Share prices have rallied strongly from their mid-June lows giving us the opportunity to lighten equity allocations further. We remain cautious, and this is reflected in our recommended portfolio positioning. We have been surprised that the more positive mood has persisted into August; equity markets have now regained more than half of their losses from earlier in the year. In this note we look at the possible explanations for the mid-year equity market rally, revisit the case for caution and outline what we believe may unfold over the remaining months of 2022.
The rally
The lows for equities this year came towards the end of a tumultuous first half. Mid-June saw US equities, as measured by the S&P500, fall to a low point of 3,666, almost 25% below the level reached at the start of the year. Since then, that index has recovered by more than half, leaving it only a little over 10% lower in capital terms for the year thus far. In the face of steeply rising interest rates and a deteriorating economic backdrop, this, in our view, is remarkable.
We have come across three possible explanations: (i) building optimism that the pace and extent of further interest rate rises may be limited, (ii) a belief that the extreme market weakness of the first half of the year was overdone in light of a better than feared second quarter earnings season from companies and (iii) ‘technical’ factors, whereby momentum investors and hedge funds, which were positioned for further weakness, have been forced to buy back short positions as risk assets rallied. As fundamental investors with little insight into the positioning of traders, we restrict ourselves to commenting in detail only on the first two drivers.
(i). The equity market rally began on 16 June. It is not a coincidence that this was the day after the US central bank, the Federal Reserve (the Fed), surprised markets with an outsized 75bp interest rate increase. This increase, in turn, was the response to a shock inflation reading the week before, with prices rising by 1% in a single month and 8.6% over one year. Bond and equity markets welcomed the Fed’s aggressive response as a commitment that inflation would be brought under control, and that a short, sharp monetary policy shock would re-establish central bank credibility. More recently, marginally better news on inflation has given investors hope that, with interest rates perhaps not rising much further, an economic slowdown can be avoided – further underpinning the rally in equity markets. The chart below shows why, in our view, this rosy scenario is almost certainly much too optimistic.
The chart shows that in previous inflationary episodes, interest rates have had to rise above the rate of inflation to bring the latter back under control. As can be seen, we are currently some distance away from this, suggesting that the Fed has little choice but to continue to raise rates. A related observation from the chart is just how serious the current inflation challenge is in the context of recent history. We have to go back 40 or more years to see inflation higher than the present level – and while we don’t expect interest rates to reach the heights of the 1980s, neither do we expect good news on this front in the near future. This is because price increases are now evident in core elements of inflation, including the key shelter component which captures the cost of accommodation. Such elements are likely to require a prolonged period of higher interest rates to get them moving lower.
In past inflationary episodes US interest rates have always risen beyond the level of inflation
(ii). The second justification for recent stock market resilience has been the continued strength of corporate earnings. To be fair, the second quarter US earning season was okay – with aggregate year over year growth of 6.7% according to FactSet. We note, however, that the earnings of energy companies made up a major part of the growth – with this stripped out, earnings declined by 3.7%. Our main observation here though is that corporate earnings lag developments in the economy by several months. A reporting season that covered earnings up until 30 June is now largely historic. As has been noted many times, stock markets are forward looking. At present, the expectation is for continued earnings growth in the coming quarters. This is, in our view, far too optimistic.
The chart below shows the strong correlation between the manufacturing outlook survey produced by the Institute of Supply Managers and the ratio of corporate earnings upgrades to downgrades. With the former likely to continue declining rapidly, this would suggest significant earnings downgrades lie ahead. Elsewhere, many of the other leading indicators that we follow also suggest that a substantial further slowdown in economic activity is looming. So, while second quarter earnings exceeded expectations, as the weight of tighter monetary policy bears down on economies, we are concerned that earnings downgrades will increase markedly, with actual future earnings materially disappointing.
Forwards looking surveys are heading lower – corporate earnings tend to follow
Finally, we consider very briefly ‘technical’ factors. As stated above, we have no special insight here. We can, though, accept that following the brutal falls in share prices from the start of the year until mid-June, equity markets were due a pause. The argument that many traders and speculators who were betting on further declines had to cover ‘short’ positions, as markets rallied, seems plausible to us. Importantly though, as fundamental investors, we should not allow ourselves to be blown around by short term moves – however surprising or unjustified they may appear. The outlook for the economy and earnings was poor in mid-June and remains so now – a recovery in share prices doesn’t change this. It can, however, provide an opportunity to adjust portfolios. As mentioned above, we have taken advantage of this by reducing risk exposure further.
Looking ahead
We continue to view the prospect for equity markets in the next few quarters as highly challenging. Leading indicators are increasingly pointing to contractions in developed economies later in 2022 and 2023. This is a very unfavourable backdrop against which to be rapidly increasing interest rates but, as Bank of England Governor Andrew Bailey admitted earlier this month, despite the UK economy heading into recession, interest rates have to continue to go up to bring inflation to heel. As we write, market expectations are for UK interest rates to more than double in the coming months, having already moved up from what was effectively zero to 1.75%. The time lags involved in the transmission of monetary policy changes to the real economy are usually estimated at between nine months and a year. This means that the full weight of tighter policy is yet to be felt – here, in the US or elsewhere.
Finally, on equities, the fundamental props to rising share prices are economic growth (and thereby corporate earnings growth) and steady or falling interest rates. The latter supports or increases the present value of the future earnings that are reflected in share prices. Both props are conspicuous by their absence at present. This is the underpinning of our cautious view.
