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-US labour market data that was released on May 5^thshowed the US unemployment dropped back to 3.4% from 3.5% the previous month, once again hitting a 53 year low. Nonfarm payrolls, an indicator of the health of the 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. Indeed, the data released on May 10^th showed exactly that.

–Given the resilient economic conditions and the sticky inflation, the US Central Bank FED, moved forward with its cautious hawkish tone on May 3^rdand delivered a 25 bps increase. This marked its tenth rate hike bringing FED’s official rate to 5.25% as widely expected by the market. What really riled the markets up was the fact that FED signalled a pause in hikes to take a breather so that they could observe the impact of their of their monetary tightening on the US economy.

–Complicating the matters further is the fallout from the bank failures that unfolded in early March. As suspected the banking issues have translated into tighter credit conditions which can potentially double down on the effect of what FED has been aiming to achieve through its quantitative tightening. After all, there is a risk that too much quantitative tightening may simply backfire and push the seemingly resilient economy over the edge.

–FED has been saying they are not done until they beat inflation. Yet, given they have gone from 75 bps rate hikes all the way down to 25 bps hikes and are even thinking of pausing, shouldn’t the long term nominal rates come down? They should. Yet markets expect not just the FED rates or inflation but also the nominal (or bond) interest rates to remain elevated all the way into the future.

–Turkish stocks continued to slide with -16.9% loss in local terms (-22.1% in US dollar basis) as of May 26^th. A big driver of the drop was the massive earthquake on February 6^th that has caused major damage. The elections that took place on May 14^th and May 28^th also weighed on the Turkish markets. Exacerbating the losses in equities in US dollar terms was the fact that Turkish Lira continued its downward trajectory with -6.3% loss against the greenback since the end of 2022.

–In May crypto markets lost some steam due to ambiguity around inflation and the rate hikes and as a result gave back some of its earlier gains. As of May 26^th Bitcoin and Ethereum were down by -8.8% and -3.2% respectively. While the losses could be considered sizeable compared to equity and bond markets, given the higher volatility in crypto currencies, the negative returns made only a small dent in their year to date returns with Bitcoin still up 61.8% and Ethereum 52.8% up on the year.

–Even though crude oil recovered partially due to a possible OPEC+ production cut, it was down in May. As of May 26^th first month futures contract for US crude oil WTI was down by -5.3% on the month bringing its loss to -9.5% year to date. Winter in Europe and North America turning out to be softer than expected has continued to weighed on the crude oil prices since late last year.

–Gold fared better than crude oil in May as well as on the year. As of May 26^th the first month futures contract for Gold was down by -1.8% on the month and managed to hold onto its gains from earlier in the year delivering 9.6% return year to date. Gold prices have been partially buoyed by the strong global central bank demand for the precious metal since the higher rates put a dent in the US Treasury returns.

In April and May markets took a hiatus from various major drama that had kept them on their toes since early 2022. That said, it was by no means an uneventful period given financial markets are always in constant flux. Indeed, there were some rather positive economic news and FED activity that augmented the optimistic sentiment in equities. Bonds on the other hand remained in disagreement with equities which kept the US yield curve inverted (that is shorter term yields being higher than longer term yields). A closer look at the recent financial news explains why.

US UNEMPLOYMENT HIT A 53 YEAR LOW 

Let’s start with the recent US economic data which didn’t show any signs of a slowdown. To the contrary, data showed that parts of the economy were still hot. US labour market data that was released on May 5^th showed the US unemployment dropped back to 3.4% from 3.5% the previous month, once again hitting a 53 year low. Nonfarm payrolls, an indicator of the health of the 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. Indeed, the data released on May 10^th showed exactly that. The year on year headline consumer price index was up by 4.9% vs. 5% the previous month while the core CPI that excludes energy and food prices was up 5.5% vs. 5.6% the previous month. Inflation indeed seemed to be coming down, but rather slowly.

