(David Morrison – Trade Nation)
We’ve just started the fourth quarter, and it hardly needs spelling out again, but this has been a truly dreadful nine months for investors. Global stock indices have plunged. Focusing on the US S&P 500, arguably the most important stock index in the world, we’ve seen it fall from a record high above 4,800 at the start of this year, to 3,560 on the first day of October. That’s back to levels last seen in November 2020, for an overall loss of 26%. That’s two years of price appreciation wiped out, just at a time when most investors thought the bull market would run forever.
No hiding place
There’s been no hiding in the bond market either. Typically considered a good place to diversify away from equities, bonds have also fallen sharply this year. Bond yields move in the opposite direction to bond prices, and they have proved to be extremely volatile. Having begun this year with a yield just over 1.5%, the key 10-year US Treasury Note rose above 4.0% at the end of September – a level last seen back in 2008 as the Great Financial Crisis took hold. But back then 4.0% was hit as yields fell, rather than on their way up. But it’s not just US Treasuries which have been hit. The Bloomberg US Aggregate Index, which is the broadest measure of the bond market, has fallen 14.6% so far this year.
The catalyst for the sell-off in risk assets has been the relentless rise in inflation, not just in the US but around the world. Again, there’s little point in going over the dynamics of the pick-up, but it’s clear that central bankers were wrong when they insisted that price rises were ‘transitory’. By the time they woke up, high inflation was embedded across most of the global economy, so much so that headline prices, including food and energy, are currently rising at rates between 8 and 10% for the US, UK, and Euro zone. That’s four to five times above central bank targets.
The response has been to tighten monetary policy. The US Federal Reserve has raised rates aggressively from below 25 basis points in March this year to 325 basis points in September. But so far there has been no evidence that inflation has peaked, and the current expectation is that the Fed will continue to raise rates into 2023 until it hits a ‘terminal’ rate just over 4.5%. No wonder financial markets have sold off so heavily.
Risk asset rally
But on the first trading day of October, as we passed into the fourth quarter, there was a strong rally across all risk assets. There was a simultaneous pull-back in the US dollar, while the yield on the 10-year Treasury Note fell to 3.60% from over 4.00% a few days earlier. We saw other markets rally sharply as well. Gold, and notably silver, shot higher after months of steady decline. Even the British pound found some love.
Bear market rally?
There’s no doubt that US equities were, and remain, very oversold. But is this current move, which at the time of writing is just a few days old, just another bear market rally? Or could it be the resumption of the bull market which began back in March 2009? We’ve certainly seen this story before. Back in June, after hitting a new low for the year, the S&P 500 snapped back sharply and went on to rally up into mid-August. Markets were very oversold then as well. As we know, the rally ran out of juice, and turned down again, until we hit a fresh low on Monday 3rd October. So, we could see the same thing again. Rally, reversal, then another lower low. But as far as the bulls are concerned, things are rather different now. Sue, inflation as measured by the CPI and PCE is yet to peak. But look how much further along the Fed is in terms of monetary tightening. As we know, the market has priced in a ‘terminal’ Fed funds rate of around 4.6% next year. That’s weighing on businesses and individuals now and going forward. But what if inflation has already peaked, and the indicators haven’t picked that up yet? What if the Fed pauses earlier than the market currently expects? Then the bulls could argue that it’s time to put cash to work and start buying up attractively priced bonds and equities. It would certainly be a gamble. After all, if we are now in a full-blown bear market there could be a lot of pain still to come. But it’s worth bearing in mind.