Correction or recession? | BetaShares

Correction or recession?

BY David Bassanese | 31 January 2022
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Global markets

It’s nice to be back from holiday.. what did I miss? One of the downsides of being a market analyst is that it’s often hard to switch off from markets even when on a break, especially when volatility spikes and there are big market-moving events. The past few weeks are a case in point!

All that said, what we’ve seen to date is largely what I’ve been fearing since the Powell pivot in early December, when the U.S. Fed chair dropped reference to inflation being “transitory”. This confirmed expectations that the Fed would raise rates this year, which in turn meant bond yields would likely move higher – which in turn would put downward pressure on still lofty U.S. PE valuations. What’s perhaps most surprising is the speed of the market correction, with the S&P 500 down 9.8% from its recent 3 January peak at the low last Thursday. What’s less surprising is that the more interest-rate sensitive growth/technology sectors (and so the U.S. market) have been hit hardest, with value/defensive areas holding up better.

So where are we today? U.S. 10-year bond yields have leapt from around 1.5% to almost 1.8% since late last year. I still think they will break above 2% in H1 this year. The S&P 500 forward PE ratio has declined from 21.7 to a (still lofty) 20.3, which suggests some caution in thinking the bottom for the market is already in. The good news so far is that corporate earnings remain robust – indeed, what turns a mid-cycle valuation-driven market correction (of 10 to 20%) into an ugly bear market (20 to 50% decline) is when earnings also collapse, which in turn would require a U.S. recession.

With U.S. inflation high but likely peaking, I think the Fed does not (yet) feel the need to engineer a recession – and will pull back from aggressive tightening if the economy itself starts to wobble. The one risk to this is if the U.S. unemployment rate plummets further (to 3.5% or less), especially if labour force participation remains stubbornly low – which in turn leads to further hard-to-ignore wage inflation.

In terms of market events last week, annual growth in both U.S. core consumer inflation and the employment cost index were not a loss worse than feared at  4.9% and 4.0% respectively – which is welcome – though both remained uncomfortably high. Q4 U.S. GDP was stronger than expected, with annual growth surging to 6.9% – due to still solid consumer spending and business efforts to rebuild depleted inventories.

The Fed meeting essentially confirmed it will raise rates in March – and understandably the market is now only left to debate whether it will be 0.25% or a ‘shock and awe’ 0.5%. I still think the former, but I can’t rule out the latter – depending critically on labour market indicators, such as this Friday’s January payrolls report. Unemployment is expected to hold steady at 3.9%, and annual growth in average hourly earnings to lift from 4.7% to 5.2%. A sharp further drop in unemployment would be very unwelcome.

Australian market

As expected, when the U.S. sneezes we catch cold – with local stocks not spared from the global sell-off, especially blue-sky growth areas such as technology. A bounce back in iron-ore prices – reflecting China’s renewed concern with growth – has seen recent outperformance by resources.

Last week’s consumer price index report was a bit hotter than expected, which has added pressure on the Reserve Bank to also signal higher interest rates this year. We’ll of course learn more following this Tuesday’s policy meeting, Governor Lowe’s Press Club speech on Wednesday and, of course, the quarterly Statement on Monetary Policy on Friday. The bottom line is that the RBA will be forced to revise up its inflation forecasts, which in turn means it will signal higher rates at least by next year – but it may still resist the urge to signal higher interest rate this year, on the view that wage growth might remain relatively contained for a while yet. If so, this may see a paring back in still aggressive local market rate hike expectations – and further downward pressure on the $A.

That said, the Q4 wage price index report is due out on 23 February – if it shows a sharper than expected lift in annual wage growth (from 2.2% at present) pressure on the RBA would intensify. My base case has long been that the RBA would not raises rates until early 2023 – which I concede is looking vulnerable. But it really comes down to whether local wage inflation does take off quite quickly and/or whether the RBA changes its thinking and lifts rates even if it does not. I’m not yet prepared to concede on either of these points, which is why I see the $A potentially heading lower despite the rebound in iron-ore prices.

Have a great week!

3 Comments

  1. steve fantham  |  January 31, 2022

    welcome back your pragmatic updates are very pertinent

  2. Alan Matonti  |  January 31, 2022

    I think the Index comparision table at the top is misleading and of limited use for time periods MTD, QTD & YTD as they are ALL THE SAME – ie the first 4 weeks of January.
    Could they be made TRAILING Month, Quarter & Year etc so they actually cover different time periods and therefore may give some insight to trends etc.
    Thanks for the article.

    1. BetaShares Client Services  |  February 4, 2022

      Hi Alan,

      Thank you for taking the time to provide your feedback.

      Please note, although it may not be as relevant for 1st Feb, this is a standardized format that will provide more information as the month and quarter progresses.

      We will however consider the change and pass this suggestion on to the relevant parties.

      Sincerely,
      BetaShares Client Services

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