Strategist Alfonso Peccatiello talks about sticky inflation, monetary policy becoming more restrictive and his investment recommendations.
At the beginning of March, global stock markets started to recover. The MSCI AC World index is now only around 5% below its record high. The Russian attack on Ukraine no longer seems to concern market participants. Meanwhile, the Federal Reserve is sounding increasingly hawkish and interest rates are pointing steeply upwards across the board.
What does this mean for investors? «This is not an environment where corporate earnings are going to surprise on the upside», says strategist and author of the weekly newsletter «The Macro Compass», Alfonso Peccatiello. The Fed, he says, is determined to fight inflation - and to do that, consumer demand must be curbed. Consequently, financing costs will have to increase. This is not a favorable environment for equities. In an in-depth interview, the strategist tells us how he is currently positioned and reveals what he thinks of gold and when there will be an opportunity to enter the bond market.
The Fed is becoming increasingly hawkish, interest rates are rising – and yet, the stock market does not seem to care. What do you make of that?
There are normally two things that spook equity markets: the first is a change in the monetary policy stance and the second is a more aggressive tightening cycle than expected. What happened in December was that Fed chairman Jerome Powell signalled a serious turn when he said inflation has become sticky and the risk of inflation expectations becoming unanchored had increased. At the January press conference, Powell repeated his message and sounded even more hawkish. Given this pretty aggressive change of policy stance, equity markets started to reprice. All the highflyers such as the ARK innovation fund, Tesla, and all those highly valued companies with expected cash flows growing far into the future were hit hard, as investors adjusted the discount rate higher.
Have markets digested the new monetary stance?
The bond market has reacted accordingly and is now pricing in Fed interest rate hikes to above 2% at the end of this year and to about 2,5% next year. The Fed’s dot plot is out saying rates are going to 2,75% in 2023, which is above the neutral rate.
Equities, with some exceptions, have not reacted that strongly. Since the beginning of the month, they have even recovered quite a bit.
After the recent bounce, the S&P 500 forward price-earnings ratio is at around 19 or 20. That is relatively elevated given where real interest rates are likely headed. I still believe «Don’t fight the Fed» cuts both ways – when it eases and when it tightens. The Fed’s memo is clear: ‹Financial conditions are too easy, demand is simply too strong. We cannot do anything on the supply side. What we can do, however, is to make sure demand goes down›.
That doesn’t sound good for risk assets
The Fed wants to contain the animal spirits that are fuelled by buoyant asset prices that make everyone feel wealthy and encourages them to spend. For that, interest rates need to move up. That makes it harder for borrowers to go on a borrowing binge. Given this backdrop, you have to be really brave to be long risk assets unless you think earnings will pick up.
Is this an environment for solid earnings growth?
No, it is not. Earnings are a cyclical driver for equities that is boosted when ample liquidity is flowing through the economy. That was the case when the US government threw a lot of cheap credit at Americans in 2020 and 2021. In addition, banks were generously extending loans since the government basically provided loss guarantees. That ended in March 2021. After that, the government hasn’t done any large fiscal spending anymore, and banks have reverted back to their normal lending business, which is not buoyant. On top of that, we now have a cyclical slowdown due to supply bottlenecks, the war in Russia / Ukraine, etc. This is not an environment where earnings will surprise to the upside. Still, analyst consensus estimates for S&P 500 12-month forward earnings stand at about 9% annualised. That’s pretty optimistic.
What are your expectations?
I believe that the Fed wants to slow growth back to trend which would be compatible with earnings growth at around 6 or 7%, especially as margins will come under pressure due to higher inflation. Of course, there’s the risk that growth will fall below trend. So, I expect earnings to grow at 4 to 5%, not 8 or 9%. While it is true that markets have been adjusting to a more hawkish Fed, you have a very committed Fed, which makes it hard to see valuation multiples increase in this cycle. In short: I am not comfortable with risk assets at the moment.
With the yield curves signalling slower growth, will the Fed still hike aggressively?
I’m sure the Fed is going to increase the Fed fund rates by 50 bp in May. It started with only 25 bp because of the war and also to prepare the ground. And then, through the summer, it will go above 1% and in September it’ll maybe go to 1,5% roughly - if nothing breaks. There have been many instances where the Fed has hiked into an inverted yield curve. The point here is: What is the Fed’s incentive scheme?
And what are the Fed’s incentives?
The Fed’s enemy number one, two and three is inflation. In the last press conference, Jerome Powell gave such a strong assessment of the economy one got the impression that there was no weakness at all. He was telling the public that he is extremely confident about the US economy, and this is reflected in the summary of economic projection. The Fed is projecting that it is going to hike rates above the neutral rate – which it estimates at about 2,4% – and keep it above neutral for two years. And yet, it expects the unemployment rate to stay at 3,5%.
How is this going to work?
Powell is giving a highly optimistic assessment of the US economy because he has an inflation problem. When you look at inflation expectations, the longer-term expectations are somewhat above the Fed’s target, but not significantly so. But in the medium term from 2022 to 2027 the situation has changed: The Michigan consumer survey indicates that consumers expect inflation for the next five years to be at 3 to 3,5%. Market based indicators signal expected inflation of about 3,5% for the coming five years. But most importantly, if you look at the shape of the curve via caps and floors you understand that the right tail is getting much fatter than it was a year ago. In other words, traders are attaching a non-negligible probability that inflation prints will remain at 6%, 7%. If consumers also start expecting such «tail events», their behaviour could start to change, potentially leading to a wage-price-spiral.
Is there a risk that the Fed is going to break the economy?
