Are equity markets or bond markets wrong?

-On February 6^th two massive earthquakes of 7.7 and 7.5 magnitude hit eastern Turkey. It created unprecedented destruction in the region as well as in Syria with the human toll over 45,000 dead at the time of writing this article. There are many many more missing. That means the numbers will only rise in the coming days, but no one knows by how much. Given the extensive loss of life and property damage, we wish Turkey, Syria and everyone who have lost their loved ones our deepest condolences.

 –Similar to earthquakes, short of a crystal ball, it is almost impossible to forecast the market moves with certainty especially over longer time frames. One can perhaps approximately predict the returns of a couple of assets over a specific period but not all markets over different time horizons. Yet that doesn’t deter investors from trying. They keep guessing continuously and fail over and over again.

 –Markets are trying to figure out how everything will unfold not just in equities but in other asset classes such as bonds, currencies, commodities and even alternatives. There doesn’t seem to be consensus amongst them either. You can easily observe this disconnect if you just compare what is priced into the US bond markets vs. the equity markets.

 –While the US yield curve was upward sloping by end of 2021, as of February 24^th it is inverted or sloped downwards. This means the short term interest rates are higher than the long term ones. In other words, the bond markets are expecting somewhat of a recession or economic slowdown over time. The short end is generally driven by the Fed funds rate. The longer end of the yield curve which is driven by the bond markets’ expectation of nominal rates and inflation in the future are lower than the short term ones which means rates are expected to decline over time. 

 –Bond markets expect the Fed rates to remain elevated for a little while, then expect the inflation to eventually drop in the long run. The recent US data pointed to a still hot labour market which means inflation may not slow down as fast as expected or at all. Naturally, once the data was out the Fed officials started to talk about a 0.5% rate hike at their next meeting on March 22^nd as opposed to 0.25% which is what the markets were originally betting on. In fact, there was even some expectation of a rate cut this year. Now looking back, this change in market sentiment sounds totally unexpected.

–As we noted in our previous issues, given the difficulty in predicting inflation, the markets could be in for a surprise regarding how sticky the inflation may be. The bond markets appear to have adjusted to this reality of a potentially persistent inflation. However, equity investors still seem a bit too optimistic under the circumstances. As of February 24^th the global equity indicator MSCI All Country World Index (ACWI) and the emerging market index MSCI EEM were both up on the year 3.9% and 4% respectively. As for the US equity index SP500 that is also up 3.4% on the year. These are moves that sometimes happen over a year.

 –Equity markets not only priced in the slowing inflation, but also the rate cuts which would naturally boost the economy… except they seem to be skipping the part about the reason for the rate cuts, which is an economic slowdown. According to equities, inflation will just magically disappear and without any economic slowdown Fed will shift gears into the rate cuts.

–Same as in January crypto markets continued to be one of the biggest beneficiaries of this positive equity market sentiment. As of February 24^th Bitcoin and Ethereum were up 39.7% and 33.6% respectively year to date. Part of this spike in crypto is in part due to the negative sentiment surrounding the FTX blow up somewhat dissipating as markets gained more clarity regarding the extent of the losses in FTX.

 –Despite having a phenomenal 2022 with a 194% return in Turkish Lira (109% in US dollar basis), Turkish stocks continued their slide with -8.2% return in local terms (-9% in US dollar basis) as of February 24^th. A big driver of the drop was the massive earthquake that is estimated to have caused close to $80 billion in damages, though the actual amount is yet to be determined. In the meanwhile the Turkish Lira continued its downward trajectory with -0.9% loss against the greenback over the same period.

–The relief rally commodities enjoyed in January on the back of China reopening reversed in February. Winter in Europe and North America turning out to be softer than expected has weighed on the crude oil prices.This was offset by Russia declaring an unexpected production cut starting in March, albeit only to a limited degree. Indeed, as of February 24^th first month futures contract for US crude oil WTI was down by -5% year to date.

 –After a directionless 2022, gold had finally started to show some sign of life in January delivering 6.5% return. However, the gain in gold was quite short lived as gold gave back its entire gain in January and dropped by 6.6% in the first three weeks of February. This month is another beautiful reminder of the fact that there is no perfect investment for investors. There is only perfect portfolio construction. Investors who don’t put their eggs in one basket and instead diversify their portfolios and their risk will be the ultimate winners in the marathon of investing.

Every month we aim to shine some light on what shocked or surprised the global financial markets and what that could mean for investors. In keeping with the same spirit, this month we would like to open up with discussing another major and unexpected shock, one that has caused not only economic devastation but also unimaginable tragedy given the colossal loss of life it triggered.

On February 6^th two massive earthquakes of 7.7 and 7.5 magnitude hit eastern Turkey. It created unprecedented destruction in the region as well as in Syria with the human toll over 45,000 dead at the time of writing this article. There are many many more missing. That means the numbers will only rise in the coming days, but no one knows by how much.

