Fed’s tightening and global slowdown an unfortunate mix

Chief Investment Officer's team
10 May 2022
Powell’s terminal rate “between 2% and 3%” fails to woo investors


  • Powell’s terminal rate “between 2% and 3%” fails to woo investors
  • Equity valuations more appealing amidst signs of capitulation
  • Global economic woes compounded by heightened geopolitical risks

Stocks suffered the fifth straight week of losses amidst the withdrawal of Fed liquidity and a still rumbling Russia-Ukraine conflict. Long-dated yields made new highs for the year, alongside the US dollar, further tightening financial conditions. We would be tempted to look at the glass half full, with the US economy still resilient, higher Fed rates ahead now fully discounted and deflating equities with early signs of capitulation. On the one hand we could, but on the other there still is the big unknown of the impact of Quantitative Tightening on markets, with previous precedents, QT1 in early 2008 and QT2 in 2018, all pointing to disruptive effects.

The Fed did not surprise markets, with a 50-basis-point hike, more hikes of the same magnitude lying ahead and the starting of the shrinking of the balance sheet from next month. But it was surprising that Powell said that the terminal rate, the one to be expected at the end of the monetary cycle, sits “between 2% and 3%”. That holds when inflation is around the target level, 2%, but with core PCE at 5.2% YoY, the hiking should not even be done with a policy rate at 3%. This begs the question of whether the Fed is really committed to fighting price pressures beyond the official rhetoric.

While the US economy is barely dented by different sources of volatility as indicated by the ISM manufacturing and the jobs report, Europe and China are faring nowhere near that well, and Europe’s decision to phase out Russian oil imports by year-end will only add to economic woes. As the Western and Russian positions become more and more irreconcilable, investors should be aware of growing downside risks.Stay safe.

Cross-asset Update

There is still nowhere to hide for investors. With the major asset classes in negative territory year-to-date with the exception of gold, one wonders what could prompt markets to inflect higher. Valuations, liquidity, abating geopolitical risks?

Valuations are important and this point only could be debated for long. We cut to the chase and say that, although stocks are now better priced, looking for average historical price-to-earnings could be deceptive. Are we interested in convergence towards the last ten-year average multiples? Not so fast. That was the past decade, which reflected Goldilocks conditions, that is both muted growth and inflation commanding the highest valuations. Assuming with some common sense that we are no longer under a Goldilocks regime, but rather witnessing a derating from a less favorable growth-inflation tradeoff, we should then be expecting lower average multiples than in the past. Valuations are slow-moving, so anyway we won’t be able to use them as a timing factor, but past averages may offer less comfort than usual and from this viewpoint markets are not oversold.

Liquidity is the lifeblood of markets and it is being removed across the G7 countries at the same time, something which may well account for today’s struggling equities. With asset purchases yet to be reduced by $410bn in the Group of Seven, there is a legitimate concern that the struggling will persist until the bulk of the tightening has been carried out. Although the shrinking of the Fed’s balance sheet has not even started, the past disruptive episodes of Quantitative Tightening suggest that at some point the Fed could backtrack. But we are not there yet.

As for geopolitics, the Russia-Ukraine conflict is dragging on with no quick end in sight. The West now wants to achieve a “strategic defeat”, while Russia intends to annex the occupied regions, control the South of Ukraine and landlock the remainder of the country. Over-ambitious plans on both sides could see them in the conflict for the long haul.

It seems fair to conclude that not all the bad news is out yet and we should brace ourselves for more volatility, before at some point investor capitulation kicks in. Meantime, one should put money to work with an eye to downside risk. In this sense we see hedge funds and income generation across both equities and fixed income as viable strategies. The HFRX Global Index, the most followed hedge fund benchmark, is down only 2.5% for the year, while the Shanghai Dividend Index, comprised of high-dividend-yielding companies, has lost less than 1.5% YTD. Even though diversification has for now lost some of its luster, high-income and absolute return strategies play a role in the current market environment.

