This is definitely not the best of all possible Panglossian macro worlds as the S&P 500 is 20% below its January peak, growth stocks continue to get crushed on Nasdaq while credit spreads have almost doubled and Brent crude is at $114. The Powell Fed waited too long to tighten with its myopic mantra of “inflation is transitory” and has pivoted to monetary tightening at a time when economic growth and consumer spending has begun to decelerate. An ugly word from the 1970’s now explains the macro zeitgeist: stagflation.
The 2 year Treasury note at 2.48% is still below the 10 year T note at 2.75% but it is only a matter of time before the yield curve inverts as in late 2007. This is the grim macro message of both the stock and bond markets.
Real estate is the next fools gold as US mortgage rates have risen a full 200 basis points in 2022 even as its home builders trade at 4.5 times forward earnings, a clear metric of imminent distress. The Fed will continue to tighten since it is so far behind the inflation curve as King Dollar remains uber-strong, a scenario that promises a bloodbath in the inflated global property market even here in the GCC. The world also faces the worst sovereign debt crisis since Mexico, Brazil and Argentina went belly up in the 1980’s.
The US stock market has a bad rap for having forecasted 12 of the last eight recessions, yet I feel Mr. Market may not be entirely wrong this time as jobless claims creep up while the PMI slips below 50 in the next three months. So the earliest that the Powell Fed can signal a pause in its monetary tightening regime will be in the September FOMC, the moment that may well see a cyclical bottom in risk assets.
The history of US business cycle since the 1990’s suggests that the rate of change in corporate credit spreads peaks four months before the S&P 500 index bottoms, a macro correlation that also suggest that a cyclical bottom may well emerge in early autumn, even though seven weeks of consistent selling in the indices do not exactly cause captain and kings of Wall Street to turn cartwheels with joy.
Higher interest rates and a growth scare have been the backdrop for an epic valuation multiple derating in US equities in 2022. The Nasdaq’s valuation metric has gotten crushed from 32X forward earnings at its peak to 22.4X now. Yet it is premature to catch a falling knife while earnings misses still plague the market, as the poor bulls in snap learnt the hard way with a 41% fall in one ghastly session alone only proving that catching a falling chainsaw can prove fatal.
The S&P 500 now trades at 15.7X forward consensus earnings but Mr. Market may be too optimistic to project $250 in earnings next year. If so, downside risk on the S&P 500 is all too real till 3400, a level that corresponds to the 25% hit that a recession scenario would suggest. Fear inflated volatility curves now mean some stellar option market strategies to make money in trades where the risk/reward is unfairly skewed.
Matein Khalid is Strategic Advisor, Asas Capital
Also published on Medium.