Apart from the substantial loss of life, this is one of the largest earthquakes in the region. Just to put it into perspective, in the 1906 San Francisco earthquake that is considered one of the most severe earthquakes historically, the fault line break was 400 km whereas in this case it was 500 km.

It is also unique in the sense that it was not just one but two separate and major earthquakes just nine hours apart, which is considered very rare. To put the damage into perspective, while an earthquake with 6 magnitude creates energy equivalent to 1 atomic bomb, a 7.7 magnitude one creates energy equivalent to over 130 atomic bombs. Now imagine two of those in the same area in one day and imagine the combined level of damage.

The other bizarre fact was that the two earthquakes were only 8.6 and 7 km below the surface whereas other famous earthquakes have been much deeper. For example the one in Japan in 2011 that caused the massive tsunami thereafter was 25 km deep, making these recent earthquakes exponentially more destructive and therefore more deadly.

Given the extensive loss of life and property damage, we wish Turkey, Syria and everyone who have lost their loved ones our deepest condolences.

 IT IS IMPOSSIBLE TO FORECAST MARKET MOVES

Now back to the markets. Similar to earthquakes, short of a crystal ball, it is almost impossible to forecast the market moves with certainty especially over longer time frames. You can perhaps approximately predict the returns of a couple of assets over a specific period but not all markets over different time horizons. It is virtually impossible.

Yet that doesn’t deter investors from trying. That is because it is in our nature to want to reduce ambiguity around us. We are wired to want to be in control of our environment and our future. As a result we constantly hazard a guess about what the future holds… and we generally fail. This is exactly what the markets have been doing regarding inflation. They keep guessing continuously.. and they fail over and over again. Even more interestingly, it is not like they just miss the actual numbers; they fail with a sizable margin of error. Why? Well, because they do not have a crystal ball that can show them the future.

As you may remember in our previous issue we noted the investors’ dilemma going into 2022 as follows:

“ …many investors got burned in 2022. For this very reason, investors are keen to get a sense of how they should be positioning their portfolios, and right now it all seems to depend on the path of inflation. Yet inflation seems elusive…..and the developed market central banks, particularly the US Central Bank (FED) has not been great at forecasting inflation. In fact, they have been really bad at it, so Fed decided they would make decisions “meeting by meeting”. They of course reiterated their resolution to stump out inflation as well. This means there will likely be more market volatility than before as the markets will try to “guess” which data FED is going to focus on and how they will interpret them, which is more of an art than science.”

This is exactly what the markets are doing; they are trying to figure out how everything will unfold not just in equities but in other asset classes such as bonds, currencies, commodities and even alternatives. There doesn’t seem to be consensus amongst them either. You can easily observe this disconnect if you just compare what is priced into the US bond markets vs. the equity markets.

Let’s start with bonds and the best gauge for that is the US yield curve.

Source: Bloomberg, EKR Total Portfolio Advisory

BOND MARKETS ARE EXPECTING A RECESSION

Above is how the US yield curve has changed over time. While it was upward sloping by end of 2021, as of February 24^th it is inverted or sloped downwards. This means the short term interest rates are higher than the long term ones. In other words, the bond markets are expecting somewhat of a recession or economic slowdown over time.

To understand what that means, let’s first look at the short end of this curve. The short end is generally driven by the Fed funds rate. Now if you look at the 6 month rate on the curve, it is 4.9%. This is slightly higher than the current Fed funding rate of 4.75% which was set on February 1^st. The 12 month rate sits almost at 4.75% same as the Fed rate. What the bond market is saying is that the Fed is expected to keep raising the rates and not drop below the current level over the next 12 months.

Let’s now look at the longer end of the yield curve which is driven by the bond markets’ expectation of nominal rates and inflation in the future. These numbers are lower than the short term ones which means rates are expected to decline over time.

For example, as of February 24^th the bond markets expected the nominal rates (nominal rate = real rate + expected inflation) over the next 10 years to be at 3.95%, which is the 10 year rate on the yield curve. Now you may be wondering how much of that 3.95% is the inflation expectation. We can easily calculate that by using the US 10 year Treasury Inflation-Protected Securities (TIPS) which represent the real rates. 10 year TIPs was at 1.57% as of February 24^th. Therefore the market’s 10 year expected inflation is at 2.38% (3.95% – 1.57%). This is slightly above Fed’s target of 2% annual inflation.

BONDS ALSO EXPECT FED RATES TO REMAIN HIGH

All of this in basic English means bond markets expect the Fed rates to remain elevated for a little while, then expect the inflation to eventually drop in the long run. This sounds pretty reasonable right? After all, Fed has been saying exactly that. That is they are not done until they beat inflation, and they are not sure when that will be but we are told they are “strongly committed to fighting inflation” as Federal Reserve Chair Jeremy Powell put it couple times.

