Turbulence at 30,000 Feet

by | December 6, 2021

We all know the feeling. You are sitting in your airplane seat, feeling fine, and then suddenly your stomach is in your throat as severe turbulence shakes your sense of normalcy. Financial markets hit an air pocket last week, and the market moves were sharp and unsettling. Price volatility across global equity, fixed income, currency, commodity, and cryptocurrency markets spiked. In some cases, setbacks were severe. Global equity indices swung violently, with daily moves of more than 2%. Bitcoin was savaged, falling 10% in a single day.

After a prolonged period of steadily rising asset prices and subdued volatility, it would be easy to conclude that last week’s jolt was simply overdue. In our experience, such an argument often comes from a kind of intellectual laziness. In capital markets things happen for a reason, and ‘overdue’ isn’t usually one of them. So it is worth considering why investors are becoming more jittery.

One reason is another ‘air pocket’—the vacuum created by the end of a positive earnings season. This year, outsized gains in major equity indices have tracked outsized profits growth. With the third quarter profits season over, however, investors have lost a key source of support without finding another to replace it.

But it is worse than that. Corporate profits growth peaked around mid-year and has begun to slow significantly. The consensus of analyst forecasts for 2023 projects profits rising a decent 8%. That is a far cry from nearly 40% growth registered in Q3 2021. 

The important point is the rate of change. Earnings growth is likely to be positive for at least several more quarters. But a slowdown in the growth rate—a negative ‘second derivative’—is an unwelcome signal. In various tactical asset allocation models, including our proprietary ones, sharply slowing profits growth is a negative for returns. Markets don’t like inflection points, and one has just arrived.

It is worth delving a bit deeper into the reasons behind the earnings slowdown. The most obvious, and least important, is that so-called base effects (comparisons with favorable year-ago levels) are fading. 

More significant is that as the economy returns to output levels last seen before the pandemic arrived, operating leverage is fading. Briefly put, companies slashed spending during the pandemic and delayed resuming it even when their customers returned. But the days of rising revenues without a commensurate increase in costs are over. Companies are now scrambling to hire, invest, overcome supply bottlenecks, and restore customer loyalty. All of that comes at a cost—namely a squeeze of corporate profit margins.

Fading earnings growth sits oddly alongside stretched equity and credit market valuations. Investors have piled into both markets based on faith in ever-rising profits and a lack of compelling alternatives. High valuations, of course, also have been supported by super-low interest rates and the commitments of central banks to keep them there.

Both assumptions are now under scrutiny. And if corporate revenues falter, earnings growth could even stagnate or turn negative. 

That’s why investors are taking greater note of surveys that show flagging consumer confidence. They are fretting even more about gummed-up global supply chains. They are becoming more concerned about falling inflation-adjusted median household income as price inflation outstrips wage inflation. And they are glancing nervously at the arrival of the Omicron Covid variant and the policy responses to contain it via travel and gathering restrictions. 

As for interest rates, Fed Chairman Powell’s recent decision to ‘throw in the towel’ on ‘transitory’ was not merely a change in Fed semantics. Rather, it reflects a shift at the Federal Open Market Committee (FOMC) regarding the risks posed by US inflation. The implication is not that the Fed has pivoted to a ‘super-hawkish’ stance, but that it is jettisoning overly confident forecasts and moving back to data-dependent decision-making. 

Yet that change in the Fed’s approach arrives just as the economic data are becoming more confusing, volatile, and even inexplicable. Supply chain disruptions are proving to be larger, more widespread, and longer lasting than previously assumed. Product and labor markets are proving to be less responsive to incentives offered by higher prices and wages, with the implication that either inflation will remain elevated for longer, output depressed for longer, or possibly both. Finally, the massive disparity between the household and businesses surveys of the US labor market in Friday’s employment report provide a vivid example of the challenges of setting policy based on the incoming data.

In short, the Fed is reverting to policy predicated on data dependency precisely when the data are less dependable. Match that with slowing earnings and stretched valuations, is it any surprise that investors across all asset classes are becoming more jittery? Toss in the arrival of Omicron, extreme market positioning driven by TINA (There Is No Alternative—to equities), and demanding valuations, and the preconditions for higher volatility are established.

As 2021 draws to a close, extreme spikes in equity, fixed income, currency, commodity, and cryptocurrency volatility will probably subside. After all, the global economy is not careening off the rails. 

Nevertheless, cross-asset volatility is unlikely to fall back to the very subdued norms of recent years. Despite a solid (if uninspiring) global growth backdrop, slowing corporate profits growth, demanding valuations, and less predictable monetary policy responses are moving to the forefront of investor thinking. Market confidence has been fundamentally rattled and will not readily bounce back. 

Get ready for a world of lower returns and more frequent episodes of volatility. There is more turbulence ahead. It is probably a good idea to listen to the pilot and keep your seatbelts buckled.

About the Author

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy.

Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland.

From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT.

At both GAM Investments and UBS Investment Bank Larry was widely recognised for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others.

Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

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