December starts with higher hopes

Chief Investment Officer's team
05 December 2022
December starts with higher hopes
A lower US ISM Manufacturing and a relatively dovish Powell speech supported all asset classes last week…


  • A lower US ISM Manufacturing and a relatively dovish Powell speech supported all asset classes last week
  • … Led by stocks from emerging markets with growing signs of an imminent reopening in China
  • Sentiment and positioning are normalizing, but uncertainty should still prevail in the coming quarters.

Last week was no exception in Q4’s positive orientation, with all asset classes delivering positive returns. In the developed world, weak manufacturing activity supported anticipations for an imminent moderation of the pace of monetary tightening. To that extent, Fed Chairman Powell’s speech was a bit ambiguous, but most Fed watchers interpreted it as opening the door to a 50-bps hike next week. Markets didn’t pay too much attention to a higher than expected number of job creations in the US in November but focused on a lower number of job openings in October instead. This kind of confirmation bias is typical when sentiment turns, which is undoubtedly happening. The emerging world was buoyant, as China is taking initiatives to find a way out of its struggle with Covid: more vaccinations, and an easing of testing rules indicate a gradual shift away from its strict Covid Zero policy. This explains a 6% jump in Hong Kong’s stock market, which continues this Monday morning as we write.

Our central scenario seems to be unfolding, with slower activity and moderating inflation combining to unlock some of the value generated by excessive pessimism. Sentiment is undoubtedly turning, but it’s important to highlight that fundamentals haven’t yet. A pause from central banks will require more than a slow fall in inflation. We believe that inflation will ultimately normalize, but the trajectory and timing remain highly uncertain, especially as jobs and wages remain positively oriented in the West. Monetary tightening should be slower, but also potentially more restrictive and for longer than initially anticipated. This is why we have kept our positioning unchanged, close to neutrality, and currently focus on next year and its binary outcome on inflation. Stay safe.

Cross-asset Update

The month of November saw the partial reversal of the year’s narrative marked by headwinds from higher inflation, rising borrowing costs, and lockdowns in China. Global equities recorded their first back-to-back monthly gain in more than a year, IG bonds posted their biggest monthly positive return since 2008, and the US dollar weakened by 5% against a basket of major currencies. Are we back to the good old normal with markets finding a bottom and crosscurrents gradually retreating? Not really, although investors are rightly anticipating rising odds of peak policy rates round the corner and peak inflation now behind us.

There are two issues with renewed optimism, though, one related to the message sent by the US labor market, the other to the lagged effects of the tightening of policy. While the Federal Reserve has had some success in the battle against goods and services inflation, the war is not won until there is some slack in the labor market. This means that non-farm payrolls should drop to 100,000 per month, the level in keeping with stable employment, as against the 263,000 added in November, and wage growth slow down to 0.2% per month, versus the still speedy 0.6% that showed up in last Friday release. That in turn has hawkish implications: for unemployment to rise, the Fed will have to keep rates at high levels, and for long enough indeed. And, recession or not lurking further down the road, tighter policy will have to start to bite in 2023, with repercussions both on the economy and earnings. So, risk assets may well continue to rise in the short-term, but most likely not supported by the drivers of a new bull market.

And maybe they are more likely to rise than not into early next year. With peaking inflation and wage gains still pretty sustained, purchasing power will come back to consumers, prompting the conclusion that a recession will be avoided in the United States. At the same time, should the Fed even raise rates by 75 basis points, investors would all the more be looking to the forthcoming end of the tightening. Meanwhile, chatter of China’s reopening, following the nationwide protests and with Beijing set to support the economy, should only get louder, boosting cyclical stocks and the European markets. Yet, equity valuations can only expand so much as rates remain high, so a fully-fledged bull market should be expected only once the Fed starts easing rates, a 2H23 occurrence at the earliest.

As risk asset gains remain capped and higher policy rates start to bite in 2023, gold should turn in a positive performance in 2023. Buying on weakness should be the new guiding principle, as compared to selling strength in 2022.

Fixed Income Update

The life of a fixed-income investor has been challenging in 2022. Chairman Powell provided the proverbial straw to the investors with his remarks that the slowdown in rate hikes should be coming soon and that there has been some progress in the fight against inflation. This was the first part of his speech, and markets got excited to hear this. The treasury yield curve bull-flattened as the long-end of the curve moved down by roughly 17 bps over the week while the 1-2 year part remained stickier. The benchmark 10-year yields dropped by 20 bps on Wednesday during the speech. The following day it breached the psychological 3.50% momentarily. This is the challenge the Fed faces. Every time they make a dovish tilt, the financial conditions tend to ease significantly, with risky assets rallying. The market had also quickly forgotten the hawkish utterances from other Fed members, such as James Bullard and John Williams, during the start of the week.

