Markets suffered their biggest one day fall since the height of the pandemic provoked market crisis in March 2020, with the US Nasdaq down 5.5% and the S&P 500 down 4.3% after the latest US inflation numbers showed core inflation still on the rise even though energy prices have been on the wane. We issued a more detailed analysis of the underlying inflation drivers and why the market reacted so strongly last week, which you can view on this website if you missed it. This was followed by further weakness later in the week, as the market digested the fact that rates might have to go higher than expected to head off inflationary pressures, leaving the S&P 500 and the Nasdaq down almost 5% and 6% respectively for the week. Most other markets followed suit but to a lesser extent, ending the week between 1.5% and 3% down. The economic news has been getting more gloomy from China to Europe and finally the US with a down beat report from FedEx, a traditional US bellwether. At a sector level, it was both large tech stocks and materials stocks that led the market down, embodying the increasingly stagflationary theme - one where stubborn inflation and slowing growth leaves the Fed and even governments with little opportunity to add further stimulus if and when there is a downturn. One apt description of the situation we have heard is that the Fed is now ‘chasing the puck’ as it can’t skate to where it thinks it will be, as neither they nor anyone else now has any idea when inflation will peak or how quickly it will drop. Interest rates act with a nine month to 2-year lag on the economy, so it is only with a great deal of hindsight that the Fed will know if they have gone too far. Simultaneously, a barrage of Fed officials have been at pains to convince the market that they are serious about heading off inflation, and now the market finally believes them. Worst still, this situation and the blunt tools at policy makers’ disposal means we will never even know the counter factual, that is to say, what would happen if the Fed doesn’t engineer a recession, as now seems inevitable. This, and the ongoing energy shortages in Europe, amounts to a lot of uncertainty for markets and explains why implied volatility (the cost of hedging risk) has been rising especially quickly for the European and US stock markets, as that is where the market sees the most risk right now. One of the few sectors to perform well last week was healthcare stocks, along with utilities and banks. Meanwhile real estate trusts were one of the sectors worse affected by higher interest rate expectations.

Given this backdrop, it is also worth noting that the market’s base case is still that short-term inflation will peak soon, and that rates will also fall sharply relatively soon (in 2024) having peaked in the next 12 months or so. The following graph, showing expected short-term rates (as opposed to long-term borrowing rates), demonstrates the quite precise trajectory that the market anticipates, and how markedly it shifted just last week. For Australian investors (and borrowers) it is also interesting to note where expectations are diverging vis a vis Australian monetary policy. The shifts in expected rates mirrored those of the US, but where the market expects us to land is quite different - the market is presumably expecting Australia to have either a much stronger economy and/or a more persistent inflation problem. Last week RBA Governor Philip Lowe was at pains to walk what is arguably an even narrower path than that of the Fed, given a highly leveraged property market. On the one hand, Governor Lowe said on Friday “The fact that we’ve raised interest rates quite a lot already increases the strength of the argument for smaller increases going forward. We are closer to a normal setting now, which means that the case for large adjustments in interest rates is diminished.” On the other hand, he also said “The RBA will do what is necessary to make sure that higher inflation does not become entrenched, and we are committed to returning inflation to the 2 to 3 per cent target range.” Market implied Australian inflation a year from now is 4% (1% higher than in the US,) and so the graph below suggests that, if the market is right, Australia will be struggling with a bigger inflation problem than the US and for longer.

As one might have expected, most government bonds fell, credit spreads rose again and most commodities were also in the red, reflecting expectations of economic weakness and underpinning the markets fear that there are few winners in a stagflationary environment. This week, various central banks line up to put actions to their words and the Federal Reserve is expected to raise US rates by 0.75%, but 1% is now a possibility. Let’s hope last week was a case of ‘sell the rumour, buy the news’ but it looks like this uncertainty will be with us for a while.  

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