losses and makes bond yields now highly sensitive to the direction of economic data surprises in coming months. The bad news is that there has not been any progress made on bringing inflation back down, even if price pressures might be close to a peak (ex-Australia).

In addition, the shift from quantitative easing (QE) to quantitative tightening (QT) will also drive upward pressure on bond yields, as central banks step back from their government bond buying programs and as investors demand a higher term premium (additional yield for longer dated bonds) vis-à-vis central banks, which are less price sensitive.

On a relative basis, investors have been paid handsomely to be in short duration assets across both bonds and equities (via value stocks). However, short duration (relative to the benchmark) is no longer appropriate, given the substantial increase in long bond yields, combined with a reduced need to sell bonds for equities.

Credit markets are more nuanced and while the cycle is intact, and fundamentals remain strong, we don’t think credit will stay immune to the dislocations impacting the global economy. With economic growth set to slow and corporate fundamentals unlikely to improve (as a peak in profit margins indicates), we think spread widening will remain the underlying trend across credit markets. It is possible that credit, like other risk assets, gets a short-term reprieve if bond yields are sustainably topping out. However, we don’t see a material or sustained narrowing in spreads, as we look out further than the next quarter or two.

Positioning for high uncertainty and downside risks

We are in unusual times, where markets will remain volatile and trade on shifting sentiment. These are conditions where investors must return to basic investment principles. Now, more than ever, portfolios should be constructed for many possible outcomes, so they are resilient to the risks that might emerge.

When volatility is high, diversification is crucial. While bonds have weighed on portfolio returns in recent months, they offer strong protection against recession, as do alternative investments and select real assets that benefit from elevated inflationary environments. Similarly, valuations are correlated with long-term returns. Buying stocks/markets cheaply is a strong leading indicator of forward returns. While markets are not outright cheap, there are pockets providing attractive entry points for ‘through-the-cycle’ investing.

At a broad portfolio level, we think raising cash and adding liquidity (to avoid selling assets at a discount) is prudent. Focusing on private markets, quality and defensive assets can help protect against volatility, as will reducing exposure to areas where valuations remain expensive.

We prefer areas that benefit from current disruptions, or which might exploit a strategic tailwind (such as energy efficiency, food security, automation or cyber security). Finally, it feels like uncertainty is the only certainty, but correction periods provide opportunities for long-term investors to accumulate assets at discounted prices.

Jason Todd CFA is Head of Wealth Management Investment Strategy at Macquarie’s Banking and Financial Services group.

Disclaimer: This article contains research issued by Macquarie Equities Limited ABN 41 002 574 923 AFSL 237504 (MEL), a Participant of the ASX, for the use of licensed financial advisers only. It does not take into account the objectives, financial situation or needs of any person. In no circumstances is it to be used by a person for the purposes of making a decision about a financial product or class of financial products. Past performance is not a reliable indicator of future performance. MEL is not an authorised deposit taking institution for the purposes of the Banking Act 1959 (Cth), and MEL’s obligations do not represent deposits or other liabilities of Macquarie Bank Limited ABN 46 008 583 542 AFSL 237502 (MBL). MBL does not guarantee or otherwise provide assurance in respect of the obligations of MEL.

 

QUESTIONS

To answer the following questions, click here.

1. What has been the primary cause of the sell-off in both bonds and equities through the first half of 2022?

    1. Slowing economic growth.
    2. Rising inflation and interest rate tightening fears.
    3. The conflict in the Ukraine.
    4. President Biden’s Build Back Better Plan.

 

2. Why has the fight against inflation become ‘unconditional’?

    1. Because inflation is harder to tame than boosting economic growth.
    2. Because inflation is easier to tame than boosting economic growth.
    3. Because once inflation expectations begin to rise they quickly fall.
    4. Because once inflation expectations fall they rise.

 

3. What economic characteristics will likely see a recession be both short and shallow?

    1. Structural supply side shortages in energy.
    2. Excess inventories that will need to clear.
    3. An overleveraged consumer and/or business sector.
    4. A lack of structural excesses that do not need to be purged.

 

4. Arthur is concerned about the possibility of Australia falling into recession and the effect this will have on his investments. However, his financial planner, Kathy, is confident Australia will avoid a recession due to which of the following?

    1. Elevated house prices.
    2. Weak migration and population growth.
    3. The RBA will not need to tighten monetary policy as much as other developed nations.
    4. The expansionary fiscal policy of the new Labor Government.

 

5. Margaret is considering various investment scenarios for her client, Jack. She understands when market volatility is high, portfolio diversification is crucial. When adding liquidity to a portfolio to avoid selling assets at a discount, what are the two big drivers of a decline in global liquidity conditions that Margaret needs to be aware of?

    1. An expansion of quantitative tightening and rising interest rates.
    2. An expansion of quantitative tightening and falling interest rates.
    3. An expansion of quantitative easing and rising interest rates.
    4. A contraction in quantitative easing and falling interest rates.

 

 

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