Given the resilient economic conditions and the sticky inflation, the US Central Bank FED, moved forward with its cautious hawkish tone on May 3^rd and delivered a 25 bps increase. This marked its tenth rate hike bringing FED’s official rate to 5.25% as widely expected by the market. What really riled the markets up was not the rate hike though. It was the fact that FED signalled a pause in hikes to take a breather so that they could observe the impact of their of their monetary tightening on the US economy. This wasn’t at all unexpected. It is not a secret that FED is not good at forecasting inflation and given every economic cycle is slightly different, it is impossible to forecast how effective the monetary policy will be.

BANKING ISSUES TRANSLATED INTO TIGHTER CREDIT CONDITIONS

Complicating the matters further is the fallout from the bank failures that unfolded in early March, which we discussed in great length in our April issue. As suspected the banking issues have translated into tighter credit conditions which can potentially double down on the effect of what FED has been aiming to achieve through its quantitative tightening. After all, there is a risk that too much quantitative tightening may simply backfire and push the seemingly resilient economy over the edge. The final impact is hard to know until the higher rates have a chance to work their way through the economy which is exactly why FED is getting increasingly cautious with its monetary policy.

At least one market really liked FED’s signal to potentially pause; equities. Similar to earlier in the year, not only equities continued pricing in the slowing inflation, but also potential future rate cuts which would naturally boost the economy. Stronger than expected US corporate earnings, particularly in technology sector, simply added fuel to the fire despite the ongoing ambiguity around whether the US Congress will reach an agreement to raise the debt ceiling or not. As of May 26^th the US equity index SP500 was up 9.5% on the year while NASDAQ, the gauge for technology stocks, was up by a whopping 24% over the same time frame. The global equity markets benefitted from the rally in the US. The global equity indicator MSCI All Country World Index (ACWI) and the emerging market index MSCI EEM were both up 9.2% and 2.9% respectively.

BONDS EXPECT FED RATES TO REMAIN HIGH

Interestingly though the US bond market is still disagreeing with the equity markets. Similar to earlier in the year, bonds still expect the FED rates to remain elevated for some time, and then expect the inflation to eventually drop in the long run but very very slowly. To get a better sense of how the market sentiment changed in rates let’s take a look at how the bond markets’ 5 and 10 year inflation expectations moved since late 2021 as illustrated in the chart below. The data points are calculated using the US yield curve which represent the nominal rates and the US Treasury Inflation-Protected Securities (“TIPS”) which represent the real rates. Taking the difference between the two (i.e. nominal interest rates – real interest rates = expected inflation) then gives the implied (or breakeven) inflation that is expected by the markets.

Source: Bloomberg, EKR Total Portfolio Advisory

The first takeaway from the above chart is that the expected inflation in 5 years has dropped slightly compared to couple months ago (the red line vs the purple line). If you were to follow the news, you will notice this is where most of the focus lately has been. This is however not the key highlight and falls short in providing the big picture which is where investors should be focused on. That brings us to the second takeaway… and that is the fact that markets’ expectations of 5 and 10 year inflation have gone up visibly not just since the end of 2021 (blue line) but also the end of 2022 (green line). In other words, bond markets increasingly think inflation in the long run will remain elevated. This is another way of saying that the bond markets are still not convinced that FED’s monetary policy will be successful, at least not as much as equities do.

MARKETS EXPECT THE NOMINAL INTEREST RATES TO REMAIN ELEVATED IN THE LONG RUN

This actually makes sense because FED has been saying they are not done until they beat inflation. Yet, given they have gone from 75 bps rate hikes all the way down to 25 bps hikes and are even thinking of pausing, shouldn’t the long term nominal rates come down? They should, but as the chart below shows, that is not what is going on. If you look at the yield curve as of May 26^th (see the purple line) it is higher than the one two months ago (red line) and front end is higher than the one at the end of 2022 (green line). That has two meanings. First, markets expect not just the FED rates or inflation but also the nominal (or bond) interest rates to remain elevated all the way into the future. Second, over time markets’ expectation of nominal rates has gone up contrary what the FED has been trying to achieve, i.e. lower both inflation and nominal rates.

