Casual fans of American football or basketball often quip that the game only begins in the fourth quarter, when outcomes are frequently decided. For investors, a similar sense accompanies the passage of 2022. After an awful first nine months of the year, 2022 portfolio performance now hinges on the final quarter.
As the final three months of 2022 get underway, investors are again confronted by slumping asset prices and soaring volatility. The brief mid-year rally that was underpinned by hopes for peak inflation and peak policy rates was snuffed out by reports of higher than-expected US core inflation and a nasty (if overblown) bond market reaction to the UK ‘mini-budget’. Major equity indices declined sharply in September and are now flirting with, or making, fresh cyclical lows.
Let’s take a closer look at what will be the critical success factors for the final quarter of 2022.
Key outcomes hinge on timing. Will peak inflation arrive before demand destruction creates nasty feedback loops for growth and profits? Can peak policy rates arrive soon enough to moderate the destructive global growth impacts of higher interest rates, more inverted yield curves, and a surging US dollar? Can central banks achieve their inflation objectives before a financial accident ensues?
We begin with the third quarter corporate profits reporting season. Ordinarily, companies play a game with equity analysts, talking down earnings prospects ahead of reporting to improve their chances of generating a ‘beat’. And ‘beats’ typically exceed ‘misses’, with positive surprises often helping markets out during rough patches.
But as they sift through a deluge of earnings releases over the coming six weeks, investors may be less interested in how companies did last quarter and more focused on profits guidance through year end and into 2023. In turbulent and uncertain times, guidance increases in importance relative to realized profits outcomes. But in current circumstances, confronted by generational highs in inflation, the war in Europe, a China reluctant to assume the locomotive role for the world economy, and political economy dislocation in the UK and western Europe, one can imagine that senior executives in many industries will be reticent to provide encouraging outlooks.
This week also brings a bevy of Fed speakers, accompanied by key data releases spanning global manufacturing, services, and the US labor market. Investors hoping to see cracks in the Fed’s hawkish consensus are likely to be disheartened. Given the latest disappointing US core inflation numbers, it is difficult to see how the Fed can provide much reassurance to jittery investors.
Peak inflation, if it is to be realized soon, requires some weakening of total spending in the economy. But demand destruction also risks undermining corporate profits. It could also set off a series of negative feedback loops from spending to profits, jobs and wages, leading back to spending that could mire global growth and corporate profitability in a deep rut. In that sense, the bullish case for markets rests on the arrival of peak inflation before monetary policy tightening does too much damage to the economy.
For the real economy, the picture remains mixed, replete with signs of both weakness and resilience. Globally, weakness is concentrated in residential and non-residential investment. That’s unsurprising for several reasons. First, higher mortgage and corporate bond borrowing rates typically slow borrowing and spending for big-ticket items. Second, uncertainty weighs on capital spending plans. Finally, soaring house prices in many countries, including the US, have sharply reduced housing affordability.
In contrast, labor markets remain more resilient. Worker shortages in many countries may be contributing to forms of labor market hoarding, where companies retain scarce workers for fear they may not be able hire them back following temporary layoffs. The resilience of the US labor market will be on display in the September employment report, which despite consecutive quarters of falling GDP, rising costs of capital and considerable economic uncertainty, is still expected to show healthy US job gains last month.
A resilient labor market can and probably will cushion the ongoing slowdown. But it also provides greater justification for the Fed (and other central banks) to hike rates even further. Across capital markets, higher interest rates undermine global equity markets via at least three transmission channels.
First, higher discount rates depress the present value of future corporate cash flows (e.g., dividends), putting downward pressure on valuations.
Second, higher policy rates induce a ‘bear inversion’ of the yield curve, with rates rising across all maturities, but more at the front end of the yield curve. A bear inversion of the yield curve raises financing costs for all companies. It also squeezes the profitability of financials.
Finally, higher US interest rates lead to a stronger US dollar. For other advanced and especially emerging economies, the depreciation of their currencies against the dollar increases import prices and hence domestic inflation. To combat surging prices, other countries must then hike rates even more aggressively. A strong dollar, in other words, intensifies the degree of global monetary policy tightening.
So, what’s the bottom line?
A durable equity market recovery requires compelling evidence that peak inflation has arrived before demand destruction becomes excessive. Threading that needle would permit falling risk premiums and bond yields to support equity valuations while also creating the preconditions for a relatively brief and shallow earnings slump.
But returning to our sporting analogy, the fourth quarter is underway, and the clock is ticking. Not only is the ‘home team’ behind (given negative investment returns year-to-date), but time is running out for peak inflation to arrive before peak demand destruction.
Investors of all varieties have tuned in to watch the fourth quarter. They may not like what they see.
