Economic Insights for October 2022: A Record Checking against What Actually Happened

The following were the economic insights for October 2022.

The global economic outlook continued to deteriorate.  Inventory rebuilding lost momentum, and end demand weakened under high inflation, tight fiscal policy, and worsening financial conditions.  Consumer demand shifted from goods to services, adding further pressure.  The peak of the technology cycle was expected to hit Asian exporters, excluding Japan, through the second half of 2022 and most of 2023.

The Federal Reserve’s Trajectory, and the Dollar's Response

Risk-off sentiment returned after a higher-than-expected CPI report.  The Federal Reserve’s 75 basis point hike, taking rates to 3 per cent, magnified that reaction, alongside a stated commitment to reach 4.25 to 4.50 per cent by year-end.  The inflation hawks were making up ground on earlier reluctance to raise rates, and the prolonged hawkish stance across central banks fed a growing fear of recession.  The US dollar rose against most major currencies, treated as the haven asset it usually becomes in this environment.

China’s Divergent Path

The People’s Bank of China kept its rate unchanged, holding an easing bias against mild inflation and an uncertain outlook.  China could not risk a slowdown severe enough to loosen the Communist Party’s grip on power, and this divergence from US policy fed directly into uncertainty over the domestic property market.  Economists downgraded growth forecasts below the government's own target, and the unclear direction of the zero-Covid policy added further risk to the outlook.

The Portfolio Positioning at the Time

Asset allocation remained the dominant driver of portfolio outcomes.  Accelerated rate hikes, rising recession risk, and the threat of rising unemployment across developed markets kept most funds underweight equities and cautious on bonds, favouring lower duration.  Growth was not expected to rebound without central bank easing, pushing many managers toward larger cash allocations, now generating a meaningful risk-adjusted return in its own right.

Equities were recommended underweight, given the rising risk of a hard landing and earnings expectations still judged too optimistic.  A neutral stance on Asia, excluding Japan, was recommended for those already invested, given local central banks turning hawkish despite improving activity.  Investment-grade credit spreads looked unattractive after their recent rally, with default rates expected to rise and a genuine risk of cascading sovereign bond defaults.  US credit was recommended underweight as spreads widened, with short-maturity credit treated as the closest cash-like proxy.  The Federal Reserve’s aggressive tightening had already exacerbated liquidity constraints for highly leveraged entities, flattening the yield curve as short rates rose faster than long rates.

The Federal Reserve did not stop at 4.25 to 4.50 per cent.  It kept raising rates into 2023, reaching 5.25 to 5.50 per cent by July 2023, its highest level in 22 years.  China abandoned zero-Covid abruptly in December 2022, following nationwide protests the previous month, ending the policy uncertainty this report flagged, though the property crisis it also warned about deepened through 2023 and 2024 regardless.

The warning about liquidity constraints for highly leveraged entities proved prescient in a way this report could not have specified.  Silicon Valley Bank and Signature Bank collapsed in March 2023, followed within days by Credit Suisse’s forced takeover by UBS, the first banking crisis directly traceable to the pace of this same rate-hiking cycle.  The S&P 500 finished 2022 down roughly 19 to 20 per cent, its worst year since 2008, before recovering sharply through 2023 once the rate-hiking cycle showed signs of ending.  The underweight equity call held for the remainder of 2022.  It cost upside for anyone who held that position too far into 2023, once the market began pricing in the eventual pause this report could not yet see coming.

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Terence Nunis | Executive Chairman, Equinox Zenith | Author, The 1% Playbook: The Billionaire Cheat Code