Cascading stock market declines likely to resume soon
The S&P 500 ended last week 6.6% higher - registering its best weekly gain since November 2020. For a perspective, in comparison, the FTSE 100 (the U.K.), DAX (Germany), and CAC 40 (France) all rose by more than 2% in the week.
With reference to the FTSE 100, even though this benchmark stock market index (the U.K.) recorded its biggest weekly gains in over two months last week, the market movements were quite choppy as oil and gas stocks came under renewed pressure due to concerns regarding the impact of a 25% windfall tax slapped on profits of oil and gas companies in the U.K. Globally too, stocks edged higher on Friday towards their first weekly gain in two months.
In Asia, notably, Indian equities recorded their second consecutive weekly gains on Friday.
Backdrop (S&P 500)
Returning back to the S&P 500, despite the rally last week, it was yet 13.2% down from the January 3 peak (4796.56). Further, prior to last week, the S&P 500, which has been dragged down by tech stocks, fell for seven consecutive weeks and briefly descended into a bear market on the 20th (May). It fell below the 20% threshold (a bear market is one when stocks drop at least 20% from their most recent peaks), before paring losses shortly before the close of trading on that day.
S&P 500 - reasons underlying the rally last week
The underlying reason for the S&P 500 rally last week is that investors are betting that given the economic contraction in the U.S. in Q1 2022, ongoing weakness in several U.S. economic indicators, and early signs that inflationary pressures could be peaking, the Fed might refrain from hiking rates aggressively. The weakening of the U.S. dollar, more resilient corporate earnings in the U.S. (including some upbeat updates from retailers there), and less-hawkish commentary by the Fed too supported this rally.
S&P 500: rally likely to fizzle out this week or soon
Having stated the above, I expect last week’s rally vis-à-vis the S&P 500 (and global stocks) to fizzle out this week or rather soon. Further, my take is that the Fed will probably go in for three more rate hikes this year – 50 basis points each in June, July, and September.
I think the markets are being overly optimistic vis-à-vis rate hikes by the Fed (I doubt if the Fed will pause in September) this year and about the trajectory of earnings growth in the U.S. over the next two years. Moreover, corporate earnings growth in the U.S. is likely to disappoint significantly – possibly over the next year or even more (due to reasons stated later in this article).
The key question that investors in the U.S. (and globally) should now ask is: how excruciating or painful will the fall in markets ultimately be for them? They should be particularly wary of growth stocks which will probably fall more, given the increasingly disconcerting economic milieu in the U.S. and globally, and the impending rate hikes. When choosing to invest in such an uncertain environment, one should be wary of the so-called ‘growth traps.’
Particularly with reference to tech stocks, I think they still have a long way to go (downhill) – the trajectory of interest rates is especially important for these stocks. if the Fed raises rates in quick succession, then one should possibly expect big falls in tech stocks.
Why the S&P 500 rally is likely to fizzle out soon
Though headline inflation in the U.S. slowed to 8.3 y/y in April, it came down from a 40-year high of 8.5% y/y in March and is yet running at more than three times faster than the Fed’s 2% inflation target. Further, core PCE cooled in April but not much. Moreover, while inflationary pressures may have peaked in the U.S., one cannot gloss over the fact that inflation is far too high and sticky for comfort. Due to the reasons mentioned below, high inflation in the U.S. may turn out to be more persistent than anticipated.
This in turn may result in the Fed hiking rates more than expected this year, with obvious greater downside risks for asset prices, notably U.S. equities. I doubt whether headline inflation in the U.S. will average below 7% this year. Moreover, if there is any developed country that is unlikely to escape stagflation in the near future, apart from the U.K. (which is most vulnerable), it is the U.S.
Several economic indicators there are pointing toward a sharp slowdown in growth (however, I don’t think a recession is imminent – due to reasons stated later in the article).
Next, we have to appreciate that the labor market and wage growth in the U.S. remain solid and stock valuations are yet unrealistically high (which necessitates more monetary tightening and fiscal support removal to moderate demand). Further, supply-chain disruptions and elevated commodity prices (of gas, crude oil, wheat, and heating oil in particular) - due to the ongoing Russia-Ukraine war - are likely to linger on, or even exacerbate if this war escalates – which could result in a more direct confrontation between Russia and NATO in the near future.
Next, there is a renewed possibility of oil prices staying elevated and hovering around current levels (around US$ 118) or even going up higher (despite lower demand from China and the strong possibility of deceleration of global demand for oil in the second half of this year), due to geopolitical tensions, the possibility of a marked contraction in Russian oil exports as EU seeks to ban Russian supply, impediments to enhancing oil production in the U.S., the unlikelihood of OPEC+ expediting oil production – this cartel has a meeting on June 2, but I don’t expect them to budge from last year’s oil production deal)), oil inventories running low, and the U.S. driving season. Consequently, the oil market is likely to remain undersupplied this year. As it is, oil prices are hovering at a two-month high.
Next, the Chinese economy will probably not grow more than 4.5% this year or even lower. The effectiveness of recent policy stimulus measures in China is likely to be undermined by the gargantuan levels of debt hovering over its economy. Further, such measures won’t be of much help until policymakers in China ease their draconian covid-policy.
The economic recovery in China is likely to be slow and bumpy. Therefore, in addition to the factors mentioned above, the downward pressure on earnings growth and profit margins in the U.S. over the coming quarters - due to elevated input costs, the persistence of supply chain disruptions, and lower demand - is likely to be more than expected. Wage growth pressures, in the face of persistence of high inflation, are also not likely to abate or moderate significantly over the coming months of this year.
