Economy slows down and conflict rages on

Chief Investment Officer's team
04 April 2022
Conflict rages on in spite of Russia’s focus on separatist republics


  • Conflict rages on in spite of Russia’s focus on separatist republics
  • Booming labour market clashing with Fed’s stance on inflation
  • We see limited upside on the 10-year treasury yield from current levels

It was an eventful week in terms of macro releases and developments related to the Russia-Ukraine war. The announcement by Russian officials that the offensive will be focused more on the separatist republics, and wound down elsewhere, had no follow-through in terms of the easing of the conflict. We still hope that a narrowing of its geographic scope could entail its faster resolution. The ruble, after being cut in half soon after the invasion, recovered strongly owing to strict capital controls. Hence, there could be a limit to the pain the West can inflict via sanctions, which so far have not had relevant spill-over effects globally. Biden’s plan to release crude emergency reserves for the next 6 months to contain price pressures could have actually incentivized OPEC+ countries to avoid any production increases beyond the ones already on autopilot.

The US jobs report pointed to a still booming labor market, though consumers continue to lose purchasing power and business confidence slipped. We would expect higher inflation and a tighter policy at some point to translate into higher unemployment, in contrast with the Fed official forecasts. In about two weeks the start of the earnings season should see a weaker release, considering the tough economic conditions in Q1. Overall, we would tend to see equities still range-bound, as the headwinds of an evolving slowdown phase, lower earnings and higher policy rates play out at the same time. We maintain the view that investors will have opportunities to buy on further weakness. We see US yields as not being far from an interim peak, if our view that the US economy is set to decelerate further and commodities are now overbought holds. This in turn would be food for thought at the April TAA Committee in relation to our global treasury underweight and DM equity overweight.

Cross-asset Update

Investors continue to be concerned about the stagflationary effects of the Russia-Ukraine conflict, translating into higher commodity prices and shocks to growth. Indeed, the two countries combined lead in commodity exports across energy, industrial metal and agricultural commodities; and the unintended consequences of war for the business cycle should not be underestimated, as “contagion works in mysterious ways”, according to World Bank’s chief economist Carmen Reinhart. Yet, focusing too much on current events to account for portfolio risks could prove to be blatantly misleading. There is shorter-term shocks, as well as slower-moving factors persistently working in the background which could easily be neglected by investors. The ongoing war falls under the former category, the deteriorating growth-inflation outlook across this decade under the latter. Both imply growth rising more slowly than inflation, yet on different time horizons. Focusing exclusively on this crisis as the only stagflation factor can give the false impression that once the war is over something resembling a goldilocks scenario could again materialize. We do not think this is likely. For instance, inflation as a policy choice, hence for the longer term, stems primarily from the turn towards greener economies, requiring commodity-intensive investments, driven by governments across major world countries. So, even under the optimistic scenario of a quicker end to the conflict, investors should still strive for allocations making portfolios resilient to the stagflationary-leaning regime we see ahead on a multi-year time frame.

The shift to value within equities and the outperformance of cash-generating companies and the ones paying higher-than-average dividend yields could prove to be more durable than most investors expect. Growth should have a place in any stock portfolio, but we would suggest that it should be growth at reasonable price as well. The pharma sector is currently a good example of growth companies offering appealing valuations. The bull market in commodities could resurrect some long-forgotten sectors like basic resources, currently not even 3% in terms of market cap of the S&P 500. These investment styles should be adding value to client portfolios under conditions of a less favorable growth and inflation trade-off.

Within fixed income, although US yields in our view should take a breather, safe bonds cannot be easily recommended due to persistent duration risks. Bonds offering higher coupons in keeping with acceptable credit profiles should be preferred, offering a buffer against rising price pressures. At the same time, continued rates volatility, affecting spreads, will require more active management within credit as well.

With no resolution to the Russia-Ukraine conflict in sight, gold should maintain its war premium and in case of tension further escalating it would again be climbing towards its all-time highs. But against the backdrop of the Fed tightening sharply, we would tend to think that levels above $2,000 could prove to be untenable.

Fixed Income Update

All eyes are on the FOMC meeting minutes to be released this week on Wednesday, 6th April. There will definitely be more information regarding the Quantitative Tightening, which is widely expected to start in May. During the last QT of 2017-19, the maximum monthly cap size was $30 billion for Treasuries and $20 billion for mortgages. The phase-in period was a year. Several Fed speakers have already intimated that the monthly caps will be larger this time with a shorter phase-in period. Moreover, the Fed has $326bn T-Bills. Offloading bills should have no tightening effect via longer-term interest rates. However, it could relieve some of the demand for the Fed's reverse repo facility.