Fixed Income Update

It was a paradox that the markets took the highest single-day rate hike in two decades as a dovish signal last Wednesday. The culprit was Chairman Powell's confirmation that a 75 bps rate hike was off the table. The Fed is caught between "a rock and a hard place." Either they hike sharply and crash the economy, or they become lenient and let wage growth spiral. They rhetoric seems to be following the first route with the expectation that economy will weather the demand shocks. Markets seem to think otherwise, leading to a bear steepening of the US Treasury yield curve as longer-term risk premia decrease. The price actions resembles the taper tantrum of 2013. This tussle has resulted in the belly of the curve trading near its 2018 highs. We believe slower growth expectations could flatten the curve. Hence, we advise investors to extend their duration in bonds and credits to 7 to 10 year maturity periods.

Quantitative Tightening details were published, and Chairman Powell said that the current rate of balance sheet run-off is equivalent to one rate hike per year. It remains to be seen how the markets react to the liquidity withdrawal once the actual process is underway. The QT will start in June with a $30bn Treasury run-off and $17.5bn MBS run-off, which will gradually increase to a $60bn treasury and $35bn MBS run-off within three months. The current pace will allow the Fed to shave off $2.4-$2.6tn from its current balance sheet within three years.

Credit spreads have widened since the start of the year to reach near their highest levels in the last five years. This has led to YTD drawdowns ranging from 9% to 14% across various segments. Some segments, such as IG credit, now offer a greater than 3.7% yield for a duration of less than 6.75. These levels are starting to look attractive. We advise more cautious investors to add some defensive assets at current levels, should they be worried about rising volatility. Moreover, as yields peak out, developed market IG credit offers a good chance to add duration to the fixed income portfolios. We would also advise clients to stay clear of adding long duration in either emerging markets or High Yield segments.

MENA bonds have been volatile due to the lower interest from the local markets owing to the holidays last week. Investment Grade sovereigns have lost between 2 to 3 points on cash bond prices, while high yield sovereign bonds lost between 1 to 2 pts the previous week. Longer duration bonds have been more affected due to the yield's sell-off. Local sovereign and real estate sukuks have performed much better.

Equity Update

Higher volatility with equities ending lower globally for the week. China and India equities were down almost -7% and -5% respectively. European equities fell 4%. UAE markets fell a percent but retain gains of close to 20% YTD. Whilst the S&P ended at 4123, close to where it began the week, it is now in its 5th week of decline and saw two +/- 3% trading days last week and YTD has fallen -13%. The Nasdaq with the Treasury 10-year yield above 3%, has fared worse with growth sectors affected by the higher discounting factor for present value and is down 22% YTD. The energy sector continues to benefit from higher oil prices and is the only sector up YTD.

A key question is how the rising interest-rate environment is going to affect margins for corporates and consumer demand. From India and Brazil to the US, rates have been recently raised by Central banks. The latest U.S. jobs data showed U.S. hiring advanced at a robust pace in April and affirmed expectations the Fed will remain on its accelerated rate-hike path to combat stubbornly high inflation. A small labour force also necessitates wage hikes to attract workers.

Inflation is a big worry with the UK’s BOE seeing a 10% CPI print by October, the US at 6.6% PCE and over 8% CPI and Indian numbers well over 6%. Supply chains remain in disarray with no resolution in sight for the Russia Ukraine conflict, though China lockdowns will eventually cease as virus cases fall. Currently 345mn people are living in full or partial lockdown in 46 cities. Shanghai the world’s largest port is in lockdown, and many Shanghai subway stations are closed. China’s economic activity contracted sharply in April with PMI (47.4) falling to the second lowest level since 2008, the global financial crisis (only behind the COVID-19 outbreak in Feb 2020). As of end April, 25% of China's GDP was still under full or partial lockdown.

Keeping in perspective earnings growth and valuation multiples, fundamental parameters for equities are favourable. However, volatility will stay through the tightening cycle. This provides opportunities and over the longer term equities have returned 6% p.a. with the US leading at returns of 7% p.a. and 16% over the last 10 years. Tech, the biggest weight in global and US indices, has seen the Nasdaq rise 450% over the past 10 years, so for longer term investors a 22% fall is not a big dent. But quality matters as 49% of the Nasdaq is more than 50% below their 52-week highs, 58% of Nasdaq is more than37.3% down, and 77% is in bear market, down >20%. Our positioning favours the US in developed markets and the UAE and India in emerging markets.

