Markets Weekly podcast – 5 September 2022

Henk Potts (HP): Hello. It’s Monday, 5^th September and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.

My name is Henk Potts, Market Strategist for Barclays Private Bank. Each week I’ll be joined by guests to discuss both risks and opportunities for investors.

Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then consider the outlook for equity markets. Finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

The hangover from the hawkish Fed continued last week. Equity markets have sold off aggressively, after hopes that the Fed chair would use the Jackson Hole Policy Symposium to offer a soothing message to investors were dashed, as a hawkish Jerome Powell pledged that the Fed will keep at the task of lowering inflation till the job is done, despite acknowledging the resulting steeper policy path will cause pain for households and businesses, including a period of below-trend growth and softer labour market conditions.

The rationale for the restrictive policy stance was predicated upon the importance of the Fed’s commitment to deliver low, stable inflation over time, regardless of the source and the need to avoid a self-reinforcing inflation spiral, with high inflation expectations becoming ingrained in the public’s consciousness.

What does that mean in terms of the path of policy in the United States? With not even a glimmer of a pivot, the next Fed meeting, on 20th September, the decision for another 75-basis point hike or a step down to 50-basis points continues to be data-dependent. The key datapoints will be the inflation prints and the labour market reports.

Friday’s labour market report finally showed some early signs that labour demand is slowing. Nonfarm payrolls increased by 315,000 in August. That was a deceleration from the 528,000 jobs which were created during the course of July.

The unemployment rate rose to 3.7%, although that was partly a reflection of the increase in the participation rate, which rose to 62.4%. Given our expectation the momentum in labour markets will continue to gradually soften and price pressures will slowly ease back, we still think, on balance, though, a 50-basis point increase in September is more likely, followed by 25-basis point increments in November and December.

In terms of market performance, equity markets continued to drift lower last week, marking a miserable end to the month. The S&P 500 fell 3.3% last week and was down 4.2% in August. The Nasdaq underperformed and was down 5.2% last month.

In Europe, despite the 2% rise on Friday, the STOXX 600 still fell 2.4% last week, and was off 4.5% through August, giving back around half of its summer rally. European markets, of course, have opened in the red this morning, down round about 1.3%, which was actually less than was anticipated. That’s after the energy crisis was plunged deeper into turmoil. This was after Russia said gas flows through the Nord Stream pipeline won’t restart after a period of maintenance.

EU officials have been bracing themselves for the prospect of supply cuts. They’ve been searching for alternative sources of energy and filling up storage facilities. Gas futures have surged 35% overnight, and prices are now four-times higher than they were a year ago.

EU energy ministers will meet on Friday. No doubt they’ll be discussing interventions in energy markets, including price caps, rationing, support for suppliers, and windfall taxes on producers.

The prospect of higher interest rates has pushed the US dollar to its highest level against the basket of currencies in 20 years. The dollar index is trading at a two-decade high of 1.10 this morning. It’s up 14.7% year to date. The euro is back trading below parity. Meanwhile, sterling has fallen to 1.145 against the dollar. To remind you, the pound was down 5% through August. That’s the most since the Brexit vote back in 2016.

In terms of the outlook for FX markets, near term we continue to believe they’re likely to be driven by risk aversion, growth rate projections, interest rate predictions, and investment flows, which will be positive for the US dollar.

However, in the medium term, mild dollar depreciation could be on the cards. The dollar is starting to look overvalued. You can argue that markets have already fully priced in the rate-hiking cycle. The dollar, remember, historically increases growing into a rate-hiking cycle, then eases back. The dollar could also ease back as risk appetite stabilises and US economic outperformance narrows, but we’ll certainly be watching those foreign exchange markets very carefully indeed.

Moving on to the UK, the next British prime minister will be announced today at around about 12.30 UK time. If elected, a Liz Truss premiership, we think, could create upside risk to GDP and possibly the rate path in 2023.

Truss has said she intends to hold a fiscal event on 21^st September. Based on news reports, a support package totalling £40 billion to £50 billion, or 2 to 2.5% of GDP, could be announced. Her campaign has pledged £30 billion of tax cuts, including a reversal of that 1.25 percentage-point increase in National Insurance contributions, a reversal of the corporation tax hike, which was due to start next April and would have lifted corporation tax from 19% to 25%, and a moratorium on green levies.

