Evidence is mounting that a bleak economic backdrop is improving after the peak

Central bank policies are the main cause of the financial distress in global markets this year.

The Federal Reserve cut five years of rate hikes to five months to fight inflation. Recent macro events such as the Truss Gilt crisis in the UK, the Russian gas crisis in Europe, China’s ongoing Covid lockdowns and profit warnings from winners of the stock market pandemic added pressure on investor returns.

However, there is mounting evidence that the worst of the macroeconomic challenges the market has faced since the start of the year is now past its worst. This improving macro backdrop, best epitomized by the collapsing dollar in recent weeks, should provide strong tailwinds for asset prices (both bonds and equities) into year-end and beyond.

The rally in equity markets this month was triggered by the latest inflation data in the US. There is ample evidence that inflation, particularly in the US, has peaked.

Official inflation data in the US has finally started to catch up with what real indicators have been showing since the summer. This month’s data showed that US core inflation excluding housing fell month-on-month.

The price of durable goods in the US, which experienced an unprecedented surge in the wake of the pandemic, is now falling significantly. Prices for used cars, TVs and laptops are now down year-on-year and should see a 20-30 percent drop by the end of the year.

Prices at the pump have fallen 40 to 50 percent since the peak of the Ukrainian invasion. Health insurance premiums will fall next year.

The ultimate irony is that official US housing market data is the main contributor to inflation due to a calculation lag. In the real world, the US housing market has ground to a halt.

These kinds of price declines never happened during the embedded inflation fears of the 1970s and 1980s.

Comparisons to that era have always been a bad analogy for investors. They ignore the structural changes in economies over the past 50 years, including debt levels and demographics, but most importantly the structural implications and the deflationary nature of technology.

They also ignore the outsized and lagged impact that Covid has had on a short-term cyclical basis.

Peak inflation leads to peak policy tightening which the market is now trying to accommodate. The headwind of pushing five years of tightening down to five months could become a gentle tailwind for asset prices over the next three years as tightening is gradually unwound.

The global coordinated slowdown in central bank tightening that began six weeks ago, marking the beginning of the end of the tightening cycle, is beginning to be confirmed by this peak in inflation data.

Since the crisis in Great Britain, the mood music of the central banks has gradually shifted. They don’t have the political mandate to create financial instability.

Western real estate markets and global bonds are shaking from their extreme rises this year. Interest rates in the US, UK and EU will rise over the next three months, but the tightening cycle is ending.

Close

Prices at the pump are down 40 to 50 percent from the peak at the start of the Russian invasion of Ukraine. Photo: Reuters

The debate has now shifted to slowing the pace of migration. It will pause later in the year and then move to a cut within a year of the last rate hike, as it has after every rate hike cycle for the past 150 years.

Ironically, the large number of layoffs announced this week in the US will initially continue to fuel risk appetite and asset prices as US payrolls data are likely to turn negative soon, signaling the end of Fed tightening (and eventually the end of the tightening) will further accelerate loosening).

As stock prices are rewarded for operating/spending cuts, expect more to follow.

Disney, Fedex, Amazon have followed Meta, Snap, Twitter and others lately. Reversing the over-hiring caused by the pandemic, many of these layoffs are not yet indicative of a protracted recession.

This is also true domestically, but it is clear that foreign direct investment employment is the biggest risk factor for 2023 in Ireland.

If central bank policy sets the tone for positive broad-based market performance, the timely resolution of the other risk factors year-to-date will determine the pace, direction and composition of the rally.

Chinese President Xi Jinping’s reconfirmation has kickstarted a year-long formal process to reopen China’s economy after three years of the tightest Covid lockdowns, and also gave an unexpected boost to the struggling real estate sector.

The US mid-term produced a very market-friendly scenario. Ukraine’s historic victories have further isolated Russia as an unusually mild winter removes the risk of energy shortages in Europe this winter and gives the continent even more time to adjust to a global liquefied natural gas (LNG) world for 2023.

A peaceful solution to the war in Ukraine can be achieved, which would bring untold benefits to the world economy and society.

The global stock market for European investors bottomed out five months ago. Despite some notable rallies recently, the positive investment backdrop and multiple opportunities are just beginning to play out.

Next year will be the mirror image of this year, with asset prices doing better as markets have immediately and dramatically priced in the delayed impact of rate hikes on consumers and the economy over the next year.

Mortgage rate hikes will hit different regions to varying degrees – Ireland is in one of the best positions – but overall consumer spending will cool (not collapse) from record levels this year and accelerate the return to a more normal inflationary environment.

Some slowdown in economic growth early next year is inevitable. Western consumer spending, US housing and record employment levels (particularly IT) are fragile and unsustainable. That should be the extent of the slowdown.

It’s more important for investors to identify which parts of the economy will slow or surprise relative to expectations. It won’t be hard to beat the expectations lows.

In response to the various crises this year, the EU and the US have accelerated domestic production of key technology inputs for the future and accelerated investment in net-zero technology, incentivizing domestic solutions and investment.

Spending on defence, digitization and decarbonization will create jobs and economic growth. Investments in LNG infrastructure will boom. Capital spending expectations for industry have increased this year. Every problem we face in the world will be solved by further future investments.

Investor sentiment has never been this low, but this is an opportunity-packed backdrop.

Low-risk investors can earn a return on bonds. Dividend investors can find healthy returns on banking, energy, and mining stocks.

Growth investors can get exposure to long-term assets at half what they were six months ago as management finally becomes more shareholder-friendly.

The investment universe of green investors has multiplied as all companies adopt an ESG framework.

Overall valuations of bonds and stocks have not been this low in over a decade, while earnings have held up admirably.

Central banks’ tightening too quickly in the belief that inflation will persist is slowly coming to an end. Peak inflation and peak policy tightening should give investors a much better backdrop next year to see the long-term returns they have become accustomed to over the last 10 years.

Philip Byrne is Head of Equity Investments at Merrion Investments, part of Cantor Fitzgerald Ireland.

https://www.independent.ie/business/irish/mounting-evidence-that-a-bleak-economic-backdrop-is-improving-after-peaking-42158034.html Evidence is mounting that a bleak economic backdrop is improving after the peak

Fry Electronics Team

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