A narrow corridor for soft-landing

Chief Investment Officer's team
19 July 2022
Inflation remains intense in the US and Europe, while various indicators confirm a decelerating growth


  • Inflation remains intense in the US and Europe, while various indicators confirm a decelerating growth
  • A higher than expected US CPI number didn’t really shock markets last week
  • We expect high volatility but remain reasonably constructive for the medium-term

At +9.1% year-on-year, the progression of US consumer prices released last week was higher than forecast, and also pointed to inflation broadening to more segments of the economy. Retail sales were also strong, but in an overall context of impressive resilience, indicators such as industrial production or the NFIB Small Business Outlook confirmed a sharp deceleration. Bottom-line, the Fed will continue to tighten, at an economic cost.

Markets took a stance: weekly returns were negative, but ended better than when the CPI was released. This confirms that inflation and its consequences are not a surprise anymore, and that a material level of economic risk is already priced-in. The level of the US 10-year Treasury yield is -30 basis points below its year high, forming a clear inversion of the curve. This unambiguously reflects an acknowledgment of a ballistic tightening which will lead to a sharp slowdown.

Markets are aware, but households are suffering from an intense purchasing power squeeze, especially in Europe, which also faces a historical heat wave at the time when energy supply is both insecure and expensive. This creates pressure on political leaders who cannot, this time, borrow their way out with magic money: there is none anymore. Risks are serious.

This is why we keep on expecting extreme volatility for the months to come. However, we have not changed our cautiously constructive view. First, the end of artificially abundant and free money is fundamentally sound. Second, the corridor for a global soft-landing is narrow but it’s not impossible: the economy has been so far very resilient and China is restarting. Third, valuations are much more reasonable and investors are extremely pessimistic. We just need inflation to abate. Stay safe.

Cross-asset Update

Although soon after Wednesday’s US inflation release markets briefly priced in increased odds of a 100-basis-point hike in July, the final reaction was more muted, with long-dated treasury yields closing the session below where they were trading pre-CPI. On Friday longer-term inflation expectations as per the University of Michigan survey printed at 2.8%, a one-year low, while equities rallied and the S&P 500 Information Technology Index ended the week down only 0.3%, not exactly a sign of panic for the inflation outlook. The Bloomberg Commodity Index closed down as well and more than 15% below its June high. Overall, investors are looking through the current high inflation and must be taking the view that the Fed’s tightening will be impacting growth and ultimately taming price pressures as well. The big unanswered question is how deeply growth will be curtailed in the process.

Bonds are starting to discount a bleak outlook, as the 10y2y term spread, the difference between 10- and 2-year treasury yields, is currently deeper in negative territory than it was in 2006, and the 10y3m could invert within a few months. A harsh slowdown induced by the Fed’s tightening seems unavoidable, and it is not yet fully reflected across macroeconomic data. The notable difference this time is that during past yield curve inversions equities continued to rally, whereas year-to-date they are deeply in the red already, so the bulk of the bad news could be priced in. This is what motivated Bank of America’s Michael Hartnett, the renowned strategist, to say that a bad Q2 earnings season could yield ‘proper capitulation’. A strong rebound could delay that final act, though, and the very Bank of America Merrill Lynch Bull & Bear Indicator, a gauge of investor sentiment, continues to linger in ‘buy’ territory, in itself raising the odds of that rebound.

High-yielding bonds on the other hand are not pricing in a lot of bad news as compared to equities. Judging by historical drawdowns during hard landings we could say that equities have priced in 70% of the bad news, while US HY corporate bonds only 50% considering current spreads levels as against recessionary levels. The best risk-return trade-off should be in high-quality bonds, with treasury yields expected to be capped with the worsening of the macroeconomic outlook. So, in pecking order and assuming more bad news yet to come out we would have a bias towards high-quality bonds, then equities and lastly high-yielding bonds. Gold is oversold but only due for a rebound rather than a bull market, given the amount of tightening left and Powell’s statement at the June policy meeting that “we’d like to see positive real interest rates across the entire curve”.

Investors are anticipating a steeper monetary cycle in line with Powell’s hawkish tones, but also a quick reversal to more accommodative conditions. According to Eurodollar futures policy rates should again be headed lower after February 2023. That seems like a lot of wishful thinking to us: will the Fed want to risk higher inflation again by prioritizing growth, or will they err on the side of caution to avoid severe damage to their reputation?

