No gain without pain

By Greg Smith, Head of Retail at Devon Funds

September proved a challenging month for markets, with investors intently focussed on the tightening plans of the Fed and other central banks around the world, as many officials double down on efforts to contain inflation. At the same time economies have remained resilient, as have corporate earnings in many instances. This has certainly been the case in New Zealand with June quarter GDP coming in ahead of expectations by some distance, and the reporting season a solid one. This, and further weakness in our currency, has arguably helped the New Zealand stock market hold up better than many international peers.

In what was a volatile month, the NZX50 fell 4.6%. In comparison the S&P500 fell 9.3%, while the Nasdaq dropped 10.5% as higher-priced growth stocks fell further out of favour amid concern over rising interest rates. Across the Tasman, the ASX200 fell 7.3% during the month.

Globally, investors have been concerned around the view that interest rates will be ‘higher for longer.’ A hotter than expected inflation print in the US has provided the catalyst for volatility. The annual rate of inflation was lower at 8.3% but ahead of forecasts of 8% and “core” inflation accelerated for the first time in six months. This cemented the prospect of another large rate hike which was duly delivered when the Fed met. Fears over inflation have intensified, despite a significant drop in gasoline/oil prices. Food prices continue to surge and double digits annual gains represent the sharpest pace since 1979.  

The Fed put through a third consecutive 0.75% increase in rates (to a range of 3-3.25%) which was less than the 1% rise that was also potentially on the cards. The outlook was always going to be under scrutiny, and it appears the Fed is far from done in the current tightening phase. The “dot plot” of individual officials’ predictions pointed to further large increases and no rate cuts before the end of next year.

The Fed now expects the terminal rate (where it ends its tightening regime) to reach 4.6% in 2023. This implies possibly another 0.75% hike (which would be the fourth in a row) in November. A key sentence from Jerome Powell was that “Higher interest rates, slower growth and a softening labour market are all painful for the public that we serve, but they’re not as painful as failing to restore price stability and having to come back and do it down the road again.”

Powell said his main message was that the central bank officials were “strongly resolved” to bring inflation down to the Fed’s 2% goal and added that “we will keep at it until the job is done.” The comments invoked comparisons with Paul Volcker, the Fed Chair whose aggressive tightening in the 1980’s ultimately brought on a deep recession.

Many like to bring up Volcker, with comparisons regularly made, but there are however some big differences between the two eras. Over four decades ago, the US central bank was much slower to react to inflation in the 70’s which ultimately peaked at just under 15% in 1980 – this time it looks to have peaked at 9.1% in June. The central bank during that time took rates to 20% in 1981, and no one is really suggesting rates will get much above a quarter of that level over the next 18-months. The scenario this time around is very different. The Fed is not behind the curve to the same extent.

The world’s largest economy is coming from a position of strength – a noted change from the Fed’s previous statement highlighted that recent indicators point to “modest growth in spending and production.” Officials have lifted their median unemployment forecast to 3.8% by the end of this year. They see the jobless rate reaching 4.4% in 2023, where they predict it will hold through 2024 before easing back to 4.3% in 2025. This is hardly an apocalyptic scenario.

For all the alarm bells, the US economy is not rolling over, despite the aggressive tightening seen already this year. US consumer spending (which makes up two thirds of the economy) rose 0.4% in August, double forecasts, and after a fall in July. Consumers (confidence rose last month) have more in their pockets thanks to the fall in petrol prices. This is a trend being seen elsewhere. US manufacturing has ticked higher recently, and continuing claims for unemployment remain near historically low levels. US new home sales surged in August.

Recent Fed comments and inflation prints though have seen a reaction from the bond market, with the yield on the 2-year Treasury jumping to 4.2% while that on the 10-year approached 4%, a level not seen in a decade. US 30-year mortgage rates have risen to 6.8%, the highest level since 2007. 

Where the Fed goes, other central banks often follow. This is all the more so currently given that strength in the US dollar has compounded the level of imported inflation for many countries. Certainly, an issue for the UK, where the pound recently sank to a record low after a range of tax cuts were announced (these have subsequently been reversed). After hiking rates by 50bps, the Bank of England has taken the step of intervening to shore up the currency, announcing a plan to buy long-dated bonds. Peak inflation forecasts have at least moderated to 11% in October, from 13% previously.

Inflation is meanwhile still running hot in Europe, hitting 10% in September, up from 9.1% in August. Food prices have surged, but the bigger story is gas, which drove a 40% annualised increase in energy prices. Gas would appear to be the biggest ‘weapon’ in Russia’s arsenal, in a war that is not going well for Putin. The inflation print looks to have sealed the deal on another 75bps hike by the ECB when it meets this month.

