(Bloomberg) – A sell-off in the riskier corners of the market deepened as the UK’s plan to boost its economy fueled concerns about elevated inflation that could lead to higher interest rates, adding to fears of a global recession.
It was a sea of red over the stock trading desk as the S&P 500 briefly broke its June closing low — and failed to break its intraday low for the year. Chartists looking for signs of where the flight might be easing had identified this as a potential area for support. However, the lack of a full blown capitulation could be an indication that the drawdown is not over yet. Goldman Sachs Group Inc. lowered its target for US equities, warning that a dramatic upside in the interest rate outlook will weigh on valuations.
As risk aversion prevailed, Wall Street’s “fear gauge” rose to a three-month high, with the Cboe volatility index temporarily above 30. Throughout the year, the US equity benchmark hit short-term lows whenever the VIX traded above these levels, according to DataTrek Research.
A rise in the greenback to a new record swept global currencies aside. The euro slipped to its weakest level since 2002, while sterling hit a 37-year low – with former US Treasury Secretary Lawrence Summers saying “naïve” British policies could create the circumstances in which the pound rallied above the parity with the dollar could fall.
10-year government bond yields fell after previously exceeding 3.8%. Meanwhile, US two-year interest rates rose for 12 straight days — an uptrend not seen since at least 1976.
“It looks like traders and investors are throwing in the towel this week in what feels like the sky is falling,” said Kenny Polcari, chief strategist at SlateStone Wealth. “If everyone stops saying they think a recession is coming and accept that it’s already here – then the psyche will change.”
Liz Truss’ new British government implemented the biggest tax cuts since 1972 at a time when the Bank of England is struggling to contain inflation, which is nearly five times its target. The plunge in gilts means investors are now betting on the central bank raising interest rates by a full point to 3.25% in November, which would be the sharpest hike since 1989.
Read: Powell says economy may be entering a ‘new normal’ post-pandemic
Commodities came under pressure across the board amid heightened fears of a hard economic landing. West Texas Intermediate settled below $79 a barrel for the first time since January and has posted its longest stretch of weekly losses this year. Even gold – a safe haven asset – failed to gain on a rising dollar, falling to its lowest level in two years.
The greenback’s strength has been relentless and will also put “significant pressure” on corporate earnings — which will be a major headwind for equities, said David Rosenberg, founder of his eponymous research firm.
KKR & Co. sees potential trouble ahead, including a mild recession next year, with the Fed narrowly focused on raising unemployment to tame inflation. The U.S. labor shortage is so severe that it’s possible the Fed’s tightening won’t work, wrote Henry McVey, chief investment officer of the company’s balance sheet.
“This is a more draconian outcome than falling corporate earnings,” he noted, “because it will encourage the Fed to tighten even more.”
Investors are flocking to cash and avoiding almost all other asset classes because, according to Bank of America Corp. become the most pessimistic since the global financial crisis, Michael Hartnett wrote in a note.
“It’s a recognition that interest rates will continue to rise here and that will put pressure on earnings,” said Chris Gaffney, president of world markets at TIAA Bank. “Valuations are still a bit high even though they have fallen, interest rates have much more to rise and what impact will that have on the global economy – are we headed for a deeper recession than everyone expected? I think it’s a combination of all of that, it’s not good news.”
Extreme pessimism
Indeed, stocks are still a long way from obvious bargains. At the June low, the S&P 500 was trading at 18 times earnings, a multiple that beat valuation lows in all of the previous 11 bear cycles, data compiled by Bloomberg shows. In other words, should stocks recover from here, this bear market bottom would have been the most expensive since the 1950s.
Gloomy sentiment is often viewed as a contrarian indicator for the US stock market, assuming that extreme pessimism could portend better times. However, history suggests stock losses could accelerate even further from here before the current bear market ends, according to Ned Davis Research.
In another threat to equities, various iterations of the so-called Fed model, which compares bond returns to equity returns, show that equities have been the least attractive relative to corporate and government bonds since 2009 and early 2010 respectively. This signal catches the eye of investors who can now look to other markets for similar or better returns.
The notion that companies with rock-solid balance sheets at least offer solid payouts is crumbling. The pool of S&P 500 companies whose dividends bring in more than cash has plummeted 70% this year.
“The next question is when and how far earnings estimates for 2023 go back,” said Ellen Hazen, chief market strategist and portfolio manager at FL Putnam Investment Management. “The earnings estimates for next year are too high, they really haven’t come down, and when that happens you’re going to have more equity pain because on top of the multiple going down through the yield mechanism you’re applying the earnings, there’s going to be several coming down as well.”
As slower growth and tighter financial conditions begin to catch up with companies, a wave of downgrades will come for the US investment grade corporate bond market.
So say strategists at Barclays Plc, who say companies are under pressure on margins due to high inventories, supply chain issues and a strong dollar. The company expects the average monthly downgrade volume to grow to $180 billion in bonds over the next six months. The current monthly average is closer to $40 billion.
Read: Private equity writedowns spur increased SEC scrutiny
Some of the key movements in the markets:
Stocks
- The S&P 500 was down 1.7% as of 4 p.m. New York time
- The Nasdaq 100 fell 1.7%
- The Dow Jones Industrial Average fell 1.6%
- MSCI World Index fell 2.1%
currencies
- The Bloomberg Dollar Spot Index rose 1.3%
- The euro fell 1.5% to $0.9693
- The British pound fell 3.5% to $1.0868
- The Japanese yen fell 0.6% to 143.30 per dollar
cryptocurrencies
- Bitcoin fell 2.2% to $18,823.63
- Ether fell 2.4% to $1,292.77
Bind
- The 10-year government bond yield fell four basis points to 3.68%
- The 10-year German government bond yield rose six basis points to 2.02%
- The 10-year UK government bond yield rose 33 basis points to 3.83%
raw materials
- West Texas Intermediate Crude fell 5.3% to $79.06 a barrel
- Gold futures fell 1.7% to $1,651.80 an ounce
©2022 Bloomberg LP
