Equity rally challenges Fed and Ukraine conflict

Chief Investment Officer's team
29 March 2022
Tail risk of sharper slowdown growing but recession not in the offing


  • Tail risk of sharper slowdown growing but recession not in the offing
  • Markets still challenged by falling earnings and higher inflation
  • Headwinds manageable once ceasefire stage achieved in conflict

As the Russia-Ukraine war rages on, investors can only hope that eventually a middle ground is struck and a ceasefire is agreed alongside a serious round of negotiations. That might entail that Russia refocuses on the Eastern breakaway republics, rather than the whole of Ukraine. It might be the case that the West would keep softer sanctions working for some time, until it is ingrained in the Russian leadership that invasions of sovereign countries are not tolerated. The above scenario would represent a benign development of what otherwise could turn out to be a conflict with nasty repercussions for the global cycle.

Meantime, in spite of the forceful rally staged by global equities in the last two weeks, markets will have to deal both with the Fed’s accelerated tightening and the slowing of earnings. We doubt Jay Powell’s narrative that employment will remain steady in spite of the aggressive removal of stimulus. The bulk of the U.S. aggregate demand is consumption and last week’s University of Michigan readings, plumbing new lows for the year, gave little room for comfort. Inflation is biting and the purchasing power of consumers is being eroded significantly. As the tail risk of a sharper slowdown is put into starker relief, investors are advised to fade equity rallies and buy renewed weakness we deem likely in Q2.

Although US yields have repriced dramatically following the Fed’s first hawkish turn in January, we hold the view that there is not much upside left, barring negative surprises from a longer-lasting conflict fanning more inflationary pressures.

Amidst still heightened uncertainty, risk taking should be very targeted and diversification remains the keyword.

Cross-asset Update

All roads lead to inflation nowadays, it seems. BlackRock’s Larry Fink said in his letter to investors that the Russia-Ukraine war is bringing the era of globalization to an end, which in turn has implications in terms of higher price pressures. Actually, the ratio of global trade to GDP peaked in 2008 according to World-Bank data, and at the end of 2020 that ratio plunged below levels last seen in 2004. Well before the current conflict both Donald Trump’s trade wars and the Covid crisis were already challenging globalization. The recent shocks should convince CEOs to localize supply chains, prioritizing precaution versus efficiency, hence the prices of world traded goods should tend to increase. But other forces in the background will tend to work in this same direction, due to what is known as constrained growth and is also a global phenomenon. As the pool of available labor in an economy shrinks, a way to avoid inflationary pressures is to increase productivity. In the emerging economies this pool of labor, as people shifted from agriculture to manufacturing, seemed to be inexhaustible, propelling EM growth via exports. Now that the transition to the manufacturing sector in the major emerging economies is over, unless technological progress comes to the rescue, labor will not be able to spur growth any longer and price pressures will be the inevitable outcome. Since boosts to productivity are hard to come by requiring multi-year investments, we are most likely headed towards labor-constrained growth, implying a deteriorating growth-inflation trade-off globally. On top of this, commodity-intensive investments required for the building of greener economies and underinvestments in basic resources in the past decade will continue to put upward pressure on commodity prices, adding fuel to the inflationary fire.

The bottom line is that, although powerful structural deflationary trends remain well in place, mainly represented by ageing populations and technological progress, the above-mentioned secular forces operating in the opposite direction are gaining traction and going to shape a very different decade ahead. Repercussions will be felt across asset classes, and primarily in what is being labeled as the crisis of the equity-bond portfolio, whereby the future returns of traditional asset classes are deemed to be well-below historical averages as inflation compresses equity multiples and heightens government-bond volatility.

Investors are advised to make their portfolios more resilient to the new regime. Within equities, selecting companies with pricing power should be a priority. Cash-rich companies, hence also the high-dividend paying ones, should be outperforming in the longer term. Within fixed income, a preference for higher-yielding bonds should offer some cushion against rising price pressures. Outside of traditional assets, allocations to absolute-return strategies should be raised, making portfolios less volatile, hence less prone to large drawdowns coming with long times to recovery. As for commodity investments, only possible via futures, investors must be careful about the adverse effects of positively slanting futures curves eating into capital gains.