Investors seem to have ignored the second part of the speech, where Powell did reiterate that the rates will have to remain higher for longer in this cycle. This was nothing new and demonstrated the desperation of a market looking for a lifeline. Friday's stronger-than-expected labour data dampened the so-called animal spirits and points to the volatile landscape around us. The yields initially increased as a result but recouped most of the losses as the Fed downshift hope weighted more positively on market sentiments. The Fed will try hard not to repeat the mistake of December 2018 as they attempt to bring down market buoyancy post the FOMC meeting next week.

In the Eurozone, the CPI came in lower than expected at 10% (Est. 10.4%) from the prior print of 10.6%. In the first instance of bond sales from the developed market central banks, BoE completed its first sale of Gilts amounting to GBP 346 Mn in a start to the quantitative tightening (QT), with Governor Bailey insisting that the markets can't absorb a massive sale of assets. QT will be a constant theme in 2023, when the top central banks, except for BoJ, try to unwind their bloated balance sheets. The demand reduction from the largest buyers of the bonds would limit how low bond yields can go next year unless a severe recession engulfs the world economy.

Investors need to cut the noise and focus on fundamentals at this stage, especially on the riskier segments of fixed income. High-quality, short duration bonds provide an oasis of calm amid the volatility. High Yield fundamentals will continue to deteriorate, and access to the market will remain challenged. Relative value-wise, we prefer subordinate debt of quality issuers to outright HY exposure. Emerging Markets will stay at the mercy of DM central bank policies. Demand from global asset allocators will decrease as risk-free rates increase to respectable levels while market access remains challenging for the weakest issuers. Top IG names from EM may avoid the markets if funding conditions remain unfavorable. We prefer BBB and cross-over rated sovereigns and GREs from EM.

Equity Update

This has been a volatile year so far, with the first 3 quarters seeing a selloff in global equities as worries around corporate margins and profit growth grew as a result of the combined effect of rate hikes, higher wages and rising raw material costs. Equities have however rallied strongly since mid-October, as small glimmers of hope on softening inflation, Central Banks slowing their tightening and China reopening have lifted market sentiment, with the most impact coming from the lower US CPI, last month. 10 year US Treasury yields are a percent below their peak aiding the performance and outlook of long duration sectors such as technology and the USD, while +9% from the beginning of the year has recently weakened. After rising 6% in October, global equities added almost 8% in November. Whilst the October rise was driven by developed markets, the November rally saw China equities gain 27%. Post the last 2 month rally we are close to our fair values for a number of regions including the US, Europe, Japan and India.

We remain positive US equities and in EM the UAE and India, both tactically and longer term. Tactically we see China continuing to rally. Last month we saw the biggest catalyst as a China reopening and in December, we expect global markets to remain stable to up. The China rally could continue with real estate developers receiving strong government support and many cities removing onerous COVID checking protocols in response to protests. The next big catalyst for US markets after the early Dec Fed meeting possibly leading to a Santa Claus rally if any pivot is perceived will be the Q4 result season which starts 3rd week Jan. For Q3 2022, the blended earnings growth rate for the S&P 500 is 2.5% and revenue growth rate 10.9%. According to FactSet during the months of October and November, analysts lowered EPS estimates for S&P 500 companies for the fourth quarter by 5%, a larger margin than average taking earnings growth estimates to Q4 to -2.4%.

Our bullish stance on UAE equities has been reflected in the performance of the Abu Dhabi and Dubai indices but the MSCI UAE has a 50% concentration of just 2 stocks, so its lower performance does not accurately reflect the UAE market. The recent Taleem Holdings IPO was heavily oversubscribed though the stock is trading 10% below its IPO price (in line with regional equity indexes that have fallen from earlier midyear peaks, tracking a decline in oil). 80% of recent UAE IPOs are trading above their listing price indicative of future success for listings. IPOs in the region have raised $19.2 bn so far in 2022. The KSA IPO of Saudi Aramco Base Oil Co., a refining unit of Saudi Aramco was covered within hours. Luberef, is 70% owned by Saudi Aramco, with the rest held by Jadwa, which is selling its entire stake. Luberef becomes the latest billion-dollar plus IPO in the GCC. High oil prices have benefited local economies.

India is on its way by the end of the decade to become the world’s third largest stock market and economy with GDP of more than US$7.5 Tn and an equity market cap of US$10 tn. Aiding this growth are a young demographics, accelerated adoption of digitalization, a focus on non-carbon initiatives and low dependance on other economies.

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