Inflation decelerates, markets accelerate

Chief Investment Officer's team
16 January 2023


  • It is a strong start to 2023 with all asset classes firmly in the green so far
  • Investors anticipate less tightening ahead, despite hawkish verbal comments from central banks
  • Our profiles fully participate in the rally, but we think that volatility will come back at some point.

The second week of 2023 confirmed a wind of optimism among market participants. Not without reason: December showed a clear inflexion in global inflation, as illustrated by the US CPI now at a progression of 6.5% YOY, from 7.1% a month earlier and a summer peak of 9.1%. We are still far off the Fed’s target, as several officials pointed out, but the trend justifies a slower pace of interest hikes in the West, while the East is quickly discounting the growth promises of China reopening. The latter doesn’t add to inflation so far, as factory gate prices there - the PPI - keeps on falling, while commodity prices remain far from their highs. An economic slowdown is confirmed in the West, though in line with expectations.

All asset classes were up last week, led by EM stocks and global REITS, with lower rates and a weaker dollar also supporting commodities. The US earnings season started on a mixed note, with investors taking it in their stride. In only two weeks, our profiles are up between +3 and +5%, driven also by an overweight in EM stocks.

In our view macro risks remain elevated: volatility will come back at some point. Central Banks’ mission is not accomplished, economic activity remains potentially vulnerable and expected returns for this year, from our fundamental fair values, are not spectacular. Our conviction is unchanged: investors should focus on stable and safe income within developed markets, and seek capital appreciation in EM stocks. While markets could overshoot our fair-values, without a clear improvement in the outlook, there is a level at which we may consider reducing risk.

We will detail the CIO views in our Global Investment Outlook publication and events in the coming weeks.

Cross-asset Update

Investors have found renewed hope of a Goldilocks outlook seemingly supported by peak inflation, a pause in Fed’s tightening and fading concerns about a US recession. Odds are high, as a matter of fact, that US inflation should have peaked. Core price pressures have been receding for three consecutive months, the prices-paid component of business surveys points to inflation falling towards 3% by year-end, and housing-market leading indicators suggest that shelter CPI should peak in the second half of the year to subsequently fall. As for the Fed, treasuries are telling us that J. Powell is close to pausing in this tightening cycle. The 2-year Treasury yield has traded below the upped bound of the Fed funds rate since December last year, and any past occurrence of the 2yr-Fed funds curve inversion since 1985 has seen the Fed either pause or just ease policy soon after. Although this time around Fed officials are expected to keep rates higher for longer, the December minutes seems to contradict such narrative, saying that the “cumulative effect of policy tightening could end up being more restrictive than is necessary . . . and lead to an unnecessary reduction in economic activity”. Also, the labor market continues to be resilient and investors tend to remain in benign neglect about the possibility of a sharper slowdown ahead.

In our view, one would be remiss to jump to the optimistic conclusion of a Goldilocks scenario reasserting itself. The economy, hence corporate earnings, have yet to feel the full impact of the sharpest Fed’s tightening cycle ever and of the rise in the US dollar. The housing market, that usually leads unemployment as a key sector of the US economy very sensitive to the direction of rates, suggests the outlook for jobs could be deteriorating starting from the end of the first half of the year. While we do not know whether the end-result will be a soft or rather a hard landing, the current Wall Street earnings estimates seem to be unduly biased towards the Goldilocks view.

As against what happened in 2021 and 2022, investors seeking equity upside should rather look to the emerging markets, driven by the China reopening. Beijing has lifted Covid restrictions much faster than expected, while setting ambitious growth targets that imply more stimulus ahead. So, while both the Fed and the ECB are still in tightening mode, financial conditions are set to remain on a much more market-friendly course in China. The latest China inflation report saw the CPI rise 1.8% year-over-year, only a slight gain versus November, while the PPI declined again. This should leave the door open for the PBoC to reduce borrowing costs in Q1.

Overall, amidst unabated macro risks, we still think that being highly selective remains the best approach this year. Higher-quality bonds, with peak policy rates in sight, remain the best hedge against market volatility, rather than gold, that already seems to have discounted a benign rates outlook with the year-to-date rally

Fixed Income Update

The US Treasury yield curve has bull-flattened, with long-term yields coming down by 5 to 7 bps. The robust labour market data combined with a good inflation report raises investors’ hopes for a soft landing. Markets currently price in a peak rate of less than 5% and less than 50 bps rate hikes in Q1 2023. The US 10-year yield oscillated between 3.44% and 3.62% last week, indicating persistent volatility.

