{"id":1240,"date":"2022-11-07T01:38:09","date_gmt":"2022-11-07T01:38:09","guid":{"rendered":"https:\/\/halcyonpw.com.au\/?p=1240"},"modified":"2022-11-07T01:38:18","modified_gmt":"2022-11-07T01:38:18","slug":"market-update-are-we-there-yet","status":"publish","type":"post","link":"https:\/\/halcyonpw.com.au\/market-update-are-we-there-yet\/","title":{"rendered":"Market Update | Are We There Yet?"},"content":{"rendered":"\n<p><em>Key Points:<\/em><\/p>\n\n\n\n<ul><li><em>Whether the market has troughed now or will make new lows depends on whether the US Federal Reserve is able to achieve a moderation in inflation without too much economic pain.<\/em><\/li><li><em>Decomposing inflation into its underlying drivers suggests that this is unlikely.<\/em><\/li><li><em>In a hard landing scenario, equity markets typically bottom once inflation has peaked, there has been significant monetary easing and there are signs of improvement in economic data.<\/em><\/li><li><em>In this drawdown, the economic pain hasn\u2019t even really begun yet, inflation has barely peaked, and the US Federal Reserve is till hiking rates, suggesting there is a long period of continued weak markets ahead of us.<\/em><\/li><\/ul>\n\n\n\n<p><strong><em>Please Stop the Ride, I Want to Get Off<\/em><\/strong><\/p>\n\n\n\n<p>Global markets have been weak for all of 2022 so far. US equities and longer dated bonds have both fallen around 20% as at the time of writing. For US bonds, this represents the largest sell-off in more than 50 years. For US equities, this is the 9<sup>th<\/sup> largest sell-off since the Great Depression, only eclipsed by major recessions, the Tech Bubble and the Black Monday period. Since 1900, the average size of a bear market sell-off has been around 35% and the average length of a bear market has been around 16 months. At 20% down and 10 months in, can we assume we are about halfway done? In this month\u2019s <em>Insight<\/em>, we outline what we think the catalysts will be for the bear market to be over. This will largely depend on whether the US Federal Reserve is able to achieve a moderation in inflation without too much economic pain.<\/p>\n\n\n<div class=\"wp-block-image\">\n<figure class=\"aligncenter size-large\"><img decoding=\"async\" width=\"1024\" height=\"456\" src=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture1-1024x456.png\" alt=\"\" class=\"wp-image-1241\" srcset=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture1-1024x456.png 1024w, https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture1-300x134.png 300w, https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture1-768x342.png 768w, https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture1.png 1111w\" sizes=\"(max-width: 1024px) 100vw, 1024px\" \/><figcaption><em><sub>Source: <em>Refinitiv DataStream, Drummond Capital Partners<\/em><\/sub><\/em><\/figcaption><\/figure><\/div>\n\n\n<p><em><strong>A Soft-Landing Pivot Party<\/strong><\/em><\/p>\n\n\n\n<p>What are the prospects for a moderation in inflation without a recession? This would allow the Fed to achieve its soft landing and put a floor under markets. Below, we split inflation into four key components from which we can draw out some conclusions.<\/p>\n\n\n\n<p><em>Durable goods<\/em> (cars, televisions etc) &#8211; Durable goods inflation has already moderated substantially, reflecting improved supply chains and restocked retail inventories. However, for CPI to \u201cnormalise\u201d, we would want this component to again start falling and this may not be possible with the geopolitical split between China and the US and the subsequent reshoring of manufacturing.&nbsp;<\/p>\n\n\n\n<p><em>Non-durable goods<\/em> (fuel, food etc) &#8211; Structural underinvestment in commodity production over the past decade suggests that even with a resolution to the Ukraine conflict, non-durable goods prices will remain elevated. &nbsp;Note much of this component is excluded from the core inflation calculation anyway.<\/p>\n\n\n\n<p><em>Rent<\/em> (rent and owner\u2019 equivalent rents) \u2013 Strong growth in rent costs reflects the still strong labour market and the impact of falling average household size post Covid, which saw many people move out of share houses or move into dwellings with a spare room\/office.&nbsp;&nbsp; CPI rents will likely continue to rise for quite some time given the large gap between growth in listed rents and CPI rents.