Written by:
Emirates NBD Bank PJSC (“Emirates NBD”) is licensed and regulated by the UAE Central Bank and this website aims at providing Internet users with information concerning Emirates NBD Private Banking, its products and activities. Persons having access to information made available by Emirates NBD on this website accept the following rules:

Emirates NBD uses reasonable efforts to obtain information from sources which it believes to be reliable, however Emirates NBD makes no representation that the information or opinions contained in publications on this website are accurate, reliable or complete. Published information may include data/information from stock exchanges and other sources from around the world and Emirates NBD does not guarantee the sequence, accuracy, completeness, or timeliness of information contained on this website provided thereto by unaffiliated third parties. Anyone proposing to rely on or use the information contained on this website should independently verify and check the accuracy, completeness, reliability and suitability of the information and should obtain independent and specific advice from appropriate professionals or experts. Further, references to any financial instrument or investment product are not intended to imply that an actual trading market exists for such instrument or product. Emirates NBD is not acting in the capacity of a fiduciary or financial advisor. Any publications on this website are provided for informational purposes only and are not intended for trading purposes. Data/information provided herein is intended to serve for illustrative purposes and is not designed to initiate or conclude any transaction. The information available on this website is not intended for use by, or distribution to, any person or entity in any jurisdiction or country where such use or distribution would be contrary to law or regulation. This website and anything contained herein, is provided "as is" and "as available," and that Emirates NBD makes no warranty of any kind, express or implied, as to this website, including, but not limited to, merchantability, non-infringement, title, or fitness for a particular purpose or use.

The provision of certain data/information on this website is subject to the terms and conditions of other agreements to which Emirates NBD is a party. Emirates NBD reserves the right to make changes and additions to the information provided at any time without prior notice. The information may be modified or removed without prior notice. No buy or sell orders submitted via the internet or email will be accepted. In addition, the data/information contained on this website is prepared as of a particular date and time and will not reflect subsequent changes in the market or changes in any other factors relevant to the determination of whether a particular investment activity is advisable.

Information contained on this website is believed by Emirates NBD to be accurate and true, in all material respects. Emirates NBD accepts no responsibility whatsoever for any loss or damage caused by any act or omission taken as a result of the information contained on this website. Further Emirates NBD accepts no liability for the information and opinions published on the website and is under no obligation to remove outdated information from its website or to mark it clearly as such. The information given on this website may not be distributed or forwarded in whole or in part. Accordingly, anything to the contrary herein set forth notwithstanding, Emirates NBD, its suppliers, agents, directors, officers, employees, representatives, successors, assigns, affiliates or subsidiaries shall not, directly or indirectly, be liable, in any way, to you or any other person for any: (a) inaccuracies or errors in or omissions from the information available on this website including, but not limited to, quotes and financial data; or (b) loss or damage arising from the use of this publication, including, but not limited to any investment decision occasioned thereby. or (c) under no circumstances, including but not limited to negligence, shall Emirates NBD, its suppliers, agents, directors, officers, employees, representatives, successors, assigns, affiliates or subsidiaries be liable to you for direct, indirect, incidental, consequential, special, punitive, or exemplary damages even if Emirates NBD has been advised specifically of the possibility of such damages, arising from the use of the information on this website, including but not limited to, loss of revenue, opportunity, or anticipated profits or lost business. Emirates NBD expressly accepts no liability for losses or damages of any kind arising from using or accessing this website or links to third-party websites or from viewing information on any of its web pages. Furthermore, Emirates NBD accepts no liability for any unauthorized manipulation of users IT systems. Emirates NBD expressly draws user’s attention to the risk of viruses and the threat of hacker attacks

Third Party Website:
Users may be aware that Emirates NBD has no control whatsoever over third-party websites linked to or from this website and therefore accepts no liability for the content of such websites being correct, complete and legally valid for the products and services offered on such websites. Emirates NBD’s express written permission must always be sought before including a link to this website on a third-party website.

None of the information on this website in any way constitutes a solicitation, offer, opinion, or recommendation by Emirates NBD to buy or sell any security, or to provide legal, tax, accounting, or investment advice or services regarding the profitability or suitability of any security or investment.

