Goldilocks, reloaded, but not for everyone

Chief Investment Officer's team
21 November 2023
Are we approaching an excess of pessimism


  • US October CPI inflation came out softer than expected while growth moderated just slightly
  • This perfect combination triggered a rally across asset-classes and regions
  • The US remains an exception in the global picture and its health is good news for global markets

We have written for a number of weeks that market participants are not positioned for any good news, which gave us hope for a better year-end after the massive post-summer rise in risk aversion. Still, we have been surprised by the magnitude of the market reaction to what was, after all, just a -0.1% positive surprise in the year-on-year pace of both headline and core CPI inflation in the US, to respectively 3.2% and 4%. This wasn’t the only piece of good news from the US: retail sales and Empire manufacturing were robust, even if industrial production disappointed and weekly jobless claims were higher than expected. Bottom line, softlanding is back, which cements expectations that the Fed has no reason to hike interest rates further.

US Treasury yields literally tumbled last week, by more than 20 basis points, and the dollar dropped, almost -2% weaker against its trade weighted counterparts. This provided welcome breathing room to assets from emerging markets and Europe, which actually outperformed their US peers last week. This is probably the most interesting point from last week. Outside of the US, the economic outlook is at best tepid – and an outright concern in Europe, typically. Still, the beginning of the end of the Fed’s tightening remains good news for the world, especially as investors’ positioning is particularly light on non-US assets which, by contrast, present relatively accessible valuations.

We didn’t change our tactical asset allocation in our monthly meeting last week and remain only slightly defensive. Our three profiles fully benefitted from the recent change in market winds. We will watch flash PMIs for the major regions and read the minutes of the last FOMC meeting in the coming days. Have a great week.

Goldilocks, reloaded, but not for everyone

Cross-asset Update

Investors have continued to price in an end to the tightening cycle of the major DM central banks, and now this bias is just starting to translate in a more pro-cyclical rotation across asset classes. And it is how it should be, as the Magnificent 7, and more in general large caps and US equities, cannot be expected to support risk assets indefinitely. Year-to-date the US mega caps have appreciated in line with leading indicators inflecting higher that have in turn anticipated a soft-landing scenario, while the rest of the market has lagged behind. If no-recession must be priced in, we should think that the medium-to-smaller companies and value would catch up with the larger ones and growth. Also, as financial conditions ease, EM assets and in particular stocks in the emerging countries should rally substantially. Maybe it is not by chance that European investors see an improvement of eurozone growth ahead, according to Germany’s latest ZEW survey. We should not forget that the European economy is quite open, and that China remains a very relevant market for its exports. In this sense we should then read last week’s outsize outperformance both of the Russel 200 Index and of European equities and the sizeable rebound of EM shares. The outlook should also be favorable for credit spreads to remain well-behaved, with the upturn in earnings following their recessionary phase supporting cash-flow generation. 

Usually gold and the US dollar have opposite fortunes, and next year should be no exception. A disinflationary CPI reading last week saw the reserve currency wipe out all of its yearly gains and gold rebound as money markets priced in four rate cuts by the Fed for 2023. Although this seems to be an excess for now, given Powell’s concern on inflation, global money supply, in negative territory on a yearly basis, has ample room to grow from current levels, further supporting gold and depressing the US dollar.

Investors are not getting ahead of themselves, and the above brightening scenario will be sustainable as long as the positive growth impulse currently mostly confined to the United States broadens out to other major regions. In other words, hard data will have to show that eurozone growth is indeed improving as per the latest ZEW survey, and that the Chinese recovery gains steam following the plethora of small-step stimulus measures implemented this year.

Assuming no growth slump and a soft-landing scenario implies a big if, and for now we have no reassurance that that can be the case. Yet, the positive narrative dominating markets can be extrapolated into early 2024. We think it is not now the right time to cut risk.

Goldilocks, reloaded, but not for everyone

Goldilocks, reloaded, but not for everyone

Goldilocks, reloaded, but not for everyone

Fixed Income Update

Last week saw no major coupon-note auctions. Still,Treasury markets were susceptible to macro data surprises. Case in point, after the CPI surprise on Tuesday, 10-year yields dropped 20 bps immediately, though they gained 13 bps by the end of the session. Similarly, on Thursday, after the JOLTs data showed that the continuing claims reached the highest levels since Dec 2021. The economic data thus indicated an economy that continues to cool gradually. Overall, the curve moved down, led by the 5-to-7-year part of the curve, which decreased by close to 25 bps. The long-30-year decreased by around 17 bps last week. DM sovereigns outperformed other segments within FI, delivering a +2.0% weekly return. The belly of the curve looks slightly rich after the rally. We advise waiting for dips to take duration exposure on treasuries.

