· Central bankers reaffirm their hawkish intentions
· The global economy comes under pressure from a record energy shock
· Sentiment fades as growth prospects worsen
Following a good few weeks in equity markets, risk sentiment among investors had improved considerably. This is despite the fact that little had changed in the macroeconomic outlook. Price has a way of changing sentiment whether justified or not.
Earlier this month, rates investors were pricing in a scenario where the Fed would wrap up its tightening cycle early next year, with a terminal policy rate around 3.2%. In light of worsening economic conditions, multiple policy rate cuts were also priced in for 2023. This favourable set up for risk assets had driven investor enthusiasm since mid-June. Despite the clear hawkish intentions of the Fed, financial conditions were easing.
In a coordinated effort by regional fed governors, the Fed has since tempered investor expectations for easy conditions next year. Markets have recently moved to price in a far higher terminal rate closer to 3.8%, implying larger and more frequent hikes in the near future. In his Jackson Hole speech, Chairman Powell further signalled the Fed’s intention to keep conditions tighter for longer – with inflation their key concern. In the space of a month, the Fed has been successful in bringing expectations back in line.
There are early signs that the more durable components of inflation are beginning to slow. Services components, like shelter, have been the key driver in the headline number in recent months - as inflation deepened and broadened away from energy and food. But July saw sharp decelerations in these measures, in what may be a clue for the direction of inflation into the back half of 2022. But one data point does not make a trend, and consistent slowing of a similar magnitude is required over the coming months to achieve the Fed’s stated target of 2% inflation.
Global Economic Data Highlights
The global economy is facing the combined shock of one of the fastest increase of interest rates on record at the same time that energy prices continue to soar. In Europe, one year forward natural gas and German power prices are at all time highs, rising almost tenfold since 2021.
The growth risk to corporate profits is clear, with margins likely to be squeezed by rising costs and sluggish demand. Second quarter earnings were mixed, with strong energy sector profits contributing to a misleading index level number. Below the surface, we saw sharp decelerations in earnings growth in financials, communications and the consumer sectors. Following 2Q earnings announcements, analysts revised their third quarter and 2023 estimates significantly lower. Even still, consensus earnings forecasts for 2023 remain unreasonably high and valuations are still rich at the index level - despite the obvious headwinds.
Corroborating this, purchasing manager surveys in the US and Eurozone have fallen into contractionary territory. Components of the surveys that lead, such as New Orders, have dropped considerably – indicating that the overall indexes could fall further. The ISM historically is a good lead for the proportion of large cap companies that beat or miss their consensus earnings estimates.
Global Risk Market Returns
In light of the tough current environment for risk assets and with no real catalyst for a reversal in sentiment in the near term, we feel that it is best to remain defensively allocated until we see a sustained improvement in the outlook for inflation. We are pleased with the decision to reduce risk earlier this year by trimming growth equity exposure in favour of more defensive equity positioning, as well as reducing high yield fixed income exposure.