July was an exceptionally strong month for equites – and for bonds – which came as a great relief for investors after one of the most miserable half years in history. So, can we look forward to continuing gains for the rest of 2022? I’d like to be wrong, but I believe that the answer is no. Let’s explore the reasons why.
Inflation needs to be brought under control – and that will be painful.
The rally in risk assets has occurred for the seemingly perverse reason that economic data weakened. This led markets to conclude that the US Federal Reserve will raise interest rates only a little further and will be cutting them in 2023. Equities have fallen so far in 2022, despite strong earnings growth so surely equities are a ‘buy’ if interest rates stop rising?
The big flaw in this argument is that it suggests that interest rates are close to a level that will subdue inflation and that this will occur without a recession. The reality is that US inflation has been allowed to get too high and is too persistent to be quelled by a mere slowdown in the economy. Yes, US GDP contracted in the first two quarters of 2022 but that is not a sensible reflection of the economy. After all, the US economy added a stunning 2.7mn jobs in that period. Wage inflation has accelerated strongly this yar – faster than the Federal Reserve and the markets expected. The same applies to rents. Yes, gasoline prices have fallen from lofty levels and other commodity prices have declined but these factors have a trivial influence on inflation compared with rents and wages.
In my view, the US needs a proper recession including a significant rise in unemployment to get inflation back down towards the Fed’s 2% target. And that probably needs significantly higher interest rates which will be accompanied by a fall in corporate earnings.
Investors already expect recession – but equities could well head lower.
It is true that investor sentiment became exceptionally bearish a month ago and most expect a recession. It may therefore be that equities don’t have too far to fall from here, but my guess is that they are still headed lower.
We can hardly expect Europe to deliver much support. Unlike the US, wages and rents are not the major source of inflationary pressure. In Europe it’s the cost-of-living crisis that dominates and it hard to see how Europe avoids a recession as energy bills soar. The numbers are scary. For the UK, the average home energy bill is set to exceed £3,000 in October and then rise again towards £4,000 in January 2023. Yes, some of this will be offset by government support but that will only mitigate the impact, it won’t protect industry and will be a further constraint on the public finances. Conditions differ in other European countries but for northern Europe and Germany in particular, the outlook is grim.