Market bounce but no bottom in sight

Since mid-June there has been a powerful rally in global stock markets. The idea that the US Federal Reserve might have turned dovish combined with a US earnings season that contained few negative surprises has juiced share prices.

The question on investors’ minds is: is this a sign of the market turning, or just a countertrend move in a bear market? For holders of Australian shares, the current reporting season adds spice.

With the tone set by politicians and central bankers, war in Ukraine and supply chain disruption have dominated the debate over the direction of inflation. Whilst these have been central to an understanding of ballooning headline prices, the driver to core inflation is services. And it is consumption that drives services, not war, not supply chains.

For the first time in a generation the labour market is tight. Participation rates and unemployment are low, there are many more job openings than workers available, and the risk of a wage spiral is live. 

In this context, it is audacious to assume the Fed has or will imminently move to a stance more supportive of financial markets.

Inflation is not the only area of uncertainty. Whilst we are confident that the outlook for earnings is poor, it is challenging to say exactly how bad things might become and for how long. Nevertheless, certain recognised relationships between economic measures provide clues.

For example, the ISM manufacturing index, a leading economic indicator, tends to lag inverted 10-year bond yields by about 18 months. The ISM in turn, runs ahead of moves in corporate earnings by about three months.

If these relationships hold, US profitability may not trough until the second half of 2023 and at a level considerably below current forecasts – the ISM’s relationship with inverted bond yields is not just in terms of direction but also magnitude.

Perhaps this has always been the case, but when it comes to weighing political against economic interests, politics is trumping economics.

We believe that we are seeing a rally in a bear market rather than something more sustainable. But we have also been around long enough to know that anything can happen, in which case we would encourage investors to build a portfolio that is robust in a range of outcomes – the founding principle of diversification.