Looking for equilibrium

Chief Investment Officer's team
24 October 2022
Looking for equilibrium
Volatility continues to dominate markets, understandably so.


  • Last week was better for cyclical assets than for defensive ones, with a rally in US stocks
  • Uncertainty is everywhere: growth, earnings, policy, and of course geopolitics
  • The week ahead should provide more clarity and find some - probably unstable- equilibrium

Volatility continues to dominate markets, understandably so. Last week however, was positive for cyclical assets in developed markets, helped by a good start of the corporate earnings season, despite a rise in the long end of the curve of US Treasury yields.

It’s a “New World Disorder” which lasts. Rising policy rates to fight inflation threatens growth, challenges asset valuations and annihilates risk-appetite. The US economy is simply too strong, and the shock waves from an inflexible Fed are being felt everywhere, generating conflicts between governments and their central banks, like in the UK. Meanwhile, the alternative engine of global growth of the last decades is idle. China’s Q3 GDP growth is “only” +3.9% year-on-year, with retail sales and property investment below forecasts. Markets are concerned by the future economic policy: President Xi secured a third term, and a firm grip on power, both  unprecedented since Chairman Mao. Next March will see a reshuffling of the economic leadership of the country: is a “modern socialist country” market friendly? The Biden administration took a call, with a radical ban on sensitive semiconductor technology exports.  This looks like a cold war, while escalation risk is only rising in the actual war  in Ukraine.

No doubt, volatility will remain extreme. But the week ahead will provide more clarity which could help in market’s quest for equilibrium. The earnings season will be in full swing, with most major blue chips reporting. Flash PMIs will give a more accurate picture on the state of the economy, while three central banks from G7 countries will take monthly decisions, with the ECB on Thursday being probably both the most critical and the less predictable. We keep our positioning unchanged, marginally defensive, in such a context. Stay safe.

Cross-asset Update

It has been a long bear market that has lasted throughout 2022, and the obvious question is whether it is now over, or should we expect more of the same? The straight answer is unfortunately that there can be further downside, since the Fed is not yet done tightening, and history shows that it takes time for inflation to trough, especially from the currently elevated levels. Still, rising real yields and an adverse growth-inflation mix constitute headwinds, while we need at least both peak Fed hawkishness and inflation to start to be more positive about the market outlook. Also, investor capitulation and lower valuations would be necessary, as argued below.

Let’s start from the Fed. Markets now project peak policy rates in the first half of 2023 at slightly above 5%. Although some Fed officials have recently warmed up to the idea of scaling down the size of rate hikes, there is still a long way to go to reach 5% and maybe above, never mind how much more slowly. Historically, two-year yields rolling over have indicated peak Fed hawkishness, that is nowhere near to be seen, as shorter-dated yields have continued to climb relentlessly and are lingering close to the highs of the year. According to relevant studies real income growth projected to be above 3% in 2023 in the United States, given exceptional labor-market strength, would be enough to support consumption and keep the Fed on a tightening path beyond what markets are now expecting. So, 5% might not be the peak policy rate, but maybe more 6%. Also, hoping that inflation recedes fast remains wishful thinking, as data since 1950 shows that, once it breaches 4%, it has taken inflation an average 2.6 years to decline below 2% or to trough, whereas for core inflation that timeline has extended to 3.9 years!  Now, let's leave aside slowly-receding price pressures and assume that policy rates will indeed be peaking at around 5%, then we still do not have cheaply enough priced equities. According to Bloomberg data going back to 1954, whenever in the past the Fed pushed its benchmark rate to 5%, the median S&P 500 trailing price-to-earnings ratio was 16.1, while it is now at 18. Overall, it seems peak inflation and Fed hawkishness will be more of a H1-23 event, than something achievable in the near future.

Those preconditions would be a big positive for markets, as long as a US recession is avoided in 2023. And there, the jury is still out. We remain agnostic on this front, but in the case of a hard landing equities would still be falling after an inflation peak. Hence, given the high uncertainty about the outlook, the advice to investors within the fixed income asset class is still to have a preference for shorter-duration, higher-quality credits, offering mid single-digit yields and a valid alternative to risk assets. The traditional bond-equity portfolio is now better valued, but not yet close to finding a bottom, so investors should take notice and still play defense.

Fixed Income Update

Volatility ruled the rates market last week. Global rates diverged in all directions breaking the earlier tandem moves where Gilts led the movements in the Treasuries. Benchmark 10-year UK Gilts decreased by 28 bps over the week, while US Treasury 10-year yields increased by 22 bps. The U-Turn on the tax cuts and the resignation of Liz Truss dominated the UK markets. In contrast, economic resiliency and increasing inflation expectations dominated the movement in the US Treasury yields. The steepening in the yield curve is in line with our view that the front end offers a lot of value while the back end of the curve remains vulnerable, and longer-duration bets should be placed only after we see a significant deterioration in the employment figures. ECB and BoJ will dominate the news headlines this week as the FED takes a backseat before the upcoming November rate hikes next week. Expectations are for a 75 bps rate hike by the ECB. There are no indications about QT, and any reference to that would be bearish for the Euro Area rates. BoJ faces a difficult dilemma even as the markets expect them to stay put. The 10-year swaps have been steadily climbing as trader bets for a change in the YCC policy continue to increase. The best way to stabilize the currency is intervention combined with a tweak in the YCC. But any words on YCC will put pressure on the US Treasury yields. So keep a watch out for that space.

