Markets are looking for answers

The short term outlook for the Australian share market is, at best, uncertain. This is because there are simply too many conflicting factors to pay attention to.

Last week's selling pressure on equities was caused by a general reset in bond markets following ongoing higher-for-longer signals from the Federal Reserve. When bond yields move higher, as the market prices out expected rate cuts in 2024, the direct impact is a lower valuation for equities, with some sectors harder hit than others.

This impact from left field bonds does not address the fact many an expert believes US equities in particular seem overvalued, as also explained in last week's update. Here the extra-complicating factor is that much of today's "overvaluation" can be traced back to those seven megastocks that are also responsible for most of this year's gains.

One could conclude from this there's no need to worry, assuming this apparent excess will be addressed shortly, as long as there's no direct exposure in the portfolio to the so-called Magnificent Seven, but history suggests it's unlikely to be this simple. If the likes of Apple, Microsoft and Nvidia were to pull back significantly to much lower valuations, the rest of the US market, as well as equities around the world, might simply join in on the new trend.

The risk for a deeper, broad pull back in equities has arguably become a lot more likely over the past few weeks. The local share market already corrected in excess of -4% in August, only to subsequently rally into the final week of that month. On Friday morning, -4% looked yet again on the cards for September, until the market bounced back strongly.

These moves have damaged the underlying trend signals with many a technical analyst now exclaiming global equities look "ugly" and "vulnerable" from a pure technical perspective. Seasonally, the calendar has now moved into what usually turns out is the weakest time of the year, and it generally lasts until late into October, sometimes longer.

And we haven't even touched upon the most obvious risk that is now emerging on the horizon: the next shutdown of the US government. We can all thank the broad and general disintegration of US politics for it, but the odds are very much in favour of no agreement being reached in Congress, which will deprive the Biden government of sufficient means to keep paying its bills and liabilities.

So far, not a single one of the 12 annual appropriation bills required to fund government agencies has been passed by Congress. Assuming no agreement, this impacts on roughly 25% of all government outlays. Luckily for America, spending on most major government transfer programs like Social Security, Medicare, unemployment benefits, as well as payments for interest on government debt continue during a shutdown.

Exactly how markets will respond is anyone's guess, but I'd wager major rallies remain off limits for the time being, at least until we see a conclusive political resolution on Capitol Hill.

The past decade has presented investors with two similar precedents, with prior shutdowns occurring in 2018/19 and in 2013. Both shutdowns were different in duration and impact.

The shutdown in 2018/19 lasted an eternity (at 34 days it was the longest on record) but as Congress had already passed five of the 12 spending bills, 75% of all discretionary spending had been covered. In contrast, the 2013 shutdown was shorter, but that was a full shutdown causing much larger impact immediately.

Given today's set-up looks similar to 2013's, it's probably safe to assume America might be facing yet another full government shutdown. Oxford Economics estimates some 900,000 of a total 2.3m workers could potentially be furloughed, but all workers go without pay until the shutdown ends.

As the economists explain, federal workers have always received back-pay to cover the period of the shutdown, but Congress does have to pass legislation to ensure that happens. Not all of the temporary impact on spending, by workers, businesses and the government itself, will be reversed later on.

Another consequence might be that the release of indicators and economic data by the Bureau of Labor Statistics will no longer happen. The current deadline passes on September 30th.

Rising bond yields, ugly-looking weakening technicals, seasonal headwinds and a looming US government shutdown; you'd think there's enough to keep investors on edge for the weeks ahead, but there's more:

-still uncertain what China's outlook looks like;
-ongoing strikes at American automakers;
-the resumption of student loan repayments;
-the end of post-covid childcare support payments by the US government;
-oil and gas prices are on the rise too.

The latter is a direct consequence of key producers Saudi Arabia and Russia keeping a lid on supply in order to keep the global energy market tight. In today's bifurcated world, it can also be seen as a deliberate strategy to hurt America economically, or even as a targeted erosion of Joe Biden's chances for re-election.

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Last week's bond market reset also serves as a reminder to investors the path to sustainably lower inflation numbers does not equal a down-sloping straight line and central bankers remain hellbent on not repeating the mistakes made during the 1970s when shifting too early from tightening to loosening reinvigorated inflation.

Having criticised central banks for their misguided policy and forecasts throughout 2021 and 2022, and subsequently ignored their messaging and priced in rate cuts soon after the peak in official rates, bond markets have now fallen in line with official Fed forecasts of higher-for-longer interest rates.

It would appear, at face value, direct inspiration has been taken from the so-called dot plots; median forecasts for where the decision makers at the Federal Open Market Committee (FOMC) see the official cash rate into the future. This has economists scratching their head as the irony here is, even by the Fed's own messaging, these dot plots are not meant to be actual "forecasts".

Needless to say, part of the rebuke from economists around the world now consists of historical comparisons between Fed dot plots and what actually happened next. Spoiler alert: the dot plots are pretty much useless beyond the immediate outlook. The further one moves into the future, the wider the gap with actual rates at the times projected.

Conclusion: irrespective of the bond market moves in September, we should not discount the possibility of central banks cutting rates next year. Admittedly, inflation remains a very important discussion point in this debate, and resilient economies in combination with above-target inflation readings make the latest response from bonds quite logical.

But it does call into question the Goldilocks scenario that is underpinning current market moves. Rising bond yields, as pointed out by economists last week, add more tightening even if the Fed doesn't lift the official cash rate. More pricey oil, while inflationary, also adds more pressure on spending abilities of households and businesses.

The translation of these factors combined means the odds are currently moving more in favour of economic recessions and rate cuts next year because the bond market is projecting the opposite this month. Life is full of such ironies, finance included.

Meanwhile, in the background of all of this, short positions in US bonds have risen to a mountain in contracts seldom witnessed in history. This suggests a trend reversal, whenever it arrives exactly, can be swift and violent. Central bankers will be worried about the potential for unintended ramifications.

I was also yet again reminded recently the market's obsession with a "soft landing" is simply history repeating, over and over again. A recent survey of the Wall Street Journal archives has found references to "soft landings" for the US economy tend to peak in the lead-in to the next economic recession.

Previous peaks have been registered for 2006/07, for 2000/01, 1995, and 1989. What all these past peaks have in common is that a recession eventually did follow, albeit not necessarily immediately.

For investors, I think the important message is not to get too carried away with the market's narrative of the day. What might seem like the fresh new gospel one day, can just as easily become tomorrow's self-inflicted joke.

The most plausible scenario, I continue to believe, is that economies continue to lose momentum on the back of tight monetary policies and other restraints on consumer spending. Whether they'll also suffer from "recessions", deep or mild, might just be a matter of measurement and methodology.

In terms of underlying market direction, share markets have tried to respond to multiple opposing influences through rotations in and out of opposing segments, which has kept the interest alive of short-term oriented day traders, but much less so of disappointed and frustrated investors who'd like to see trends and gains stick for longer.

As we approach the final quarter of calendar year 2023, multiple rallies and retreats, and rotations in and out of this segment and that section, has left the ASX200 with virtually no gain for the year, except for dividends paid out.

Until we see a clear positive path emerging for the economy in the US and elsewhere, or at least significantly less risks and uncertainties, the picture from the recent months may not look fundamentally different in the time ahead.

Depending on one's patience, specific strategy and appetite for risk, it may simply be prudent to have cash on the sideline. Who knows when or where that next opportunity might show up?

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