A complex and scary picture

Chief Investment Officer's team
05 September 2022
A complex and scary picture
Economic data for August confirms US resilience but also weaknesses almost everywhere else


  • Economic data for August confirms US resilience but also weaknesses almost everywhere else
  • Monetary tightening should not pause, with inflation still elevated and even rising in Europe
  • Some markets are priced for the current outlook but anxiety should keep generating volatility

Last week was rich in terms of economic news, with the release of key data for August. In summary, the US continues to create jobs and remains in expansion on most metrics, which in turn gives comfort for the Fed to follow the hawkish lines highlighted in Jackson Hole. The rest of the world is in a very different situation: global manufacturing surveys are signaling a heightened risk of recession outside of the US, which looks indeed inevitable in Europe. The old continent is in a terrible place: the energy crisis, with roots in decades of reliance on cheap natural gas from Russia, is only worsening. Expressed in euros per MWh, prices for natural gas delivered in the Netherlands have moved from 50 a year ago to 250 as we write, after a peak above 300. The impact on the balance of trade would be enough to materially hit the GDP of the euro area, even before taking into account the collapse of consumer confidence, despite large savings and so far strong employment trends. Asia suffers from China’s worries, including renewed lockdown in a megacity, as well as from less demand for goods – industrial production declined across Korea, Vietnam, Thailand or Taiwan. Manufacturing PMI there also dangerously indicate growth risk. This is scary, especially with record levels of public debt, at a rising cost, precisely when their help would be needed. But this is also complex: monetary tightening in the US and declining activity everywhere else will indeed help on the inflation front.

Against this backdrop, August ended on a difficult note and so starts September on global markets. There is no good news to expect in the short-term, but it’s reassuring to see extreme level of pessimism among market participants, and selectively reasonable valuations. Stay safe.

Cross-asset Update

With the Fed far from being done fighting inflation, asset volatility is set to remain high. Eurodollar futures, priced off Libor, are now discounting policy rates slightly above 4% until June 2023. This is no longer the Fed pivot markets had envisaged after the July FOMC meeting and Powell definitely rejected in his brief Jackson Hole speech. In the past, dovish policy shifts had been anticipated by two-year treasury yields inflecting lower, whereas the short-end of the curve is still selling off aggressively this time around, in line with the Fed chair’s hawkish message. As tightening proceeds apace and investors no longer price rate cuts to start early next year, portfolios should still be defensively tilted with a bias towards quality across asset classes.

The Fed will continue to fight inflation although US price pressures should have peaked, so market-implied inflation is expected to remain at current levels or drop further in anticipation of the tough Fed’s stance. Hence, higher nominal yields will translate into higher real rates, in turn capping equity multiples. Sustainable equity rallies are unlikely until policy turns, or markets are cheaper, and last decade’s average multiples when inflation was not an issue cannot be used as a reference point, unless one wants to compare apples to oranges. Companies with high cash-flow yields and able to grow dividends, a hallmark of balance-sheet resilience, should offer some downside protection in this environment. Likewise, high-quality bonds should still be preferred to high-yielding credits, as long as long duration is avoided. With the 10y2y yield curve inverted and the economy set to deteriorate, credit conditions remain unfavourable for junk-rated issuers. The share of zombie companies at a whopping 25% in the Russel 3000 Index suggests that it is just a matter of time before default rates pick up significantly, so investors should avoid chasing higher yields at the expense of quality.

Although in relative terms policy is going to be less restrictive in the emerging countries, with China easing and the major economies already through the bulk of tightening, dollar strength is not going to be an easy recipe for EM outperformance. Indeed, during times of rising US real rates, as it is the case now, investment flows are usually channelled to the dollar-pegged GCC region at the expense of EM assets, and this explains why the MSCI GCC year-to-date has achieved high single-digit returns. Still, valuations suggest downside across EM should be limited in spite of the lack of short-term catalysts.

Gold is not going to do much for portfolios either in a rising yield environment. A renewed gold bull market will require a policy turn as well, while a rebound is possible from the current oversold levels. So, overall, investing in high-quality bonds while avoiding long duration still seems to be the best course of action in a persistently high-volatility environment.

Fixed Income Update

Last week was all about the US Jobs report. Data showed a firm pace of hiring (close to thrice that of normal hiring). The unemployment rate ticked higher while the participation rate increased as more job seekers came into the market, lured by higher wages. As we write, markets are pricing in a 65 bps rate hike at the September FOMC meeting, which implies a 60% chance of a 75 bps rate hike. The August CPI release is likely key to setting levels into the decision. The markets currently price in a peak rate of just over 4% in six months which might be optimistic given the Fed’s assertion not to repeat past mistakes. The US Treasury yield curve bear steepened as the 10, 20, and 30-year yields moved by c.15 bps while the front-end stayed anchored.

