Insights

Are we there yet?

Tim Whybourne

June 13, 2022

Are we there yet, are we there yet, are we there yet?

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I actually still remember chanting that on long trips with my own parents when I was a kid and now several decades later, karma has come back to bite me as our 4 & 5 year old have self-taught themselves the mantra. They now torture me with it on any trip longer than an episode of “Octonauts”.. Funnily enough, sometimes I find myself chanting the same mantra to myself about this market as I stare at my screen in disbelief.

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The truth is, just like my kids in the car have no concept of time or distance or how close they are to their destination, no one knows where the bottom of the market is or how long it will take to recover.

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Don’t get me wrong, everyone has an opinion, but nobody knows, not the newspapers, not Warren Buffet, not Michael Burry and yes not myself either.

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But just because no one knows when markets will peak and trough, it doesn’t mean you can’t successfully navigate markets and extract a decent return over time. The key is time in the market and managing your investment horizon.

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The S&P 500 is down 17% year to date, its poorest performance at this stage of the year since 1970. Bonds have also had a similar start with its worst performance since the benchmark’s inception in 1973 at -7.9%

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If you break down the market even further, you can see that the index does not tell the full story. A deeper dive shows hat 50% of the Nasdaq composite is down more than 50% and 72% of the same index are down more than 25% with their average decline being -49%. This shows a market on its knees.

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Source: Livewire, With Markets Falling Is it safe to invest again, Roger Montgomery 26/5/22

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So how much worse can it get, or regarding the bottom…. ‘are we there yet’?

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In my opinion, we must be close!

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Before I set out my thesis for why I think we must be close, let’s look at what the market is worrying about at present.

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Inflation

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There is no denying that headline inflation has accelerated around the world, sitting at 40-year highs in the USA and higher than normal everywhere else. Seemingly, much of this appears to have been driven by supply-side disruptions as we have touched on previously. This includes disruption in energy commodities such as oil and gas, labour hiring due to dislocations from the start-stop nature of the pandemic, port and shipping container congestion and a variety of business purchasing excess inventory to avoid supply shortages moving forward.

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On top of this, the US economy continues to surge past the traditional estimate of full employment. The problem is that if Fed policy underestimate the strength of the US economy we face an extended period of above target inflation, if they overestimate it, we face a recession, so it is a balancing act to bring the economy through this period and navigate a soft landing.

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There are now 125 central banks around the world in the process of tightening monetary policy, according to Andrew Canobi, Portfolio Manager of Franklin Absolute Return Bond fund, this is the most restrictive tightening we have seen since the GFC.

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In Australia, markets are pricing in that the cash rate will peak at 3%, possibly by year end, which represents nearly a 10X move from where it sat only 5 days ago, but there is a strong case to say that this is too high, especially in light of the potential risk it poses to the Australian housing market, and financial stability is a key objective of the RBA. Andrew Canobi thinks that rates will peak at half that which would almost definitely lead to a rally in risk assets coupled with a strong return in bonds.

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Likewise in the US, inflation does show signs of moderating. The CPI index rising just 0.2% month on month in April and the price of used cars, televisions and smartphones are all falling for the third consecutive month. If oil prices rise less than 75% year over year going forward, then the proportionate increase we saw from April 2022 and the previous year will be less significant, contributing less to inflation in the future

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Semiconductors, the spot rate for shipping containers, luxury items, fertiliser prices and some commodities also appear to be falling month over month. On top of this we are seeing several businesses, including several US fashion retailers report 40% increases in inventory levels suggesting they have over ordered to account for supply shortages. Once these supply shortages are unblocked, they will be stuck with excess stock which should lead do discounting and lower inflation.

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Slowing Economic Growth

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Economic Forecasts for the US and around the world are continuing to fall due to fiscal drag, a high US dollar and slumping consumer confidence.

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The US government is actively assisting the Fed in slowing the economy with the US budget deficit projected to decline from 12.4% of GDP in Fiscal 2021 to 4.2% in 2022, this is the largest reduction in fiscal spending since the demobilisation following WWII.

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30-year fixed mortgages have risen from 3.1% to 5% and consumer sentiment remains under pressure. Other high frequency US economic indicators are pointing to a loss in momentum such as the S&P global flash US manufacturing PMI Index falling, representing the slowest growth in 3 months.

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However, despite the market’s expectations, companies have continued to surprise to the upside suggesting that perhaps we have a tendency to expect the worst in this market.

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Geopolitical

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The war in Ukraine has added to supply issues for commodities and the same can be said about energy commodities due to sanctions on Russian produced goods, especially oil and gas purchases. More broadly, there is concern that an escalation in tension between Russia and NATO allies could widen conflict – particularly if NATO accepts Sweden and Finland into it, which share a border with Russia.

