And it’s not just that central banks are raising rates sharply and then warning the public they will need to keep jacking up rates hard and fast to crush inflation.
What’s new and scary is that the Federal Reserve and the RBA are taking rates materially higher even as signs emerge in the US and Australia that economic growth is starting to slow, and markets have already corrected sharply.
“I can’t stress how unusual that actually is,” says market veteran Tim Toohey, who is chief economist at fund manager Yarra Capital Management.
Toohey’s big fear that the Fed and the RBA risk creating an abrupt economic slowdown that smashes corporate earnings – the hard landing markets most fear – was written all over Wall Street on Thursday night and the ASX on Friday morning.
One day after the Fed raised interest rates by 0.75 of a percentage point in the biggest rate rise since 1994, the S&P 500 tanked 3.4 per cent, taking losses over the last 10 days to almost 12 per cent. The ASX 200 is down about 9 per cent over the same period.
Earnings expectations in the wrong spot
Toohey isn’t all doom and gloom. He actually sees the possibility of a rally on global equity markets late this year as markets begin to see just how rapidly economic data has deteriorated and start to bet central banks will have to start easing monetary policy.
But a painful period looms for investors between now and then, and Toohey says those tempted to buy into what looks like a beaten-down market should be wary.
“Central banks asserting that they’ve got a lot more to do is going to continue to build that expectation that not only will the economy be slowing, but earnings expectations are just markedly in the wrong spot,” he tells Chanticleer.
“We’ve got at least several months ahead of us of where the hikes are still coming through, and the data is deteriorating materiality. That could still be a painful adjustment.”
The last two weeks – starting with the RBA’s super-sized 50 basis point rate rise on June 8, and ending with Friday’s plunge on global markets – stands out as an extraordinary time in a crazy year for markets and monetary policy.
Any forlorn hopes that Fed chairman Jerome Powell and RBA governor Philip Lowe may have held that inflation might prove transitory are gone.
And now, having been horribly caught behind the curve – Lowe, particularly with his call last October that rates wouldn’t move until 2024, and his fixation on pushing unemployment below 4 per cent – the pair are trying to win back credibility by declaring they can do whatever it takes to tame runaway inflation but still avoid a recession.
But Toohey says they are telling the public they will take rates up fast and hard just as there are signs in the US and Australia that inflationary pressures are starting to be resolved, and economic data is rolling over.
In the US, retailer’s margins are coming under pressure as inventory builds, housing approvals are down, manufacturing is slowing and for all the talk about how strong the labor market is, growth in average hourly wages is tepid.
In Australia, consumer confidence is near recessionary levels, housing market data is weakening, and business confidence has been falling for months.
How far, how fast: central banks’ big gamble
The corrections on global equity markets also add to tighter financial conditions – and yet central bankers are falling over themselves to signal they’re about to provide significantly more tightening.
“There is a real fear that central bankers think they are addressing an issue that is excess demand driven, whereas 80 per cent of what’s driving the inflation is supply,” says Toohey.
“They really can only tinker at the margin in terms of influencing the path of inflation. They seem to be prepared to risk a very abrupt slowdown in activity in a short period of time – and that’s a big gamble.
“It’s not just about where you go with rates, it’s how fast you get there that will actually generate an abrupt shift in not just sentiment, but actual action by corporates.”
And herein lies the rub for investors. Despite the 15 per cent fall in the ASX 200 this year, earnings forecasts in Australia have actually been revised up. While that’s partly to do with strong commodity prices lifting earnings in the resources sector, it also reflects the resilience of the Australian economy.
In his latest missive to investors, Dean Fergie, of small cap fund manager Cyan, lamented the 14 per cent fall in his portfolio in May.
It was frustrating, he says, “not just because share prices were falling, but also because the vast majority of our invested companies have been operating well and delivering positive news in the form of earnings resilience and, in some cases, material new contracts being awarded”.
But if Toohey is right and rate rises cause an already slowing economy to stall, then earnings forecasts need to come down materially – and so will share prices.
The big question for investors is how to navigate this environment? Picking the bottom of a market is notoriously difficult, so what stocks can ride out the potential recession ahead?
A few clues may have been provided at Morgan Stanley’s Australia summit last week, where five top Australian fund managers – WaveStone Capital’s Catherine Allfrey, Ellerston Capital’s Chris Kourtis, Pendal Group’s head of equities Crispin Murray, Regal Funds Management chief investment officer Phil King, and Tribeca Investment Partners’ Jun Bei Liu – provided their best domestic stock idea.
The focus was clearly on resilience – stocks that can navigate an economic slowdown and/or have the ability to pass on higher prices.
Murray’s pick was building materials giant James Hardie. While a beaten-up cyclical that’s faced big cost pressures might look an odd choice, he says demand should be underwritten by the fact America’s housing stock is too low and aging. And James Hardie is so good at pushing through price rises that its margins have actually increased despite inflationary pressures.
Allfrey’s idea was Carsales. While it also has pricing power (thanks to a dynamic pricing model), she says the company is making an interesting foray into “flipping” used cars (with the support of a partner). She also likes the cautious but potentially lucrative expansion it is making into the US auto market, where digital advertising penetration rates are lower than in Australia.
King likes Woodside. Not only does it have a commodity price tailwind, but he believes it can beat its forecast synergies from its recent merger with BHP’s petroleum division, eventually giving it the potential for buybacks and special dividends.
Kourtis is a big believer in Ampol, which he says has a set-up he’s rarely seen; not only does it own one of Australia’s two last remaining oil refineries, but it’s also got federal government support that effectively underwrites the refinery’s profitability.
“It’s no longer a refinery – it’s privileged and irreplaceable infrastructure,” he says.
Liu likes Johns Lyng Group, which makes the bulk of its revenue doing building and construction work for the insurance industry.
Not only does it have pricing power (contractors essentially pass through costs to insurers), but climate change means a stable level of demand regardless of economic conditions. “It’s a bottom-drawer stock,” she says.”