The sell-off in global markets accelerated last week (ending September 23, 2022). The MSCI World Index, a global equity index, slumped by 5% last week (i.e. global stocks fell by 5%). It dropped for the third consecutive day on Friday – indicating the bearish undertone of global stock markets - following rate hikes by the Federal Reserve and other central banks (such as the Bank of England and Swiss National Bank among others), and foreign currency market turmoil that has led to mounting fears of a global recession.
The Federal Reserve, as expected, hiked the federal funds rate by 75bps to 3-3.25% (the highest since January 2008), in order to tame stubbornly high inflation - which is turning out to be broad-based and more persistent than expected.
Last Friday (September 23, 2022), U.S. stocks S&P 500, DJIA, and NASDAQ Composite fell sharply by 1.7%, 1.6%, and 1.8% respectively. Other major equity markets – FTSE 100 (the U.K.), CAC 40 (France), DAX (Germany), Hang Sang (Hong Kong), Shanghai Composite (China), and the BSE Sensex (India) too fell steeply.
Disconcertingly, on a YTD basis, the S&P 500, DJIA, and NASDAQ were down 22.5%, 18.5% and 30.5% respectively. Among other major equity markets, the ones that were down the maximum on a YTD basis were Hang Seng (Hong Kong) followed by DAX (Germany), CAC 40 (France), and the Shanghai Composite (China).
Given the aforesaid backdrop, If due to the Fed’s ‘draconian’ monetary tightening there is a recession in the U.S., which is most likely, then U.S. stocks could fall by another 10-20% (the decline in corporate profits in the U.S. is likely to accelerate over the coming quarters). This in turn will have a ripple effect across global equity markets – European and Asian markets in particular. It might be noted that the U.S. stock markets account for around 60% of global stock markets.
Investors have a lot to contend with
Investors globally are now having to contend with high inflation, central banks worldwide aggressively ratcheting up interest rates, increasing prospects of a recession in the U.K., eurozone, and the U.S., the rising possibility of a synchronised global recession (with the dominant risk to global growth coming from the Russia-Ukraine war-led supply shock), increasing borrowing costs, worsening China-Taiwan relations, stomach-churning swings and falls across asset classes – more specifically, stock, bond (the bond market crash keeps getting worse), and currency markets – the threat of energy shortages in Europe in winter, the overhang of global debt that will further drag down stocks, and prospects of rising interest rates pummelling asset prices and stock valuations further over the coming months of this year and the first half of 2023.
As a result of the above, the global investment environment is fraught with heightened uncertainty.
Oil prices – likely to slump further
Oil markets, predictably, too have not been spared. Oil prices continued to fall on Friday, reaching their lowest level since January 2022 and recorded the fourth consecutive week of declines last week. The WTI (the U.S. benchmark) fell to lower than US$79 per barrel on Friday, as a result of a surge in the U.S. dollar (the dollar witnessed its strongest rally in 20 years due to the Fed’s monetary tightening) and mounting concerns of a global recession. This U.S. benchmark crude fell by more than 7% last week. Further, the price of Brent crude (international benchmark) fell below $87 per barrel on Friday.
With the rising prospects of a global recession along with the likelihood of the U.S. dollar strengthening further - given the impending rate hikes in the U.S. (the Fed policymakers, according to their median estimate, predict the federal funds rate will be in the range of 4.25% - 4.5% by the end of 2022 and close out next year at 4.5% - 4.75%) - and China’s ongoing economic slowdown, oil prices are expected to slide further in the short-term.
The marked slide in oil prices and the Fed’s hawkish monetary policy stance - which will probably result in the U.S. economy going into a recession - may soon compel OPEC and its allies to intervene and consider a reduction in output to stem the fall in oil prices.