<\/p>\n\n\n\n<p><em>Services excluding rent<\/em> \u2013 This is the most important component of the four as it is the most practical one for the US Federal Reserve to target directly. Services inflation is unlikely to fall meaningfully until the unemployment rate rises given its strong relationship with wages growth see chart below).<\/p>\n\n\n<div class=\"wp-block-image\">\n<figure class=\"aligncenter size-full\"><img decoding=\"async\" width=\"689\" height=\"517\" src=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture2.png\" alt=\"\" class=\"wp-image-1242\" srcset=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture2.png 689w, https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture2-300x225.png 300w\" sizes=\"(max-width: 689px) 100vw, 689px\" \/><figcaption><em><sub>Source: <em>Drummond Capital Partners<\/em><\/sub><\/em><\/figcaption><\/figure><\/div>\n\n\n<p>For inflation to reach 3% by the end of next year (which, by the way, is still above the US Federal Reserve target), a lot of things would have to go right. Assuming rent inflation stays elevated, goods prices would need to fall sharply (retailers would need to discount back towards pre-Covid price levels) and services ex-rent inflation would need to soften to around 3% annualised, a substantial moderation from here.<\/p>\n\n\n\n<p>This all seems unlikely to us. We think a recession is necessary to generate enough labour market slack to depress wages growth and force larger household sizes (recently unemployed moving back in with parents or housemates) reducing rents. It\u2019s not a pretty scenario, but it\u2019s the one that normally plays out.<\/p>\n\n\n\n<p><em><strong>Market Troughs in Recessions<\/strong><\/em><\/p>\n\n\n\n<p>If the chances of inflation moderating on its own are thin, the most likely outcome is that inflation normalises via a recession \u2013 as has been the normal course of events through modern history. Below, we review six of these instances, including the path of some indicative macro variables, the Fed Funds Rate and the US equity market. In doing so, we can draw out any relevant parallels with the current period.<\/p>\n\n\n\n<ul><li>Common to all instances has been an <strong>easing in the US Federal Reserve Funds Rate<\/strong> in the months and quarters prior to the equity market troughing. This clearly stands in contrast to the current situation, with the Fed still expected to increase interest rates meaningfully in the next six months.<\/li><li>In each of these periods except the Tech Bubble, the <strong>equity market troughs during the recession<\/strong> (the grey shaded area). This is consistent with the conventional wisdom that markets are forward looking and will begin to rally before there is an obvious floor from an economic data perspective. Again, with the US economy yet to formally enter a recession, this hurdle has not been met.<\/li><li>Generally, <strong>inflation (top panel, grey line) is moderating<\/strong> prior to a market bottom. If inflation has not yet peaked, it moderates almost immediately following the market trough. Inflation in the US looks like it has peaked from a year over year perspective, but we have yet to see a material downswing.<\/li><li>There is <strong>mixed data around the macro activity in the economy<\/strong> (ISM, housing starts, consumer confidence). Sometimes, an improvement in these variables in the aggregate tends to coincide with the end of a recession and beginning of the economic recovery. Given the US is yet to actually enter a recession, let alone exit one, it is too early to draw a parallel from these to the current environment.<\/li><\/ul>\n\n\n\n<div class=\"wp-block-columns is-layout-flex wp-container-core-columns-layout-1 wp-block-columns-is-layout-flex\">\n<div class=\"wp-block-column is-layout-flow wp-block-column-is-layout-flow\">\n<figure class=\"wp-block-image size-full\"><img decoding=\"async\" width=\"370\" height=\"278\" src=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.1.png\" alt=\"\" class=\"wp-image-1243\" srcset=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.1.png 370w, https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.1-300x225.png 300w\" sizes=\"(max-width: 370px) 100vw, 370px\" \/><\/figure>\n<\/div>\n\n\n\n<div class=\"wp-block-column is-layout-flow wp-block-column-is-layout-flow\">\n<figure class=\"wp-block-image size-full\"><img decoding=\"async\" width=\"370\" height=\"278\" src=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.2.png\" alt=\"\" class=\"wp-image-1244\" srcset=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.2.png 