WEEKLY OUTLOOK - JULY 25, 2022

Finance

  • Author Keishaun D. Mark, Financial Economist
  • Published August 24, 2022
  • Word count 1,327

Going into this trading week, the charts are presenting a mixed picture, and that's ok. There isn't much conviction in financial markets which means sideways price action can be expected. Market participants are trying to build a narrative they can get behind, but there are so many moving parts to this current environment, that a consensus is difficult to find. This creates opportunities for traders and tactical investors, while creating headaches for economists and policy makers.

I like starting my analysis with the US Dollar because it makes a great proxy for international risk appetite. This particular insight is important when considering the 'flight to safety' narrative that emerges in times of global uncertainty. All that risk capital has to go somewhere, and usually in rapid succession.

Looking back a week, the dollar has been trending lower. This has corresponded with the beginning of US equities earning reports, which has seen stocks drift higher on mixed but somewhat positive earnings. I do believe however, that the dollar index hitting a Support/Resistance level on a 15-year chart has more to do with the reversal in the dollar than quarterly earnings reports. Additionally, the Federal Reserve is widely expected to increase its benchmark interest rates by another 75 basis points (0.75%) at the conclusion of its policy meeting this week. The dollar should experience some marginal appreciation from the rate increase as it is widely expected.

The real impact to the currency, I suspect, will be seen during and after the press conference when market participants get to gauge the Fed's level of hawkishness going forward. We can all agree that inflation is too high and needs to come down, but I think the Fed believes it needs to happen by any means necessary. This simply means rate increases until inflation comes down which benefits the dollar, and the subsequent recession will mean flight to safety trading which also benefits the dollar.

In times of uncertainty, when safety and liquidity are valued by investors, I look closely at the US10YR Treasury market for the insight it provides. Looking back a week, the US10YR has been trending higher, and that in itself is worth noting. As the Fed pushes up rates on the front end of the yield curve by selling bonds, investors are pushing rates down on the long end by buying bonds. These trends are colliding and resulting in an inverted yield curve, where short-term rates are higher that long-term rates. This is the bond market's way of signaling its expectations for a recession. Investors tend to buy treasuries for safety and dollars for liquidity in times of uncertainty, and to an investor nothing is more uncertain than a recession.

Gold is an interesting asset to track because it's never as relatively straight forward as the other asset classes. Sometimes the price of gold is influenced by industrial demand as it is used in manufacturing some electronic devices as well as jewelry. Sometimes the price of gold is influenced by inflation expectations of investors, as it is considered a long-term inflation hedge. Other times still, the price of gold in influenced by investors perception of liquidity in financial markets, as it is also considered a store of value. Finally, there are times when the price of gold is influenced by multiple factors, at different magnitudes.

In our current economic environment, the price of gold is predominantly being influenced by investor's expectation of inflation, followed by industrial demand. Central banks across the developed world led by the Fed are fighting inflation by raising interest rates. This has the direct effect (with some variable lag) of dampening demand by way of the labor market with rising unemployment. Less people working simply means less money to push up prices for goods and services (electronics and jewelry). Downward pressure on prices also means falling inflation and less of a need for investors to hold gold as a hedge.

Crude oil demand is fairly straight forward, as it is an essential industrial input. It factors into the obvious areas like transportation and energy, but also areas like food production and manufacturing. Easy to see why oil prices have such a direct effect on the inflation consumers experience. Like most other commodities markets, oil prices are a function of quantities supplied and demanded coming into equilibrium on any given trading day.

At the onset of Vladimir Putin's war with Ukraine in Q1, Russian oil accounted for roughly 10% of all US oil imports according to reporting by Bloomberg. Once the economic sanctions began against Russia, oil prices spiked on the assumption that Russian oil would be taken completely off the market. Prices subsequently fell as China and India continued to buy Russian oil which kept global supplies fairly stable. When the Fed went on the offensive against inflation in early Q2, the outlook for demand for oil started worsening as the risks to a global recession started increasing. OPEC+ and the other major oil producers globally are not committing to increasing supply as they have not been investing in production capacity in the most recent economic cycle. Therefore, the falling price of oil can mostly be explained by falling demand for the commodity, as economic activity slows in response to rising interest rates.

The equities story is one of hope. Hope that inflation has peaked, hope that the Fed can stick a 'soft landing', and hope above all else that the US consumer can remain resilient. Two of which seem unlikely, and the third doesn't mean what I think the markets think it means. Firstly, there's no historical example of the Fed sticking anything close to a soft landing when tightening monetary policy, and I don't see why this time would be any different. Secondly, the Fed's fight against inflation is a fight against the US consumer because their spending habits are pushing up prices. Therefore, by default the consumer cannot remain resilient as economic activity slows in response to higher interest rates.

Lastly, equity markets are hoping for a peak in inflation as they assume it means a shift in Fed hawkishness which could benefit earnings multiples. What is more likely to happen is the price increases experienced year-over-year will plateau, but prices should remain high relative to recent years. That's not a signal to the Fed to slow down, they need to get from accommodative policy to neutral policy, and on to restrictive policy to get consumer prices to actually fall. So, while current US corporate earnings reflect a resilient consumer thus far this year, the outlook going into the second half of the year is not as optimistic.

This pending recession will be the first real test of the viability of crypto as a 'Big Boy' asset class. To date, the crypto universe is trading in-line with other risk assets like stocks. A lack of fundamental data means analyzing crypto is a purely technical pursuit, and from a technical standpoint the trend is lower, and the strong positive correlation to equities supports that narrative. Monetary policy has been ultra-accommodative for more than a decade leading up to the current economic environment. That accommodation not only fueled higher asset prices, but also an exuberance among market participants that led to discounting risk. The Fed did an about turn and is now racing in the opposite direction to remove accommodation which is in turn dragging asset prices lower. The more losses investors have to realize, the more exuberance turns into pessimism, and the more of a weighting they assign to risk.

Consumers have been complaining about inflation while investors have quietly celebrated the appreciation in their portfolios. Now the Fed is leading central banks around the world down a path of higher interest rates to fight inflation to the short-term detriment of investors. But this too shall pass, and when it does there will be a myriad of new investment opportunities as the economy embarks on the next phase of the business cycle.

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At RunTheNumbers Financial Economic Consulting, we specialize in the intersection of economics and finance. Our focus is on the use and distribution of resources in markets where decisions are made under uncertainty. We evaluate how time, risk, opportunity costs and information create incentives or disincentives when developing strategic and tactical investment plans.

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