Risk-off environment remains intact.

Please read the Disclaimer before reading this article.

As I did in my previous post, I summarize my investment outlook from early 2022 for different asset classes in the table below. You can also see what happened since I wrote my investment outlook and what my current views are.

Market	My view in early 2022	What has happened until now	My updated current view
Stock market	"I think we'll see a significant correction in the broad markets this year (15% drop or higher?)"	The max drawdown for the S&P500 was 21% since I wrote my investment outlook.	I think we could now see a total drawdown of 30-40% in the S&P500 from its peak earlier this year.
Bond market	"With both growth and inflation slowing in 2022, how likely is it that interest rates will move substantially higher? Not so likely if you ask me. ... For now, the price action is telling that interest rates will go higher, but my current guess is that fundamentals will trump the technicals."	Interest rates rose sharply. Technicals trumped fundamentals, I wasn't expecting this. In my previous update (April 10th), I wrote that I'm more convinced than ever that interest rates will decline. Since then, interest rates have risen higher from about 2,75% (US 10 year) to a high of 3,48%.	​I remain of the opinion that interest rates will decline sharply. As I'll explain in this article, the moment to actually take a position in bonds might come soon.
Commodities	​"With inflation peaking, and the correlation between commodities and inflation being very high, I think chances of another good year for commodities are rather low."	Commodities rose sharply. I wasn't expecting this at all. Would commodities have risen this sharply without the situation in Ukraine/Russia? We'll never know.	Commodities are now showing clear signs of breaking down. Downward pressure will continue.
Precious metals	​"With both growth and inflation peaking this year, I think the worst is over for gold. I'll be looking to identify nice buy set-ups in these markets."	​Gold is up almost 2% since I wrote my outlook early this year. Not great, but compared to what stocks and bonds have done, not bad at all if you ask me.	I tried once to get in this trade this year but got stopped out. I keep looking for good entry points because I think gold will move higher.
Crypto currencies	​"Add to that the risk-off environment I see coming in 2022 and I can't see any reason to become bullish on these assets."	Bitcoin is down 50% since I wrote my investment outlook.	I remain bearish on this asset class.

Let's update some of my views on these different asset classes.

Commodities

In early 2022, my leading indicators were showing me to be bearish on commodities. This was a bad call for the first few months of the year. We'll never know if commodities would have had this strong run without the geopolitical situation in Ukraine and Russia (probably not) but it is what it is.

Things are finally coming together. As the following chart shows, copper is clearly breaking down from significant support levels.

Not only copper, the materials sector (XLB) and oil sector (XLE) are also showing very bearish price action patterns.

I think the decline in the commodity complex has finally started. You can read my previous two articles if you want to know more about the fundamental reasons.

Bond market

In previous articles, I showed some leading indicators on inflation and growth. Both were heading down and I showed how historically this would be bullish bonds.

Inflation remained strong (because commodities remained elevated) and therefore interest rates kept rising.

Now that commodities are breaking down, we can expect for breakeven inflation rates to also come down. As the chart below shows, there is a very strong correlation between the two. (I used copper in this example.)

Now that commodities are probably gone as a factor keeping inflation and interest rates elevated, the next question we need to answer is about the Federal Reserve.

Throughout the year, we have been hearing about the monumental rate hiking cycle that the Fed would be executing this year.

In a very short time, the Fed has raised the fed funds rate to 1,75%.

In the following chart, I'm looking at the fed funds rate (grey) and 10 year yield (blue) to see when the 10 year yield peaks in relation to the fed funds rate.

As you can see, the 10 year yield normally peaks together with the last rate hike and sometimes it peaks 1 or 2 'rate hike meetings' before the fed funds peak.

What do I learn from this? Well, I should have given this more importance when I became bullish bonds early this year. Even though I said that technicals were supportive of higher yields, I probably shouldn't have written that fundamentals were already aligned.

With the current pace of rate hikes per Fed meeting, we probably haven't too much Fed meetings left before this rate hiking cycle is over. Since longer-term yields peak between 0 and 2 'rate hike meetings' before the last rate hike, we're getting very close.

But how do we know when to pull the trigger?

Take a look at the following chart of the 10 year yield. It broke out above a significant resistance level and is now retesting this level. If this resistance level, that now turned into a support level, fails, it's time to bet on bonds.

Stock market

In early 2022 I warned that the S&P500 would decline 15 to 20%. As you can see, I now think that we'll see an even bigger decline. Let me explain.

We want to know what the price of the stock market will be.

To know this, we need to know what earnings the companies will produce, and how much investors are willing to pay for these earnings.

Price stock market = earnings x investors willingness to pay for these earnings

The willingness of investors to pay for a certain amount of profits is what we call the P/E ratio or stock market valuation.

If investors are bullish and there are no clear risks, they are more willing to pay for a certain amount of earnings, thus they bid up the market valuation or the P/E ratio.

If we write it with mathematical symbols, we get:

P = E x P/E

Of course, the difficult part is knowing what the E and the P/E will be.

Let us start with the E part of the equation.

The reason I'm becoming more bearish and why I'm expecting a bigger decline than 20%, is because analysts have earnings expectations of around 10% growth for the S&P500.

If you take this growth rate, you can calculate the earnings number that this implies (because we know last year earnings).

