Global equities - Where could it all go wrong?

One mistake that people make when looking at investment markets is to assume that all the data that are released will point in the same direction and therefore confirm whatever conclusions are there to be seen. Nevermore is this the case than when it comes to writing outlook pieces like this – we draw a nice trend line through the past and project it out into the future. To make matters worse, we, as humans have this awful habit of seeking out only the data that prove our point of view – psychologists call this “confirmation bias” – whilst ignoring everything else to the contrary.

The reality is that there will probably never be a time when the data are so perfectly aligned that we can wrap a neat little bow around it and be 100% confident in what is going on or what will happen. So rather than trying to forecast exactly what will happen, perhaps a better endeavour is to identify some of the major factors that could swing markets one way or the other over the next year.

Given the importance they have amassed since the global financial crisis, it is inevitable that we focus on central banks, and in particular the US Federal Reserve (the Fed). As we look into 2022 perhaps one of the biggest risks to markets comes from the Fed that is forced to act too far and too fast on interest rates. Short-term interest rate markets have already priced the potential for three interest rate increases in 2022, but what could cause the Fed to go even further?

The obvious answer is inflation, or more accurately, should the wave of price increases witnessed over the last year become a political issue. Key to this will be how companies and households manage to deal with the elevated inflation that is percolating through the global economy. Having met with several companies in recent months, it seems that managements have been putting through a series of price increases in recent months, firstly, to offset raw material price increases and secondly, to try to recoup the “higher costs to serve the customer” (supply shortages, freight, labour), with little in the way of reduced demand or volumes of sales.

One might have thought that if inflation were going to bite, it would be felt by the likes of the big retailers – either they would have to take a margin hit by absorbing some of the rise in product costs or the customer base would need to rein in spending a bit. So far, there is little to no evidence that either of these is happening with revenue at both Walmart and Home Depot, for example, comfortably beating expectations while gross margins remain stable.

On the consumer side, there is a conundrum to ponder as we try to square the apparent serious drop in consumer confidence with the recent retail sales data or these financial results from retailers. There is more than one measure of confidence (University of Michigan, Conference Board) so fixating on the worst reading might be misleading and as a general principle, it’s usually a good idea to watch what people do (retail sales) rather than what they say (sentiment) and, for now at least, public behaviour would indicate that things are just fine.

Simply put, people are spending more, at least in nominal terms, but some of this may simply represent money illusion – you feel wealthier after a nominal pay rise, even if it buys you less when you go to the shops.

Official data already suggests that real wage growth is negative, workers have been slow to return to the workforce after COVID-19, and pandemic payments ended a few months ago, but spending power remains strong. So, where is this coming from?

A look at the macro data suggests two sources. The savings rate has declined significantly in recent months and is now at it’s lowest level since the end of 2019. It is reasonable to posit that people are simply spending more of their monthly incomes (and possibly anything squirreled away in recent quarters) to maintain consumption amid elevated prices.

The other big change is the willingness to use revolving credit again. Households aggressively paid down credit card balances at the peak of the pandemic, reflecting both risk aversion and the infusion of cash from the government. However, the monthly change in credit card usage has bounced back strongly over the last few months.

The good news is that outstanding credit card balances are still below the pre-pandemic peak, so clearly there is room for credit to expand further to fund consumption.

For the time being, it looks like households have enough of a cushion in income, savings, and available credit to pay whatever retailers are asking – but that
may not last forever. If the market continues to price runaway inflation without the evidence of real wage growth, then the consumer will hit a biting point at
some stage – and might just start complaining to their politician.

How long it takes for the politicians to jump on the bandwagon (or soapbox) and start demanding action on inflation from the Fed is anyone’s guess - as is
whether the Fed will be forced to listen. Having recently secured another term in office, Fed chair, Jay Powell, might let the screaming masses howl for some time to come – but maybe he won’t!