Written by:  Mutsumi Kagawa (Chief Global Strategist, Economic Research Institute of Rakuten Securities)

(9/12/2022)

 1. Improvement in “financial stress” supports US stocks

 November’s employment data and the ISM non-manufacturing index in US were stronger than expected, raising uncertainty over monetary policy, and weighing on the stock market. However, looking back at the stock price trends for this quarter, we can also see some solid movements. The S&P500 index has increased by 9.7% and the Dow Jones Industrial Average has increased by 17.0% since the end of September (as of the December 7). The improved inflation outlook and expectation of changes in policy rates are the reasons for stock price movements with strong support this quarter. FRB Chairman Powell said in a speech on November 30 that the FRB would continue to raise interest rates to curb inflation, but he also said the pace of interest rate hikes “would slow down as early as December”. Long-term bond yields (10-year bond yields) fell to the 3.4% level, and the US “Financial Stress Index” actually declined, thus supporting stocks (Chart 1). The Financial Stress Index is calculated by the Office of Financial Research of the US Department of the Treasury for monitoring financial risks. It is an index that indicates the level of tension on domestic and overseas financial markets. Recently, investors’ risk appetite, market volatility, dollar liquidity and credit spreads have improved. The Financial Stress Index has fallen since October, indicating tensions in financial markets are easing. An improvement in financial stress will help lower risk premiums, making it easier for stocks to recover. On the other hand, uncertainty about the economic slowdown is deep-rooted. So, we need to be careful because stocks may face volatile movements depending on the deterioration of the earnings outlook.

<Chart 1> Declining Financial Stress Index supports US stocks

(Source) Created by Economic Research Institute of Rakuten Securities, Inc. from Bloomberg (beginning of 2018 – Dec 7, 2022)

2. What the US bond market has factored in

The US CPI (Consumer Price Index) for October, announced on November 10, was a “reverse CPI shock” that made a positive impact on the stock and bond markets. Year-on-year CPI growth slowed down significantly to 7.7% from 8.2% in September, below average market forecast (7.9%). Shortly after the CPI announcement, long-term bond yield (10-year bond yield) fell, and the stock market recovered. Chart 2 shows changes in stocks (S&P500 index) and various interest rates (FF interest rate, short-term bond interest rate and long-term bond interest rate) since the beginning of the year. Recent statements by FRB officials such as Chairman Powell, the rate hike at the next FOMC (Federal Open Market Committee) to be held on the 13th and 14th of next week will be reduced to 0.5%. On the other hand, the terminal rate forecast (the final destination of the policy rate) is expected to be revised upwards slightly. The bond market has begun to factor in the peaking of inflation and the trend of the policy interest rate, and the long-term bond interest rate is trending below the FF interest rate (3.75~4.0%).

<Chart 2> Long-term bond interest rates have fallen below policy rates

(Source) Created by Economic Research Institute of Rakuten Securities, Inc. from Bloomberg (beginning of 2022 – Dec 7, 2022)

Considering the bond market interest rate trend and the current FF interest rate outlook calculated in the futures market shown in Chart 2, after FOMC raises the FF interest rate (guidance target upper limit) by 0.5% net week, it is highly likely that the terminal rate will reach around 5% in the first half of 2023, thereafter the FOMC will raise interest rates by 0.25% each in February and March next year. Moving forward, if the rate of increase in the PPI (Producer Price Index) for November, which will be announced on December 9, and the CPI for the same month, which will be announced on December 13, slow down further, and business sentiment is expected to slow down, a slowdown in the pace of monetary tightening and a shift to accommodative policies in the second half of next year are anticipated as a “strong forecast”. Thus, it is expected that share buybacks (buybacks) by bearish investors who are afraid of “high inflation” and “acceleration of interest rate rises” will extend buying (buyback) the stocks.

3. Pay attention to the decline in the average US gasoline price

 Nevertheless, there is also a view that “carelessness is a major enemy” until the rising wages, housing expenses (imputed rent) and service prices slow down. Under these circumstances, I would like to confirm the downward trend in gasoline prices and crude oil futures, which are said to have a significant impact on consumers’ “inflation expectations” with Chart 3. This is because changes in gasoline prices are considered important for US, which is generally known as a “automobile society”.　According to a survey by the American Automobile Association, the recent average gasoline price in US is in the $3.3 per gallon (approximately 3.8 liters) range (December 7), fell from the $5 range in June this year. Compared to the situation where the price hovered around $4 around this spring, the year-on-year growth in gasoline prices in the first half of next year is expected to be negative (assuming the current level continues). The decline in crude oil futures, which is the main cause of the decline in gasoline prices, is affected by forecast of an easing of supply and demand due to economic slowdown caused by of the spreading of Covid-19 infection in China and the interest rate hike trend in US. In addition, the G7 (seven major countries), Australia and the EU (European Union), implemented measures to set a “price cap of $60 per barrel” for Russian crude oil on December 5. The sanctions against Russia by Western countries related to the situation in Ukraine are attracting attention as a key response to prevent crude oil prices from rising and to cut off the funding sources for President Putin to prepare wars in Russia. The decline in gasoline prices, which reflects these circumstances, is expected to calm consumer and financial market inflation expectations going forward. If inflation forecasts clearly show signs of peaking out, interest rates in the bond market will stabilize and decline, which is expected to support the recovery of stock prices.

<Chart 3> Pay attention to the decline in the average US gasoline price

(Source) Created by Economic Research Institute of Rakuten Securities, Inc. from Bloomberg (beginning of 2022 – Dec 7, 2022)