- Stock market stumble questions rosy scenario of lower inflation, a peak in interest rates and a soft economic landing
- Markets now seem more frightened of a strong US economy forcing the Fed to keep rates higher for longer
- But the US yield curve is still steeply inverted, a traditional recession warning, while Transport stocks are flagging, and consensus earnings forecasts are in retreat
“The rally in share prices around the world since October has been stoked by hopes that inflation would gently decelerate, interest rate hikes would stop and then become rate cuts and as a result the global economy would suffer nothing worse than a soft landing, or even start to soar once more after avoiding an encounter with the ground altogether,” says AJ Bell investment director Russ Mould. “But investors are starting to wonder once more whether such a golden trifecta is likely as economic data proves resilient, inflation (excluding energy) a little sticky and central bank policymakers continue to talk a tough game. The markets’ current preoccupation therefore seems to be that good news for the economy is therefore bad news for asset prices, as it may force interest rates to go higher for longer than hoped, but the risk of recession is still one that cannot be dismissed lightly, either.
“Although China is reopening, the key to this debate may well be the USA, the world’s largest economy and one useful exercise may be to try and block out 2020 to 2022 altogether, given the extraordinary challenge posed by COVID-19 and the massive amount of monetary and fiscal stimulus (let alone scientific research) that were deployed to beat it off.
“Think back to 2019. The US economy was losing momentum and then President Trump was trying to goose it into life before 2020’s election, not least by leaning on the Federal Reserve to keep policy loose. It can be argued that the US is now returning to that trajectory as the Fed steps away from ultra-loose policy, Capitol Hill stops authorising stimulus cheques and the debt taken on during 2020-22 starts to weigh.
Source: FRED – St. Louis Federal Reserve database
“One tried-and-tested indicator, the Dow Jones Transportation index, was going nowhere fast in 2019 and it has lost momentum again over the past year. The benchmark has thus far failed to recapture its November 2021 high, even after a furious rally from the autumn low. This is worth bearing in mind if Dow Theory holds good, because it asserts that the Industrials will always follow where the Transports go.
Source: Refinitiv data
“Another reliable market indicator was looking pretty lacklustre in 2019, too, namely the yield curve. US two-year Treasuries were yielding more than US ten-year government paper, to suggest fixed-income markets were expecting a slowdown in the US economy and looser monetary policy in response.
“Two-year yields are moving higher, to suggest the US Federal Reserve may not take as passive approach to setting monetary policy as markets would like, since the US two-year Treasury yield has an uncanny record of moving some six to nine months before the Fed.
Source: Refinitiv data
“However, the inversion of the yield curve is even more dramatic now that it was in 2019. The last time two-year Treasuries yielded this much more than ten-year Treasuries was January 1980, just as the USA was about to lurch into a recession. Fixed-income investors seem to fear that policy will stay tighter than expected owing to the fight against inflation, only for the damage to come in another way, namely an economic downturn.
Source: Refinitiv data
“Most tangibly of all, US corporate profits are starting to feel the strain.
“A year ago, analysts were looking for aggregate earnings per share (EPS) from the S&P 500 index of $225, up from $198 in 2021, with further progress to $247 in 2023. Consensus forecasts now think earnings fell in 2022, to $197, while 2023 estimates are down to $220. If the US economy does hit a bump, then even 12% earnings growth this year could be hard to achieve, even allowing for some of the fierce cost-cutting already in evidence at some of America’s largest corporations.
Source: S&P Global Research
“Those earnings forecast downgrades help to explain why the S&P 500 is still lower than it was at this time last year. A soft landing or unexpected growth could quickly cure the ills that trouble corporate earnings and boost the index, but a sharp downturn could put earnings forecasts, and the benchmark, under more pressure.
“Markets still think the US Federal Reserve can save the day with interest rate cuts, and they may well be right. But history shows the Fed starts to cut only once something has snapped – the economy, the markets or both. Frantic rate cutting did not provide immediate succour in either of the 2000-03 or 2007-09 bear markets.”
Source: Refinitiv data
