Competing policy measures leave markets worried
Posted 23 September 2022
The last two weeks have been sobering for investors world-wide, with all major markets (including bond markets) falling between 5% and 10%. This has come after an encouraging recovery rally over the summer that was driven by falling oil prices, which fuelled expectations that the worst of the inflationary headwinds were behind us, allowing central banks to pause their aggressive monetary tightening course, and that a turnaround in economic fortunes was therefore imminent.
However, following the late-August Economic Symposium meeting of central bankers held at Jackson, the realisation has set in that such hopes were premature and the summer rally proved no more than a bear market rally (see also our separate article that discusses the timing of recovery rallies). Since then, central bankers have resumed their aggressive rate hiking, taking us back to interest rates between 2.5% and 3.5% (UK, US) that we have not had to contend with for 15 years. On top of this, markets have also had to come to terms with politicians’ actions to counter rising economic headwinds that have been at complete odds with the decades-long preceding era of fiscal prudence. If that was not enough, a cornered Vladmir Putin cranked up his war rhetoric, with his retreating troops increasingly making him look a loser, thereby increasing the likelihood of much longer-lasting geopolitical uncertainty.
When there is a meaningful shift in those parameters market participants have grown accustomed to over significant time periods, it is perhaps not surprising they feel uncertainty rising and as a result are inclined to reduce their market risk exposures.
Taking a step back, it is undeniable that this downcycle has likely not reached its trough yet. Therefore, hopes for the usually very rewarding recovery rally have proven premature. On the other hand, it appears that a number of elements that made up the cocktail of formidable downdraft headwinds have gone beyond their lows and indeed point toward markets reaching the capitulation level sooner rather than later. The energy price shock is receding as the price of oil continues to fall, and is now trading a good 40% lower than at its peak, while fiscal countermeasures announced across wider European markets should soften the blow, not only for consumers but also businesses.
Whether the aggressive fiscal counter cyclical measures announced by the UK’s new Chancellor – the most generous consumer and business energy support subsidies across Europe and the largest package of tax cuts in 40 years – will arrest the UK’s current decline toward recession is questionable. However, we note that this fiscal largesse also stands in stark contrast to the austerity that followed the Global Financial Crisis (GFC) recession which led to a decade of subdued growth. One consequence from it is all but certain though: the feared decline in corporate earnings, and thus the running dry of stock market ‘fuel’, should now be smaller than had been feared.
Where does this leave us (and fearful investors) of what may lie ahead? Markets are right to accept that we are not out of the woods yet, but at the same time we suggest this latest bout of downdraft is getting us increasingly closer to where markets may be pricing in more bad news than actually lies ahead – in other words what is also known as capitulation and usually the turning point. As outlined in the second article this week, the ongoing economic downturn has the format of a classic, relatively short cyclical one, with few elements that would make us fearful it will turn into a long-lasting structural recession.
Against this backdrop, it is essential for investors to hold their nerve and not risk missing the onset of the recovery rally, which in such cases has historically front-loaded much of the returns available from the ensuing bull market period. This time, being ‘in the market’ may be even more crucial given higher interest rates and bond yields may well lead to overall lower average return levels during the next cycle.