A jump on the stock markets seems possible in the short term due to the technical conditions.
After a first half of the year with disastrous performances for equities and bonds, investors do not yet seem to agree on a stable scenario for the coming months. On the one hand, central banks have declared war on inflation, which has turned out to be higher and more persistent than initially expected. On the other hand, the release of economic indicators reflecting slowing growth momentum fueled expectations of a global recession.
A semester to forget
Is it really necessary to review the development of the financial markets since the beginning of the year? Some figures: The market for US government bonds lost almost 10% in the first half of the year and government bonds from the euro zone more than 12%. All segments of the credit market recorded a predominantly negative overall performance. In equities, the MSCI AC World Index (in dollars) shows a 20.9% drop as of June 30th, the chronicle of which tells us that this is the largest semi-annual drop in the 34-year history of this index. The 0.3% increase recorded by the same index since the beginning of the month (July 6th) seems very timid. In addition, volatility in equities, and even more so in government bonds, remained elevated throughout the semester as investors struggled to visualize the implications of the US Federal Reserve’s actions.
Within a month, investors switched from a scenario in which central banks would not have to raise interest rates as much as expected because inflation would lead to a much less favorable scenario for risky assets (less than growth, more inflation).
A dual mandate? Which dual mandate?
As the weeks wore on, the Fed chair became much less optimistic about the economic outlook, conceding to Congress that the soft landing would be “very difficult” to pull off.
Indeed, weaker business surveys, disappointing consumer spending and falling consumer confidence drove the Atlanta Fed’s (GDPNow) real-time estimate of GDP growth in the 2 data available from July 1). The designers of this indicator state that it is not a forecast. However, should this figure be confirmed at the first Q2 GDP estimate (expected on July 28th), the US economy would enter a situation of “technical” recession after the 1.6% contraction recorded the year before embark 1st trimester.
The expectation of a Fed interest rate hike contained in the futures markets tended to decline in view of fears of a recession. But the minutes of the June 14 monetary policy meeting, which ended with a 75 basis point hike in the Federal Funds Target Rate, showed that the FOMC (Federal Open Market Committee) remained very concerned about inflation. The “Minutes” published on July 6 reported concern among many members about the possibility of inflation taking hold as “inflationary pressures are yet to show any sign of abating”. The Fed’s message is getting clearer: monetary policy must become tighter to cool the economy.
Therefore, what should surprise us is not a technical recession (defined as two consecutive quarters of GDP), but the possibility that the Fed will accept, or even target, a lull in economic activity that will lead to a rise in unemployment in order to curb inflation, by putting a strain on domestic demand.
The majority of FOMC members believe that growth risks are on the downside due to the external environment (war in Ukraine, health situation in China), but also mention the risk that further tightening of financial conditions will negatively impact the business than expected.
In fairness, let’s acknowledge that the minutes mention the dual mandate (maximum employment and price stability), but the general tone leaves the impression that fighting inflation (which the Fed says also includes communicating with the public) is a high priority.
What consequences for the markets?
The combination of high inflation and limited growth or even a recession has historically been an unfavorable situation for many asset classes, which explains investors’ nervousness ahead of the summer.
Since the beginning of the year, however, the increase in nominal and real bond yields in particular has weighed on stock valuations via the corporate cash flow discount factor. On the other hand, the earnings prospects are still high considering that stocks should incorporate a recessionary scenario at this point.
While leading indicators of activity have already reversed, the expected results, while able to resist, could start to show signs of weakness, particularly in the Eurozone, which would further weigh on equities. The earnings season that starts in a few days could prove decisive.
A bounce in equity markets seems possible in the near term given technical configurations, but it would remain unpredictable and could present opportunities to reduce our portfolios’ equity exposure to cheaper levels, as we have regularly done since February. .
In the bond markets, the credit spread levels that have been reached can offer opportunities (particularly in the investment grade segment in the euro zone) if the implied default rates appear too high.