It is worth noting there’s been very little detail on the spending or forecast side to discuss how these measures would be paid for.

Alongside that, around £10 billion to £15 billion of further emergency cost-of-living-related support, to help with energy bills, could be announced. The government is reportedly considering a freezing of energy bills at the current levels for two years, with suppliers borrowing from a deficit fund arranged by the government through commercial banks, with the government recuperating costs, possibly via higher energy bills over many years.

In principle, this could actually be a very attractive policy for the government as it could keep headline inflation much lower if it was universal, in the near term, and if considered a loan it would cost much less on headline public sector net borrowing.

The Truss campaign has promised a review of the Bank of England’s mandate. While the government can change the 2% inflation target for price stability without legislation, more fundamental changes, such as adding an economic target, would require legislation. Changes to the mandate are expected to face a high bar, while any perception that monetary policy is becoming politicised could prompt an adverse market response.

But in terms of the growth impact, we estimate the combined effect of the National Insurance and corporate tax measure could boost GDP by around half of 1%. In terms of the impact on rates, stronger growth, marginally higher price pressures may encourage the Bank of England to run a slightly tighter monetary policy. Any reaction, of course, we think would be delayed until implementation, so any additional rate hikes in 2023 are likely to be limited to around about 25 basis points.

So that was the global economy and financial markets last week. In order to discuss how investors should be positioned within equity portfolios, I’m pleased to be joined by Dorothée Deck, Cross Asset Class Strategist for Barclays Private Bank.

Dorothée, great to have you with us today as always. As we know, the second-quarter earnings season is now drawing to a close. What have been the main takeaways that you’ve been reviewing and what’s your view on the current earnings forecast?

Dorothée Deck (DD): Hi, Henk, great to be with you. So, yes, most companies have now reported second-quarter results in the US and in Europe. Earnings have increased by 7% year on year in the US and by 15% in Europe. So, that was led by strong revenue growth, partially offset by margin contraction on the back of higher input costs.

Relative to analysts’ expectations, corporate earnings have surprised positively by 4% in the US and by 10% in Europe. That’s less than in previous quarters, but it remains quite resilient, given the sharp deterioration that we’ve seen in the macroenvironment.

Now, the headline figures can be a bit misleading, because the bulk of the earnings growth was actually driven by the energy sector, as oil and gas prices soared. So, if you exclude the energy sector, earnings would have been down 3% in the US and down 4% in Europe. But, most importantly, company management provided cautious guidance for the rest of this year and all of next year, and as a result, we have now started to see earnings downgrades in the past couple of months, especially in the technology sector, communication services, and consumer discretionary.

Despite those revisions, we believe analysts’ forecasts are still too optimistic and will have to come down materially in the coming weeks. And to give you some numbers, stock analysts are still expecting global earnings to grow by 11% this year and 6% next year. However, business surveys already suggest much lower earnings in the coming months, and our top-down earnings model is actually consistent with broadly flat earnings growth in 2022.

HP: So, if earnings forecasts are likely to be downgraded materially in the coming weeks, what are the implications for equity markets?

DD: Well, that’s an interesting question because some market commentators have argued that we have not seen a bottom in equity markets this year because earnings forecasts haven’t troughed yet. We disagree for two reasons.

The first one is that, on our numbers the equity market is already discounting a 9% decline in global earnings in 2022. And the second reason is that, using history as a guide, equity markets generally trough several months ahead of economic activity and corporate earnings.

So, we looked at the past nine equity bear markets in the US, using data going back to 1966, and we found that the S&P 500 has tended to bottom five months before a trough in the ISM manufacturing index, and 12 months before a trough in corporate earnings, and that applies to both trailing- and forward-earnings estimates.

We conducted the same analysis in Europe, and although the data is somewhat more mixed, it paints a similar picture. European equities also tend to trough before activity and earnings. So, it’s very difficult to say whether the June lows represent the bottom for equity markets this year, or whether we will retest those levels in the near term.

What we can say, though, is that based on history, we do not need to wait for the last earnings downgrades to see a sustainable rebound in markets.

HP: Dorothée, what does history tell us about the time that it takes for investors to recoup their losses after a bear market?