The recent US data is not showing sign of slowing inflation. US labour market data that was released on February 3^rd showed the US unemployment now dropped further to 3.4%, a 53 year low. Nonfarm payrolls, an indicator of job market, was also much higher than expected. This all pointed to a still hot labour market which means inflation may not slow down as fast as expected or at all. Indeed, the data released on February 14^th showed exactly that. The headline consumer price index was up by 6.4% while the core CPI that excludes energy and food prices was up 5.6% over the last 12 months, both higher than what the markets anticipated.

Naturally, once the data was out the Fed officials started to talk about a 0.5% rate hike at their next meeting on March 22^nd as opposed to 0.25% which is what the markets were originally betting on… or should we say they were hoping for? In fact, there was even some expectation of a rate cut this year. Now looking back, this change in market sentiment sounds totally unexpected, right?

INFLATION MAY BE A BIT STICKY

As a matter of fact it is not unexpected at all. As we noted in our previous issues, given the difficulty in predicting inflation, the markets could be in for a surprise regarding how sticky the inflation may be. That is turning out to be the case.

The bond markets appear to have adjusted to this reality of a potentially persistent inflation. However, equity investors still seem a bit too optimistic under the circumstances. As of February 24^th the global equity indicator MSCI All Country World Index (ACWI) and the emerging market index MSCI EEM were both up on the year 3.9% and 4% respectively. As for the US equity index SP500 that is also up 3.4% on the year. These are moves that sometimes happen over a year.

EQUITY INVESTORS MAY BE VERY DISAPPOINTED

What is the source of all this excitement in equities? They not only priced in the slowing inflation, but also the rate cuts which would naturally boost the economy… except they seem to be skipping the part about the reason for the rate cuts, which is an economic slowdown. According to equities, inflation will just magically disappear and without any economic slowdown Fed will shift gears into the rate cuts. It does sound a bit like a fairy tale, doesn’t it?

And even if equities are right, which is a big if, you can’t have both bonds and equities be right simultaneously. This means some investors will be sorely disappointed with their investments… and the current indicators seem to be pointing to equities.

CRYPTO MARKETS CONTINUE TO BENEFIT FROM POSITIVE SENTIMENT

 Same as in January crypto markets continued to be one of the biggest beneficiaries of this positive equity market sentiment. As of February 24^th Bitcoin and Ethereum were up 39.7% and 33.6% respectively year to date. Part of this spike in crypto is in part due to the negative sentiment surrounding the FTX blow up somewhat dissipating as markets gained more clarity regarding the extent of the losses in FTX.

TURKISH STOCKS SLIDE DUE TO THE EARTHQUAKE 

Despite having a phenomenal 2022 with a 194% return in Turkish Lira (109% in US dollar basis), Turkish stocks continued their slide with -8.2% return in local terms (-9% in US dollar basis) as of February 24^th. A big driver of the drop was the massive earthquake that is estimated to have caused close to $80 billion in damages, though the actual amount is yet to be determined. In the meanwhile the Turkish Lira continued its downward trajectory with -0.9% loss against the greenback over the same period. It might be an interesting and volatile period for investors in Turkey if the Presidential election originally targeted for mid-May indeed goes ahead. If the elections are pushed back, it might provide a bit more stability and support to the Turkish markets given how markets tend to prefer the status quo.

JANUARY RELIEF RALLY IN COMMODITIES REVERSED IN FEBRUARY

The relief rally commodities enjoyed in January on the back of China reopening reversed in February. Winter in Europe and North America turning out to be softer than expected has weighed on the crude oil prices. This was offset by Russia declaring an unexpected production cut starting in March, albeit only to a limited degree. Indeed, as of February 24^th first month futures contract for US crude oil WTI was down by -5% year to date.

After a directionless 2022, gold had finally started to show some sign of life in January delivering 6.5% return. Part of it was driven by the strong global central bank demand for the precious metal since the increasing interest rates started to put a dent in the US Treasury returns. Gold price was also supported by the demise of crypto prices, which is gold’s biggest contender. However, the gain in gold was quite short lived as gold gave back its entire gain in January and dropped by 6.6% in the first three weeks of February. This was partially due to the strong comeback in crypto currencies. As a result, as of February 24th the first month futures contract for Gold was down by -0.5% year to date.

NEXT PERIOD MAY BE VERY PAINFUL FOR SOME

Even though the bond markets appear to be catching up to the sticky inflation issue, equity investors still seem to be wishfully thinking that inflation is no longer a problem. The next couple months will tell which investors got it right. Naturally it will prove to be very painful for those who didn’t.

This month is another beautiful reminder of the fact that there is no perfect investment for investors; there is only perfect portfolio construction. As we always reiterate those investors who don’t put their eggs in one basket and instead diversify their portfolios and their risk will be the ultimate winners in the marathon of investing.

ELA KARAHASANOGLU, MBA, CFA, CAIA

International Finance Expert

karahasanoglu@turcomoney.com

ela.karahasanoglu@ekrportfolioadvisory.com

https://www.linkedin.com/in/elakarahasanoglu/