Two huge shocks dominate the landscape – the hawkish turn of the Federal Reserve and other central banks, and Russia’s invasion of Ukraine. These events together naturally increased the risk of recession or economic slowdown. They also undermined earnings growth hopes. Rising interest rates, international disruptions and soaring commodity prices are making it harder for companies to make money.
Recession worries, earnings outlook dips
Practically, Absolute Strategy Research of London conducts a quarterly survey of major fund managers that asks investors to assign percentage probabilities to specific outcomes. Since the last quarter, the fear of a global recession has increased sharply, accompanied by a drop in hopes of higher profits:
However, it is unclear whether lower earnings expectations have yet found their way into market prices. The willingness to wait for the situation in Ukraine to clear up probably dissuaded analysts from producing new forecasts. Looking at ‘earnings momentum’, defined as the proportion of earnings forecasts that are on the rise, the work of Societe Generale SA’s quantitative team shows that positivity is indeed on the decline. However, there are still barely more downgrades than upgrades:
Meanwhile, Bloomberg’s full 2022 earnings estimate survey showed minimal change in the first quarter (outside of the energy sector) in developed markets. This chart is in local currency – the Japanese earnings forecast is lower if you take into account the fall in the yen:
Emerging market estimates have taken a hit, but so far the numbers reported to Bloomberg for the developed world have barely changed. Where there is great confidence, however, is that earnings multiples will decline. This is a natural consequence of rising interest rates, according to the mainstream logic that most investors learned in business school. The Absolute Strategy report finds that fund managers are bracing for stocks to get a lower multiple of lower earnings 12 months from now. Not happy, but logical:
Logic therefore dictates that end-of-year forecasts should be down. And they have, a little.
Where will we be on December 31?
The business of predicting a market level on a specific day 12 months in the future is pretty silly. But equity strategists seem compelled to play along. In December, I wrote about research by Aneet Chachra of Janus Henderson Investors US LLC. You can find it here. Among many interesting findings, he showed that “average” years are rare. Typically, the stock market rises by double-digit percentages, punctuated by occasional sharp declines. It could be around 7% or 8% on average, but years with solid single-digit percentage increases are unusual.
Yet this is what the vast majority of major auction houses predicted in December. Here is the Chachra dashboard offered then:
At early December prices, this implied a gain of just over 8% on average – although very few actually expected this outcome. Then a great end to December left their end-2022 targets much less exciting at 3%. Now Chachra repeated the exercise. The drama of the first quarter has shaken up the forecasts, but not all in the same direction:
After the events of the past 90 days, three strategists have seen fit to raise their estimates for the December 31 market level. The number of homes forecasting a decline for the year fell from two to three. Whoever predicts a fall at the turn of the year now thinks there will be a gain. Overall, the projected implied yield for the year fell to 1.5%.
However, the good news is that strategists now almost universally believe that now is the time to buy. From where the market closed on Thursday, only two houses – Barclays and Morgan Stanley – believe there will be a negative return by the end of the year. And both believe that the market will only drop slightly:
The range remains canyon-like. But that might be reasonable, as a poor first quarter portends excitement for the rest of the year. In the following table, Chachra ranks the performance of the last nine months of the year according to whether the first quarter was positive or negative. The market tends to improve after a bad quarter, which is quite reasonable since buying prices will have just fallen when investors buy. However, the median return for these nine months is very weak after a negative first quarter, which shows that the overall average is driven by a few large peripheral rallies. And the standard deviation of returns is much, much higher than it was after positive first quarters:
Conclusion: It was anyway a useless exercise to try to predict the level of the index on December 31, and it is even more difficult now after a bad first quarter.
Hasta La Victoria Siempre!
