Third quarter with a focus on liquidity and demand resilience. The in-depth analysis of Antonio Cesarano, chief global strategist of Intermonte
The second semester begins, which, in some respects, seems to have potentially different characteristics compared to the first, during which there was an almost monothematic focus on two themes: • galloping inflation • growing problems on the supply chain front. The result: Stock markets are falling, rates and commodities are rising, in the face of the appreciation of the dollar following the acceleration of restrictive monetary policies. The post-pandemic phase has created the "revenge spending" effect: the boom in demand that remained unfilled due to constraint during the pandemic has poured into the market, putting supply in difficulty; as a result, consumer prices have risen. The war added the final "icing", not so much in terms of further rising prices, as of an increase in the persistence of inflation to high levels. A bit like it happens with rain: you can have a less rainy year, but the aggravating factor that several consecutive months of no rain occur. In summary, the persistence and continuity of the phenomenon can make its impact much stronger. In the face of increased persistence, central banks have thrown in the towel. The Fed, in particular, has changed its attitude. Now the goal is to drastically curb growth with rapid rate hikes and (last but not least) doses of quantitative tightening from June with acceleration to September (-$95 billion per month). And history so far teaches how much the arrest of the growth of liquidity then has a weight on the price lists.
After this brief excursus we come to the second semester The high inflation scenario has been priced in as a central bank response with Fed Funds estimated at 3.5% by March 2023. Now, for the second half of the year, the focus shifts to the recession hypothesis, after the countless US data pointing in this direction, no longer excluded even by Powell, with the Atlanta Fed hypothesizing a decline in GDP of 2.1% annualized in 2Q, which would imply a technical recession for the US. • What is emerging from the latest data is a potential drastic decline in demand on various fronts, paradoxically just when some first sign of a less stressed supply chain arrives, especially on the chip front • Companies in the US manufacturing sector, for example, are recording a decline in new orders (now in a contraction zone) in the face of still very high stocks, the result of a phase in which stocks have been the key to positively addressing the demand boom
The pendulum of stagflation, therefore, could remain unbalanced on the "stag" theme, increasingly understood as a recessive hypothesis. In this context, the performance of the individual asset classes could be as follows during the second half of the year, with particular focus on the quarter just begun: Rates and commodities are falling along with the stock exchanges. This does not exclude hypotheses of technical rebounds but the expected trend is the one previously outlined. What are the logical mechanisms that explain the conversion of the decline in liquidity into a negative impact on equity markets and potentially positive for Treasuries? • The lower liquidity translates into greater difficulty on the part of US companies to refinance themselves in terms not only of cost, but also and above all of quantity. In the second half of the year, High Yield companies issued $26 billion, the second lowest level on a quarterly basis since 2006. • Lower issuance potentially leads to lower pay out ratios, especially with reference to the volume of buybacks • Fewer buybacks bring less support to the stock market, given their importance in the bull market years with the exceeding of $ 1000 billion in 2021
• Widening of corporate spreads, starting with the high yield sector, resulting in a preference for the safe haven of Treasuries
The fall in Treasury rates is in turn also fueled by the expectation of a scenario similar to the one that emerged during Volcker's Fed presidency that started at the end of the 70s: substantial rate hikes at the end of 1979, with a discount rate raised to 13% and then quickly brought back to 10% during 1980, in the face of the emergence of the recession. Subsequently, after the recession, Volcker resumed the rate hike phase to continue the fight against inflation.
AT A GLANCE • For the third quarter of 2022, the expectation is of an average context characterized by: falling rates and commodities • decline in equity prices that in the quarterly of July and September could lead to a global revision of the high levels of EPS in both the case of the S&P500 index and the EuroStoxx600
• At the heart of this development is central banks that are struggling to curb growth, even with high doses of liquidity drainage. • At the end of the year/beginning of 2023, these manoeuvres could lead to an easing of the restrictive grip of central banks, to the point of assuming a reversal in the course of 2023. In this context, the declines in equities in 2022 could represent a favorable sowing ground in view perhaps already at the end of the year but more realistically 2023. Between the end of 2022 and 2023 we could also see a reduction in inflation, but paid first in terms of the decline in demand, called to do the dirty work of rebalancing supply and demand after the strong post-pandemic changes. • On the interest rate front, the upward phase of the first half of the year could give way to an opposite trend, with a target of 2/2.25% on the 10 y US sector by the end of the year, a level induced both by outflows from the corporate market and by the expectation of a Fed reversal in 2023, and by the simultaneous sharp decline in commodities, an important prelude to assuming an easing of inflationary pressures starting from the US. • If this scenario proves to be correct, the resulting fall in rates (first nominal rates and then real rates) could on average favor the growth sector over value in the quarter, all in relative terms, at least in the current quarter. • In order to assume absolute benefits, it will be necessary to wait for signs of an end to the restrictive maneuvers of central banks, primarily the QT of the Fed and other central banks. • Meanwhile, within the trend outlined for the quarter, there may likely be rebounds linked to short-term excesses that can once again be grasped by jointly monitoring financial conditions indicators (fear & greed for example) together with the level of the Vix (better as close as possible to the 35 area). • The main risk (positive for equity markets) for such a scenario is the end of hostilities in Donbass. The news could induce a marked rebound of short and then the word would pass to the verification if this news will be accompanied (and in what times) to the easing of sanctions on the European side and to a more regular flow of gas and other raw materials / finished products (refined products in the first place) Russian.