370w, https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.2-300x225.png 300w\" sizes=\"(max-width: 370px) 100vw, 370px\" \/><\/figure>\n<\/div>\n<\/div>\n\n\n\n<div class=\"wp-block-columns is-layout-flex wp-container-core-columns-layout-2 wp-block-columns-is-layout-flex\">\n<div class=\"wp-block-column is-layout-flow wp-block-column-is-layout-flow\">\n<figure class=\"wp-block-image size-full\"><img decoding=\"async\" width=\"371\" height=\"278\" src=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.3.png\" alt=\"\" class=\"wp-image-1245\" srcset=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.3.png 371w, https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.3-300x225.png 300w\" sizes=\"(max-width: 371px) 100vw, 371px\" \/><\/figure>\n<\/div>\n\n\n\n<div class=\"wp-block-column is-layout-flow wp-block-column-is-layout-flow\">\n<figure class=\"wp-block-image size-full\"><img decoding=\"async\" width=\"371\" height=\"278\" src=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.4.png\" alt=\"\" class=\"wp-image-1246\" srcset=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.4.png 371w, https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.4-300x225.png 300w\" sizes=\"(max-width: 371px) 100vw, 371px\" \/><\/figure>\n<\/div>\n<\/div>\n\n\n\n<div class=\"wp-block-columns is-layout-flex wp-container-core-columns-layout-3 wp-block-columns-is-layout-flex\">\n<div class=\"wp-block-column is-layout-flow wp-block-column-is-layout-flow\">\n<figure class=\"wp-block-image size-full\"><img decoding=\"async\" width=\"370\" height=\"277\" src=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.5.png\" alt=\"\" class=\"wp-image-1247\" srcset=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.5.png 370w, https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.5-300x225.png 300w\" sizes=\"(max-width: 370px) 100vw, 370px\" \/><\/figure>\n<\/div>\n\n\n\n<div class=\"wp-block-column is-layout-flow wp-block-column-is-layout-flow\">\n<figure class=\"wp-block-image size-full\"><img decoding=\"async\" width=\"370\" height=\"277\" src=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.6.png\" alt=\"\" class=\"wp-image-1248\" srcset=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.6.png 370w, https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture4.6-300x225.png 300w\" sizes=\"(max-width: 370px) 100vw, 370px\" \/><\/figure>\n<\/div>\n<\/div>\n\n\n\n<p>Given the above, the key triggers we are looking for are:<\/p>\n\n\n\n<ul><li>Economic data begins to show signs of improvement (or at least no longer deteriorating);<\/li><li>Inflation has peaked and is trending lower; and<\/li><li>US Federal Reserve is actively easing policy in response to falling inflation and the recession.<\/li><\/ul>\n\n\n\n<p>Although we are nowhere close to meeting these conditions in the current episode, we can make some educated estimations about when they may come to pass given our forward view of the global economy.<\/p>\n\n\n\n<p>The most important consideration is when the recession is likely to begin. The US Federal Reserve, by forecasting a rise in the unemployment rate from a low of 3.5% to 4.4% is implicitly acknowledging a recession. Since World War Two, there hasn\u2019t been a single instance where the US unemployment rate has risen by more than 0.4 percentage points that hasn\u2019t been immediately followed by a recession. Consensus forecasts have a similar profile for the unemployment rate in the US and imply economic growth is weakest in the first half of next year. There are signs the US economy is cooling. Job openings have fallen sharply. Business sentiment surveys have fallen a long way from the peak and while they remain expansionary, leading indicators suggest they should fall further over the coming year (see chart below, which implies and ISM reading of between 30 and 40 at some point in the next twelve months).