Uncertainty not fully priced-in

By Robert Ducker

Global equities rallied strongly since the mid-June lows, with cyclicals off their relative lows. During this period investors have generally digested weaker economic prints, signs of possible escalation from Russia in terms of gas flows to Europe and rising political risk in Italy where the Government has resigned which could potentially delay flows from the EU Recovery Fund. Yet, global equities have gained 10.7% since mid-June lows as the weaker economic environment has pushed the real yield back down to zero.

We are currently experiencing an equity market that lacks any meaningful direction. In June global equities fell 8.6%, then recovering 8.0% in July. Such big swings are not normal, but a reflection of the uncertainty that currently prevails. Economists have been arguing that we are close or at peak inflation for several months, but actual data is yet to confirm this. The implication should inflation peak is quite clear, central banks would be able to reduce the pace of rate hikes. This explains the outperformance of long duration assets during July, with global growth (+14.5%) generally nearly double the total return of global value (+7.1%).

Additionally, investors are getting nervous on the outlook for global growth. The FED Funds Rate target range has increased by 225bp from 0.0% - 0.25% in the first seven months of 2022, equivalent to 32bp hike every month. This is similar in magnitude to the most recent rate hike cycle, but that was spread over a period of 37 months, equivalent to a 6bp rate hike per month. Looking back at previous rate hike cycles since the 1980’s, this has so far been the most aggressive tightening cycle. Obviously more rate hikes are expected in the coming months, with another 100bp rate hikes expected until the end of the year, taking the equivalent monthly rate hike to 29bp, still the highest within our sample.

FED rate hike cycles

The current rate hike cycle is the most aggressive since the 1980s in terms of pace. It is expected that by the end of the year, the FED would have hiked rates by 325bp

* - More hikes are expected in the upcoming months

There is usually a delay from when monetary action is taken until it feeds into the economic data. The danger of a fast-tightening cycle is that probably, we are still yet to feel the full impact of the 225bp rate hike. This was confirmed by Chair Powell during the July FOMC meeting. The US is technically already in a recession as real GDP has contracted for two consecutive quarters. However, the strength of the labour market, evidenced by the strong July payroll data which came in well above expectations, suggests that the US economy is not in recession. There is more concern around Europe, with economists now expecting a recession in the region by the end of the year. The key risk for Europe is energy, with Russia closing the gas taps during July due to maintenance work. This has already weighed on industrial production in Germany, and would have a greater impact should gas levels do not return to more normal levels over the upcoming weeks.

Risk sentiment has recovered somewhat in July as shown by the Goldman Sachs Risk Appetite Indictor. As mentioned earlier, this has happened at a time when the macro-economic backdrop is weakening, a market where bad news is good news. The main driver of this recovery is the expectation that the interest rate hike cycle has peaked, with slower rate hikes expected as we approach the year-end. Additionally, some market participants expect a rate cut in 2023.

In conclusion we expect equities to trade in a band until we get more clarity on the growth and inflation mix. There is also a risk of a downward revision to earnings expectations, especially in Europe. Consensus is currently expecting EPS growth of 15% in FY22 and 4% in 2023, with the FY22 growth expectations supported by commodity players. It is important to note that unlike 2022, 2023 will not benefit from a post-COVID spending surge, which could also weigh on earnings. Finally, a scenario where Russia cuts gas flows to Europe could lead to a 20% decline (from current estimates) in EPS.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.