Fixed Income Update

It is that time of the year again. Everyone has started talking about the yield curve inversion after the blistering rise in the US Treasury yields last week. YTD 10-year treasury yields have risen by 99 bps. 2-, 5-, 10-, and 30-year yields rose 34bp, 43bp, 35bp, and 19bp, respectively, with most of this move occurring on Monday and Friday amid relatively hawkish Fed commentary. Markets are pricing in more than 85bp of rate hikes between now and the June FOMC meeting and a terminal rate at 2.95%. The current treasury market performance resembles Q1 21, where 10-year yields went up by 83 bps. According to JP Morgan Research, since the introduction of the US GBI in 1986, there have only been 11 instances of successive quarters of negative total returns, with the weakest performance of -5.6% over 4Q20/1Q21. In this strongly negative return backdrop, a similar move in 2Q22 seems somewhat unlikely. However, over the long run, the yields can continue going higher, especially as the Fed is falling behind the curve; they would need to move faster into the restrictive area, classified as overnight rates above 2.5%.

Credit indices were a sea of red in terms of last week's performance, mainly driven by the movement in the underlying yields. Most of the segments have retraced the post-Russia-Ukraine spread widening, and we expect spreads to be range-bound. According to a Goldman Sachs report, leverage and net profit margins have plateaued after analyzing the Q4 earnings reports. On the positive side, balance sheet liquidity positions and debt servicing capacity remain remarkably strong relative to historical standards. This gives us some comfort that though liquidity is receding, the credit defaults should remain range-bound.

The primary issuance market has remained lackluster in Q1 2022. There are two key drivers behind the muted volumes. First is the elevated market volatility, and secondly, the rotation from Fixed to floating rate products. The slowdown is evident in riskier segments such as High Yield, where YTD, only around $40bn of bonds have been issued, which is the slowest start to the year since 2018. In addition, the Q1 EM Debt issuance stands around $131bn compared to $237bn in Q1 2021.

GCC and broader MENA bonds performed well last week. The GCC bond index spread has tightened by 16 bps. Bahrain and Oman's bonds have given the highest YTD total return due to their high oil-beta. Egyptian bonds have rebounded post the currency depreciation last Monday and the surprising 100bp rate hike by the CBE. This is expected to stem the FX outflows from the country and bring it closer to a deal with IMF. As a result, we are comfortable adding Egypt bonds with 5-7 year duration to the portfolios with appropriate risk appetites.

Equity Update

A second week of gains for global equities and the technology sector in spite of rising yields as the Fed has turned more hawkish with an accelerated tightening cycle. A flatter rate curve is now pricing in an increased risk of recession. Also worrying is how aggressive the Fed will be in combatting elevated inflation pressures. Global equities (-5.7% YTD) are back to levels before the Ukraine Russia war with U.S. stocks gaining close to 2% last week, following the week before gains of 6.1%. Tech, including unprofitable tech also rebounded in spite of rising yields. European equities are lagging US returns, after leading in the earlier part of 2022. The energy sector had a strong week as oil prices continued to rise alongside other commodities with Russia and Ukraine now in their 2nd month of conflict and sanctions increasing on Russia.

High inflation, rising rates and slowing growth are serious headwinds. Higher rates imply lower valuation multiples, while lower growth and rising costs impact margins and earnings. We have remained constructive on equity performance and the U.S. in preference to European equities. Whilst earnings downgrades are rife across the board, we see larger downgrades to European corporate earnings. Besides Russian market share European companies are also affected by the China zero Covid policy as many large automakers and food companies have considerable revenue generation from China. Shanghai is in lockdown awaiting results of a massive testing blitz joining other regions in the country.

Emerging market performance is being led by commodity exporters the GCC and LATAM. We are overweight both geographies. The UAE markets had another positive week and resumption of dividends in the Dubai real estate developers along with continued demand uptake are strong tailwinds.

The supportive announcements from policymakers in China the week before were not sufficient to turn the market around and the MSCI China is still down -16% year to date. Gains in China and Hong Kong markets were short lived as investors await certainty on the Government reassurances. The market is facing multiple headwinds from repercussions from the Russia/Ukraine conflict, ongoing weakness in the property market and an Omicron outbreak in Mainland China and Hong Kong. Delisting risk for US listed Chinese companies is not over. Earnings downgrades continue for China tech. The regulatory crackdown has affected gaming, ecommerce and digital payments. Alibaba and Meituan were two of the more prominent companies fined for monopolistic practices over the past year. Tencent followed Alibaba in reporting its slowest quarter of growth on record with revenue growing in the single digits as online advertising sales declined for the first time. Gaming (Tencent’s biggest division) revenue is flat reflecting a months-long licensing halt. TenCent market cap is down by half a trillion dollars since its peak in 2021. WeChat messaging platform, saw monthly active users grow 3.5% to 1.27bn, but concerns on its payment services are in focus. For China's Internet industry to rally less regulatory scrutiny and faster resumption of game licensing are needed. Till then we stay neutral.

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