Investor focus on inflation report and earnings season

Chief Investment Officer's team
10 October 2022
Investor focus on inflation report and earnings season
Last week started on a positive note but gains were retraced on a buoyant US job report

AT A GLANCE

  • Last week started on a positive note but gains were retraced on a buoyant US job report
  • Monetary tightening is here for long, and global PMIs show that pressure is starting to be felt
  • Our recommended positioning is only marginally cautious, yet selective

The first week of any month is always rich in terms of economic data. Activity indices, especially the September PMIs for major regions, consistently indicated a global slowdown, with the notable exception of the ISM Services in the US. The post-covid recovery is maturing and the synchronized monetary tightening is starting to have an impact, at least on sentiment and investment decisions. Alas, the week ended with a – marginally – better than expected US employment report, which reversed the initial rebound of risk assets. The US job market remains hot, and the Fed outright hawkish. All in, last week was extremely volatile but modestly positive for most asset classes.

The data is not inconsistent with our central scenario which still gives a chance of success to bringing inflation down without pushing the US into a severe recession. The jury is obviously still out, which is why we also expect volatility to persist for longer. This week’s inflation data and the minutes of the Fed’s last FOMC will of course be highly scrutinized. We may however pay even more attention to the Q3 corporate earnings season which just starts. The bar of expectations doesn’t look so high, and management guidance should provide interesting reading about business reality. Our positioning is now marginally less risky than our strategic allocation, with an overweight in cash and in the safest segments of fixed income, while we are clearly underweight on high yield and debt from the emerging markets. We are more balanced on equities, where we are close to neutrality, with a preference for the US as a region, along with UAE and India within emerging markets. It’s time to be patient and potentially opportunistic as volatility seems unlikely to abate anytime soon. Stay safe.

Cross-asset Update

Markets attempted a rebound last week, that, depending on the preferred narrative, can be put down to a cherished renewed Fed pivot, low valuations or oversold technical conditions. Although a rally may well unfold in Q4, it should eventually fail as the previous ones due to investor-unfriendly central banks. In this respect the outlook for growth and earnings will be key, without forgetting that the Fed remains firmly in tightening mode. Technically markets are imbalanced, with a combination of panic, as indicated by the inverted VIX term structure, and extremely low breadth pointing to oversold levels being reached.

We don’t see a recession by year-end, while equities are discounting a mild one already, with an S&P 500 peak-to trough drawdown of -25% this year. The labor market remains exceptionally strong and it will take the Fed quite some time to raise the unemployment level above 4-4.5%, the area above which a harsher slowdown is expected to kick in. Hence, a hard landing should be more of a H1 2023 possibility than an impending certainty. Investors may on the other hand be concerned about receding earnings, and on this front as well we cannot be too negative either. Bottom-line growth is projected to run in the low single-digits for US large caps in Q3, quite a low hurdle to overcome given the still healthy economic conditions. As for yields, one has to distinguish between the shorter- and the longer-dated ones. Investors will be tempted to look through the current tightening cycle once we are past the November hike, with only few more left in 2023 according to consensus. And at the longer-end of the curve Treasury yields are now well-above market-implied inflation, a sign that initial undervaluation has been closed, at least for now. Also, a market low before the mid-term elections, to be held in early November, would a common seasonal pattern in the four-year presidential cycle. Overall, recession odds, the low earnings hurdle, the way investors could be expecting the tightening to evolve, and seasonality should provide some support for a fledgling rally.

If market action proceeds along these lines, one should expect the change in sentiment to extend to other asset classes, like high-yielding bonds, the US dollar and gold. Credit spreads should tighten, the dollar be range-bound and gold continue to rebound. A Q4 rally should not have hope to turn into a new bull-market, though, running counter to the tightening of financial conditions the Fed is pursuing at all costs. Should financial conditions ease meaningfully, Fed officials would be striking back with a vengeance by means of reinforced hawkish rhetoric and renewed impetus for jumbo hikes now unexpected in 2023.


Fixed Income Update

Fed officials kept up their hawkish talks throughout the week to temper last Monday and Tuesday’s rally. The heightened pitch and solid jobs data kept the market on edge. The Treasury yield curve bear flattened, with the 1-year yields increasing by 28 bps over the week. Peak rate expectations increased to 4.63% in Q1 2023. Credit spreads tightened significantly in the first two days last week to reverse course later, ending slightly tighter.

The effect of the Fed's QT is being felt by the smaller banks as they see reserves drain. Their cash assets have fallen by $36bn through Sept 30th. They could fall by another $75bn before year-end. When small banks feel the pinch and start bidding for cash, further declines in aggregate Fed balances will have to come out of the large bank and foreign bank reserve positions or from the reverse repo facility.