DD: So, history shows that, in previous bear markets, it took about a year on average for US equities to form a bottom, 36% below the previous peak. And then it took another two years for investors to recoup their losses.

Now, those numbers represent averages and the recovery times actually vary quite significantly, between three months and six years. We didn’t find any clear pattern to explain what drove recovery times, but during those bear markets, trailing earnings typically declined by 16% in the US and the ISM manufacturing index dropped to 40 on average.

In Europe, historically it took about a year for equities to trough, 38% below the previous peak, but investors needed to wait longer than their US peers to recoup their losses. So, the average recovery time was about three years, but it was very much distorted by the bear market of 1973 and 2008. If we exclude those two, the average recovery time was about two years, in line with the US.

Trailing earnings typically decline by 24% during European bear markets while the ISM bottomed at 40 on average.

HP: As we’ve been discussing this morning, equity markets have come down significantly following Jerome Powell’s speech at the Jackson Hole Policy Symposium. Does that change your near-term outlook on equities? And how should investors be positioned within equity portfolios?

DD: So, global equities are down 8% in the past couple of weeks, and down 5% since Jay Powell’s comments at Jackson Hole, which were more hawkish than expected, as you mentioned earlier.

So, he clearly reaffirmed that the Fed is serious about getting inflation under control, even if that results in some pain for the US consumer and the economy. The Fed is committed to continue tightening policy and keep the policy rate at restrictive levels for some time, which obviously has negative implications for growth and the discount rate applied to equities.

Equities had actually rallied by 13% from mid-June to mid-August on the expectation that the Fed would soon be forced to pivot and abandon their hawkish stance, but the rally started to reverse as soon as it became clear that this scenario was now increasingly unlikely to happen.

Other central bankers at Jackson Hole also indicated that rates will continue to rise, so this does not change our view on equities in the near term. We continue to see high volatility in the coming weeks, and we expect markets to be driven by headlines on inflation, growth, and monetary policy.

In that context, investors should position portfolios for an extended period of high volatility and keep hedges in place. We will also increase diversification across sectors, regions, and styles. In the near term and until that narrative changes, the sectors most sensitive to rates and inflation will be the most vulnerable, namely the broad technology sector, communication services, and consumer discretionary.

Cyclicals will also be at risk of slower growth, but we continue to see investment opportunities in some dislocated parts of the market, such as industrials and banks. Industrials have overreacted to the deterioration in the macroenvironment and benefit from long-term structural trends. And banks should be one of the main beneficiaries of higher rates and they also appear disconnected from current level of yields.

If, as we expect, inflation starts to moderate and we avoid a deep recession, those sectors should outperform.

HP: Well, thank you, Dorothée, as always, for your insights. Investors will no doubt be hoping that the sell-off in August proves to be a mere hiatus in the rally that started in July. But as you quite rightly pointed out, markets still have plenty to digest, including slowing growth and higher policy rates.

Moving on the week ahead, market attention will focus on the European Central Bank meeting on Thursday. Money markets imply there’s more than a 60% change that the Governing Council could be forced into an aggressive 75-basis point rate hike, after the August inflation print came in at a higher-than-expected record 9.1% year on year.

The price pressures were led by an increase in food and energy prices. Perhaps of more concern for policymakers was the core reading, which excludes food and energy. That rose to a new all-time high of 4.3%.

The outlook for eurozone inflation remains elevated. CPI is not forecast to peak until September, at 9.5%. It’s predicted to average 3.9% during the course of 2023, while core inflation is forecast to be above 2% through the forecast horizon taking you through 2024.

In terms of the policy path, we think the European Central Bank will try to use a small window before a recession to prove they are determined to tame inflation and normalise policy, hence we’re now seeing a more aggressive policies rate path consisting of 75-basis points this week.

The risk is we only get half of 1% followed by 50-basis points in October and 25-basis points at the December meeting, taking the deposit rate to 1.5% at year-end. We now expect the Governing Council to hike rates further during the course of 2023, as activity turns increasingly negative through the course of the winter months.

And with that, I’d like to thank you once again for joining us. I hope that you’ve found this update interesting. We will, of course, be back next week with our latest instalment, but for now may I wish you every success in the trading week ahead.