The way I see this bear market playing out is in 3 phases. The good news is we’ve already been through the first phase. That was the first 6 months of the year that saw the S&P500 in the US down 20% and the NASDAQ down 30%. The first phase was all about inflation driving interest rates up and the subsequent one-off re-rating of asset prices that followed. In that situation there is no recovery or bounce back per se, it was an adjustment due to the mathematics involved in valuing assets. Higher interest rates mean lower asset values. In simple terms that 20% fall was the result of interest rates moving from 0% to 3%.
That was phase 1.
Phase 2 is all about what happens over the next 6 months. I’d separate this phase into 2 parts. The first part is all about the downgrades in company earnings we can expect during that time. How severe those downgrades are will determine how markets perform next. Many institutions haven’t updated their forecasts for specific company earnings or entire sectors simply because of how difficult forecasting has become in the last few months given all the volatility in the world. From the price of commodities through to the impact of unprecedented currency moves, these will all impact company earnings.
You only need to look at the price of oil to see just how difficult forecasting is right now. You can find forecasts from leading investment institutions that range from $65 a barrel to $380 a barrel and anywhere in between. The thing is both ends of the extreme are plausible within the context of the scenarios outlined with competing forces of recession risk versus chronic underinvestment in an essential commodity. Currency is another issue. The continued strength of the US dollar as capital moves to perceived strength and stability is starting to reverberate across the world. The Euro is basically at parity with USD now and the Yen has plummeted against the dollar.
Earnings season in the US for Q2 begins at the end of the week and over the next several weeks will provide a glimpse into the real impact all these variables are having on businesses’ bottom lines. In Australia, we will see companies reporting their full year results in August. How earnings look this quarter and the next two will really dictate how deeply the slowdown is going to bite and how quickly markets stabilise. The issue has been compounded by companies becoming increasingly reluctant to provide earnings guidance along the way due to the unpredictable nature of the current business environment. But that only makes the situation worse when the actual results come in below expectations and analysts are caught off guard and need to adjust quickly and dramatically.
The second part of phase 2 is all about the potential for shocks to the system in the next 6 months. There are mini disasters everywhere in the world right now and we only need one to spiral out of control to send the financial world into a panic. It could be a currency break down or a bigger country with a Sri Lanka type problem, an energy shock, or a genuine black swan event. But there are just so many more issues than normal bubbling below the surface that I don’t think markets are adequately weighing the risk of something breaking. Every one of these machinations has a consequence and it won’t take much for something to break and create a more severe dislocation in markets.
In that mix of variables, we’ve got a US inflation report out tonight and the Nord Stream 1 gas pipeline between Russia and Germany being closed for 10 days for annual maintenance. There are real fears that Russia may not turn the gas back on. I think this is a real threat and if it comes to pass would cripple both the German and European economies. Regardless of timing, it remains a threat to Germany’s economy, and by extension Europe’s until they have removed their reliance on Russian energy.
Phase 3 covers the first 6 months of 2023 and will be all about where interest rates finally settle as we head into the new year. For many months markets have assumed about a 3% Fed/RBA rate. Once we come out the other side of the earnings adjustments the next question will be, where do rates end up? The risk being that Central Banks increase rates much further than needed for fear of being out of line again. Happens every economic cycle. My view is that Central banks will be forced to raise higher for longer to extinguish inflation and to ensure that it does not return as it did in the 70s and 80s. That’s going to be difficult if the world exits phase 2 in a recessionary environment.
So, the next 6 months will be critical for investors, and I will be pleasantly surprised if company earnings prove to be resilient. However, if consumer spending falls off a cliff, which I do expect, then businesses will be in for a tough time. It’s impossible for the average household to maintain their usual discretionary spending when they are being hit with massive hikes in mortgages, fuel, energy, and groceries simultaneously. There’s simply less money to spend on everything else. Companies are going to notice it. If not this quarter certainly in the next 2. Almost everyone will need to tighten their belts and make hard choices about their discretionary spending.
I would expect within the time frame of phase 2, between now and the end of the year, we are going to see markets really start to work out the magnitude of the issues at play. I expect the market to fall further and find a bottom in that time and that the investment opportunities we have been waiting for will come sooner rather than later.
General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.