And it’s not just that central banks raise rates sharply and then warn the public that they will have to keep raising rates hard and fast to crush inflation.
What’s new and scary is that the Federal Reserve and RBA are raising rates substantially even as signs emerge in the US and Australia that economic growth is beginning to slow and markets have already corrected sharply. .
“I can’t stress how unusual this is,” says market veteran Tim Toohey, who is chief economist at fund manager Yarra Capital Management.
Toohey’s big fear that the Fed and RBA risk creating a sharp economic downturn that crushes corporate earnings – the most feared hard landing markets – was written all over Wall Street Thursday night and the ASX Friday morning .
A day after the Fed raised interest rates 0.75 percentage points in the biggest rate hike since 1994, the S&The P 500 fell 3.4%, bringing losses over the past 10 days to almost 12%. The ASX 200 is down around 9% over the same period.
Earnings expectations in the wrong place
Toohey isn’t all catastrophic. He actually sees the possibility of a rally in global stock markets later this year as markets start to see how quickly the economic data has deteriorated and start betting that central banks will have to start easing the Monetary Policy.
But a painful period looms for investors between now and then, and Toohey says those tempted to invest in what looks like a down market should be wary.
“Central banks that say they have a lot more to do are going to keep building this expectation that not only will the economy slow down, but earnings expectations are definitely in the wrong place,” he told Reuters. Chanticleer.
“We have at least several months ahead of us to know where the upsides are still going, and the data is deteriorating materiality. It could still be a painful adjustment.
The past two weeks – beginning with the RBA’s 50 basis point rate hike on June 8 and ending with Friday’s plunge in global markets – stand out as an extraordinary moment in a crazy year for markets and the Monetary Policy.
All the vain hopes that Fed Chairman Jerome Powell and RBA Governor Philip Lowe might have thought inflation might prove to be transitory have disappeared.
And now, having been caught horribly behind the curve – Lowe, particularly with his call last October that rates wouldn’t budge until 2024, and his fixation on rising unemployment less than 4% – the pair is trying to regain credibility by declaring that it can do whatever it takes to rein in runaway inflation while avoiding a recession.
But Toohey says they are telling the public they will raise rates quickly and hard amid signs in the United States and Australia that inflationary pressures are starting to subside and economic data is turning.
In the United States, retailer margins are under pressure as inventories pile up, housing approvals fall, manufacturing slows and despite all the talk of a strong labor market, growth in average hourly wages is lukewarm.
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: the big bet for central banks
Corrections in global equity markets are also contributing to the tightening of financial conditions – and yet central bankers are crashing to signal that they are about to undertake much deeper tightening.
“There’s a real fear that central bankers think they’re preying on a problem of excess demand, when 80% of what drives inflation is supply,” Toohey says.
“They can really only tinker at the margins in terms of influencing the path of inflation. They seem to be willing to risk a very sharp downturn in activity in a short period of time – and that’s a big bet.
“It’s not just about where you’re going with rates, it’s how fast you get there that will actually generate a sharp shift in not just sentiment, but actual corporate action.”
And therein lies the catch for investors. Despite the ASX 200 falling 15% this year, earnings forecasts in Australia have actually been revised upwards. While this was partly explained by high commodity prices which drove up profits in the resource 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 his portfolio’s 14% drop in May.
It was frustrating, he says, “not just because stock prices were falling, but also because the vast majority of our companies we invest in were performing well and delivering positive news in the form of earnings resilience. and, in some cases, major new awards.
But if Toohey is right and the rate hikes stall an already slowing economy, then earnings forecasts must drop significantly — and so should stock prices.
The big question for investors is how to navigate this environment? Picking the bottom of a market is notoriously difficult, so which stocks can weather the potential downturn ahead?
Some clues may have been provided to Morgan Stanley Australian Summit last week, where five of Australia’s top fund managers – Catherine Allfrey of WaveStone Capital, Chris Kourtis of Ellerston Capital, Pendal Group Head of Equities Crispin Murray, Regal Funds Management Chief Investment Officer Phil King and Jun Bei Liu from Tribeca Investment Partners – provided their best stock idea.
The focus was clearly on resilience, i.e. stocks able to ride out an economic downturn and/or pass on higher prices.
Murray’s choice was building materials giant James Hardie. While a beaten cyclical that faces strong cost pressures may seem like an odd choice, he says demand should be underpinned by the fact that the US housing stock is too low and aging. And James Hardie is so good at pushing through price increases that his margins have actually increased despite inflationary pressures.
Allfrey’s idea was Carsales. While it also has pricing power (thanks to a dynamic pricing model), it says the company is making an interesting foray into “flipping” used cars (with partner support). It also appreciates the cautious but potentially lucrative expansion it is making in the US automotive market, where digital advertising penetration rates are lower than in Australia.
King loves Woodside. Not only does it have a tailwind on commodity prices, but it believes it can beat anticipated synergies from its recent merger with BHP’s oil division, possibly giving it the potential for buyouts and special dividends.
Kourtis is a big supporter of Ampol, who he says has a setup he has rarely seen; not only does it have one of the last two oil refineries in Australia, but it also enjoys the support of the federal government which effectively guarantees the profitability of the refinery.
“It’s no longer a refinery, it’s privileged and irreplaceable infrastructure,” he says.
Liu likes Johns Lyng Group, which earns most of its income from doing building and construction work for the insurance industry.
Not only does it have pricing power (contractors essentially pass the costs on to insurers), but climate change means a stable level of demand regardless of economic conditions. “It’s bottom drawer stock,” she says.
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