For my detailed views on China - country risk, please refer to the link below (EUROMONEY, May 12, 2022). Please scroll down the article to the sub-topic - ‘Ímage Tarnished’ to read my views.
S&P 500- impending fall
Due to the aforesaid reasons and the impending marked economic slowdown in the U.S. in the second half of this year, and particularly in 2023, the S&P 500 is likely to resume its decline soon. Further, due to the aforesaid reasons, it seems to me that the bear market in the U.S. is likely to be more severe than average this time - particularly as stocks valuations are yet high.
The S&P 500 will probably fall more and there is a possibility that it could bottom out between 3400 – 3600 later this year, which if it happens, will be a heart-rending 24.7% – 29.1% lower from the January 3 peak of 4,796.56.
The earnings growth of companies in the U.S. seems set to decelerate over the coming quarters and weakness in the same is likely to persist well into the next year (2023). I don’t think that the S&P 500 is yet priced in for such an occurrence. Further, given the impending monetary tightening in the U.S., one could expect a disruptive tightening in financial conditions from bonds and credit to money markets over the coming months, with obvious downside implications for U.S. stocks. over the coming months of this year.
Why I don’t expect a recession in the U.S.
The U.S. economy is very likely to slow down significantly over the coming quarters of this year, and particularly in 2023 (monetary policy affects economic activity with long and variable lags). It is unlikely to avoid stagflation. However, quite a few factors (stated below) are likely to ensure that the U.S. economy will not fall into a recession.
While I expect consumer spending (which accounts for around 70% of GDP in the U.S.) to possibly slow down sharply in the second half of this year, what could prevent a recession is that households in the U.S. yet have savings that they can dip into (even though they have been rapidly running down their savings this year) and enough cash in their checking accounts, household wealth recently touched record highs, y/y private sector wages and salaries are up strongly (if we look beyond the headline rise in personal incomes (0.4%) in April), the labor market should continue to remain relatively strong this year, and wage growth is unlikely to moderate enough in the second half of this year. Further, the U.S. consumer is not overladen with debt.
All these factors are likely to enable the consumer to go on spending in the second half of this year, albeit at relatively subdued levels. Further, corporates in the U.S. have strong cash balances. Moreover, despite rising mortgage rates, the real estate fundamentals in the U.S. are such that house price growth (and demand) is likely to sustain over the coming quarters, albeit at much lower levels, than the current frenetic pace of growth in the same.
As a result of the above, I expect the U.S. to escape a recession.
A point worth mentioning here is that wage growth pressures may have peaked and possibly it is expected that earnings growth may moderate in May (from April) and over the course of this year, which in turn might help the Fed in taming inflationary pressures. However, if high inflation turns out to be more persistent than expected (which I think will be the case), wage growth is unlikely to decelerate or moderate enough over the coming months of this year. Consequently, the Fed may have to go in for a rate hike (probably 50 bps) in September too.
Lastly, due to various factors (stated above) that are likely to result in high inflation turning out to be more persistent than expected, I doubt whether the Fed will be able to get inflation under control without raising rates at regular intervals and going in for three rate hikes of 50 bps each in June, July, and September. Markets are currently waiting to see if the Fed is able to successfully engineer a soft landing.
Inflation in other major developed and emerging economies
Having stated the above, just for a perspective, in the eurozone, inflation in its three largest economies, Germany, France, and Italy, surged to 7.4% y/y, 4.8% y/y, and 6.2% y/y respectively in April. Further, in the U.K., inflation shot up to a 40-year high (9% y/y) in April, as energy and food prices spiralled, and it is expected to go up higher this year.
Among major developed economies, I am most downcast about the U.K. economy’s prospects
(I have been closely tracking and analyzing the U.K. economy, and its financial markets since 2003). Among developed economies, it is most vulnerable to stagflation due to labor shortages, energy crisis, lack of adequate investment and under capacity, and Brexit. Further, disconcertingly, business activity growth in the U.K. fell to a 15-month low in May, which has fuelled risks of a recession.
The Bank of England raised rates to 1% in May. I expect further rate hikes of 25bps each three times this year, with the next rise possibly in June (inflationary pressures are too uncomfortably high in the U.K.).
There is a strong possibility of inflation going up over the coming months (likely to reach around 10% this year and drop next year – according to the Bank of England) – with supply chain disruptions and a weaker GBP (it has been falling against the U.S. dollar and the euro too) posing upside risks to inflation.
Next, among major emerging economies apart from China, where inflation reached 2.1% y/y in April (a five-month high but much lower compared to other major emerging economies), inflation shot up notably in Argentina, Brazil, India, and Mexico by 58% y/y, 12.1% y/y, 7.79% y/y, and 7.68% y/y (21-year high) respectively in the same month.
Having stated the above, emerging economies must brace themselves for more capital outflows (already, billions of dollars have flowed out of emerging market mutual and exchange-traded bond funds, and equities since the inception of this year), monetary tightening and equity market falls over the coming months of this year. This is due to expected monetary tightening by the Fed, the likelihood of persistence of high inflation due to factors mentioned before in this article, the possibility of oil prices going up higher, increasing risk aversion, and the probability of escalation of geopolitical frictions.
Among the most vulnerable emerging economies in terms of capital outflows and global liquidity tightening are Brazil and India (not to mention higher oil prices).
More synchronized monetary tightening by developed and emerging economies (barring China) is on the way (with reference to India, I expect the RBI (India’s central bank) to raise its policy rate by 1% this year).
More than 40 central banks have already raised rates this year. Global and the U.S. stock markets are in for a rather volatile period. Investors should be prepared for cascading stock market declines over the coming months of this year.
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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