'Risk-on' for markets

The stock markets may rise over the short term, but it is too early to conclude that the 'worst is over' for the US economy

Stock markets are ruled by “sentiment”, which drives money in and out of those. Bullish sentiment is described as a risk-on period while bearish sentiment is called risk-off. The US market and economy have a profound influence on emerging markets and it is worth paying attention to them. Until the last week of October, the US markets were in risk-off mode, battered by the relentless rise in the yields of US bonds. The 10-year yields hit 5 per cent in the third week of October, a level last seen in 2007, as the monetary policy seemed to favour “higher (rates) for longer”; to control inflation, the US Federal Reserve (Fed) pushed the benchmark interest rate in just 16 months from 0.25 per cent in March 2022 to 5.5 per cent by July 2023, one of the fiercest rate hikes in history, taking it to the highest level in 22 years. Last week, after the monetary policy meeting, the Fed announced a pause for a second time. It said the bond market, by pushing up yields, was doing its job of cooling the economy; so further rate hikes were not needed now.

Traders and investors have interpreted this as the end of rate hikes with a high chance of rate cuts after six months, and, so, have switched back to risk-on mode. The benchmark index S&P500 rallied a sharp 5.85 per cent last week. The Indian market, after a week of decline, has stabilised and looks set to follow the “mother market”, ie the US stock indices, by going higher. The question is: Is this another deceptive bounce or is the market, which is always forward-looking, discounting all the negatives and climbing over the wall of worry comprising wars, rate hikes, global trade weakness, and the rise of protectionism? I believe the US economy is not yet out of the woods, and, to the extent it influences the global market, one should remain wary.

Calamity postponed?

The US war over inflation may be over for now but we have not seen its full aftermath. While the US consumer inflation rate dropped from a year-on-year peak of 9.1 per cent in June 2022 to 3.7 per cent last month, it is well above the Fed’s 2 per cent target. Indeed, it would be facile to think that the sharpest rate-increase cycle over just 16 months would damage the economy only minimally. Rate increases hit the economy with a lag, and we are yet to see how small businesses and consumers will deal with the massive rise in the interest rate burden. As long as the Fed rate and long-term bond yields remain high, the negative impact on the US economy continues. At 5.50 per cent, the Fed’s benchmark rate is 2 percentage points above the headline inflation rate. A 2 per cent real yield is a serious damper on the economy and has been a headwind for stocks historically.

Here are some pointers. The US ISM manufacturing index for October dropped to 46.70, marking the 12th consecutive reading below 50, which indicates contraction. The index for September was 49 and 50.20 one year ago. The already unaffordable US housing market is getting worse. The housing affordability index of the National Association of Realtors has hit a 40-year low. This is not surprising because nationally, the average long-term fixed mortgage rate is nearing 8 per cent, its highest level in 23 years. Sales of heavy trucks are falling off the cliff. On Friday, shipping giant Maersk, a bellwether for global trade, announced plans to reduce its workforce by more than 10,000 people, and said it expected profits to be at the low end of prior guidance. The stock fell 18 per cent to its lowest level since October 2020. “Our industry is facing a new normal with subdued demand, prices back in line with historical levels and inflationary pressure on our cost base,” Chief Executive Officer Vincent Clerc said in a statement.

Remember labour?

A long period of prosperity, helped by cheap capital (due to extremely low interest rates) and booming global trade, has made us forget the wider social and political impact of high interest rates and protectionism that were a reality in the 1970s. Think of the impact of economic stress on another factor of production: Labour. Workers’ strikes in the US are at their highest since 2000, with 4.1 million days lost in August to labour activism. According to Bloomberg, unions are winning big for the first time in decades. Workers are resetting their expectations and demanding more than they did a few years ago, in response to the higher cost of living. Unions are negotiating large contract settlements, 25 per cent to 28 per cent pay raises, more paid time off, more health benefits, etc. It takes 24 months for the Fed tightening cycle to show up in the US labour market. It is 20 months now, after the first rate hike in March 2022, and the unemployment rate in October rose to an almost two-year high of 3.9 per cent. Jobless claims are up 9 per cent in the past six weeks and 26 per cent in the past 12 months. One-third of the jobs added were government hires. Also, there were downward revisions to the August and September payroll numbers. Indeed, payroll numbers were revised downward in every single month of 2023. The last time this happened was during the great financial crisis of 2008. All this does not mean that the stock markets will not rise over the short term. But it is too early to conclude that the “worst is over” for the US economy; the lag effect of extremely high interest rates is still on the cards. Will emerging markets like India escape from it?

The writer is editor of www.moneylife.in and a trustee of the Moneylife Foundation; @Moneylifers