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However, this risk may be dissipating as, contrary to many fears, President Putin did not declare war on Ukraine and announce a general mobilisation of the Military at his May 9 victory over Nazi Germany commemoration speech. Many thought that if Putin was going to declare war, then this would have been the moment, so this is a very positive sign that he didn’t and points to it being much more likely that this becomes another frozen conflict as opposed to a World War.

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COVID-19

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The shutdowns in Beijing have added further disruption to global supply chains but cases in China appear to be slowing, which could enable an easing in restrictions and clear the way for policy stimulus to boost growth.

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Sentiment

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Last week the University of Michigan reported that their index of consumer sentiment for May slumped to its lowest level since 2011. However, history shows a remarkable negative correlation between consumer sentiment and future returns. In the year following a confidence trough, the market has on average risen an astonishing 24.9%.This is not to say we have hit a low in consumer confidence as it can certainly get lower but one thing for sure is that the lower this reading gets, the closer we get to the bottom! Interestingly, Wall St consensus for the S&P500 shows implied upside of almost 40% from the current levels within the next 12 months.

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So again, are we there yet?

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With so much bad news priced in, and almost every fund manager we talk to telling us that they are seeing the proverbial ‘baby being thrown out with the bathwater’. We are starting to see pockets of value appear back into markets with our 5-year return expectations looking very attractive.

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In the short run, markets appear to be very oversold. The chart below illustrates that the negative change in the 12-month forward P/E rarely gets worse than it is now implying that this metric is due to bounce.

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Source: Livewire, With Markets Falling Is it safe to invest again, Roger Montgomery 26/5/22

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In a recent note, JPMorgan Chief Global Strategist wrote, volatility is the price you pay for better long term returns on equities and valuations are a bad guide to short term returns but a better indicator of long-term gains. He wrote that in the context that we have seen markets sell off significantly and this could potentially end up being an attractive entry point in the near term. He also comments that good investment decisions are based on logic rather than emotion and the best decisions often take advantage of the emotions of others, well investors emotion has rarely been more negative than it is now!

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What is strange about this market sell off is that the global economy, although slowing, is still doing well. Only last week some US economic data came out suggesting the real GDP could still be growing at 4%-5% annualised in the current quarter. The market is worrying about the Fed punishing the economy through higher interest rates because of this strength.

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So, what could pull the market out of this slump?

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Ideally, we would love to see inflation dissipate and navigate a soft landing without pushing the economy into recession. This case is still entirely possible with some positive signals starting to emerge.

The US consumer is still fiscally strong and there is evidence of pent-up demand at unprecedented levels given the supply chain and labour shortages have caused low inventories of vehicles, homes, and consumer goods for sale. Combined with the pent-up demand for family travel, this could be enough to sustain consumer demand.

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The unemployment rate in the US does not appear to be showing too many signs of falling apart with the recent May Jobs Report forecasting the addition of circa 300k jobs, which will see the unemployment rate remain around 3.5%. The lack of available workers should also have the affect of stronger capital investment as businesses are forced to be more efficient which should in turn help to sustain the economic expansion.

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These same forces should see inflation fall. One of the things I learned in economics 101 was that if prices remained high enough the market would always find a way of bringing them back to par. In the real world, high prices should be met with increases in production, which should stabilise and reduce prices in both food and commodities towards the back end of this year. JPMorgan expects inflation to fall by 4% year over year by the fourth quarter of this year and 3.2% by the fourth quarter of next year.

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In my view, the market is simply waiting for signs that both growth and inflation are slowing so that the Fed can reduce their hawkish tone and therefore the trajectory for interest rates. Once we get some clarity on this markets can carry on.

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Even if we don’t navigate a ‘soft landing’ and we end up in recession, this would not necessarily be all that bad for equities as a recession would mean that the Fed ‘Put’ would be back on the table and open the potential for bad news to be good news for markets once again.

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Recession is simply just a term used to describe two quarters of negative growth and in my reading thus far, most commentators thinking that we might end up in recession are typically talking a relatively shallow recession that could end up being positive for equity and risk markets if it brought interest rate cuts back to the table. Fidelity recently reported that they believe the most likely scenario is that of a soft landing at 40% likely hood and a 35% chance of recession.

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UBS believe the key question markets need to ask is whether the Federal reserve can successfully bring inflation down to target while keeping the rate of economic growth above zero. They believe markets will finish the year higher than they are with a target of 4300 on the S&P for their base case and 4700 and 3300 for their bull and bear cases respectively.

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Ultimately, I don’t know if we have hit the bottom of the market or not, if you listen to Morgan Stanley, Mike Wilson believes that stocks could rally for the next few weeks before seeing the index drop to 3400 this year before beginning to recover into the end of the year.

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Where markets head in the next few months or even the next year is not so relevant for a long-term investor. Where markets sit at the moment, I find it very unlikely that in a decade from now that this will not look like a good buying opportunity. Timing the market is a near impossible task but when you take into account companies like Amazon trading at the price it would take to purchase only one of their business units (AWS) I think the baby has been thrown out with the bathwater in several instances.