Financial conditions in the future are set to tighten as the Fed’s runoff caps are set to double to their announced peak of $60bn USTs and $35bn MBS per month this month. Over time, we expect banks will start to compete via higher rates to retain more desirable deposits. The summer rally was powered by two key forces: the repricing lower of imminent recession risk and growing expectations of a dovish Fed pivot. At the Jackson Hole Economic Symposium, Fed Chair Powell delivered an unambiguous message that a dovish pivot is not in sight. As a result, we could expect a complete unwinding of the rally.

Credit spreads widened further last week, with Pan-European HY the worst affected. We would advise clients to reduce Pan-European HY exposure now owing to the growing macro risks in the region. Moreover, ECB continuing its fight against inflation with an expected rate hike of 75 bps on 5th September would put pressure on the refinancing rates, while the exacerbating energy crisis in the area and talks about energy rationing could put company profitability under pressure. All other sub-segments were in red, with the total return of HY and EM Debt in the bottom quartile. We remind investors to keep their duration short and go up in credit quality.

Regional credit markets are still in the upper half among different segments, having lost 10.3% YTD. The higher duration of the asset class makes selectivity key. We currently like subordinated debt of solid banks, low duration, High Yield, and strong IG GREs from the region that trade at a discount to their sovereign counterparts. Primary issuance has shown signs of coming back to life. ADCB is expected to issue a 5-year USD green bond this week, as it completed the Roadshows last week. Egyptian and Turkey bonds continue to be under pressure from adverse macro fundamentals. Though we have seen a pullback in CDS of both countries, the bonds would remain volatile.

Equity Update

The summer rally in markets, that started in mid-June, saw an about turn in August, a trend that’s continued into early September, as markets are pricing in a more hawkish Fed and ECB. The MSCI All Country World index fell 3.7% in August, with the MSCI Eurozone -6.4%, and US equities -4%. EM equities fared better and China, India, the Dubai and Abu Dhabi markets and LATAM were amongst those that had a positive August. While China has got one of the worst returns amongst large markets year to date, lately it’s been trading sideways. The availability of audited accounts to US regulators of China companies listed in the US, starting with Alibaba and NetEase, has given the China equity sector a boost.

Globally tech hasn’t had a great 6 weeks, with the rise in bond yields. Sentiment around tech shifted as hopes faded that the Fed was on the brink of a more dovish turn, reinforced by Chair Powell at the Jackson Hole symposium in late August. Rhetoric from ECB officials was also more hawkish, as Eurozone inflation hit a record 9.1% in August due to soaring energy and food prices. We remain overweight high-growth tech subsectors that incorporate the trends of the future and the synergy between tech and healthcare.

Despite the uncertain backdrop around the path of inflation, energy prices, the war in Ukraine, and economic policy in China, we are confident of long-term equity returns, with some selectivity in play. September is expected to mark the end of outsized rate increases. Earnings resilience and a tight labor market are the biggest pushback to US recession fears along with strong consumer balance sheets, record buybacks, still fairly light positioning, and China stimulus. Strong results and forecasts from Lululemon Athletica demonstrate that affluent shoppers are still active despite the inflationary pressures affecting the lower-income consumer segment. Headwinds continue with an overhang from QT, with balance sheet reduction set to nearly double in September. Earnings revisions ahead of the Q3 earnings season could reflect on slower growth and margin pressure

We favour positioning equity portfolios towards more resilient economies such as the US, domestically focused such as India and commodity exporters such as the UAE. Quality remains key as these companies are more resilient in periods of weaker growth and elevated market volatility. With inflation likely to remain above central bank targets for some time, valuations are important and that metric is in favour as after a significant derating over the past year, the S&P 500 is now trading on a trailing price-to-earnings ratio of 19.2X. and forward 17.3X vs the start of 2022, when the index had a trailing P/E of 24.4x. EM equities trading at a forward P/E of 11.3X look more attractive, but China policy remains important for equity performance. We remain overweight Indian equities. In the midst of slowing global growth India stood out with GDP growth of 13.6% y/y, though off a low base. The outlook for India's growth momentum is robust both in relative and absolute terms with government policies containing input inflation. Robust rains are good for rural income growth in FY23. 6-7% GDP growth with macro-stability looks to be the aim of policymakers for the foreseeable future.

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