July 2022 - It’s ugly when the Fed doesn’t care about a bear market
This past week has seen Wall Street flooded with earnings releases as the July reporting season hits full flow. A good earnings season with plenty of positive surprises would normally set the scene for a strong share market performance. And by and large this has been a decent reporting season so far. But 2022 isn’t a normal year and its likely that positive earnings will have little, if any impact on the share market. That is because the only show in town this year has been central banks versus inflation.
Going back to basics for a moment, it shouldn’t be that surprising that it’s turning out to be a robust earnings season, inflation starts when demand outstrips supply. And when demand is strong businesses tend to thrive, hence the strong earnings companies are currently posting. So why is the share market down so much this year? It’s because central banks across the globe are focused on taming inflation by increasing interest rates, despite the fact that may risk a recession in 2023 if they tighten too much.
To understand how different that is from the previous 2 decades, let’s look at what the US Federal Reserve (Fed) did at the start of 2019. It was a classic example of what is known as the “Fed Put”. That is when the Fed cuts the cash rate in response to a share market drop. What is happening in that instance is the US central bank eases monetary conditions to support US corporates and their spending behaviour.
The Fed knows that when US corporates see their share price dropping significantly, the exact number varies by company and CEO, but let’s say down over 20%, those corporates postpone investments in new plants or product development and start to cut staff numbers, to try and boost short term earnings to prop up their share price. If enough companies follow that path, demand drops out of the economy as company spending drops, unemployment rises, and job security weakens.
For the past 2 decades the Fed has made avoiding that scenario its key priority, as it seeks to steer clear of painful recession and deflation. Hence why, in early 2019, the Fed cut aggressively in response to the US share market dropping close to 20% in the final quarter of 2018, even though all US economic readings were still healthy and improving. By initiating the “Fed Put”, they hoped to see share prices recover as investors realised that the central bank had their backs and would do whatever it took to see the market make new all-time highs. Which in turn would trigger companies to keep spending capital and hiring more staff. And that is exactly what happened.
Chart showing the cut in interest rates in 2018
Source: Bloomberg
The above chart also shows that the cash rate was then rapidly dropped all the way back to zero in response to concern the virus would trigger a recession. It’s always easy in hindsight but the combination of zero interest rates and huge fiscal stimulus over the course of 2020 and 2021, in conjunction with supply chain constraints, created the highest global inflation in a generation. Hence the rapid, recent hikes in the Fed rate this year, first 25bps, then 50bps and then the first 75bps hike in two decades.
It's the last of those rises that truly cemented a bear market start to 2022, with a sharp June sell off. You can see in the bottom right corner of the chart the response of the share market to the 75bps hike in mid-June. The share market dropped like a stone, falling over 10% in 6 days.
Chart showing the S&P500 getting really ugly in June
Source: Bloomberg
This rather unseemly rush to the exit door in June was a response to the reality that the Fed will not be playing the “Fed Put” until inflation is well under control. The Fed knows that by letting the share market enter bear market territory demand will start to ease. History tells them that corporates across America will shift into belt tightening mode, to shore up near term earnings. Politically unpalatable though it may be, the Fed wants unemployment higher, and it knows a bear market creates a firing environment.
In America, workers can be fired with zero notice, never mind a consultative process. And already we are seeing many companies starting what is likely to be a growing trend, Tesla and Rivian, Re/Max and Redfin, JP Morgan and Goldman Sachs, Carvana and Coinbase, PayPal and Microsoft, Netflix and now Apple have all laid off staff so far in 2022. As the breadth and quantum of firings increase demand at an economy level will ease. Furthermore, capital expenditure by these corporates, and many more, will in all likelihood be deferred into 2023 or beyond, further easing demand.
So that’s all a bit grim and doesn’t exactly portray a share market that is likely to bounce back to its highs in the near term. That the Fed were not supporting the share market and deploying the “Fed Put” was a bitter pill that the market struggled to digest in June.
But there is some good news lurking out there for equity investors. And its back where we started this conversation, the current reporting season is showing companies in pretty robust shape. In addition central banks being determined to stamp out inflation is actually good medium term news for companies. Events can unfold very rapidly in the share market, and it was interesting to see that the above expectations July CPI print of 9.1% and the subsequent talk of 75bps or 100bps at the next Fed meeting did not distress the market like it did in June. In fact, their share market subsequently rose.
Investors now understand that inflation is the priority but with large and on-going interest rate hikes it will be wrestled under control. And once that is dealt to, the “Fed Put” is back on the table because as much as anyone they do not want the share market to price in a deep recession. As they say in Scotland, “it’s an ill wind that blows no good”, and while central banks jacking up interest rates has been painful for investors in 2022, it does mean that in 2023 they will have plenty of ammunition to bolster economies once inflation recedes.