The outlook for corporate defaults is worsening quickly as cash cushions built during the pandemic erode, and borrowing conditions tighten. Moody's sounded alarm bells as it mentioned in a largely unnoticed report yesterday that the share of companies failing to pay debt on time could soar more than threefold next year due to a liquidity squeeze and worsening trading conditions. In the US, default rates could grow from below 2% to 7.8% by August 2023 in a more pessimistic forecast, while the baseline calls for 4.4%. That compares to a 3.7% long-term average and a current trailing 12-month default rate of less than 2%. The pessimistic figures are shown to be reaching 6.5% in the EMEA region from about 2%. Meanwhile, the pile of troubled debt in the US is beginning to spike. According to Bloomberg, there was roughly $204bn of dollar-denominated debt trading at distressed levels as of Sept 30th, up 3.7% from the week before.

In emerging markets, Turkey was downgraded by S&P to B from B+, mentioning Turkey's external position as a critical weakness. S&P projects Turkey's general government debt-to-GDP ratio at 38% at 2022-end. However, this figure is considerably more sensitive to exchange rate effects than previously, given that 68% of the debt is denominated in foreign currency, or roughly twice the FX-debt pre-2018 currency crisis levels. Despite this, Turkey could tap the market for a $2.5bn 3-year Sukuk priced at 9.75%, in line with conventional bonds and wider than the existing Sukuk curve.

India's hopes of entering the bond indices took a backseat as global investors are still reluctant to commit to India's $1tn government bond market amid a standoff over tax concessions. As a result, the expectations of inclusion and announcements on this have moved to next year.

GCC primary markets saw some deals last week. Oman's outlook was upgraded to Positive by Moody's. PIF, the KSA's sovereign wealth fund, priced a three-tranche note, including a 100-year maturity one, the first long-maturity green bond in the world. There was strong demand from investors with book coverage of more than 7x as the pricing was significantly wider than the KSA sovereign curve. FAB issued a 5-year Green bond with around 5.25% yield. All issuers offered generous new-issue premiums in a sign of times to attract investors.


Equity Update

A 2 day rally for equities at the beginning of the week lost steam by mid-week and ended with a sharp sell-off on Friday, with strong US job data and consumer credit growth reports, cementing the Fed and other Central banks tightening path. However, overall it was a positive week, with the All Country World Index “ACWI” +1.7% and all regions gaining. In line with higher energy prices, on the back of the OPEC+ cut, the oil exporting economies performed better i.e., the GCC and LATAM and the energy sector gained 10%. This supports our OW positions on the UAE and energy sector. US equities which we prefer, are doing better than European equities though both are down over 20% Year to Date. We recently took the UK to underweight as the weaker Sterling affects USD returns and the fiscal deficit will weigh on consumer demand, as will the higher energy prices.

We are neutral equities with a slight underweight on emerging markets, with the strong USD a burden on returns and inflows as are higher oil prices a drag on the oil importing nations. Whilst valuations look attractive, we continue to see growth downgrades, so we recommend staying invested, but selective. Many regions are trading at 10X or below forward earnings including the UK, China and broader EM. The S&P 500 is at 16.2X forward earnings below 10 years and close to 20 year averages. Value as a factor has outperformed growth so far in 2022, after a decade of growth in the lead (driven by tech) and remains an outperforming factor in a rising rate environment. But earnings will remain the decisive factor for longer term performance.

Financial conditions further tightened last week, with US Treasury yields higher, the yield curve steeper, the USD stronger. Q3 earnings which take off this week, are not only about numbers but guidance - as they will indicate the dynamics of demand. It’s Sophie’s choice: lower earnings and revenue will indicate slowing demand – exactly what Central banks want in order to tame inflation – but also the increased possibility of recession. The US chipmakers Micron and AMD gave disappointing guidance last week. High-end microprocessors are a vital ingredient of manufacturing, and a slowdown in their demand is indicative of a broader slowdown in industry. This week earnings from the banks, PepsiCo and Delta Airlines will provide a broad representation of sectors. CPI data out later this week will also be watched closely.

The UAE continues to see successful listings in a world where IPO’s have dried up. Healthcare provider Burjeel, which priced its offering at the bottom of the range to ensure investors got some support post listing, was multiple times oversubscribed (29X as per Bloomberg) and raised USD 300mn. Burjeel operates hospitals and medical centers in the UAE and Oman and is planning an expansion into Saudi Arabia. The Dubai government has listed 3 of the planned 10 divestments with considerable interest from local and international investors with the balance planned across the next few years. ADNOC’s two divestments have performed well, as have other Abu Dhabi listings. The strong sustainable dividends remain the main attraction for investors.



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