Perhaps the most visible winner of the first quarter, in absolute and relative terms, is Latin America. Stock markets there staged a prodigious rally, with Brazil being the best performer in the world. Relative to the global index, including both developed and emerging markets, the MSCI Latin America just had its best quarter ever. (I had problems with the graphing software, so the following graph is straight from Excel, for which I apologize):
As things stand, the continent with its many material producers is the big winner from de-globalization, as the rich world seeks new suppliers. He also benefits from no longer falling. The region’s trajectory this century was painful, driving China’s rise and commodity boom to massive outperformance in the first decade, collapsing as commodity prices raw materials were falling, then suffering a terrible blow from the pandemic. It bottomed – at a relative level not seen since a Brazilian currency crisis in early 1999 – on the last day of 2021.
There’s a reason why investors are always looking for low-priced or good-value assets. The money you can make quickly on a bounce is special. If we are truly in the early stages of another upward wave in commodity prices, which is looking increasingly likely, then the chart shows there is room for LatAm shares to boom further. much higher.
I don’t have the energy to dive back into the controversy over the inverted yield curve just now. There is a fierce and fascinating debate going on about whether to take this week’s brief reversal seriously and whether to view the bond market’s signal as skewed by central bank intervention. The fall in short-term bond prices that contributed to the curve inversion created a historically bad quarter for government bonds. However, now that they are cheaper and the yield curve points to a recession, it might be a good idea to position yourself for bonds to outperform equities over the next five years.
This graphic is by Luca Paolini of Pictet Asset Management Ltd. and shows the five-year performance of stocks versus bonds versus the spread of 10- and two-year bond yields, with a five-year lag. The ability of the yield curve to determine which asset class will do best over the next five years seems odd:
Based on this, the big outperformance in equities this quarter could end up looking like a fake. However, this chart shows five-year returns; looking at returns over the next 12 months alone, Absolute Strategy found that fund managers still expect stocks to outperform. Still, with the proportion of people believing this to be the lowest since the third quarter of 2019, so confidence is starting to shift:
If there is a painful trade for the rest of the year (excluding the horrors that await Ukraine), it could imply that equity multiples finally falter in the face of rising bond yields. Over the past few weeks, the pain has been in the surprising rally in speculative stocks.
I’m tempted to say it’s good that the term is over. But that’s just a date in a calendar. Once April begins, Russian troops will still be in Ukraine and inflationary pressures across the world will still be intense.
More bulletins from the earworm war. My son almost drove me crazy walking around the apartment endlessly singing “Livin’ on a Prayer” by Bon Jovi. I forced him into submission by playing Lightning I, II, Arcade Fire’s new single, until he knew it by heart. Now he’s found an answer and can’t stop singing Slade’s Cum On Feel The Noize. Meanwhile, the female contingent among my offspring is already addicted to Harry Styles’ new single, As It Was. When asked what I thought of the video, I revealed my age saying that his tattoos looked ridiculous and he must regret them now. This was greeted with hilarity and condescension. (It’s a good song, though, and the video ends at the Barbican Center in London, which I liked.)
I don’t know what my next move should be. I’m tempted to throw him a more singable Arcade Fire song, like No Cars Go. Or I could at least try to up the caliber of my son’s taste in early 70s heavy rock dinosaur songs: Paranoid by Black Sabbath perhaps, or Smoke on the Water by Deep Purple, or 20th Century Boy by T. Rex, or We Will Rock You by Queen. Another great riff to sing along to as you go around the house might be Bowie’s Ziggy Stardust. Or You Really Got Me, the first big heavy riff; I heard it was the very first heavy metal song, and after hearing Metallica do it, I think I can believe it. I can handle any of these like an earworm more comfortably than anything from Bon Jovi. Any other suggestions?
Have a good weekend everyone.
More other writers at Bloomberg Opinion:
• China’s Great Madness Breaking Russian Sanctions: Tim Culpan
• Putin would be mad to cut the gas in Europe: Liam Denning
• No one really understands real interest rates: Tyler Cowen
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
John Authors is Managing Editor for Markets. Prior to Bloomberg, he spent 29 years at the Financial Times, where he led the Lex column and chief market commentator. He is the author of “The Fearful Rise of Markets” and other books.