Fixed Income Update

The divergence between June inflation data and future inflation expectations moved markets in opposite directions late last week. While the earlier data printed a record 41-year high spurring 100 bps rate hike talks for the July FOMC meeting, the inflation expectations data have notably softened, with 5–10-year expectations dropping to 2.8% in the preliminary University of Michigan July report. The three-year inflation expectations in the NY Fed's survey have declined 0.3pp since April, and market-based measures have materially declined as well. The softening of expected price pressures combined with dovish Fed speak calmed the market’s nerves. Strong inflation numbers kept up the pressure on the front-end of the curve even though the long end pushed lower helped by the slowdown scares. The 2s10s part of the curve remains the most inverted since 2007 at -20 bps. US Treasury markets will struggle for direction as the week is light in terms of data releases post a data-rich previous week and FOMC blackout has also begun.

US bank earnings provided an interesting update as a host of banks suspended share buybacks as they try to bolster their capital ratios quickly. This would benefit the G-SIB banks that continue to be leverage-constrained, and in the face of a potential forthcoming recession, they are looking to build capital where they can. According to an interesting JPM report, in 2Q22, $111bn of HG bonds were upgraded, which outpaced, albeit marginally, the $99bn of downgrades over the quarter. The ratio of upgrades to downgrades was 1.2x in 2Q22. This is a notable decline from 1Q22, when this ratio was a healthy 6.4x backed by solid credit fundamentals. Another noteworthy point was that the three-fourths of the downgrade activity in 2Q22 took place in June ($68bn of $99bn), while the majority of upgrades took place in May ($63bn of $111bn). Rising stars amounted to a further $11bn in 2Q, counterbalanced by $5bn of Fallen Angels after two quarters of no HG to HY downgrade activity. Further strengthening this trend of weaker credit is an S&P report that indicated there were 40 bankruptcy filings in June, up from 30 in May and the highest number since April 2021.

Emerging Market saw fund outflows. EM sovereign credit outflow related to distressed selling has crowded out the impact of commodity prices as EM sovereigns react more to liquidity than fundamentals. Some of the HG EM sovereigns in the Middle East have very tight spreads compared to their DM counterparts and we could see a little bit of spread widening there as funds move out for relative value plays. High-beta EM sovereigns have been hit particularly hard as outflows accelerated. EMBIGD HY spreads are now close to 1000bp, standing at the 77th percentile of the 15-year range. EM Corporates Ex. Ukraine and Russia have fared relatively better. However, due to this outperformance, the EM corporate spread levels do not look attractive anymore from an overall asset allocation perspective.

Equity Update

Global equities fell across the board last week, with the UAE and KSA the only exceptions. Particularly hard hit were the China and Hong Kong markets, after a softer-than-expected Chinese Q2 GDP report. Global equities are down 20% YTD with EM and DM in synch. The better performers remain the UAE (OW) and India. Our OW EM Asia call is having mixed results, with China losing all of its last month’s gains in one week. The stronger USD is also not helping trade and importing inflation into the Asian countries and also affects their repayments for USD denominated debt. Our preference for the US over Europe is finally seeing some traction as energy concerns and inflationary pressures are riling European markets. Not that it is any consolation, with markets everywhere continuing to oscillate as they evaluate the implications of aggressive central bank tightening amid slowing economic activity.

We expect a stormy end of summer for markets as central banks continue to raise rates. Though equities are cheaper than they were at the beginning of 2022, they are trading on earnings expectations that could likely be revised down if inflationary pressures persist. With tightening monetary conditions, investors are looking at lower multiples. The S&P 500 traded last week at 16X one-year-forward earnings, down from 21.5X at the end of last year. As historical equity returns over longer periods (including deep troughs) show gains of +7% p.a. for global equities, we should look past the current volatility and use this as an opportunity to accumulate the companies with products and services catering to future trends and cash flows are growing and not highly leveraged.

S&P 500 companies are on track to achieve an earnings growth rate of 4.2% and revenue growth rate of 10.2%, y/y for Q2 and net profit margin of 12.4% with 7% of companies having reported (largely financials). The slightly lower margin (Q2 2021 was 13%) is a result of higher costs. PPI was higher, +11.3% y/y in June, the second highest on record. Companies are worried about inflation, not surprising with the 9.1% CPI print.

U.S. equities rallied heading into the weekend, but the major indexes still closed negatively for the week. Economic and earnings data were in play with June retail sales higher than expected, consumer sentiment improved from record lows, however, industrial production and capacity utilization came in below forecasts. Q2 earnings season in the early stages, is being received well so far, albeit a few hiccups. Investors are looking to the coming weeks to reveal winners and losers as to who can maintain profits as costs rise. The financials sector was in focus as some of the biggest institutions reported and guided on still strong consumer activity and trading revenues but higher credit costs and declining investment banking results as M&A and IPO action cools. Citigroup topped forecasts and was along with other major US banks that rallied post the earnings releases. JP Morgan is suspending buybacks as worries increase for an economic slowdown. In rising rate environments, banks can charge higher rates, on mortgages and other loans. However, as the fear of recession and economic slowdown increases many banks are looking to preserve cash to cover potential defaults.

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