Fed Flattens False Hope

August saw equity markets resume their downward trajectory as the MSCI All Country World Index, a broad measure of global equity markets, fell 4% during the month. Stock prices across the globe sank as the US Federal Reserve (“Fed”) reaffirmed its commitment to tackling soaring inflation thereby signalling to investors that it would continue to increase interest rates. As a rule of thumb, the direction of interest rates and stock prices tend to function in an inverse relationship with increasing interest rates met with falling stock prices.

Those anticipating that the Fed would soften its stance towards increasing interest rates saw their hopes dashed following comments from the Fed Chairman, Jay Powell, at this year’s Jackson Hole summit. The annual event sees central bankers, finance ministers, academics, economists and various others with economic prowess gather in Wyoming to discuss macroeconomic issues and monetary policy. Taming inflation has been the core focus for central banks and CPI data for the US in July exhibited signs that inflation pressures may be easing. An increase of 8.5% year-on-year was lower than the expected 8.7% and on a month-on-month basis CPI remained flat. Core CPI, which strips away the impact of food and energy prices, came in at a 5.9% year-on-year increase, identical to the June print, and when price comparisons are made against the previous month, the increase was only 0.3%, below the 0.7% increase experienced during June. While the above data does point to a potential slowdown, it is worth pointing out that an annual inflation rate above 8% is still uncomfortably above the level that the Fed would be willing to tolerate.

A slowdown in inflation might have swayed the Fed to reduce the extent at which it is hiking interest rates. Such a possibility stirred up renewed, albeit weak, optimism as the market began to percolate higher, but in the days leading up to the economic symposium, minutes released from the Fed’s meeting in July poured cold water over the idea. Discussions among Fed officials during July indicated a need to keep interest rates at restrictive levels “for some time” and with that investor optimism dissolved as investors came to terms with the idea of a higher interest rate environment for a longer period of time.

Powell’s Jackson Hole speech confirmed what many were now suspecting, as he emphasised that the Fed would “keep at it until it is confident that the job is done” even if further rate increases were to “bring pain to households and businesses”. Clearly, despite July’s slowdown in inflation, the Fed still remains concerned with the rate at which prices are increasing and the chairman’s speech has galvanised the Fed’s hawkish stance.

US bond markets echoed the hawkish outlook of the Fed as the yields on the 2-year and 10-year treasuries climbed higher during the month, ending at 3.4% and 3.1% respectively. The shorter-term instrument continues to trade above its longer-term counterpart, a sign that often, but not always, portends an upcoming recession.

Prices for US equities, which initially rose on fleeting optimism, began to sink on the expectation of higher interest rates and were battered down further by the Fed’s confirmation thereof. The S&P 500 index ended the month down 4% as technology stocks bore the brunt of the pain. In general, tech stocks fall into the growth category and are considered to have a longer duration profile. In simple terms, this means that the bulk of their expected earnings or cash flows lie further out in the future owing to higher growth expectations. Stocks with longer durations are more sensitive to rising rates which would account for the tech-heavy Nasdaq Composite falling 5% during August.

Fearful of a possible recession, investors have increased their focus towards more defensive sectors. Utilities eked out a gain during the month, consumer staples held up better than most but healthcare was somewhat of an anomaly, registering relative underperformance against the broader S&P 500 Index. Bipartisan legislation introduced by President Biden could reduce the pricing power of pharmaceutical companies, a bitter pill to swallow that led to downward pressure in their respective stock prices.       

While inflation is showing signs of slowing down in the US, the same cannot be said for Europe. Inflation data prints continue to exceed expectations with July showing consumer prices in the eurozone increased 9.1% on a year-on-year basis, as CPI in the UK and Germany rose to 10.1% and 8.9% respectively, the highest levels seen in four decades. The soaring cost of food and energy, with natural gas a particular bugbear, continue to drive inflation levels higher and the fast-approaching cold months of winter have many speculating that inflation in Europe will only continue to trend higher.

An already under-pressure European consumer will have to deal with the likelihood of sizable interest rate hikes as European central banks position themselves to tackle inflation in the region. Yields on longer-term European government bonds climbed precipitously during the month as benchmark yields for the UK and German 10-year instruments increased from 1.89% and 0.85% to 2.82% and 1.54% respectively. As with the US, rising rates have also proven painful for European equities as we saw declines in major European indices such as the French CAC 40 (-5%), German DAX (-5%) and the Netherlands AEX (-6%). The UK’s FTSE 100 Index held up relatively better than its European neighbours, declining slightly over 1% during August.  Contributing to the relative outperformance were larger index weightings in defensive sectors such as consumer staples and healthcare as well as sizable weighting towards the energy sector, specifically oil majors BP and Shell.

The energy sector was the standout performer during the month despite the price of oil continuing fall. Concern over an economic slowdown or worse, a recession, has led to speculation that oil demand may dry up somewhat leading to downward on the price of oil. Brent crude fell below the $100 level having declined 12% during the month to end August at $96 a barrel and American marker, West Texas Intermediate, fell 9% as it closed the period at $90 a barrel.   

Chinese equities continue to be plagued by the impact of severe lockdowns but Hong Kong’s Hang Seng index and mainland China’s CSI 300 index were boosted during the month following news that Beijing may order state-run groups to guarantee property developer bonds. China’s housing market has been thrown into turmoil as homebuyers across China have boycotted mortgage payments on pre-sold homes, still in the process of development, which has already led one major property developer to default on its debt. The two indices were also boosted by the news that Beijing and Washington have seemingly reached an agreement that would allow US regulators to access audit documentation of Chinese companies listed on US exchanges. To date, the US has had no access to these documents and had threatened to delist Chinese companies should they not agree to do so. Despite the aforementioned positive developments, the two indices still ended the month in negative territory as the Hang Seng and the CSI 300 declined 1% and 3% respectively. Neighbouring Japan continues to maintain its accommodative monetary policy, even as inflation climbs above the Bank of Japan’s target rate. The Nikkei index was one of the few indices to register a positive gain during the month, climbing 1%, but reluctancy to raise interest rates has preserved the weakness of the Japanese yen against the US dollar, so much so that in US dollar terms, the Nikkei actually fell 3%.

South Africa’s local index held up relatively well though still suffered a decline as the JSE All Share Index ended the month 2% lower in rand terms – in US dollar terms, the performance was more in line with other indices having declined 4% during the month. Gains from consumer staples along with strong performances from coal miners were offset by broad declines in the remainder of the resources sector. Lockdowns in China and a recessionary mindset led commodity prices to soften during the month with declines in industrial metals such as aluminium (-3%), copper (-1%), iron ore (-2%), lead (-4%) and nickel (-4%) as well as platinum group metals with falls in platinum (-6%), palladium (-2%) and rhodium (-2%).

Amidst the market meltdown, investors continue to favour the safe haven of the US dollar over the likes of gold as higher interest rates heighten the appeal of the greenback. The price of bullion continues to trickle lower, declining 2% during August, to end the month at $1,716/ozt. The yellow metal’s new age counterpart, Bitcoin, fared somewhat worse having declined 14% during August to close the month out slightly above $20,000.