Moving over to the UST Yields, the recent Powell pivot on 21st March seems more Volckerish. It was a bit surprising given that the 16th March Dot Plots indicated seven rate hikes, while on 21st March, Powell indicated that the plots could go outdated pretty quickly under the current scenario. With Jobs data remaining strong and inflation being stubborn, the Fed is now quickly shifting its gear with the sole aim of bringing prices under control. Everything else is a second priority now. The markets currently price in more than eight rate hikes by the end of the year, with two back-to-back 50 bps hikes in the next two meetings. Jay Powell is probably trying to get to the neutral zone as quickly as possible. Under such circumstances, it is useless to fight the Fed, and we believe the 10-year US Treasury yields can go up from here.

The credit segments were all in green last week as the 10-year yields stabilized and moved down from their recent highs. Spreads have continuously tightened to their pre-conflict levels. Emerging Market sovereign continues to outperform EM Corp as anticipated. Pan-European HY spreads are below 400 bps now, and YTD outperforms the US HY by 0.9%. Clients who would have followed our advice to go relatively OW on EM sovereigns, and Pan-European HY would have benefitted significantly from these spread compressions.

Asia HY continues to benefit from the regulators' declaration for support and returned +2.8% last week. We should have more clarity on the segment as more and more developers come out with their FY 2021 results. So far, it seems the strong developers such as Country Garden and Vanke have done reasonably well despite lower earnings. However, the situation for the HY developers is still fluid.

Govt of Sharjah issued an 8-year Sukuk last week and priced it below 4%. On high yield sovereign names, both Bahrain and Oman saw buyers with bonds closing tighter by about 7-10bps while Investment Grade issuers either remained flat or ended lower last week. S&P last week upgraded Oman's local currency LT bonds to BB- from B+. As mentioned in the last weekly, we had turned positive on Egypt post the currency depreciation, and the country's bonds were up by almost 5pts for the week. Turkey also continues to see significant buying interest with recently issued bonds/sukuks trading at par.

Equity Update

All three major U.S. stock benchmarks booked their largest quarterly drop in two years, capping a first quarter in which the Federal Reserve's monetary tightening and the Russian invasion of Ukraine have weighed on sentiment. However, the worst quarter in two years isn't so bad as the S&P 500 index is roughly 5% away from record highs. We could expect markets to be choppy over the next few months, with little visibility on when peak inflation happens and how aggressive will Fed’s tightening be. Energy stocks closed lower, giving back earlier gains, following news that the U.S. will release roughly a million barrels of oil a day from its reserves for six months beginning in May in a historic drawdown.

The dominance of tech stocks in the S&P 500 is set to shrink next year after the index’s overseer announced revisions that will reclassify the sectors of some major shares. Payment processing companies currently classified as technology firms are poised to join the financial sector, while other tech names providing outsourcing or human resources support will be classified as industrial stocks, S&P Dow Jones Indices and MSCI Inc. said in a joint statement last week. The full list of companies affected is expected to be released by December, and the changes are planned to be implemented in March 2023. The adjustments mean that the likes of Visa Inc., PayPal Holdings Inc. and Mastercard Inc. will shift from tech to the financial sector.

China modified a decade-long rule that restricted offshore-listed firms’ financial data sharing practice, potentially removing a key hurdle for U.S. regulators to gain full access to auditing reports of the majority of the 200-plus Chinese companies listed in New York. U.S.-listed Chinese stocks climbed Friday following a Bloomberg News report that regulators in Beijing are working on a framework that’ll grant their U.S. counterparts full access to auditing reports for a majority of the companies listed in New York. The compromise will allow most firms to keep their U.S. listings. There are more than 200 Chinese firms listed in the U.S. as American Depository shares, with a combined market capitalization of $2.1 trillion as of May 2021, including eight national-level state-owned enterprises.

Dubai Electricity and Water Authority (DEWA) said on Saturday that it has raised the tranche of the initial public offering for individual subscribers from 260 million shares to 760 million shares, after retail investors’ subscription requests far exceeded the offer. The company said that implies a deal size between 20.25 billion dirhams and 22.32 billion dirhams. Including the employee tranche, retail investors will represent 9.2% of the deal, according to DEWA. The company said the revised offering will result in a free float of 18% of DEWA’s share capital with the Government of Dubai owning the other 82%. The subscription period for retail investors ended on Saturday, and it is scheduled to end on April 5 for other categories of local and international investors. DEWA is expected to be listed on the Dubai Financial Market (DFM) on or around 12th April 2022.

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