Views From the Floor - From Bad to Worse? The Possibility of Consecutive Down Years

Hopes for a soft landing may be dashed by economic reality, constraining many – but not all – major markets.

 

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From Bad to Worse? The Possibility of Consecutive Down Years

Do bad things come in twos or threes? 2022 was not an auspicious collection of digits for markets, but we shouldn’t count on this year being any better. Sell-side forecasts for US equity returns in 2023 are nevertheless still overwhelmingly skewed towards upside¹, with a great deal of hope predicated on the Federal Reserve (Fed) and a heuristic that rarely do equities have material back-to-back down years.

This has generally been true in the past: down years for the Nasdaq Index have more often than not been immediately followed by a recovery year (Figure 1). However, it’s notable that in the inflationary period of the 1970s, the Nasdaq suffered two -30% years in a row. In the wake of the dotcom bubble, the index recorded three consecutive years losing at least 20% each.

We set out the case last month for expecting a hard landing based on economic and market conditions. Matters haven’t improved since then, with last week’s Fed minutes affirming its hawkish bias. Don’t call 2023 a bounce-back year yet.

Figure 1. NASDAQ Composite Index

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Source: Bloomberg; as of 31 December 2022.

The Cooperation Reduction Act? Inflation Reduction and Green Protectionism

The 2022 Inflation Reduction Act (‘IRA’), a USD 369 billion package with subsidies and tax credits for green technologies and manufacturing, is one of the most important pieces of global climate legislation.

However, it has triggered widespread criticism, with a particular focus on the impact of tax credits for electric cars made in North America and the elimination of subsidies for those produced outside the region. South Korea has raised concerns over the subsidy elimination, and there are fears that the IRA could increase the cost of renewable energy globally, pushing emerging market economies towards greater use of fossil fuels.

European countries have also been vocal about their concerns. German economy minister, Robert Habeck, has already been calling for Europe’s own ‘local content rule’ in response to the IRA² and President of the European Commission, Ursula von der Leyen, outlined plans to counter the effects of the IRA in a sovereignty fund to ensure European industry ‘continues to lead the green transition’.³

All sides will be wary of triggering a full-blown trade war with these restrictions but we may see further escalation in 2023. We have already seen a deal reached on the EU’s Carbon Border Tax Adjustment Mechanism, viewed by some as a protectionist move to insulate European manufacturers from overseas competition.

Geopolitical rivalry over green technologies is not necessarily a bad thing as countries vie for leadership positions in green innovation; indeed this could be a spur to further innovation. However, the risk of further green protectionism could lead to domestic priorities and political concerns standing in the way of the required cross bordercollaboration to resolve the global problem of climate change. If it restricts the diversity of supply of green technologies or battery metals, it could raise costs for all and have significant impacts on developing countries – the countries which need the most help with climate issues.

How Much to Hedge?

After an exceptionally tough year, investors may be wondering whether to hedge their bets. And while rising rates may have hammered both equity markets in 2022 and kept longer term equity implied volatility elevated, as measured by 8-month VIX futures (Figure 2), it has reduced the cost of one form of hedge in the options market. A oneyear zero cost collar hedge for the S&P 500 Index now has a much higher strike now as a consequence of higher rates. To buy a 90% put in 2020, you had to sell a 104% call to make it costless. Now, thanks to a better skew and higher rates, you need only sell a 112% call to buy a 90% put.

For the call option funding your hedge to hit the strike – the upside of 12%, the S&P 500 would have to rise to around 4300. This is around the upper end of the range of strategist forecasts and should provide some comfort to investors. From a downside hedging perspective at least, the equity market is cheaper if you are happy to give away some upside.

Figure 2. 8-Month VIX Futures

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Source: Bloomberg; as of 4 January 2023.

1. Source: Bloomberg, December 2022. The average year-end target among strategists surveyed by Bloomberg in December sees the S&P 500 rising 6%.
2. Green protectionism is here – this time for real – EURACTIV.com
3. AGENCE EUROPE - EU27 will analyse Commission’s proposals to respond to US ...(agenceurope.eu)