<\/p>\n\n\n<div class=\"wp-block-image\">\n<figure class=\"aligncenter size-full\"><img decoding=\"async\" width=\"609\" height=\"326\" src=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture10.png\" alt=\"\" class=\"wp-image-1249\" srcset=\"https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture10.png 609w, https:\/\/halcyonpw.com.au\/wp-content\/uploads\/2022\/11\/Picture10-300x161.png 300w\" sizes=\"(max-width: 609px) 100vw, 609px\" \/><figcaption><em><sub>Source: Drummond Capital Partners<\/sub><\/em><\/figcaption><\/figure><\/div>\n\n\n<p>The above implies 2023 will be the year of the recession in the US, satisfying the first major condition. In four of the seven major recessions since 1970 (excluding Covid), the unemployment rate has increased by only 0.3% in the first six months of its increase \u2013 i.e. the initial rise in unemployment tends to be slow. As a result, we think services inflation will moderate only gradually. Despite this, the expected fall in goods prices should see overall inflation fall sharply through next year, satisfying the second condition. In terms of the US Federal Reserve, we think they will begin to ease policy (interest rates) once they are confident inflation is under control. They are unlikely to ease policy early into the rise in the unemployment rate as they will be concerned that inflation expectations will not properly anchor back towards their target range, and they will be focussed on causing a moderation in services inflation. However, sometime in the second half of the year or early 2024, once the unemployment rate has risen well above their forecasts and overall inflation is trending lower (though still likely above their target) they should feel like the inflation job is done and that they need to address the first part of their mandate \u2013 maximum employment. This will satisfy the third condition, allowing markets to trough sometime next year, more than likely from the middle of the year onwards.<\/p>\n\n\n\n<p>Alternatively, if inflation moderates to target from here without a recession (the soft-landing scenario), equities have likely already bottomed. Evidence of this outcome would come in the form of sharply declining services inflation coincident with no great deterioration in the economy.<\/p>\n\n\n\n<p><em><strong>How Bad Does It Get?<\/strong><\/em><\/p>\n\n\n\n<p>Every market drawdown is unique, though there are clearly aspects which rhyme. Below, we summarise the major equity bear markets since the 1970s.<\/p>\n\n\n\n<figure class=\"wp-block-table is-style-stripes\"><table class=\"has-fixed-layout\"><tbody><tr><td><strong><u>Event<\/u><\/strong><\/td><td><strong><u>Drawdown<\/u><\/strong><\/td><td><strong><u>Recession<\/u><\/strong><\/td><td><strong><u>Trail PE<\/u><\/strong><\/td><td><strong><u>Macro Imbalances<\/u><\/strong><\/td><td><strong><u>Policy Stance<\/u><\/strong><\/td><td><strong><u>Crisis Elements<\/u><\/strong><\/td><\/tr><tr><td>Early 1970s<\/td><td>36%<\/td><td>Yes<\/td><td>18.5<\/td><td>&nbsp;<\/td><td>Moderate tightening<\/td><td>&nbsp;<\/td><\/tr><tr><td>Mid 1970s<\/td><td>48%<\/td><td>Yes<\/td><td>18.1<\/td><td>&nbsp;<\/td><td>Aggressive tightening<\/td><td>Oil price shock<\/td><\/tr><tr><td>1980s stagflation<\/td><td>34%<\/td><td>Yes<\/td><td>9.2<\/td><td>Stagflation<\/td><td>Aggressive tightening<\/td><td>2<sup>nd<\/sup> oil price shock<\/td><\/tr><tr><td>Black Monday<\/td><td>33%<\/td><td>&nbsp;<\/td><td>21.4<\/td><td>Household &amp; corporate debt<\/td><td>Light tightening<\/td><td>Panic selling<\/td><\/tr><tr><td>1990s recession<\/td><td>20%<\/td><td>Yes<\/td><td>21.4<\/td><td>&nbsp;<\/td><td>Moderate loosening<\/td><td>&nbsp;<\/td><\/tr><tr><td>Asian Financial Crisis<\/td><td>19%<\/td><td>&nbsp;<\/td><td>29.9<\/td><td>&nbsp;<\/td><td>Unchanged<\/td><td>Asian Financial Crisis<\/td><\/tr><tr><td>Tech Bubble<\/td><td>49%<\/td><td>Yes<\/td><td>28.0<\/td><td>&nbsp;<\/td><td>Light tightening<\/td><td>September 11 attacks<\/td><\/tr><tr><td>Financial Crisis<\/td><td>57%<\/td><td>Yes<\/td><td>20.7<\/td><td>Housing market<\/td><td>Moderate tightening<\/td><td>Financial system broken<\/td><\/tr><tr><td>2018 correction<\/td><td>20%<\/td><td>&nbsp;<\/td><td>22.3<\/td><td>&nbsp;<\/td><td>Moderate tightening<\/td><td>&nbsp;<\/td><\/tr><tr><td>Covid<\/td><td>34%<\/td><td>Yes<\/td><td>26.4<\/td><td>&nbsp;<\/td><td>Moderate loosening<\/td><td>Mortality and lockdowns<\/td><\/tr><tr><td><em>Current episode<\/em><em><\/em><\/td><td><em>24%<\/em><em><\/em><\/td><td><em>&nbsp;<\/em><\/td><td><em>23.6<\/em><em><\/em><\/td><td><em>China debt<\/em><em><\/em><\/td><td><em>Aggressive tightening<\/em><em><\/em><\/td><td><em>&nbsp;<\/em><\/td><\/tr><\/tbody><\/table><figcaption><em>Source: Refinitiv DataStream, Drummond Capital Partners<\/em><\/figcaption><\/figure>\n\n\n\n<p>Comparing the current period to the instances in the table above, though the US economy is not in recession, we think it will be during 2023. The starting valuation for equities is elevated, but not as extreme as around the Tech Bubble or indeed even Covid (though valuations