Globally, we are at the threshold of a protracted stagflationary environment, financial conditions are tightening, the U.S. stock markets are in bear market territory, and the U.S., Eurozone, the U.K., Chinese, and major emerging markets’ (except Saudi Arabia, the UAE, and India) economic outlook over the next 12 months looks increasingly disconcerting.
There seems a more than 50% chance that both the U.S. and Eurozone will go into recession over the next 24 months and 12 months respectively. The U.K. economy will probably fall into a recession later this year (which will possibly be protracted, deep, and brutal) and the Chinese economy is likely to grow well below 4% in 2022 - amid a broadening real-estate market downturn, weak consumer demand, and draconian Covid-19 containment measures.
Emerging markets’ as a whole will slow down considerably too over the next 12 months, as a result of headwinds from tighter monetary policy globally and domestically, and simultaneous slowing down of the U.S., Eurozone, and Chinese economies.
Against this parlous economic backdrop, the short and medium-term market (the U.S. and global markets) outlook is negative and clearly the worst of the bear market is not over. Worryingly, the housing markets in the U.S. and the U.K., where they play a pivotal role in economic activity, too are in for tough times, which in turn is likely to have strong downside implications for consumer spending and growth in these two economies over the coming year. Importantly, in recent months, demand has fallen precipitously in the U.S. housing market and affordability is at a 30-year low.
Turning to markets, recently, on the first day of September, the U.S. stock market indexes (S&P 500, Dow Jones, and Nasdaq) were down for the fifth consecutive session, while treasury yields spiked (the 10-year treasury rate rose to 3.26%) and the U.S. dollar strengthened – all indicative of tightening financial conditions. Bond yields have soared in the U.S., as the Fed confronted with the highest inflation in about four decades is likely to remain hawkish vis-à-vis its monetary policy stance.
Underlying these market-related developments and tightening of financial conditions are market expectations that the Fed is likely to continue to hike rates aggressively. These expectations have been bolstered by the continued strength of the U.S. labor market (even though the job market cooled in August relative to July), which in turn raises fears of a wage-price spiral. The y/y average hourly earnings rose in the U.S. by 5.2% in August – unchanged from July. These are strong wage gains.
Outside the U.S., the global markets (particularly in Europe and Asia) continue to wrangle with the downside impact of tighter monetary policies and lackluster global manufacturing data.
Returning back to the U.S., given that inflation remains too uncomfortably high there, even though the headline figure decelerated to 8.5% y/y in July from 9.1% y/y in June, household finances are in sound shape, and job growth in the U.S. remained solid in August (underscoring the U.S. economy’s resilience), I expect the Fed to raise rates by 75 bps in its Sept. 20-21 policy meeting. It had earlier raised its target benchmark interest rates by 75 bps in July to a range of 2.25% - 2.5%.
For a perspective, nonfarm rolls increased by 315,000 in August – the 20th consecutive month of job growth - and slightly better than expected after rising sharply by 526,000 in July. The unemployment rate edged up to 3.7% in August, from a five-decade low of 3.5% in July. The increase in the same was partially due to more people re-entering the labor market and it also reflected a modest increase in the number of workers losing their jobs. The Fed’s decision to hike rates by how much in September may also depend on the data on consumer prices in August – to be released on Sept. 13th
In my opinion, the Fed is likely to go in for draconian monetary policy tightening to quell inflation and avoid a wage-price spiral that wreaked havoc on the U.S. economy in the late 1970’s. The quest will be to pummel demand and force the unemployment rate to go up significantly higher. The rates are likely to remain elevated for several quarters, as monetary policy works with long and variable lags vis-à-vis its impact on demand and growth.
Inflation in the U.S. is expected to have fallen further in August from 8.5% y/y in July. Economic indicators related to the housing market, manufacturing, and consumer spending among others seem to suggest that it is likely to decelerate over the coming months. However, uncomfortably high inflation will probably persist throughout the second half of this year. As a result, the Fed is unlikely to relent from its aggressive hiking stance. I expect inflation on the CPI measure to average over 8% this year in the U.S.
The deceleration in inflation is likely to be gradual even if the Fed hikes rates aggressively, given that the U.S. economy continues to be in a relatively good shape, consumer demand is yet resilient (due to a still strong labor market and solid household finances), wage gains continue to be strong, gas prices are elevated, and supply chain constraints persist (they could even get exacerbated due to China’s ongoing economic slowdown and geo-political risks such as the Russia-Ukraine conflict and China-Taiwan related frictions). All these factors are likely to ensure that high inflation persists more than expected in the U.S.
Having stated the above, the U.S. relative to the U.K. and eurozone has great advantage in terms of energy, as fracking has resulted in self-sufficiency in oil and gas, which should make it relatively easier for the Fed to tame inflation when compared to these two economies. The eurozone is too reliant for its energy requirements on Russia, while the U.K. has underinvested in its hydrocarbon reserves. Therefore, these two economies are facing the brunt of the rise in energy prices.
Turning to the U.S. stock markets, at the end of August, the S&P 500 and Dow Jones Industrial Average (DJIA) on a YTD basis were 17.2% and 13.3% lower respectively. The S&P 500 ended the month down 4.2%.
Going forward, as on September 6, given stronger than expected economic data, specifically, the ISM services index, which rose to 56.9 from 56.7, the S&P 500 fell 0.5%, DJIA fell 0.60%, and the Nasdaq was down 0.74% and it kept alive the possibility of the Fed hiking rates by 75 bps in September. The 10-year treasury yields rose to a 10-year high of 3.35%.
Having stated the above, it is widely known that September is historically the worst month of the year for equities. Over the coming months of this year and the next (particularly in the first half of 2023), there is likely to be considerable volatility in stock prices – both in the U.S. and globally. The U.S. markets account for over 60% of global stock market and what happens there sends ripples across stock markets globally.
Given the impending economic slowdown and the possibility of a recession in the U.S. over the next 24 months and the Fed’s hawkish stance and determination to quell inflation, U.S. stocks, in my estimation, have not yet bottomed out. They could possibly fall between 10% - 20% from current levels (as of September 6, the S&P 500 closed slightly above 3,900) by the end of this year amid decelerating growth in the U.S. As a logical corollary, the ripple effect on global stock markets is likely to be substantial.
The bear market is certainly not over and expect a marked fall in corporate earnings in the U.S. in 2023.
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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