The US October CPI came in at a lower-than-expected annual increase of 7.7% (the expectation was 7.9%) and triggered a big rally in stocks as well as bonds. The S&P 500 rallied well over 10% to be out of bear market territory, however, it is still down around 17% from its high. Meanwhile, the tech-heavy Nasdaq remains in a bear market, with a loss from its peak of around 30%. (Bear market is generally defined as a prolonged market drop of 20% or more from recent highs). The US 10-year Treasury yield is trading around 3.8%, down from its October high of 4.3%.
The US dollar index fell by over 7%, as the Australian dollar has rebounded over 8% from its 2½-year low of US61.69¢. All this is mostly as a result of inflation having likely peaked and markets anticipating that future US Fed rate rises will be smaller than the recent string of 0.75% rises and that the peak in interest rates may be lower than expected. The Australian dollar has also been helped by China’s apparent softening of coronavirus restrictions, and a subsequent rise in the price of economically sensitive commodities such as copper. Higher commodity prices and stronger growth almost always benefit the Aussie dollar.
Are we out of the woods?
We would urge caution as the jury is still very much out on whether this is just another bear market rally or if we are in the clear from here.
Firstly, the US Core CPI (which excludes food and energy) remains very elevated at 6.3%. It is only marginally down from the 40-year high in September of 6.6%, and a long way from the 2% target.
Secondly, every time markets have become exuberant, there has been no shortage of Fed officials hosing down expectations. The reason the Fed does not want rapidly rising equity prices is that this represents an easing of financial conditions, and this makes it harder to combat inflation.
Thirdly, monetary policy operates with variable lags. So, with the Fed having quickly raised rates, much of this has likely not impacted the real economy yet. These lags mean that the chances of tightening too much are very high based on historical outcomes, with the probability of a hard landing far exceeding that of a soft landing for the US economy.
Where to from here?
If the Fed is going to keep rates high for a lengthy period, current estimates for S&P 500 are likely too high if the economy slows. Earnings estimates in the US have actually been falling, it is energy stocks that are masking that trend.
There is a risk interest rates will continue to go higher. Longer term we believe the Aussie should trade in the 70’s rather than the current 63 US cents.
We are still not comfortable enough to add to growth assets as we are expecting a downgrade cycle in stocks as economies slow down, particularly after the strong rally we have had. We believe we are approaching the top of the trading range for stocks and if it were to go much further, valuation becomes an issue in the US (which is over 60% of the global index).
We would continue to be patient in this market and look to take advantage of opportunities that will likely arise in a very volatile market.
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