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A false dawn for US markets

17 October 2022

One way to know if markets are overstretched is if negative news fails to sink equity markets further. What we saw last Thursday was different, namely a deep pool of bargain hunters. When inflation in the US surprised by its resilience (September 8.2% YoY versus 8.1% expected), the S&P500 dropped sharply lower. After losing 3.5%, the S&P500 started a surge an hour later that pushed the contract circa 6.3% higher with this wave of euphoria reaching Asia and the Eurozone.

What we saw was likely extreme bearish positioning being reduced. This is an encouraging sign, but it is not yet a new dawn—we continue to prefer cautious positions.

A first step towards a new reality

US inflation was driven north by higher than expected housing rents that are typically very sticky in an economic slowdown. Durable goods and services were also significant contributors to inflation indicating that mid to high income Americans are doing well. On the other hand, lower income households are having difficulties borrowing to buy cars and trucks, which saw price declines. That may be due to lower confidence in the future and fear of a recession, rather than a weaker job market. Additionally, lower income households may find credit more difficult to access as banks tighten their lending standards. For example, the credit premium on a 30 year Mortgage Backed Security loan has risen to 1.1% (for the best credit scores). The Fed’s Senior Loan Officer survey shows a tightening of lending standard since July 2021, though far from recession levels. The slowdown therefore is being led by lower, and increasingly mid-income households as the support of a red-hot labor market begins to fade.

A brave new world

As higher interest rates bite, low and mid-income households with high credit card debt will feel the pain. Consequently, retailers will see a further move away from expensive goods toward cheaper substitutes, which means the CPI with its fixed weights is overstating real inflation (versus the PCE targeted by the Fed). Deflationary forces should tell slowly but increasingly over time as demand cools down and very elevated profit margins are reduced. The problem is that the Fed’s policy is driven in part by fear in the social media and the front page of the New York Times. It suggests that the Fed may well be forced to overtighten to win the media war.

What does it mean?

The Fed will probably be able to avoid a deep recession, but it is too early to call the bottom of the upcoming economic slowdown. However, the odds should steadily improve in the coming weeks and months with investors hesitating to invest in riskier longer duration assets. Till then, we continue to prefer the safety of Covered Bonds and Equities with a Quality & Value tilt.



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