Equity Strategy: Monetary signals are pointing to trouble ahead - not to be dismissed lightly

Speaker: Mislav Matejka, Head of Global Equity Strategy

The equity market rebound since October is drawing investors in. Many, who were convinced last summer that any rally should be seen as just a bear-market rally, are now nurturing increasing optimism that recession can be avoided altogether and that earnings could stay resilient. While we were looking forward to a market rebound from Q4 of last year, and believe that initially Q1 will stay robust, given what was light positioning and supportive seasonals, we do not expect that there will be a fundamental confirmation for the next leg higher, and see rally fading as we move through this quarter, with Q1 possibly marking the high for the year. The key monetary signals are sending warning signs: 1. Yield curve is staying heavily inverted. We have never escaped a recession from this point. 2. Money supply keeps moving lower in both the US and in Europe. In fact, US M1 has entered outright contraction territory, on a yoy basis, for the first time since 2006. 3. Bank lending standards have been tightening, with a sharp falloff in demand for credit, similar to what has been seen ahead of past recessions. 4. Are market expectations for Fed cutting rates in 2H going to be vindicated, especially if there is no pain in the real economy? We could indeed see a Fed pivot, but perhaps only in response to a much more problematic macro setup than the market is currently looking forward to. Historically, equities do not typically bottom before the Fed is advanced with cutting, and we never saw a low before the Fed has even stopped hiking. It might be premature to believe that recession is off the table now, when Fed will have done 500bp+ of tightening in a year, and the impact of monetary policy tended to be felt with a lag on the real economy, of as much as 1-2 years. The damage has been done, and the fallout is likely still ahead of us. US mortgage payments as a share of income doubled,  and the savings rate has gone down almost to zero. 5. Finally, even as the Fed goes on a pause after March/May, quantitative tightening will stay in the background. A year ago, a measure of “excess liquidity” – the expansion of central banks’ balance sheets relative to the growth in the nominal economy, has peaked, and started to contract for G5. In 2022, the differential was at -5%. This year, excess liquidity reduction is likely to be much more significant, at -14%. The question is whether financial markets will absorb this without any hiccups, especially after the complacency has crept in, with VIX at 20 and Bull-Bear optimistic now.

 

This podcast was recorded on 19 February 2023

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