Investment Comment
15th July 2022
The only way is up
This week saw record breaking temperatures across Europe and record-breaking inflation in the US. For interest rates it seems that the only way is up.
Investors (including us) are looking for clear signs that inflation is peaking. This week’s US inflation report was expected to show signs that core inflation (excluding food and energy, which are particularly volatile and most impacted by the war in Ukraine) was slowing, but that was not to be. Headline US consumer price inflation (CPI) for June accelerated to 9.1% year on year, driven by a rapid acceleration in energy prices and further increases in food prices from already-elevated levels. More concerning was that core CPI rose 5.9% year on year and accelerated over last month.
The larger-than-expected rise in US inflation shifts expectations for the Fed (US Federal Reserve) and strengthens the case for more aggressive interest rate rises in the short-term. Since the last meeting, the decision for the central bank’s governors when they meet at the end of July was seen to be a choice between hiking by 50 basis points or by 75 basis points. Now, at least 75 basis points is priced in as a certainty, while the chances of a blockbuster 100 basis-points hike are now around one in three.
Market performance in 2022 has hinged on this sharp change in interest rate expectations as stickier than expected inflation, exacerbated by the Russian invasion of Ukraine, has forced central banks into action. The chart below shows market expectations (based on futures) of the level of interest rates (specifically the US Federal Reserve policy rate) at each Fed meeting over the next 12 months. Markets and central banks started the year sanguine about inflation with a broad view that this was a transitory phenomenon driven by supply/demand imbalances created by the Covid pandemic and associated lockdowns. At that stage, markets expected interest rates to still be below 1% by the end of 2022. As the chart shows that rapidly changed, with markets now expecting rates to hit 3.5% by the end of 2022. That surge in interest rate expectations is what has driven the sharp fall in bond yields this year and contributed to the fall in equity valuations, particularly in long-duration growth stocks (notably technology).
Interest Rate Expectations have risen sharply in 2022 but recession risks suggest falling rates next year.
Source: Bloomberg (There are eight Fed meetings each year, which is why not all months are shown on the x-axis)
What is interesting is that looking into next year, investors expect the Fed (and other central banks) to have finished hiking and be cutting rates again. For investors, fears of inflation have now switched to concerns that central bank tightening could drive the economy into recession thereby forcing bankers to ease on the brakes once again.
Earnings season kicks off
This week also saw the start of the Q2 earnings season in the US. Earnings growth has remained robust despite market falls and so shares have become cheaper. The big question is whether that earnings strength can be maintained as economic growth slows. This earnings season should give us insight into how companies are performing and if signs of recessions are visible. As is typical, the major US banks are the first big earnings report of the season, and they don’t get bigger than JPMorgan. At the headline level results disappointed as investment banking revenue fell sharply. Whereas 2021 was a great for dealmaking, there has been a dearth of corporate activity in 2022 and the resultant fees have fallen away. However, there was little sign of an impending recession looking at their more traditional banking activities. Debit and credit card sales volumes rose 13 per cent from the first quarter and 15 per cent from a year ago, suggesting that the US consumer remains in rude health and is happy to spend (also borne out by strong retail sales data just released today). Commercial loan volumes rose by 7 per cent against last year, faster than in the first quarter, suggesting business confidence may not be as poor as feared. On the negative side mortgage demand was down, which is a direct result of higher interest rates, but does not necessarily signal a recession.
As the results season progresses the state of the corporate sector will become clearer and also the likely path of earnings. We believe that the US economy can avoid recession, with the household and corporate sector in robust health. If that is the case earnings should remain positive and with more attractive valuations investors may well regain their confidence.
Gareth Thomas, CFA Head of Investment Management
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