were much higher through 2021 prior to the start of the current correction). There are no obvious major macroeconomic imbalances in major developed economies at the moment. However, there are clearly deep problems in China, which is the world\u2019s second largest economy. This still compares favourably to the Financial Crisis at least. Monetary policy now is being tightening more aggressively than in most previous periods, reflecting the largest mismatch between inflation and its target since the 1980s. We have yet to see major crisis fears. While this could still happen, the current drawdown feels relatively orderly outside of some issues around margining for liability driven investors in the UK.<\/p>\n\n\n\n<p>Aggregating the above and aligning it with our forward view of the global economy, it seems unlikely this bear market will feature a total market decline towards the lower end of the range. However, a decline as great as the Financial Crisis also seems unlikely given the lack of systemic problems in the economy (outside of China). Something around the average seems most reasonable to us.<\/p>\n\n\n\n<p><em><strong>Portfolio Positioning<\/strong><\/em><\/p>\n\n\n\n<p>It is our expectation that the market will not bottom until inflation has peaked, the US Federal Reserve is easing policy and economic data suggests the end of the recession is in sight. As a result, your portfolio remains underweight equity exposure. This is likely to remain the case (notwithstanding shorter-term tactical changes to take advantage of oversold or overbought conditions) until either the US Federal Reserve is cutting interest rates during the recession or services inflation moderates in earnest, increasing the probability of the soft-landing scenario.<\/p>\n\n\n\n<hr class=\"wp-block-separator has-alpha-channel-opacity\"\/>\n\n\n\n<p class=\"has-small-font-size\"><strong>Disclaimer<\/strong><\/p>\n\n\n\n<p class=\"has-small-font-size\">Prepared by Drummond Capital Partners (Drummond) ABN 15 622 660 182, AFSL 534213. It is exclusively for use for Drummond clients and should not be relied on for any other person. Any advice or information contained in this report is limited to General Advice for Wholesale clients only.<\/p>\n\n\n\n<p class=\"has-small-font-size\">The information, opinions, estimates and forecasts contained are current at the time of this document and are subject to change without prior notification. This information is not considered a recommendation to purchase, sell or hold any financial product. The information in this document does not take account of your objectives, financial situation or needs. Before acting on this information recipients should consider whether it is appropriate to their situation. We recommend obtaining personal financial, legal and taxation advice before making any financial investment decision. To the extent permitted by law, Drummond does not accept responsibility for errors or misstatements of any nature, irrespective of how these may arise, nor will it be liable for any loss or damage suffered as a result of any reliance on the information included in this document. Past performance is not a reliable indicator of future performance.<\/p>\n\n\n\n<p class=\"has-small-font-size\">This report is based on information obtained from sources believed to be reliable, we do not make any representation or warranty that it is accurate, complete or up to date. Any opinions contained herein are reasonably held at the time of completion and are subject to change without notice.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>Key Points: Whether the market has troughed now or will make new lows depends on whether the US Federal Reserve is able to achieve a moderation in inflation without too much economic pain. Decomposing inflation into its underlying drivers suggests that this is unlikely. In a hard landing scenario, equity markets typically bottom once inflation <a href=\"https:\/\/halcyonpw.com.au\/market-update-are-we-there-yet\/\" class=\"more-link\">[&hellip;]<\/a><\/p>\n","protected":false},"author":2,"featured_media":1251,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[3],"tags":[],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v22.6 - https:\/\/yoast.com\/wordpress\/plugins\/seo\/ -->\n<title>Market Update | Are We There Yet? - Halcyon Private Wealth<\/title>\n<meta name=\"description\" content=\"Global markets have been weak for all of 2022 so far. 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