by Kevin McCreadie, MBA, CFA®, AGF Management Ltd.
The strength of the economy and financial markets rides on the ability of the U.S. Federal Reserve and other central banks to strike the right balance with interest rates, says AGF CEO and Chief Investment Officer.
After selling off for a good part of the first quarter this year, equity markets have rallied aggressively in recent weeks. Does that mean the worst is over for investors?
It’s been a nice run for stocks since they bottomed near the beginning of March and there may be further gains ahead given the current trajectory, but investors are still facing a very uncertain backdrop and more volatility should be expected.
One of the key risks continues to be the Ukraine War. While ceasefire talks have helped calm market jitters, an actual resolution to the conflict still seems like a long way off and the chance of it escalating from here could be a very real possibility following new reports that scores of unarmed Ukrainian citizens have been killed by Russian troops.Either way, the war’s impact on investors is bound to be long-lasting – especially as it relates to commodity markets for food and energy, which have been severely disrupted by shortages and are likely to remain disjointed even if an agreement between Russia and Ukraine can be reached sometime soon.
The other big risk – and perhaps greatest – is the start of the U.S. Federal Reserve’s latest rate-hiking cycle this past month and its plan to tighten monetary policy further this year in hopes of reining in inflation which is growing at a rate in the U.S. not experienced in decades. In a way, the Fed (and other central banks like the Bank of Canada dealing with the same issue) is between a rock and a hard place. If it doesn’t raise rates aggressively enough, the current high level of inflation could persist and become more of a drain on economic growth by curtailing consumer discretionary spending. Think about it: The more everyone pays for gas and groceries, the less there is to spend on other goods and services that help fuel the global economy. But if the Fed raises rates too quickly or by too much and borrowing costs for consumers and businesses follow suit, the negative effect on economic growth could be just as bad or even worse. So, it’s crucial that the Fed and other central banks strike the right balance, but that’s often easier said than done. As history shows, it’s policy mistakes more than not that end up causing recessions.
How will investors know that central banks are striking the right balance and engineering a “soft landing” for the economy?
The obvious indicators are official government statistics related to GDP growth, inflation and consumer spending, although it’s important to remember these stats are released with a lag and represent what’s already happened – not what’s going to happen. Given current circumstances, the ideal outcome with respect to these numbers might be a series of moderate decreases over the next few months, which, from current levels, would suggest the economy is still able to grow modestly despite higher rates, but also that consumer prices are starting to wane because of them.
Global Purchasing Manager Indexes (PMIs) measuring manufacturing activity are another good gauge of the economy’s health. As it stands now, PMI scores are greater than 50 in many countries around the world, indicating a business cycle expansion, according to Markit Economics. In the U.S., for example, the S&P Global US Manufacturing PMI hit 58.5 in March, its highest level in six months. Again, the question isn’t so much where PMIs are today, but where they are headed from here. It’s not unreasonable to think they will fall given the uncertainty we’ve talked about, but they have a long way to drop before signalling something more ominous like a recession is on its way.
Then, of course, all eyes are also on the U.S. Treasury yield curve, which may be telling a very different story than PMIs right now. That’s because parts of the yield curve have inverted in recent days, including the segment defined by the two- and 10-year yield spread that has been one of the more reliable predictors of economic slowdowns in the past.
As a reminder, an inversion occurs when yields on the short end of a particular spread are higher than the yield on the long end of it. While it’s unclear why that may lead to recession exactly, one of the big reasons may be the negative impact it has on banks that still largely make money by borrowing short term at low rates and lending longer term at higher rates. In other words, when yields invert, banks are less incentivized to lend, which curtails growth.
Interestingly, it can take months before economic growth turns negative following certain inversions along the curve. Moreover, not everyone believes the inverted two- and 10-year yield spread is the recession barometer to worry about, choosing instead to focus on the inversions involving three month- and longer-dated yield spreads, which, to date, are still nowhere near inverting, according to Bloomberg data. Either way, it may not seem like a recession is imminent, but the U.S. Treasury yield curve may be the most important indication of where the economy is headed and should be closely monitored going forward.
Beyond these indicators, what can investors expect from first quarter earnings results as they start to roll in later this month?
Earnings season will be closely scrutinized – much like it always is – and should play a key role in determining the direction of equity markets over the next couple of months. Companies that have been able to maintain their profit margins by raising prices in the face of higher inflation this past quarter should be in better position to beat expectations than those that haven’t – at least generally speaking – but guidance about future earnings may play a bigger role than usual in determining how well investors receive the results. Those that say they will continue to manage through the risk of higher inflation and higher interest rates stand to gain the most, but with the uncertainties presented by the Ukraine War and central bank tightening, it is hard to see many companies taking an aggressive stance when it comes to their outlook for the next few quarters.
Kevin McCreadie is Chief Executive Officer and Chief Investment Officer at AGF Management Limited. He is a regular contributor to AGF Perspectives.
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This post was first published at the AGF Perspectives Blog.