Indeed. In a rosy scenario, the Fed can increase rates to 3% and nothing really happens. However, if it overestimates the interest rate that the economy can handle, the alternative scenario could be pretty bad. If you look at companies in the private sector with high levels of debt, they will run into problems as the combination of a higher Fed funds rate and widening credit spreads will increase their costs of capital dramatically. If the borrowing rate for these companies increases from 3 to 5%, they will struggle to keep their leverage ratio stable. Consequently, corporates don’t borrow anymore but start deleveraging, which is akin to destroying credit. And this leads to a slowing economy, and we start seeing a situation like at the end of 2018, beginning 2019 when risk assets first sold off, then consumer sentiment deteriorated and then the economy weakened until the Fed stepped in and stimulated again.
There has been a lot of talk about a possible Fed put, i.e. the level in the S&P 500 where the Fed ends its hawkishness. Where is that level?
Imagine the S&P 500 drops by 20% in a month. Will Powell start to ease again? Of course not! He cannot do that if he wants inflation expectations to normalize. The balance of incentives is now completely different from the situation in 2018. To put it differently: the Fed put is at present far out of the money. Actually, Powell is not even acknowledging that a put exists - on the contrary, he is saying financial conditions need to become tighter.
How do you position yourself in such a challenging environment?
Overall, I am positioned for a further flattening of the US yield curve by selling the 2-year future and buying the 10-year future, adjusted for duration. Furthermore, I am positioned for a further increase in German and Italian yields. On Tuesday, I closed my short positions on US junk bonds as measured by the HYG ETF and my short positions on the Russell 2000. These trades are all based on the premise that the Fed will not stop hiking until the yield curves invert, because the Fed’s incentive scheme is much different from 2018. Powell is telling us that he wants to curb demand and increase borrowing costs because that’s the only way to tame inflation. In general, the time to be bullish is when the Fed eases, not when the Fed tightens. So, who am I to go against the Fed? I will go with it.
What would you recommend a long-only investor should do?
That is a difficult question, given that we are in a situation that is like Q4 2018 on steroids because we have an inflationary problem we did not have back then. In Q4 2018 basically no asset class delivered a positive return. This year, there have been some assets that have had a positive return – commodities, for example. If you really have to be long, I would advise you to focus on less risky low-beta stocks, such as pharma stocks. You will still be hit, but less so than with a broad index. I would look for companies or industries with strong balance sheets, little debt and that are less cyclical than other sectors. Overall, make your portfolio more robust and increase your cash allocation. This is probably the smartest move right now.
What about bonds?
At some point not too far in the future, bonds will start to offer a decent return. If we are getting closer and closer to a point where peak hawkishness is priced into bond markets and the breaking point for the economy is approaching, bond yields will start falling again. However, we are not there yet.
What would be an attractive entry point?
If you are a long-term investor and especially if you are a European or a Japanese investor and you get offered a 30-year US treasury bond at 3%, you get a decent term premium exposure and you are getting exposure to the dollar. Which, if things go as I expect, is not the worst thing to have as an additional hedge to your portfolio.
You mentioned commodities. Are they a buy?
Yes, the environment is favorable for commodities, but they embed a strong political call. What if Russia and Ukraine sit at a table and come to some sort of an agreement and Ukraine can start exporting wheat again? And Russia can start exporting oil again in size? In this scenario, commodity prices will fall significantly – something we have seen at the beginning of this week. And look at the implied roll yield in many commodities. If you are able to get your hands on physical commodities today, you get a huge benefit because of the scarcity. There is literally not enough commodities around. The whole situation is exacerbated by Covid-lockdowns. However, some of these factors are already priced in. For commodity prices to rise much further, you would need an additional mismatch between demand and supply that is not yet reflected in the prices. Can it happen? Of course. However, it remains largely a geopolitical call and that’s a domain I don’t have superior information on. I don’t like investing when I don’t have a good sense about the balance of risks and rewards.
What about gold?
If the Fed is telling you that it wants real interest rates to go higher, that’s not an environment where you want to hold gold or other precious metals.
Is there a case to be made for Chinese equities?
Chinese equities have been completely battered over the last year and a half. There is the 20th Party Congress in Autumn and I don’t think that President Xi Jinping and the People’s Bank of China are very keen on having a super weak economy at that time. So, they are already trying to restore credit to sectors such as the real estate and technology sectors that have been badly affected – by their own policies, by the way. The policy makers would like to see at least some stabilisation in these areas. Given low valuations and depressed sentiment towards the asset class, having a look at some Chinese stocks could make sense for a medium-term investor. Always keeping in mind, however, that in the short-term volatility can be very high.
Where does Europe fit in?
The Eurozone is basically 19 countries that have very little in common with each other, and don’t have a coherent energy or military policy. And now it is paying the price for that. There is an interesting thing to say, though. The European fiscal response to the pandemic was much less aggressive than in the US, but it is spread over time. This is in contrast to the US, where the fiscal stimulus was highly focussed on 2020 and early 2021. In the EU it takes time to do things and they set up the Support to mitigate Unemployment Risks in an Emergency (SURE) program and then the EU recovery fund. They are still disbursing funds today and will be disbursing funds until the beginning of 2023. This means that a big chunk of the fiscal impulse will stimulate the EU countries this year – unlike in the US. Given the spread out nature of the European stimulus, the EU might be better off than the US to counter a cyclical downturn, always assuming the Russian war does not escalate further. Economists are naturally less positive on Europe than on the US, as in the past the US has always been more dynamic. But this time there might be some divergence that is in favor of Europe.