By Jerry Thomas, CIO at Sarasin & Partners
The summer rally in equities is firmly behind us. For overly optimistic investors, it proved to be a false dawn, while for the realistic, it offered a good opportunity to rebalance equity weightings in multi-asset portfolios.
Rallies are a common feature of bear markets, and this bear is no different. We have had four rallies so far in 2022. The most recent saw the MSCI ACWI rise by 13.2% in US$ and has now largely reversed. There may be more to come and patience is needed – but how can investors discern when a bear market has reached its nadir?
Equity strategists try to gauge whether a bear market is nearing its trough by assessing three rules of thumb: economic indicators, changes in the Federal Reserve’s monetary policy stance, and the rate of decline in earnings expectations.
Mild recession likely
Purchasing managers’ indices provide a useful indication of future economic growth via the levels of activity experienced by supply chain managers. A PMI reading above 50 usually indicates growth. In mild recessions, PMIs tend to bottom in the high 40s, while hard landings send them to the low 40s.
The September reading for the US PMI was 50.9 for manufacturing – on the brink of contraction – and a much more robust 56.7% for services. From this, we can reasonably conclude the US economy is losing momentum, and a mild recession is likely.
As for the Fed’s monetary policy stance, the central bank has emphasised its intention to stay the course in fighting inflation. Jerome Powell made this abundantly clear at the August Jackson Hole Economic Symposium. Persistently strong inflation data released after Jackson Hole has strengthened this view.
Market pricing suggests US rates will peak in the first quarter of 2023 at about 5%, and US interest rates will be cut in the second half of 2023. It should be remembered, however, that both the Fed and the bond market have proved poor forecasters of inflation and policy in this cycle. For the current headline US CPI rate of 8.3% to reach the 2% inflation target by mid-2023, month-on-month inflation would need to slow rapidly from 0.7% to 0.1%. If inflation does not cool, assumptions around the terminal rate could rise beyond 5%. For now, the best we can do is assume monetary easing is not imminent.
Quantitative tightening (QT) is a feature of this market cycle that has not been present in the past and further complicates the outlook. The Fed has laid out a plan to reduce its $9trn asset portfolio, and as at September 2022, it aims to reduce this by $95bn per month. It is unclear how QT will impact the shape of the US yield curve, the value of the US dollar, and therefore the tightness of financial conditions. It is also hard to judge how the Fed might adjust this plan according to circumstances, or how markets will respond.
Eyes on earnings
Our final tell-tale of having reached a durable bottom in equity markets is a slowing in the rate of decline in earnings expectations. While earnings behave very differently in different bear markets, one unifying factor is when the rate of decline in earnings expectations begins to slow and equity markets start to price in an improving outlook, even if the economy is in recession and profits are falling.
As with PMIs and interest rates, we are far from this stage. Today, the outlook for earnings is increasingly challenged by slowing global economic momentum. Higher prices, as companies pass on the impacts of inflation, will tend to reduce demand, while labour costs – which tend to lag inflation – are likely to rise in 2023.
Earnings expectations in the US are now just beginning to fall, with S&P 500 earnings expectations registering a mere 3% decline since the start of Q3 2022. Current aggregated bottom-up expectations are for US company profits to grow by 9% in 2023 and 7% in 2024. Unless a recession can be avoided, earnings expectations for 2023-4 appear to be as much as 25% too high. We may be months away from any slowdown in the rate of change in earnings downgrades.
Bear markets tend to end with a final slump. A drawdown to a more attractive entry point in equities could happen quickly in the event of investor capitulation. While we do not assume we can time the market bottom precisely, we must nonetheless be ready – there would be plentiful thematic companies trading on appealing valuations.
The recent turmoil in UK bond markets might be evidence we are entering a classic disorderly period in this bear market, which could herald the eventual trough. With this in mind, we have moved to a neutral position in our multi-asset funds’ corporate credit allocation.