The burden of managing market expectations
- Expectations matter more than anything else
- The market is still repricing after it got wrong at Jackson Hole
- Currencies Reflect Recent Pressure
There is a guiding principle of market behavior that rises above fundamentals, above macro data, above central bank activity. It is the management of expectations that dominates the market.
Let’s imagine that an important macro data point will appear. Let’s say a number above 57 is fine, but the market expects a number to be 60. At the end, the data release shows 58.
The data itself is good because it beat 57. But since it missed market expectations at 60, the market reacts, and this reaction is almost always an immediate downside.
I say all this because the markets, after publishing the latest release in the US, are starting to convince themselves and even price the idea that the Federal Reserve, at its next meeting in September, will take its foot off the accelerator and (50 basis points instead of the recent 75 basis point increases) And that in 2023 it will definitely stop raising interest rates at some point, instead of pivoting.
But reality is stubborn. In his speech, Federal Reserve Chairman Jerome Powell reiterated that the goal is to control inflation no matter what, and that in his view households and businesses “will suffer” in the fight against inflation, leading analysts to expect a 75 basis point increase in September (unless there is Radical change in inflation in the weeks leading up to the Fed meeting).
Loretta Meester, president of the Federal Reserve Bank of Cleveland, said she is raising interest rates above 4% early next year and keeping them there to reduce price pressures. Moreover, she admitted that the Fed erred and that it should have started raising interest rates earlier.
The US came in above expectations of 315,000 jobs, above expectations of 300,000 jobs in August, cementing the case for more aggressive rate hikes. The latest data also showed an uptick in July and consumer confidence rebounded significantly in August.
As for the European Central Bank, some are proposing a 75-point rate hike on September 8. With energy pricing in dollars, a weak euro makes it more expensive for eurozone countries, adding to inflationary pressure. Tighter monetary policy by aggressively raising interest rates is the way to boost and combat this element of inflation.
Which is significant, as inflation in the Eurozone in August of 8.9% in July broke a new record. Excluding energy, inflation rose to 5.8% from the previous 5.4%. It rose to 8.4% in August, its highest level in more than 36 years, rebounding from 7.9% the previous month.
It is these two related factors that have hurt the market, hence the recent crashes.
Thus, under “normal” conditions, September could be another sensitive month.
It’s also worth noting that on a historical basis, September is the worst month of the year for the S&P 500 to perform in terms of investment returns, both average and repeat positive returns. Over the past 20 years, the average return has been -1.18%, over the past 50 years -0.92%, and over the past 100 years -1.08%.
For all this, there was a sign last Friday that investors haven’t lost complete control of their emotions. While it fell more than -3%, it remained near 25, well below the levels it reached when the S&P 500 suffered similar declines this year.
Keep in mind that the P/E of the S&P 500 is still higher than it was at the end of 11 bear markets. This means that despite the dips this year, the stock market can’t be said to be a bargain.
I would also like to review withdrawals. Drawdown is the percentage of decrease in the market from the highest level to the lowest level. It represents the size of a particular bear market.
The maximum drawdown so far in 2022 is as follows: S&P 500 -24%, Nasdaq -33%, -27%.
To put this in perspective, here’s the size of the biggest and smallest drawdowns from 1928 to 2020:
- 1931: -57.5%
- 1932: -51%
- 2008: -49%
- 1937: -45%
- 1929: -44.6%
- 1930: -44.3%
- 1987: -34%
- 2002: -34%
- 2020: -34%
- 2009: -28%
- 1995: -2.5%
- 2017: -2.8%
- 1964: -3.5%
- 1961: -4.4%
- 1958: -4.4%
- 1954: -4.4%
Impact of expectations
Currencies are among the most volatile markets in terms of pricing expectations for central bank moves.
The Japanese yen has fallen nearly -4% this month and reached 139.40 in July.
The USD/JPY pair is very close to the 24-year high and the 140 level, which could be a key level for the BoJ. We should be on the alert in case the Bank of Japan decides to intervene in the currency market at this level (remember that Japan supported the yen during the 1998 Asian financial crisis, when it reached the level of 146).
The euro continues to contract against the dollar, especially with the activation of the last bearish signal: loss of support.
Short positions (bearish) in the Euro reached their highest levels since the beginning of the pandemic due to the risks of dragging the region’s energy prices into recession.
Notably, last week saw an increase in short positions in EUR (44,120 contracts vs. 42,700 in the previous week). The latest record goes back to March 2020 with 86,700 contracts.
So far this year, the euro has lost -15% against the dollar and reached a 20-year low.
Meanwhile, the price climbed to 109, approaching a 20-year high and on track for a third consecutive monthly gain.