Across the Tasman, the minutes of the last RBA meeting revealed that the board sees the case for a slower pace of rate increases “becoming stronger” as rates rise. This is while the CPI in Australia moderated to 6.8% in August, and down from 7% in the year to July. Falling oil prices had a big say - automotive fuel inflation dropped from 43% in June to 15% in August. This is helping to put dollars back in consumers products - Aussie retail sales climbed for the 8^th straight month in August. Record annual sales posted by retail titan, Premier Investments (whose retail brands include Peter Alexander and Smiggle), also suggest a buoyant Aussie consumer.

The RBA has been one of the more dovish central banks, while the RBNZ has been one of the more hawkish – this week we will see Adrian Orr’s take on the kiwi dollar which has hit US$0.56, the lowest level since the GFC - good for exporters, but not so much for imported inflation.

Elevated inflation prints continue the pattern of data ambiguity and incredible amounts of noise which markets continue to face. Producer prices have moderated in the US, while oil prices, a key driver of headline inflation, have fallen 30% since their post-invasion peak earlier in the year. Mathematically it was always going to be hard for CPI prints to remain as strong as they have been. As shown below, forecasts for future inflation have fallen substantially.

Economists’ Forecasts for US CPI

Source:  Credit-Suisse

Investors will be closely monitoring the upcoming September quarter earnings season and how US corporates are handling things. Expectations are low, with earnings growth for S&P500 constituents expected to be less than 3%. Recent updates from Apple (pulling back on iPhone 14 manufacturing capacity) and Nike (big inventory build) have not helped sentiment. That said, both blue chips noted that underlying top-line demand for their products was still robust. A better-than-expected results season would bring welcome relief to markets.

Quarterly Earnings of S&P500 companies

New Zealand avoided a technical recession in the June quarter, and by some distance. The economy expanded 1.7%, which was at the top end of forecasts. The services sector, which accounts for two thirds of the economy, played a key role, rising 2.7% quarter on quarter. Covid sensitive sectors bounced back. Many forecasters ultimately underestimated the extent to which the economy would recover following the Omicron-impacted first quarter.

The level of backslapping should however be tempered. Goods-producing industries fell 3.8% quarter on quarter, with manufacturing and construction under the pump.  People are paying less at the petrol pumps, but swathes will be seeing higher mortgage bills in the months ahead as they roll off one-year deals struck last year. This is while the number of million-dollar-plus mortgages has doubled in just three years to nearly 103,000, or nearly 9% of all borrowers.

Whether a soft or hard economic landing is forthcoming remains to be seen. The uncertainty here though is why it is important for investors to focus on high quality, defensively positioned companies.

This year’s volatility has certainly had some wide-ranging impacts, not least of which has been evident in the IPO market, which has ground to a halt.  It has been 130 days since a US company raised at least US$25m in a traditional IPO. This breaks the longest previous drought, which was seen in 2008. The drought has been even worse for the high-priced technology sector.

It has been over 250 days since the bell was last rung at the Nasdaq on a tech IPO worth more than US$50m. This surpasses previous stretches seen in the aftermath of the GFC, and also the 2000’s dotcom crash. A near 30% cratering in the Nasdaq this year, and the implications for pricing and investor demand, has left corporates somewhat gun-shy. The performance of pandemic IPOs has also made investors wary. The Renaissance IPO index, which tracks US companies that listed in the past two years, is down nearly 50%. At least Europe has notched up a big IPO with Porsche AG. The €72 billion IPO for the 911 maker is the biggest since 2011.

Overall, investor sentiment has not been helped by some bold projections from those on the bearish side of the ledger. Amongst those commanding the most attention has been billionaire hedge fund manager Ray Dalio who says that markets have become too complacent about inflation and have underestimated how far interest rates will rise. The co-investment officer at Bridgewater expects inflation to fall in the short term but rise in the medium term to a sustained average level of around 4.5% to 5% (versus market implied forecasts of around 2.6%). He expects the Fed will continue to raise rates to at least 4.5%. 

The alarm bells being rung by the bearish camp are nothing particularly new, and indeed make a market. It is worth noting however that a lot of bad news has already been priced into markets (see below for a comparison of market PEs vs three months ago), and while not apocalyptic scenarios, these are certainly less than favourable ones. This is showing up in valuations. Devon MD and Portfolio Manager Slade Robertson has noted that if one takes out the US mega-cap stocks, the valuation on the rest of the SP500 is around 13-14 times earnings. 

Market PEs today vs three months ago