May 6, 2022
Jack Powell

Bond's biggest sell down since the 1980s

Most developed world share markets remain in negative territory year to date, with the NASDAQ 100 and Shenzhen CSI 300 vying for the worst performance, with both down over 18% year to date.The NASDAQ 100 declined -13.37% in April 2022, the worst monthly decline since October 2008, and is now down -22% from its December 2021 peak. The Dow Jones has lost -13.3% YTD, which is the worst start to a year since 1939.

We don't have to be smarter than the rest. We have to be more disciplined. – Warren Buffett

A volatile start to the year

Most developed world share markets remain in negative territory year to date, with the NASDAQ 100 and Shenzhen CSI 300 vying for the worst performance, with both down over 18% year to date.

The NASDAQ 100 declined -13.37% in April 2022, the worst monthly decline since October 2008, and is now down -22% from its December 2021 peak. The Dow Jones has lost -13.3% YTD, which is the worst start to a year since 1939.

Global share market indexes - YTD

Source: Google Finance, PWA

Share market declines are mainly due to inflation pressures continuing to surprise to the upside. This increases pressure on Central Banks to continue raising rates as they try to tame the inflation monster.

As shown in the table below, bond markets are pricing in between 1.25% and 2.60%  increases to official cash rates, with the U.S. Fed forecast to increase by the most over the next 12-months. The table also shows the N.Z. bond market is expecting the RBNZ to tighten a further 2.00%, which is lower than the U.S. Fed, but the RBNZ has already raised the N.Z. Official Cash Rate (OCR) four times (since October 2021) for a total increase of 1.50%. If we add this to the forecast rate rises, this totals an increase of 3.50% to the N.Z. OCR. The N.Z. OCR was 0.25% at the end of September 2021.

G10 Central Banks Monetary Policy

Source: Wells Fargo Securities, The Daily Shot

The global bond market is also declining

As inflation expectations have risen, the yields demanded by investors have also risen. An increase in yields leads to a drop in the capital value of the bonds. The longer the term to the maturity of the bond, the greater the capital impact from a change in interest rate pricing.

As shown below, the U.S. Aggregate Bond Index has now declined over 11% since its peak in price in late 2021. This is the biggest drawdown of this index in history. If we focus on longer-dated bonds, the U.S. 20-year+ Government Bond Index capital value has dropped by c.30% since the peak. U.S. government bonds are supposed to be some of the safest bonds globally, but the recent quantitative easing from the U.S. Fed during the Covid lockdown in 2020 had pushed the price of bonds to unsustainable levels.

Barclays U.S. Aggregate Bond Index (USD) – Drawdowns (%)
Source: Y-Charts, Compound, @CharlieBilello

Inflation continues to exceed expectations

The Ukraine war's impact on commodity prices is only part of the inflation pressure we see in 2022. In 2020, as I am sure we all remember, the world was introduced to a pandemic and placed into rolling lockdowns. These lockdowns had a devastating effect on the production and supply of goods.

At the same time, governments worldwide provided record-high levels of stimulus. This led to an equally significant increase on the demand side. This increase has led to suppliers being unable to meet demand.

As shown below, economists worldwide continuously upgrade their peak inflation number for 2022. The continual increase in the forecast can also be seen closer to home, with N.Z. economists and the RBNZ predicting in February 2021 that inflation would peak at about 2.5%.

Fast forward to February 2022, and N.Z. economists are now forecasting inflation to peak at over 7%, with ASB Economists now forecasting N.Z. inflation to stay above 5% for the rest of 2022 and not fall back to 3% until 2024 at the earliest.

Latest inflation forecast for 2022 – higher for longer
Source: Barclays Research, The Daily Shot

The forecast peak for inflation has constantly increased, as has the expected duration Still, the one thing that has not changed is the almost universal belief that high inflation will be transitory. It is simply a matter of how long "transitory" is.

As shown in the table below, a significant part of the increase in U.S. inflation has come from energy and food inflation. This pricing pressure is forecast to peak and reduce over 2022, with U.S. inflation forecast to be just under 4% by the end of 2022. As another example of the speed of changing predictions, most U.S. economists were forecasting that U.S. inflation would be close to 2% by the end of 2022, as recently as early-2021.

U.S. – CPI Inflation contributions
Source: Deutsche Bank Research, The Daily Shot

The more concerning observation is that core inflation (excluding food and energy prices) has been climbing and is expected to increase over 2022. This is concerning as core inflation is stickier and is more difficult for the U.S. Fed to get under control with their rate rises. U.S. Core inflation is forecast to remain above 2% into 2024.

Interest rate expectations rise rapidly

So, what does all this inflation talk mean for the markets? In March, the U.S. Fed commenced raising the U.S. cash rate to a range of 0.25% to 0.50%. This was its first hike since 2018.