If you then take these earnings and multiply them by the current P/E ratio, you arrive approximately at the current price level of the S&P500.

This means that if analysts are correct, the S&P500 is probably correctly priced right now and that we are very close to a bottom. (This point was laid out by Jurien Timmer of Fidelity.)

There is however one very big problem. I think analysts forecast of earnings growth will be completely wrong.

The next chart shows S&P500 earnings growth in blue and my leading indicator in orange.

The red triangle shows to where analysts think the blue line will move. They are expecting 10% growth. My model however is going straight down. I don't think we'll see a collapse in earnings as big as my model is indicating, but I certainly think that earnings growth will be much weaker than expected.

If earnings are much weaker than expected, this means that the stock market will continue to decline because the current price is fair value if you assume 10% earnings growth.

Let's go back to our formula: P = E x P/E

What if valuations rise? This can offset the lower earnings and this way the stock markt doesn't have to decline further.

Let's have a closer look at this idea.

I see some people talking about the idea that a peak in inflation and interest rates will be good for the stock market.

If we look back at Q4 2018, we can clearly see that this doesn't have to be the case. The stock market declined 16% from the point that interest rates peaked. (indicated in red on chart below).

(I also indicated in green a period of rising fed funds rate and a rising stock market. It's not because the current rate hiking cycle is going together with a declining stock market, that this always is the case.)

Why is a lower interest rate not always good for the stock market? Because there is no clear link between a lower interest rate and rising valuations (P/E ratio). The chart below (by the excellent Michael Kantrowitz) shows (indicated by the orange areas) periods when lower rates go together with lower P/E ratios. The explanatory variable is the credit spread (here shown by BAA spread). When interest rates decline, but credit spreads rise, valuations decline because we are in a risk-off environment.

Source: @MichaelKantro

We now know that lower interest rates are not necessarily good for the stock market and that the risk-on or risk-off environment, as indicated by credit spreads, are much more important.

So the next question becomes how probable is it that credit spreads will rise from here. This would be good for the P/E ratio and could thus be an offset for the lower earnings I'm expecting.

The following chart shows the BAA credit spread (in orange) together with the ISM PMI in blue. (Take note that the ISM PMI is inverted. A rising blue line thus shows a declining ISM.)

As I've shown in previous articles, I'm expecting the ISM PMI to decline sharply. The blue line will thus increase significantly.

Credit spreads are closely correlated with the blue line, thus with the economic cycle.

If the ISM PMI goes lower, we can expect credit spreads to get wider. This would imply that there is no room for the P/E ratio to increase.

In the red circles, I indicated two periods when the economy continued to slow (rising blue line) but credit spreads didn't rise further. It's thus possible that the economy continues to weaken but that credit spreads don't move higher.

However, we want credit spreads to go lower if we want to see higher P/E ratios.

In the following chart, I indicated by green areas the periods when credit spreads (orange line) went lower. As you can see, all these periods were accompanied by declining blue lines which means that the ISM PMI was in a rising trend. Given that all my leading indicators are showing that the ISM PMI is going down sharply, I find it very difficult to see how credit spreads could fall and P/E ratios could rise. (Very difficult doesn't mean impossible however. If you look more closely at 2019, we saw a declining ISM but credit spreads didn't widen and the P/E ratio actually increased. However, during that period we didn't see an oil price shock. Looking at history, oil price shocks seem to be one of the defining reasons when a rate hiking cycle does or doesn't lead to a recession. Since we have an oil price shock right now, I remain of the opinion that a rising P/E ratio is a low probability event.)

So, if we go back to our formula: P = E x P/E

If earning forecasts are correct, the market is correctly priced. But if my leading indicator on earnings growth is correct, and given the fact that I don't see how the P/E ratio can rise, I think the total decline in the stock markt from its peak could be 30-40%.

Fed policy

When will the fed stop its rate hiking cycle and potentially start to cut interest rates? Some people seem to believe that because inflation is this high, it's impossible for the Fed to turn dovish.

If we look at the 1960's and 1970's, we can see that this isn't correct.

The following chart shows the inflation rate in blue and the fed funds rate in black. The vertical red lines show when the fed started to cut interest rates. As you can see, the Fed has historically cut interest rates when inflation was still rising or hadn't started to decline yet. In these historical cases, inflation was around 5%, 8% and 13%.

I think history clearly shows that the Fed can, and will, turn dovish even when inflation is elevated.

I also included the S&P500 in the lower part of the chart above. We can see that the stock market bottomed around the turning point in Fed policy. This might be interesting to remember for this cycle.

The next chart shows again the S&P500, together with the vertical red lines that show when the Fed started to cut interest rates, and the US ISM PMI as a measure of economic strength. We can clearly see that the Fed gave more importance to the weakness in the economy than to inflation. Even with inflation elevated, the Fed will turn dovish.

Conclusion

The risk-off environment remains intact.

The time to buy bonds is coming closer. But please take note: do not buy bonds at a random point. Wait for a clear breakdown in interest rates. I was bullish bonds for fundamental reasons at the beginning of the year but I've haven't yet invested in them because technicals were not supportive. Be patient and wait for the opportunity to present itself.

Thank you very much for reading my article.

You can follow me on twitter: @adaptiveinvest