Source: Bloomberg, EKR Total Portfolio Advisory

There is another important message in the above graph because it also informs us as to what the bond markets think will happen with the US economy in the long run. The markets expect somewhat of a soft landing or a recession. How do we know that? That is because the US yield curve as at end of May 26^th is still inverted, which means the short term interest rates are higher than the long term ones (see the purple line). In fact, one could argue that recessionary fears have increased because the yield curve is now more inverted than it was 6 months ago (see the green line).

This negative sentiment in the bond markets is also reflected in the global bond index returns. As of May 26^th Bloomberg Global Aggregate Bond Index was down by -1.4% on the month bringing its return on the year down to 1.9%. Bloomberg Global Corporate Bond and High Yield Bond Indexes were also down on the month -2% and -0.9% respectively, dragging their positive returns from earlier in the year down to 1.9% and 2.3% respectively.

What happened in other markets?

TURKISH STOCKS CONTINUED THEIR SLIDE

Despite a great 2022, Turkish stocks continued to slide with -16.9% loss in local terms (-22.1% in US dollar basis) as of May 26^th. A big driver of the drop was the massive earthquake on February 6^th that has caused major damage. The elections that took place on May 14^th and May 28^th also weighed on the Turkish markets. Exacerbating the losses in equities in US dollar terms was the fact that Turkish Lira continued its downward trajectory with -6.3% loss against the greenback since the end of 2022.

CRYPTO MARKETS GAVE BACK SOME OF ITS GAINS

In May crypto markets lost some steam due to ambiguity around inflation and the rate hikes and as a result gave back some of its earlier gains. As of May 26^th Bitcoin and Ethereum were down by -8.8% and -3.2% respectively. While the losses could be considered sizeable compared to equity and bond markets, given the higher volatility in crypto currencies, the negative returns made only a small dent in their year to date returns with Bitcoin still up 61.8% and Ethereum 52.8% up on the year.

GOLD AND CRUDE OIL PRICES WERE ALSO DOWN

Even though crude oil recovered partially due to a possible OPEC+ production cut, it was down in May. As of May 26^th first month futures contract for US crude oil WTI was down by -5.3% on the month bringing its loss to -9.5% year to date. Winter in Europe and North America turning out to be softer than expected has continued to weighed on the crude oil prices since late last year.

Gold fared better than crude oil in May as well as on the year. As of May 26^th the first month futures contract for Gold was down by -1.8% on the month and managed to hold onto its gains from earlier in the year delivering 9.6% return year to date. Gold prices have been partially buoyed by the strong global central bank demand for the precious metal since the higher rates put a dent in the US Treasury returns.

INVESTORS SHOULD EXPECT MORE MARKET SURPRISES

Research dictates that periods of incongruence amongst market participants create market dislocations and therefore provide ample opportunity for market players to enhance their portfolio returns. That is because such periods create the perfect conditions that are very conducive to exploiting market inefficiencies. However, such market environments are also marked with increased fluctuations similar to the one we have been experiencing over the last 18 months which makes it very difficult for investors to preserve their wealth.

What makes it very challenging for investors is not just the known unknowns such as the US debt ceiling, the FED rates or the resilience of global economy that make the task daunting. It is what market participants call “unknown unknowns” such as the FTX blow up late last year and the more recent bank failures in US and Europe that came out of nowhere. It may sound convenient to assume such “unknown unknowns” are impossible to guess or quantify and therefore it doesn’t make sense to prepare for such contingencies. Yet, that would be a fatal mistake as markets have no shortage of surprises and while it is impossible to “forecast” such financial events, it is definitely possible to be prepared for them. The most optimal approach to that is always creating a resilient portfolio with not just diversified return streams but also with a diversified risk profile so that you can sleep safe and sound at night.

ELA KARAHASANOGLU, MBA, CFA, CAIA

International Finance Expert

karahasanoglu@turcomoney.com

ela.karahasanoglu@ekrportfolioadvisory.com

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