Investment Grade credits look the most attractive and offer the most bang for investor bucks. Current spreads at 166 bps are just shy of the highest level achieved in early 2016. However, the much higher Treasury yields mean investors get better returns while taking lesser duration risk. The situation is different for global high yield, where the spreads are almost 150 bps lower than the 2016 levels. The difference is even starker for the US High Yield markets, which are 300 bps away from their 2016 peak. S&P reported last week that the YTD defaults crossed the 2021 numbers. While the US defaults were below last year, European and Emerging Market defaults continued to increase. Emerging Market spreads similarly trade around 75 bps below the 2016 levels though the risk for B-rated weaker entities stays elevated. We are currently underweight these riskier segments and would await spread widening before going back in.

GCC region had so far been relatively shielded from the market turmoil losing 17% compared to 22% by the broader EM Debt YTD. The region saw a bunch of primary issuances last week. KSA issued a Sukuk and a bond maturing in 6 and 10 years at 5.268% and 5.5%, respectively, tapping the market for the first time this year. Emirates NBD, Mamoura (Mubadala), and Islamic Development Bank also issued bonds maturing in 5-year, 10.5-year, and 5-year at a yield of 5.745%, 5.68%, and 4.747%, respectively. Following the primary issuances, Arada Developments also tapped the market for its existing issuance, maturing in 2027 at a discounted price. The region saw dollar-denominated primary issuance worth $27Bn on a YTD basis, out of which $8.3Bn bonds were issued in October in a sign of a slight revival.

Equity Update

In spite of inflation numbers staying in the 8 to 10% range for the large economies i.e. the UK, US and Eurozone, and at least 75 bps rate hikes expected for all three at the next monetary policy meetings, global equities had a good week +3%. Developed markets saw all regions up, except Japan. Some green shoots: the U.K FTSE should rally this week, if political stability with a new PM comes into place. Also a pullback in European natural gas prices is indicative of peaking inflation.  US stocks closed +5% after a volatile week, with the Nasdaq slightly outperforming, with somewhat less hawkish Fed headlines and a slightly weaker USD. An article in the Wall Street Journal spoke of the possibility that the Fed might begin to slow the pace of interest rate rises from December. The yield on the 10-year US Treasury note was up last week but did not impact the tech sector, which usually performs inversely.

3Q earnings season is in full swing with one third of S&P 500 companies expected to report this week.  Overall, 20% of the companies in the S&P 500 have reported results for Q3 2022 to date. The blended earnings growth rate is 1.5% and the (blended) net profit margin for the S&P 500 is 12.0%, below the previous quarter’s. All the big tech companies report this week, i.e. Amazon, Apple  Alphabet, Meta and Microsoft. They are expected to see a revenue slowdown with the pandemic-fuelled digital activity of the past two years, having grown exponentially, now plateauing.  Revenue growth is expected to slow to 10% y/y in 3Q compared to a 29% growth in 2021. We also get results from airlines, auto companies Ford and GM and energy giants Chevron and Exxon. Guidance and numbers will be indicative of the effects of high inflation, rising borrowing costs, supply chain issues, a stronger US Dollar and challenging economic conditions. 

Tech earnings will be closely watched as a guide to the wider consumer economy, with online spending and digital advertising expected to continue falling. Social media and internet search companies are feeling the effect of  advertisers continuing to cut marketing budgets. Procter & Gamble, one of the biggest digital spenders, said last week that it had cut its advertising spending in response to falling volumes, even though higher product  prices continue to boost revenues.  The consumer industry is seeing the effect of lower demand and sporting wear leaders In Europe, Adidas and Puma gave profit warnings. JD Sports Fashion and Nike earlier have also seen share price drops on slower demand. Consumer resilience however is evident in solid bank credit metrics and credit card company commentary and airline traffic growth. We retain a US overweight relative to Europe.

EM equities were close to flat last week, as  China equities continue to fall. The Nasdaq Golden Dragon China index (China based companies listed in the US) is down 40% YTD, its lowest close in more than nine years. Not far behind, broader China equities are -36% YTD. President Xi’s reconfirmation this week has ramifications politically and economically. India and UAE equities were up 2% last week. We continue to stay positive on both regions and the UAE should see more issuance and the  sustainable dividend story remains an attraction.

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