For much of this year, I have argued that the best analogy for markets is the great 2015 deflation. That has played out in Chinese growth and key commodity prices for Australia.
However, more recently, the energy perfect storm has overtaken that metaphor and I have begun making reference to an earlier period. A closer analogy for markets now appears to 2008.
Do I mean a new GFC? No. I mean an energy and inflation bubble and bust so large that it does material damage to global growth.
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Now, I am not the only one. Albert Edwards of Societe General has also noticed the eery parallels:
As energy prices surge with a backdrop of central bank tightening it’s startingto feel a bit like July 2008. I’m sure you remember that moment of unparalleled central bank madness as the ECB raised rates just as oil prices hit $150 and the recession arrived.
The origin of the surge in global energy prices in recent weeks has been analysed by those far more qualified to write about it than I, including our own SG giants Michael Haighand Lueder Schumacher, whose thoughts are here. They believe that if it is a cold winter, high prices could persist in Europe even if Russia cranks up the short-term gas supply. Yikes!
If you think things are bad in Europe, you need to read Ambrose Evans-Prichard’s view about the ongoing energy crisis in China, which seems just as bad, if not worse than Europe. This is something that is far less reported in the west as we are preoccupied with our own crisis.
I don’t intend to fill this note with charts of gas and energy prices but instead I want to think aloud on some of the consequences of recent events.
The current high energy prices will hugely impact the debate about whether the post-pandemic surge in inflation is transitory or permanent. Breakeven inflation rates (a proxy for market inflation expectations) have surged higher, especially in Europe. Fears of a price/wage spiral seem much more realistic as ultra-tight labour markets conspire with households being bludgeoned by higher energy prices and the cost of living generally.
The increasing threat of transitory inflation becoming more permanent is prompting central banks around the world to begin their tightening cycles, either with actual hikes in rates (Norway and New Zealand) or threats of hikes next year (UK), or tapering QE (US and eurozone).
I think bond yields could continue to drift higher due to the more inflationary backdrop together with the threat of Fed tightening (yes, I do think that tapering is tightening). As the evidence shifts, US 10y yields could well attempt to explore 2-2¼%-the upper bound of the long-term secular Ice Age downtrend. Although this move would not violate the bond bull market, it would certainly feel like a violation to equity investors, and particularly to tech investors who have built nose-bleed valuations on ultra-low bond yields. We could yet see a Dec-2018-like Powell Pivot just weeks into a Fed Taper. But what about the R-word?
It is odd amid the current surge in energy prices that no-one seems to think this will all end in global recession. The US is particularly vulnerable with the OECD estimating a huge 5% fiscal tightening next year–in reality it is likely to be more around 2½% of GDP (ie still a lot).
The latest Atlanta FedGDPNowforecastfor Q3 has fallen to only 1.3% and China is slated for a zero. This can be dismissed as all Covid (Delta) related, but it could be something more, especially as the tightening Chinese credit impulse indicated some time ago that their economy would slow.
My old friend Dhaval Joshi at the BCA pointed out this week how conjoined global tech stocks have been with the US 30y bond yield since the start of this year. He calculates that if the US 30y yield rises to 2.4% from the current 2.1%, it would knock some 15% off tech stock prices. Imagine if the US 10y rose from 1.5% currently to 2¼%! We could see quite a bear market in tech! Since around February, US tech stocks have marched in lockstep with bonds.
It is not just tech stocks that enjoy super-low bond yields, but defensives too. Andrew Lapthorne shows that the bond sensitivity valuation gap among stocks has never been wider!
Just looking at the forward PE for the US tech sector against both ‘Value’ and the market, we can see the polarization in valuations kicked off after Powell’s infamous Dec-2018 pivot.
Perhaps a bigger risk to Nasdaq than higher bond yields would be a follow-on recession (like 1982). Yes, the US tech sector has enjoyed extraordinarily robust profits growth, particularly during the 2020 Covid recession. But that allowed the tech cyclicals to continue in the pretence that they were also ‘Growth’ stocks by turning in a robust profit performance. An ordinary recession would put these ‘growth’ imposters to the sword, just as they were in 2001. Equity investors should think hard about the likelihood that higher energy prices and bond yields will trigger a ‘wholly unexpected’ recession. For that is where the biggest risk might lie for investors.
The comparison is complete with a misconceived Malthusian energy panic, growth boom coming off fast, and immense property bubble deflation underway (albeit in China not the US).
I still don’t think that a GFC is in the offing. But China’s property market is clearly in deep trouble and it is going to take years to chew through the monster bad debt load with a consequent step lower for growth.
Equities are priced for neither the energy and yield blowoff nor a growth collapse on the other side of it.