Are the markets about to be blown up?
Jerome Powell could blow up the markets this weekend.
Central bankers and economists continue to warn a global recession is possible if inflation is not brought under control and consumers do not start to curb their spending.
But it seems investors are not listening…
Over the past two months share markets have rebounded and even US bond yields have risen with investors convinced that the end of the Fed’s rate hike cycle is in sight.
The S&P500 has bounced more than 15% off its June lows and the NASDAQ index is up more than 19%, with big exposure to technology stocks.
However, the US Federal Chairman, Jerome Powell gets his chance to address markets when he speaks at the annual Jackson Hole gathering on Friday night. There is a realistic prospect that he is going to blow up financial markets or at the very least hose down a two-month rally stoked by bets that US inflation has peaked at 8.5% in July.
Both equity & bond markets are pricing in that US rates will peak early 2023, before falling towards the end of the year.
At a recent economic update, we heard from BetaShare economist David Bassanese “While there are some positives, such as the likely peak in inflation, there is still a risk that global economic growth will need to slow materially to achieve a sustained slowdown in inflation.”
Furthermore, Bassanese suggested that a slowdown is not priced into earnings or even equity valuations, so there is a risk that equity markets may suffer further. With US earnings yielding better results than expected over the past few weeks.
US inflation might have peaked at 8.5%, however it is still way above the 2% level the Fed targets. However, history has shown you cannot rein in inflation to these target levels without going into a recession.
Furthermore, when the US goes into a recession, Australian will be affected. Not just our share markets, super funds, and property prices, but our unemployment is expected to rise by an estimated 1% which will limit how hard the RBA continues to rise rates.
“A rally from the lows does not mean we should expect a repeat of the past few years. ”
Furthermore, many US experts believe that it would be prudent to slow the pace of policy rate increases while assessing the effects of cumulative policy adjustments on economic activity and inflation. With the likelihood of another 1-1.25% rate rise coming, the peak of this rate cycle may be upon us.
While the Fed may shift to smaller rate increases, Powell is well aware that they may be better off risking a real recession than allowing elevated inflation rates to become entrenched. As once the genie is out of the bottle it becomes increasingly difficult to rein in.
Powell himself would also be conscious of misreading the US economy AGAIN, after at the same event a year ago he maintained the Fed stance that a spike in inflation to 30 year highs was transitory. It has since climbed to 40 year highs, seeing Powell and the Fed pivot from their transitory views.
Over the past 12 months, Powell has spoken many times and on each occasion he has managed to shake the confidence out of the markets, providing investors with little reassurance that the Fed has inflation under control, leaving markets around the globe shuttering. Whether he is contradicting previous updates or not having conviction in a plan for providing a way out.
Powell’s assumptions that economies could simply return to pre-pandemic norms, even over time, has been severely challenged by recent events.
Supply chains, whilst improving, are still not functioning as they did pre-pandemic and in some instances, have been permanently reshaped by the painful lessons of self sufficiency experienced during the pandemic.
China’s economy continues to sputter and disrupt global product supplies because of its harsh approach to COVID and in any case it isn’t the low cost production centre and force for global deflation it once was. The heightened tensions between China & the US also aren’t going to be transient and will reshape the post pandemic economic order.
As we have stated in our past posts over the last eight months, Russia’s invasion of Ukraine will have lasting impacts on energy and agricultural supplies, prices and supply chains.
Furthermore, alarm bells are ringing with ASIC coming out in recent days warning investors that signs of over-exuberance from day traders are re-emerging, as they did after the COVID-19 pandemic’s first wave.
The recent market activity has become known as the “most hated rally” because it is precisely what governments and monetary authorities don’t want to see. It suggests there is still plenty of liquidity in the system and the public can tolerate even higher interest rates.
Powell will need to address the disconnect between what the markets are factoring in and what the Fed is likely to do before investors’ optimism becomes entrenched and undermines the central bank’s efforts to tighten financial conditions.
Powell needs to erase any doubts over the Fed’s commitment to driving the US inflation rate down to its target whatever the economic damage in the process - because the risk of not doing so is far greater.
However, in doing so Powell could trigger a sell off in equities and bonds and reignite volatility in what have become complacent markets as this year has progressed. However, the Fed may see that as necessary if investors are convinced that this time, it will hold its nerve.
Source: Bloomberg
Ultimately Powell needs to get investors focused, not on where and when interest rates will peak, but how long they will remain at that level. In the developed economies, indebtedness post pandemic is at levels that mean rates won’t necessarily have to be pushed up to historical highs to flatten activity and the inflation rate.
Powell’s speech is his best opportunity to clarify the Fed’s policies and expectations and hose down expectations that rate cuts are on the Fed’s horizon for 2023. This could see a sell off on Monday morning in Australia.
Should you have any questions or concerns about your underlying investments within your super, your investment properties or any other questions, please do not hesitate to reach out to our Lake Macquarie Financial Planning advisers.
sources:
https://www.smh.com.au/business/the-economy/jerome-powell-could-blow-up-the-markets-this-week-20220822-p5bbp6.html
https://www.afr.com/markets/equity-markets/asx-to-slip-earnings-and-powell-speech-in-focus-20220820-p5bbds
https://www.afr.com/chanticleer/markets-are-giving-the-fed-the-middle-finger-20220821-p5bbhj
https://www.afr.com/markets/debt-markets/investors-on-edge-as-china-easing-adds-to-recession-fears-20220822-p5bbmz
https://www.afr.com/markets/equity-markets/company-profits-show-resilient-earnings-momentum-20220822-p5bbqi
https://www.afr.com/markets/equity-markets/higher-interest-rates-ex-dividend-stocks-weigh-on-asx-20220822-p5bbp1
https://www.afr.com/markets/equity-markets/inflation-jackson-hole-loom-over-huge-week-of-earnings-20220821-p5bbhu