With the first quarter now in the rearview mirror and the next Fed meeting not until May, the focus is now on Q1 earnings. According to IBES data from Refinitiv, earnings in the US are expected to have grown 6.4% year on year, led of course, by energy with an earnings growth rate of 240%. Other bright spots include industrials and materials, all sectors that tend to shine in times of high inflation.
Regardless of these bright spots without the energy sector, S&P earnings are expected to be just 1% above their year-ago level. The darling stocks for much of 2020 and 2021, namely technology, communication services and consumer discretionary, are now down the bottom of the earnings growth totem poll. Even with some upside surprise, ‘Q1’ 2022 is set to mark the slowest pace of earnings growth on the S&P since ‘Q4’ of 2020, when economies were emerging from their Covid driven slow-downs.
You may be sick of hearing about it, but inflation is going nowhere fast as central banks concede it is not as transitory as once believed. Just as we thought supply chains were beginning to righten themselves and inventories replenished, sanctions and supply chain disruptions due to Russia’s invasion of Ukraine have sent commodity prices soaring and with it, expectations that prices will remain higher for longer.
Looking at the S&P GSCI commodities index (a broad-based index that represents the global commodities market), prices across a broad range of commodities have increased nearly 28% in the last six months, with nearly half of that since Russia’s invasion on February 24th.
In particular, both the price of wheat and energy products have soared, signalling that food and energy costs will most probably continue to rise, bolstering the argument that inflation will remain elevated for some time. At some point, without wage adjustments, we will start to see consumer demand erode (everyone has their limit). Of course, wage rises could start a whole cycle of inflation that will be much harder to rein in.
The market’s obsession with interest rates continues. The Fed made its move in March, but the RBA has been a little more cagey. April’s minutes, however, gave us a better indication with regard to their position, particularly the expectation that inflation will break the top end of their 2-3% target band when the numbers come out for Q1 next week. If this is the case, interest rates will begin to rise sooner than previously predicted. One could say that the RBA is a little late to its own party here – the money markets have been factoring in 2-4 rate hikes in Australia through 2022 for some time now.
In the US, the Fed is sticking to its Hawkish narrative, indicating 3-4 rate hikes this year, clearly showing its determination to get inflation under control quickly. It is now highly likely the May meeting will also be used to announce the start of the balance sheet runoff. Jerome Powell has also signalled that if inflation shows no sign of moderating, the Fed might also step up the pace of tightening with a hike of 50 basis points at one of the upcoming meetings.
As the odds of further rate hikes increase, the yields on the 10-year treasury minus the 2-year treasury have turned negative, signalling a yield curve inversion. Many experts view this as an ominous signal and recession indicator (more on this below).
In our view, further tightening of financial conditions driven by the Fed’s hawkishness as well as by the fallout from the Russia-Ukraine war should be sufficient to cool down the US economy through the year (without the need for the aggressive hiking outlined in its most recent meeting). The spillover from the war is likely to be bigger, further-reaching and more durable than is currently believed, especially in a scenario of further escalation. In our view, as the shock works its way through the system, the Fed’s eventual hiking path is likely to be shallower, with recessionary risks potentially higher than the central bank currently believes.
The Feds around the world have got a tough balancing act to maintain. If one used an analogy, it is like finding the perfect speed to drive a car down a hill to ensure you don’t go above the speed limit yet retain enough momentum to tackle the next hill without slowing too much.
An additional risk to markets is China. The slowing down of their domestic economy as a result of their zero-covid strategy (much of the country is locked down) and the continued unravelling of the property construction/lending bubble is having a negative impact on the demand for raw materials. China has already cut off most imports from Australia. This said, iron ore is still holding up, gas is increasing, and there are even signs of a re-opening of the coal trade (purely as China has very few other options available).
As we have written before, how President Xi chooses to deal with Putin is also a major risk. China has already extended its ‘no limits’ pact in offering to import more from Russia, presumably by paying in the Chinese currency RMB or gold instead of US dollars. How this will affect Australian export markets remains to be seen.
Of perhaps bigger importance will be its impact on the global monetary system. The US sanctions imposed on Russia demonstrate the power of the US dollar and the power of the US government to cause serious economic damage to a country by unilaterally cutting off access to US dollar reserves (the US dollar accounts for 60% of global foreign exchange reserves). In comparison, China is now the second-largest economy (or largest, depending on the measure) and the largest buyer of most commodities, but the RMB accounts for less than 3% of global reserves (primarily as the RMB is not freely exchangeable).
Some experts are taking the view that US-Russian sanctions may have strengthened China’s resolve to reduce global reliance on the US dollar. With Xi moving quickly to arrange for payments in RMB and/or gold – for example, wheat from Russia and oil from Saudi Arabia.
The end of the US dollar’s dominance is not under threat, but it may lead to the emergence of a rival Chinese RMB bloc with China and its main trading partners and allies. One outcome may also be China selling down its $3 trillion hoard of US treasuries (it has already reduced from $4 trillion in the past 3 years). This would have two negative outcomes – the first being lower bond prices and even more losses in bond markets, and the second would be a gradual loss of standing of US debt as a ‘risk-free’ asset. Of course, the US knows what the Chinese are doing and will inevitably deploy countermeasures to ensure their dominance prevails. These developments take many years, but we need to monitor them as potential medium-term risks to investment portfolios.