A first half worth forgetting

Contrasting narratives are plausible and in play after a truly terrible six months for the markets

The year so far has proved to be very difficult for investors. There has been no place to hide, and market volatility has been elevated. In the span of a few months, we have seen the fourth fastest rise in commodity prices ever, following the Russian invasion of Ukraine, as well as the third fastest fall—over the last few weeks! Bond yields have also seen high volatility, with exaggerated moves in both directions since the beginning of the year.

Taking a look at the numbers, clearly there was no place to hide for financial market players. Unless you were invested in crude oil (Brent prices rose by 47.6 per cent till June 30) or commodities more broadly (CRB commodity index was up 25.3 per cent in the six months, you would be sitting on losses. Treasuries were down by 9.4 per cent, the MSCI Emerging Markets index was down by 17.6 per cent, S&P 500 index was down by 20 per cent and the Nasdaq was down by 29.2 per cent (all total return).

This was a horror show, and just for context, this was the worst first half start for US equities since 1962, and the worst start to the year for 10-year US treasury bonds since 1788. The numbers were even worse, but for a rally for both asset classes in late June. This was also only the fourth time in the last 100 years that stocks and bonds were both down in the US, two quarters in a row at the same time. 

With both stocks and bonds in the US and globally down, it was a horrendous performance for the classic 60/40 portfolio of stocks and bonds, the mainstay for many allocators. This model portfolio was down double digits, and its performance was in the bottom 2 per cent of rolling returns going back to 1926! So clearly, we have gone through one of the most challenging market environments ever seen, the question inevitably turns to what now?

We have seen the beginnings of a rally in equity markets globally, led by the US. Markets have been up every day, and we have a four-day winning streak. Is this a sustainable rally or just a dead cat bounce?

At its worst the S&P was down about 25 per cent, in mid-June. This is the median correction for the S&P 500 in post-war recessions. If you look at the range of data, the correction for the S&P in a post-war recessionary period has been at the minimum 15 per cent, with the median correction being 24 per cent and the extreme being 50 per cent (the global financial crisis saw a 57 per cent correction, but that was more due to the banking collapse). So in a sense, the market is already priced as though we are on the verge of entering a serious recession.

Illustration: Binay Sinha

The same data, for market corrections in non-recessionary periods (post-war era: source DB) show that the median correction has been 12.5 per cent. This is already the fourth steepest non-recessionary correction since World War II. Clearly, if you believe that the US is not going into a recession, and many think that is the case given the booming jobs market and consumer finances, then one can argue that we may have corrected enough. In this scenario, the markets may have bottomed and this rally may be real.

If you believe that a recession is inevitable in both the US and the EU, then we may have more downside to come. Given that this recession will bring on a regime change in terms of inflation and the tightening of financial conditions, the possibility of a financial accident is high. Thus, many expect the ultimate market correction to be nearer the extremes of 40-50 per cent. In this scenario there is more downside to come eventually, though it may take some time. We can easily have pull-back rallies of 15-20 per cent in the interim.

In terms of data to track, the surge in US 30-year fixed rate mortgages is worth following, rising from 3 per cent to 6 per cent, in a matter of months. It has decimated housing affordability. Every recession in the last 70 years in the US has only happened after the two-year/10-year bonds yield curve has inverted. We saw inversion in late March/early April, briefly in June and now again in July. Clearly recession risks are elevated. There is also an unusual decoupling between consumer sentiment, which is at a 70-year low, and a record low unemployment rate. Very odd!

Deciding your stance on whether the US will go into a recession in 2023 is one of the big calls of the coming months. It will determine your stance on corporate earnings and the end point on the Fed funds rate. If you feel no recession, the correction may be done. If you believe in the recession thesis, we have probably more downside to come. At least initially, the direction of US equity markets will drive global returns.

As for rates, looking at the data, it is now quite astonishing to see just how crazy an environment we were living in. As rates rise and liquidity tightens, it seems inevitable that some financial accidents will occur in some corner of the financial markets.

Just a short time ago, 40 per cent of all government debt outstanding globally had negative yields. This percentage is now down to 2.5 per cent; 10 per cent of all corporate debt outstanding had a negative yield. This is now zero per cent. Any company or CFO that did not term out their debt, or raise fresh long-term debt, has really missed a once-in-a-life-time opportunity.

The other big call relates to Japan and its central bank. The Bank of Japan (BoJ) is the last anchor of global rates, and is currently an outlier on monetary policy. It is continuing with its capping of Japanese 10-year sovereign yields (JGB) at 0.25 per cent, despite the rising costs, collapse of the yen, and the lack of sustainability of this strategy. Work done by DB shows that the current pace of the BoJ buying of JGB bonds, at approximately $110 billion per month exceeds what the Fed and the European Central Bank were buying at their peak. The BOJ balance sheet is at 140 per cent of gross domestic product, compared to 40 per cent for the Federal Reserve. This cannot continue indefinitely. Once the BoJ also throws in the towel, can yields spike globally? All the major central banks will be shedding assets and no longer injecting liquidity through quantitative easing. No investor, nor any financial market, has ever experienced quantitative tightening (QT). It will have unintended consequences. We will have global tightening of liquidity, through QT and rising rates across all geographies, as inflation is now global and central banks everywhere are behind the curve. This will happen just as economies globally are also slowing. A dangerous cocktail.

These are highly uncertain and volatile times. Contrasting narratives are plausible and in play. However, having gone through a truly terrible first half 2022, the second half of the year should be hopefully less damaging to investor portfolios. It remains an environment to build your portfolio, improve the quality of your holdings and concentrate on your best ideas.

The writer is with Amansa Capital.