As inflation pressures rise, the bond market is pricing in more significant and faster increases in U.S. cash rates. In January, the bond markets were pricing in only a 38% chance of a 0.25% increase in the U.S. cash rate in May and only three rate hikes in total in 2022. The most recent reading shows the market is now pricing in a 13% chance of a 0.75% increase in the U.S. cash rate in May and eleven rate hikes in 2022. There are not eleven more Fed meetings this year, which means that the bond market has gone from expecting a few 0.25% rate rises to multiple 0.50% cash rate increases this year.

Market pricing of 0.25% rate rise in U.S. in May
Source: The Daily Shot, Bloomberg
Market pricing of0.25% rate rise in U.S. in June
Source: The Daily Shot, Bloomberg

The U.S. bond market is now forecasting this tightening cycle (increasing interest rates) to be one of the most rapid in the last 25-years. This aggressive future pricing of rate hikes does leave some room for the Fed to change its mind and indicate a slower than forecast increasing cycle.

If inflation proves to be transitory and economic growth continues to slow, we can expect the U.S. Fed to consider walking back a few of their forecast rate rises. Given the uncertainty around inflationary pressures, we would not want to be taking any high conviction positions around where the U.S. cash rate will peak this cycle.

Current pricing for rate rises vs previous tightening cycles
Source: Bloomberg, Vanda, The Daily Shot

The "Bears" are coming out

In the investment world, there are "Bulls" (investors that think markets will go higher) and “Bears” (investors that think markets will go lower). The Bears have got a lot louder in the last month, with the AAII Bull Spread index now back in Bear territory to levels last seen in 2009.

This phenomenon is not just appearing in the retail sector but also within the institutional sector, with almost 80% of fund managers polled now expecting a slowing economy. This is the worst reading on record. In March, a fund manager's biggest fear was understandably the invasion of Ukraine by Russia, but in April, their biggest concern has changed to the fear of a global recession.

As of the end of April 2022, the U.S. GDP for the first quarter of 2022 was confirmed at -1.4%. This was a very large miss from the +1.0% growth expected by most economists. Delving into the data from this result, it is quickly apparent that the major detractor was net exports. This is due to the U.S. having the biggest trade monthly deficit ever, of -$125 billion in March 2022.

Global Growth optimism at all time low
Source: BofA Global Fund Manager Survey, The Daily Shot

Fund managers biggest "tail risk" fears
Source: BofA Global Fund Manager Survey, The Daily Shot

This may sound very dramatic and negative; however, it is arguable that share markets have already priced much of this risk in their declines year-to-date. Historically, this level of negativity has proven to be a good time to consider buying into the markets as others sell. To quote Warren Buffett, "Be greedy when others are fearful". We may now be getting closer to the "capitulation" of retail investors.

NASDAQ 100 – now in a bear market

As discussed above, the Nasdaq has fallen -22% since its peak in 2021. With a drop of over 20%, the NASDAQ 100 is now officially in a "bear market". The decline from the peak may sound significant, but it hides a much higher level of losses within this index. Over 45% of all the companies listed on the NASDAQ 100 have declined by over 50% from their peaks. A further 20% dropped more than 70%, with 4% dropping by a terrifying 90% from their peaks.

So, why is the index only down 20% when c.70% of the companies in the index have declined by more than 50%? The top 10 companies make up over 52% of the Nasdaq's market cap. These are the giant firms such as Apple, Microsoft, Amazon, Meta, etc. Why does this matter? Because it could be argued that we may have already had a "Global Financial Crisis" level correction in the Nasdaq.

Nasdaq 100 – percentage decline from company's previous peak


It has certainly been an eventful beginning to 2022. Global inflationary pressures remain the primary concern in the medium term. As we get a more precise reading of inflation's transitory (or not) nature, we will get a better feel for where interest rate rises may end. At present, any forecasts around this come with a sizeable margin of error.

Lastly, when the U.S. Federal Reserve started increasing cash rates, this did not mean that it was the end of the share market rally. As shown below, when reviewing fifteen different tightening cycles in the U.S.,   global share markets usually moved higher over 12 to 24-months. This is generally because it takes several rate rises before the economy slows and the risk of a recession starts to drag share markets lower.

S&P500 performance 12-mths before & 24-mths after the first rate hike
Source: All Star Charts Plus, Ned Davis Research, The Daily Shot

As discussed at the start, we have come into 2022 with concerns around possible volatility in the global investment markets, which has played out. How financial markets continue to move over the rest of 2022 remains uncertain, with many possible outcomes.

At PWA, we monitor these historical events and portfolios closely while remaining conservatively positioned within portfolios and maintaining a disciplined approach.

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