The U.S. economy – higher interest rates likely to remain for an extended period of time
With reference to the U.S. economy, given the evolution of inflation there and that it has been at multi-decade highs, still strong wage gains (which give rise to fears of a wage-price spiral), the state of the labour market (the unemployment rate is at a 50-year low), and solid shape of household finances, I expect the Fed to raise rates by 75bps in November and 50 bps in December. Further, it won’t be easy to quell high inflation in the U.S., as it is too well entrenched. Therefore, I expect the fed funds rate to peak in 2023 and any reduction in the same will possibly take place in 2024 only.
Inflation in the U.S. is very unlikely to fall to 2% in 2023 or in 2024. Therefore, the path to higher interest rates is likely to remain extended.
Turning to treasury yields, as interest rates rise in the U.S. to quell stubbornly high inflation, they have risen to multi-year highs. On Friday (September 23, 2022) the 2-year policy-sensitive treasury yield topped 4.20% and the yield on the 10-year Treasury, which is the rate that influences mortgage rates (and consequently the U.S. housing market), topped 3.8% - that is a source of serious concern for the U.S. housing market (which may be in for a marked correction over the coming year).
The U.K. economy – waning confidence in its economic prospects
With regards to the U.K. economy, there is waning confidence about its economic prospects, given soaring inflation, aggressive rate hikes, an impending recession, and due to a massive tax cut plan by the government that is likely to result in more debt, higher interest rates, and inflation. Government bond yields have surged there (for example, the yield on a 10-year government bond rose above 4% on Friday) as investors are betting on emergency rate hikes by the Bank of England. Stocks in the U.K. have slumped too.
The British pound fell by 3.5% against the USD on Friday (to more than a three-decade low) after the sweeping tax cuts in the mini-budget raised the prospects of a surge in government borrowing to pay for the same. A plunge to parity with the U.S. dollar is seen as increasingly likely and there is a risk of a full-blown sterling crisis.
The U.K. has a real problem at hand now. The fires of inflation could be fanned due to the slumping currency, rates may go up to 6% by the end of next year, financing the gaping current account deficit (which reached a record 8.3% of GDP in Q1 2022) is likely to be a daunting task, and the economic outlook seems even more dismal. I don’t think the U.K. economy can escape a deep recession.
Next, if the Bank of England goes in for an emergency rate hike, it will be an indictment of government strategy and if they don’t then the currency could slump further – making it even more challenging to fight the already soaring inflation (in August, headline inflation rose by 9.9% y/y after rising by 10.1% y/y in July – which was a 40-year high) that is expected to peak next year.
Chinese economy – to witness a protracted period of low growth
Regarding China, the intense distress in the property market, rolling Covid-related clampdowns, weakness in consumption, rising unemployment, gargantuan debt overhang, regulatory and policy risks, unfavourable demographics, and financial stability concerns among other challenges that pose significant downside risks to growth are likely to ensure that it goes through a protracted (very long) period of low growth. China's collision course with Washington and deepening alliance with Russia is another thing to watch out for. Therefore, investors might want to be wary of investing in China.
The OECD expects China to grow by 3.2% in 2022 and by 4.7% in 2023. Given what I have stated above, China might well grow at a lower rate than the aforesaid projections.
Global economy – growth likely to be lower than expected in 2023
With regards to the global economy, the OECD has projected a growth rate of 3% and 2.2% in 2022 and 2023respectively. Further, it estimates that Russia’s invasion of Ukraine will cost the global economy around US$ 2.8 trillion in lost output by the end of 2023.
In all probability, given what I have stated above, global growth is likely to be well below 2.2% in 2023. As a result, the bearish undertone of global stock markets is likely to continue for an extended period of time.
Lastly, given the resolve of the Fed to get inflation back to 2% and varied factors that are contributing to keeping inflation stubbornly high in the U.S., the terminal rate could peak at a higher level than is expected currently. If this happens, the U.S. and global equity markets, and the world economy are in for a lot of pain.
Disclaimer: These are personal views of Sher Mehta. This article is for informational and non-commercial purposes only and should not be used as professional or investment related advice.
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