Markets continue to worry about overtightening and recession
Sentiment is extremely negative, which might suggest the downside is more limited
Disinflation should boost sentiment, but it could take time
The overarching questions driving markets today are: is a hard landing inevitable and how low can markets go? A hot CPI for August and a more-hawkish-than-expected September Fed meeting have fueled fears of a US recession, with tightening continuing into 2023 and no relief in sight. This led to a sharp drop in markets throughout September, a seasonally weak month, and a breach of key resistance levels.
However, at this point, sentiment might have become too negative. Yes, there are plenty of obstacles on the horizon, and expectations for this earnings season are poor, but positioning is already extremely bearish, cash levels are elevated, and sentiment is near all-time lows. With such negative expectations embedded, the downside has become more limited in our view.
Moreover, encouraging signs of disinflation continue to abound, suggesting the more aggressive part of the Federal Reserve’s tightening cycle is probably over. Indeed, both consumer and business expectations for inflation have dropped, commodity prices have fallen, as have used car prices, and there are indications that rents and job openings are next. Still, it will take some time for all of this relief to come through in hard CPI and PCE data, but the downward trend is happening. Coupled with the significant tightening already done by the Fed, we should be at peak hawkishness and peak market fears, though higher for longer should not be ignored.
The situation in Europe and the UK is more complicated, with inflation not yet peaking and a near-certain recession looming. However, with the central banks’ mandate focused on inflation and the UK’s unconventional tax plan, their tightening is not over, which could lead to more pain on growth and earnings for the regions. For the UK, the majority of earnings for the FTSE 100 are not in pounds, which may bring some relief.
Overall, while we remain cautious, we expect risk assets to move higher into the end of the year, though volatility will persist. We believe that ongoing disinflation will help sentiment, especially if earnings manage to hold up in the US. The Fed will not “pivot” or turn dovish, but we may be closer to an acknowledgment that interest rates hikes are having an effect on the economy. In this context, we expect US assets to do better than other regions, especially in equity markets. Europe still has a tough winter and worsening energy crisis to deal with, and emerging markets’ fate remains tied to China’s. While policymakers may not act as forcefully as hoped to boost growth, we could see more measures to support the property market or more leniency on the zero-Covid policy following the Party Congress, though it may take time for sentiment to recover.
In the very short term, cash remains king, and the dollar as well. While we should be close to a peak in the greenback, we see few catalysts for a sharp reversal anytime soon, given the challenges facing other major currencies other than the Swiss franc. Risk appetite will be slow to recover, suggesting we are unlikely to see significant flows toward risk assets.
Tightening fears have gripped markets and led to a collapse in markets since the hot August inflation print, as growth worries weigh on sentiment and a few earnings warnings added to investor anxiety. However, we believe that we are close to capitulation and that ongoing disinflation will start to support markets, as we are getting towards the end of the Fed’ tightening cycle. Positioning is at extreme bearish levels, stocks are in oversold territory, and we are seeing a buyer’s strike, suggesting we should be close to bottoms. Still, we remain prudent for now.
Europe is likely to remain under pressure compared to the US given the unfolding energy crisis and the escalation of the Ukraine conflict, with a difficult earnings season in perspective. Emerging markets remain tied to China, where the outlook is only mildly improving, though policymakers may act more forcefully after this month’s Party Congress. In the US, we expect technology to resume its outperformance into the end of the year as earnings hold up, with defensives in general doing well as growth fears are likely to persist.
Following a higher-than-expected August US CPI and a hawkish September meeting at the Fed, yields spiked again, weighing on the bond complex as a whole. The UK’s tax plan didn’t help, with gilt yields surging, leading Treasury and Bund yields higher with them. At this point, yields should be close to a peak, especially as central bank hawkishness should be near a peak as well. As such, we maintain a more balanced allocation between sovereigns and credit. Within credit, we maintain a preference for investment grade over high yield, as growth fears are not behind us, and spreads could widen.
The dollar remains King as it continues to reach record levels on Fed tightening expectations and worries about Europe and the UK. Indeed, Mrs Truss’ fiscal plans have led to a plunge in GBP that is likely to take time to recover. And the euro remains under pressure as recession fears and a looming energy crisis weigh on the currency. While we may not see a strong reversal given stronger growth and earnings, the bulk of the dollar move should be behind us, suggesting a stabilisation is likely at some point. In addition to dollar strength, weakness is the renminbi could continue to weigh on most emerging market currencies, though policymakers appear to want to contain weakness.
Pressure on commodity prices continues, as tightening expectations are adding to growth fears around the world. Demand is gradually falling for most commodities other than energy in Europe. However, even oil prices have been retreating on recession worries, though OPEC+ could cut production again and prices may be closer to a floor. Gold remains under pressure due to higher real yields and a stronger dollar, though we may be getting closer to a peak in USD and a stabilisation could materialise. Interestingly, silver has been holding up better, a trend which could continue.
The cryptocurrency market remains under pressure as tightening expectations, higher interest rates and a stronger dollar weigh on the asset class. Cryptocurrencies have failed to hold advances, but have maintained something of a floor, with broad range-trading likely to continue. As such, it might take time for sentiment to recover and for flows to resume, but broad adoption should eventually continue.