Forward Looking:
The information contained on this website does not purport to contain all matters relevant to any particular investment or financial instrument and all statements as to future matters are not guaranteed to be accurate. Certain matters in this publication on the website are about the future performance of Emirates NBD or members of its group (the Group), including without limitation, future revenues, earnings, strategies, prospects and all other statements that are not purely historical, constitute “forward-looking statements”. Such forward-looking statements are based on current expectations or beliefs, as well as assumptions about future events, made from information currently available. Forward-looking statements often use words such as “anticipate”, “target”, “expect”, “estimate”, “intend”, “plan”, “goal”, “seek”, “believe”, “will”, “may”, “should”, “would”, “could” or other words of similar meaning. Undue reliance should not be placed on any such statements in making an investment decision, as forward-looking statements, by their nature, are subject to known and unknown risks and uncertainties that could cause actual results, as well as the Group’s plans and objectives, to differ materially from those expressed or implied in the forward-looking statements. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

Risk: In addition, before entering into any transaction, the risks should be fully understood and a determination made as to whether a transaction is appropriate given the person’s investment objectives, financial and operational resources, experiences and other relevant circumstances. The obligations relating to a particular transaction (and contractual relationship) including, without limitation, the nature and extent of their exposure to risk should be known as well as any regulatory requirements and restrictions applicable thereto. Data included on this website may rely on models that do not reflect or take into account all potentially significant factors such as market risk, liquidity risk, and credit risk. Emirates NBD may use different models, make valuation adjustments, or use different methodologies when determining prices at which Emirates NBD is willing to trade financial instruments and/or when valuing its own inventory positions for its books and records.

Investment in financial instruments involves risks and returns may vary. Before making such an investment, investors should consult their advisers on the legal, regulatory, tax, business, investment, financial and accounting implications of the investment.

Intellectual property:
The information on this website has been developed, compiled, prepared, revised, selected, and arranged by Emirates NBD and others (including certain other information sources) through the application of methods and standards of judgment developed and applied through the expenditure of substantial time, effort, and money and constitutes valuable intellectual property of Emirates NBD and all present and future rights in and to trade secrets, patents, copyrights, trademarks, service marks, know-how, and other proprietary rights of any type under the laws of any governmental authority, domestic or foreign, shall at all times be and remain the sole and exclusive property of Emirates NBD and/or other lawful parties and you acknowledge that you have no ownership rights in and to any of such items. Except as specifically permitted in writing, the information provided in this website shall not be copied or make any use of any information on this website or any portion of the intellectual property rights connected with this website, or the names of any individual participant in, or contributor to, the content of this website, or any variations or derivatives thereof, for any purpose. Further you shall not use any of the trademarks, trade names, service marks, copyrights, or logos of Emirates NBD or its subsidiaries in any manner which creates the impression that such items belong to or are associated with you or, except as otherwise provided with Emirates NBD’s prior written consent,

The information on this website solely for non-commercial use and benefit and the use of this information is not intended for resale or other transfer or disposition to, or use by or for the benefit of, any other person or entity. Information contained in this website shall not be used, transferred, distributed, reproduced, published, displayed, modified, create derivative works from any data contained on this website or disposed of in any manner that could compete with the business interests of Emirates NBD. Any part of this website may not be offered for sale or distribute it over any medium including but not limited to over-the-air television or radio broadcast, a computer network or hyperlink framing on the internet without the prior written consent of Emirates NBD. The information contained on this website may not be used to construct a database of any kind. The data on this website shall not be used in any way to improve the quality of any data sold or contributed by you to any third party.

Recipient Acknowledgements
In accessing this website, you acknowledge and agree that there are risks associated with investment activities. Moreover, you agree that your use of this publication is at your sole risk and acknowledge that the responsibility to obtain and carefully read and understand the content of documents relating to any investment activity described on this website and to seek separate, independent financial advice if required to assess whether a particular investment activity described herein is suitable, lies exclusively with you.

Emirates NBD Bank (P.J.S.C.) is licensed by the Securities & Commodities Authority and subject to regulation, supervision and control of the Authority.
Head Office : Baniyas Road, Deira, PO Box 777, Dubai, UAE