The turbulence comes from new areas such as BoJ, where traders expect the central bank to take a new direction once current governor Kuroda steps down in April. Last December, investors were blindsided by the BoJ move to double the 10-year JGB yield target. Currently, the 10-year JGBs trade above the 0.5% limit set by the BoJ as bets grow that the central bank would be forced to let go of its ultra-loose monetary policy to fight the multi-decade high inflation in the country. The yield curve of JGBs has an unusual shape, with 8 and 9-year bond yields above the 10-year mark. It is not a typical inverted curve, as the very long-end of the curve remains steep.

The growing belief regarding soft-landing has helped all the fixed-income sub-segments remain in the green this year. The High–Yield market has been a chief beneficiary of this move, with global HY returning 3.7% YTD. The High Yield spreads are 50-bps tighter since the beginning of the year. Our favoured asset class, Investment Grade, is not far behind, notching +3.2%, fueled by the yield rally. EM Debt has returned 2.2%. The asset class has benefitted from the decrease in yields, but spreads have not compressed from the already tight levels.

The cherry on the top has been Asia HY, which has jumped significantly, after Beijing stepped in. The asset class is up 5.1% YTD and has gone up 30% since early November. As per the recent REDD reports, China plans to provide for healthy developers financing totalling CNY 450bn. Chinese financial regulators are working on a 21-point action plan that would include a CNY 200bn (USD 29.3bn) special fund to help with deliveries of residential properties and another CNY 100bn (USD 14.9bn) to support rental housing loans. The government also intends to speed up the disbursement of CNY 150bn (USD 22.4bn) in loans that have already been announced for home deliveries.

Emerging market primary bond sales are off to a cautious start, with mainly IG deals being priced. Strong sovereigns, SoEs, and D-SIBs have successfully sold bonds as they took advantage of the lower yields and tighter spreads prevailing in the market. The notable deal so far has been the multi-tranche KSA issuance which priced reasonably higher than its sovereign curve. All the tranches trade at a premium in the secondary market, with the longest duration being the outperformer. As long as yields remain volatile, we suspect this will be the theme and advise investors to take benefit of long-duration quality bonds to capture capital appreciation potential.

Equity Update

Global equities have had a positive start to 2023, despite uncertainty regarding the impact on the economy from aggressive monetary policy targeting high inflation. Last week, markets reacted well to US inflation numbers, with a decline in the headline CPI, though uncertainty over the Fed reaction function remains. The Q4 earnings season started with mixed releases from Financials. In Europe, German 2022 GDP growth was better than expected, indicative of a softer impact of higher energy costs on industries.

YTD EM equities have outperformed at +7.7%, with DM a little behind at +5.2%. EM performance has largely been driven by MSCI China +12% in the first 2 weeks of 2022. India and the GCC are in positive territory, returning +1 to 2%. We are currently overweight Emerging market and underweight Developed market equities. DM equities barring Japan had a very positive week. The S&P 500 gained 2.7%, the Nasdaq 4.8%, last week, led higher by consumer discretionaries, technology and materials. Treasury yields settling down (trending lower) and a weaker USD helped these sectors with large overseas revenue. The UK FTSE 100, with a higher composition of strong dividend payers from financial to energy companies, continues to outperform, though economic growth estimates have been severely revised down.

Worries about an earnings recession in the developed economies has grown, hence guidance is being watched closely. The Q4 earnings season in the US began last week with the big banks, amongst others Bank of America and JPMorgan posting significant increases in revenue, though making high provisions for loan losses, while Citigroup fell short of earnings forecasts. Net interest income rose for the banks on the back of higher rates, while investment banking income fell on lower M&A. Consumers continued to spend on credit cards, though mortgage originations fell sharply. Banks are being watched as bellwethers of the health of the economy, with consumer demand reflected in credit card spend, as well as loans for autos and homes. Blackrock saw a reduction in AUM from a year before. In the healthcare sector UnitedHealth Group beat forecasts and reaffirmed its guidance.

European equities have outperformed recently on cooling energy prices and high exposure to the China’s reopening. China is Europe’s biggest trading partner and the easing of strict zero-Covid policies has lifted luxury goods groups, such as LVMH which is trading at a record high gaining +14% YTD, also much in the news for appointing new top management. Luxury good makers have seen a pickup in sales as more tourists visit Europe and China stores reopen. European equities have since the 2008 financial crisis lagged the US, which benefited from the high growth and increasing share of technology companies and record-low interest rates. With the recent rise in rates the value factor has come to the fore. However, with the ECB focused on fighting inflation, and raising rates even as economic growth slows, borrowing costs of European companies will rise along with the slowing of consumer demand.

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