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In search of a new equilibrium after the summer rally petered out in Jackson Hole

Yves Bonzon
Yves Bonzon9/20/2022 05:42 PM GMT+08  • 7 min read
In search of a new equilibrium after the summer rally petered out in Jackson Hole
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Bear markets, where equity markets fall by over 20% from their previous peak, are all-in-all a rare phenomenon. Over the last 70 years, the S&P 500 has entered bear market territory a total of 11 times before peaking again. Some of these bear markets were over and done with rather quickly, like the pandemic-related drawdown in 2020 or the 1987 Black Monday crash. Others, like the one following the burst of the dot-com bubble or the one related to the Great Financial Crisis, were usually associated with severe recessions or financial turmoil, and they lasted longer and brought equity valuations significantly lower. These can be qualified as ‘secular bear markets’. Finally, there were bear markets that we would call ‘cyclical bear markets’, which lasted for shorter periods of time and were ultimately milder.

The last two categories of bear markets were characterised by one or (usually) more bear market rallies, where equities bounced back rapidly and violently before retesting or even undercutting their previous lows. In cyclical S&P 500 bear markets, the most prominent rallies typically lasted a little over two months, with equity prices rising +12.4%, on average. In that sense, the summer rally that pushed US equities up +17.4% by mid-August as compared to their mid-June low was slightly shorter (lasting only two months), but it was stronger, when measured against the historical average.

Ultimately, the short-lived uptrend was upended, as the hawkish message from the US Federal Reserve (Fed) became clearer in the run-up to the anticipated annual central bank symposium at Jackson Hole, Wyoming. Many market participants expected the Fed to strike a more accommodating tone, with inflation peaking and interest rates supposedly having reached neutral territory. Fed Chairman Jerome Powell disappointed markets, which quickly moved to reprice for a somewhat longer and more aggressive tightening cycle. As of 13 September, the S&P 500 is down -18% from its January 2022 highs.

The US economy is slowing but resilient

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Despite the market turmoil, the US economy continues to power through. While macroeconomic indicators and sentiment surveys are slowly but surely pointing to further deterioration, especially in the housing market, the US labour market remains exceptionally resilient. Employment gains continue to surprise to the upside, while initial jobless claims have recently been declining faster than expected.

Meanwhile, the unemployment rate is close to historical lows, and employee compensation is proving to be robust. While the rise in energy prices and other supply-chain disruptions have put significant pressure on US household wallets, that pressure is now peaking. Importantly, the cooling in the housing market suggests that shelter inflation (rent price increases), which accounts for around a third of the consumer price index, will be lower next year.

Moreover, despite tighter financial conditions brought on by the current central bank action, the economic cycle continues to be supported by the absence of prior imbalances in the private sector, such as widespread excessive leverage. Instead, private credit continues to grow at a moderate pace.

Ultimately, the resilience of the US economy will encourage the Fed to stay on its tightening path, yet the market is not pricing in a recession. The developments in energy markets and the housing sector should allow inflation to start normalising towards year end, but the Fed is not going to stop until it is sure the rise in prices is truly contained. The longer this process takes, the higher will be the risk of a policy mistake and a resulting recession.

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The point at which central bank officials can declare ‘mission accomplished’ is unfortunately unknown; however, it is unlikely that they will be able to reach the official 2% target. The structural increase in political risk and strategic shift to rewire global supply chains, which were aggravated by the outbreak of the war in Ukraine, have ended the ‘supply-abundance’ era in the West. Going forward, structural inflation will be ‘3% plus’ rather than ‘2% minus’.

In Europe, energy shortages should be avoided

Turning our focus to Europe, the energy crisis continues to make headlines ahead of the winter heating season. Pressured by Russia, which has indefinitely turned off the tap on the Nord Stream 1 pipeline, Europe’s efforts to increase storage and secure alternative sources of natural gas supply are in full swing. These include the ramp-up of liquefied natural gas (LNG) import capacities, as well as targets to reduce industrial demand.

For the record, natural gas is the largest energy source used for heating European households and is also a key input to production processes across several industries. Recent improvements in addressing the issue on both the supply and demand sides are reflected in European natural gas prices, which have fallen significantly since their peak at the end of August but are still well above average levels. In fact, market pricing continues to remain at odds with the fundamental picture, according to our Julius Baer Research analysts. Natural gas storage levels are well in line with seasonal patterns, and European storage is currently also filling up at above-normal speed despite Russia’s curbs. For now, we do not observe a physical shortage of natural gas. In the absence of an unusually cold winter, Europe is well equipped to deal with the shortfall in Russian gas.

Importantly, enacted measures to ease the related risks are not merely tactical. Indeed, Europe needs to structurally reorganise its energy supply chains. The legacy European business model, with cheap Russian energy supplies as one of its main supporting pillars, is being challenged and will have to prove its future viability. This will take time.

In the meantime, similar to the US, the European economic cycle is not subject to the unwinding of private-sector imbalances. Lately, the European Central Bank (ECB) has expressed its intentions to start discussions about shrinking its balance sheet in early October. Unlike in the US, however, quantitative tightening is far riskier in Europe, as we do not expect private-sector credit demand to compensate for the impact of central bank liquidity contraction. We remain concerned that the current uptick driven by the corporate sector is due to (negative) temporary factors (e.g., raising bridge financing in the context of higher energy bills) rather than structural factors. If our concerns materialise, economic growth in the region will be restrained in the face of a decline in broad liquidity aggregates and a stagnant (at best) money multiplier. We remain tactically cautious on European assets but are aware of their valuation levels – potentially close to cheap enough to be reconsidered for the longer term.

Outlook into year end

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Arguably, markets were overly enthusiastic in the run-up to the US consumer price index inflation data release for August. What followed was a violent sell-off across asset classes amid the prospect of more aggressive central bank action going forward. While a retest of the June equity market lows certainly remains in the cards, we see the Fed becoming less hawkish by year end, on the back of falling commodity prices. On the corporate side, while earnings estimates have been revised down, except for the oil & gas sector, profit margins remain resilient for now. Against the backdrop of a violent reset in the cost of capital, the market is looking for a new equilibrium, as we are exiting financial repression territory. Undoubtedly, this is a painful process.

On the flipside, however, the outlook with regard to forward-looking returns is much better than at the beginning of the year. In the short term, better-than-expected inflation numbers and a ceasefire in Ukraine remain the two catalysts that could trigger a sharp rally in risk assets. If the US enters a technical recession, US Treasuries should outperform bonds exposed to credit risk.

Should the Fed manage to engineer a soft landing, it will be the other way around. We remain invested with a hedge, as the bottoming process has been postponed for now, until incoming data paints a more encouraging picture regarding price pressures in the economy, but we are prepared to use continued weakness in the markets to reposition our portfolios for 2023 and beyond.

Yves Bonzon is group chief investment officer at Julius Baer

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