Credit spreads continue their grind lower with robust investment-grade credit demand meeting increased supply pace. IG spreads compressed by 4bps. This is despite an eye-popping $75bn of bonds priced MTD, including large AT1 issuances that have received robust investor demand. Helped by longer duration, IG credit generated +1.86%. HY and EM debt returns were also positive but at a lower rate of +1.37%. This year, it has been rare that our positioning has delivered such a perfect result.

Current HY spreads predict less than a 2% forward default rate. However, most analysts estimate a 3.5% to 4% default rate. That should result in a spread widening of about 100-150 bps from current levels. According to S&P, the proportion of 'CCC/C' ratings to the total is historically large, with many firms already seeing negative cash flow and large maturities due in 2025. Defaults are becoming more widespread across sectors, but consumer-facing sectors such as consumer products, media and entertainment, and health care are likely to continue leading among defaults as these remain sectors with high leverage and strained cash flow, according to the rating agency.

We have seen a slew of AT1 issuance globally. However, the GCC region has remained muted. ADIB kickstarted the niche segment in July with a perp sukuk issuance. However, there has been a long gap till this week as ADCB is selling an NC5 5-year $ perpetual with IPTs at 8.625%. Bloomberg doesn't classify any of the GCC Bank perps as CoCos. Because none of the perps issued from the region have clearly defined CoCo Action Trigger points, unlike their Euro Area Bank counterparts, which specify a defined limit of CET1 that would trigger the Conversion action, instead, it is up to the Central Bank of the country to decide the Non-Viability Event of any Bank. Bucking global trades, the prospectus of the bond has a permanent partial/full write-down clause as the Non-Viability Event Trigger Action, similar to Swiss bank perps. So, according to the prospectus comparison, these bonds carry CoCo characteristics and similar risks.

Goldilocks, reloaded, but not for everyone

Goldilocks, reloaded, but not for everyone

Equity Update

Last week was undoubtedly a great one for the equity asset class, especially as the rally built on the previous two-week gains to print a third one. If seasonality patterns repeat (the kind of statement to be taken with a caution in what we always called the “year of unpredictability”), and as we basically have only 3 weeks of really active trading before the end of the year, this bodes well for equity returns in 2023.

The US S&P 500 gained 2.2% last week to close just above the 4,500 mark, which happens to be our official 2023 year-end fair value. But the most interesting is elsewhere: small caps, value, and the ex-US markets all outperformed markedly. The Russel 2000, which reflects US smaller companies, and the Europe Stoxx 600, a broad measure of European stocks, both gained more than 5%, while emerging markets added 3%. A weaker dollar, expressing perspectives of less financial tightening for the world, was clearly good news for everyone.

The week was also interesting in terms of sectors. Rates sensitive segments such as real estate and utilities logically outperformed, but they were closely followed, not by tech, but by the most cyclical sectors: materials, industrials and consumer discretionary, in that order. There is some logic: we are talking about the probable absence of a recession in the world’s largest economy, at a time when China also shows signs of economic stabilization. Taking into account valuations, positioning as well as concentration (not much has been impressive apart from the so called Magnificent Seven in the US), this is a good reason for cyclical assets to shine again.

We only have a handful of major economic data and policy events ahead in 2023. Assuming that the US economy remains resilient, without overheating on inflation or the labor market, the Fed would have no reason to hike on December 13 th, which is our scenario for long. The last three weeks were positive on stocks, but investors’ sentiment and positioning are still far from euphoria. They could continue to climb the wall of worry and confirm the current year-end rally, which could even extend into early 2024.

The year-ahead will certainly not be an easy one, however. On one hand, under the assumption of no accident on growth, the good news is that the earnings recession is over and year on year comparisons will become green, quarter after quarter. On the other, macro visibility remains relatively low on both growth and inflation, the end of interest hikes is not yet the beginning of interest rates cuts, and relative valuations of stocks versus bonds remain quite stretched. We tend to think that 2024 could be a year providing more value to selectivity than to plain beta exposure.

Goldilocks, reloaded, but not for everyone

Goldilocks, reloaded, but not for everyone

Goldilocks, reloaded, but not for everyone

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