Navigating in low visibility

Chief Investment Officer's team
12 April 2022
Navigating in low visibility
The FOMC minutes confirmed an accelerated tightening, sending shockwaves across markets


  • The FOMC minutes confirmed an accelerated tightening, sending shockwaves across markets
  • The war in Ukraine and a resilient covid in China also add to uncertainty
  • We will review our 2022 central scenario, but also note that valuations have improved

Volatility remains the name of the game this year, and last week was no exception. The minutes of the March FOMC meeting confirmed support for at least one 50-basis-points hike and for a possibly imminent start of the balance-sheet runoff. This took a toll on markets, starting with long duration assets such as government bonds and growth stocks. The levels of interest rates are impressive compared to their recent history, with the US 10-year Treasury yielding 2.77% as we write. Uncertainty is also exacerbated by the war in Ukraine and a still large Omicron drag in China. Gold was the only positive asset class last week, and the situation is similar on a year-to-date timeline.

We will hold our monthly tactical asset allocation committee this week. We will change our central scenario for the year, around the accelerated tightening from Western central banks and the amplifying effects of the war on a backdrop combining slowing growth with rising inflation. At this stage we keep on thinking that global growth is dented rather than derailed, but uncertainty should remain extreme. The good news is that so far the global expansion is resilient, and that valuations have improved in many asset classes.

This week is all about inflation. March numbers were just released in China, and they slightly exceeded expectations for both consumer and factory prices – the former however remains very contained there with only +1.5% year-on-year. The picture should be very different in the US, where the March CPI, released Tuesday, is expected to exceed +8% over 12 months. The earnings season will also kick off with US financials. Most Western markets will be closed on Friday for Easter weekend, and the ECB will meet on Thursday. Stay safe.

Cross-asset Update

From above-trend growth to recession concerns is a big leap, yet we have got here as it was also a big leap from all-out stimulus and temporary inflation to a steep tightening cycle and not-so-temporary price pressures. While the probability of the economy contracting this year has increased, it not in the United States that one should look to for such an occurrence, but rather Europe, due to war spill-overs. While in China, if the authorities insist on zero-covid policies and mismanage stimulus, the soft patch could turn into something harsher. Two quarters of back-to-back negative growth should not be a big deal, in a year where headwinds are plentiful to say the least. Historically, the six months before the mid-term elections have been the weakest in the four-year presidential cycle showing up in US equity returns since records are available, and this time negative seasonality comes alongside steep tightening, inflation at multi-decade highs and a war. But given negative real rates and a strong labor market, the US economy should only go through a slowdown phase. Q2 could be the worst quarter, if projections of services recovery from the covid crisis are correct.

In the euro area life is not that easy, though. In its worst-case scenario the ECB has projected real GDP at 2.3% at year-end, which either means super-flat growth throughout 2022, or a contraction at one point. Exposure to Russian trade, the energy shock and deteriorating confidence would be driving the downturn. Uncertainty remains high, but considering how enthusiastically European leaders are embracing the prospect for future hardship for the sake of stopping Putin, the worst case could easily become the base case. In China achieving growth above 5% would have implied no covid lockdowns in 2022 and starting meaningful stimulus much earlier. It could be very difficult now for infrastructure investments to drive a sustainable up-trend in growth, considering the poor conditions of the real estate sector, accounting for one quarter of GDP.

Now, paradoxically, Fed officials must be hoping that Europe grinds to a halt and China struggles further. This way, the negative spill-over effects from overseas plus the planned removal of stimulus would manage to curb aggregate demand in the United States, avoiding a Fed-induced recession due to overtightening. And while Jay Powell looks forward to receiving some help from the other struggling economies, the tightening of financial conditions to be yet achieved remains so significant, that, “If Stocks Don’t Fall, the Fed Needs to Force Them”, as ex Fed vice chair Bill Dudley wrote on his Bloomberg column.

Once the Fed was enticing investors to buy the dips, now they are suggesting that rallies be faded, and we hold the view that only selective dips should be bought. Financial conditions have not yet tightened enough to warrant much risk taking.

Fixed Income Update

The March FOMC meeting minutes released last week set the cat among the pigeons. The post-minutes market reaction saw a sharp sell-off US Treasuries with a steepening of the curve. The 10-year yields increased by more than 30 bps last week. Moreover, there were a lot of details mentioned about the Quantitative Tightening plan. The max run-off rate will be at $95bn, and the phase-in period will be three months starting from May. As mentioned in the last weekly, this is a much faster pace than the previous 2017-19 cycle. The markets currently price in nine rate hikes in the next six meetings till the end of the year, and the terminal rate currently priced in is 3%. We believe we are very near peak hawkishness, and it might be a good idea to lock in some of that attractive yield available now. Moreover, the March hawkish pivot of Powell & Co forces us to relook at our year-end fair values.

All the long-duration assets were poorly affected due to the rates sell-off. US Treasuries lost 1.6% while EM Debt lost 2.2% last week and took over the dubious mantle for the worst-performing segment within Fixed Income from Asia HY, which rallied by 0.3%. The rally in Asia HY is not driven by fundamentals but is a relief rally. Big institutions have pulled out money from the segment during this rally. In March alone, there was an outflow of $400mn from the segment. So, investors should be cautious while bottom fishing in the segment.

The credit sell-off presents us with several opportunities to put new money to work. We finally have some respectable yields in various parts of the asset class. We highlight four such opportunities that are i) locking in short term yields – The 3-5 year part of the UST yield curve is approaching multi-decade highs, and with spreads relatively wider to the start of the year, investors can look to locking short duration yields in solid credits, ii) Subordinated bank debt – moving down the capital structure of banks offers an attractive opportunity for investors looking to secure yield in quality papers, iii) Floating rate instruments should generate positive returns if the Fed can move forward with its tightening plan and iv) Asia USD IG debt currently offers an attractive 250 bps+ spread for the 5-10 year duration papers. The area we would avoid adding is long-duration High Yield. We anticipate spreads to widen from current levels as we are at peak quality in High Yield. In addition, historically, a flat yield curve cautions against high-yield as they have underperformed treasuries on average when the yield curve inverts.

GCC spreads look quite tight and returns from current levels will be driven by duration and UST yield movements. In spread terms, up to 5yr maturity of IG names widened by 5bps and on the long end tightened by 10-13bps w/w. On high yield names, Oman traded soft for the week – down by about 0.875c on the long end of the curve specifically. Away from GCC, talks of Turkey's sovereign bonds' inclusion in credit indexes helped boost flows on the name.

Equity Update

After 3 weeks of gains, global equities fell 1.5% last week with inflation at decade highs, raising concerns that a more aggressive monetary tightening cycle will affect global growth and corporate profits. The US Treasury 2s 10s temporary yield curve inversion continues to be a key focus as it is indicative of recession. And US equity performance as per statistics is positive the first year following a yield curve inversion. Economic data points to slower but not negative growth. Recent PMIs and the labour market remain strong in most economies. However oil and food prices will meaningfully impact consumer spending. Food is 17% of the consumer basket in DM and upto 40% in emerging economies. It’s not the same everywhere, with Europe more affected than the rest of the world by gas and oil supply issues from Ukraine/Russia. European economic growth downgrades lead at almost double the rest of the world. Many Middle East countries depend on wheat and sunflower oil from Russia/ Ukraine.

Profit expectations were muted for Q1 and Q2 to start with and analysts are still hopeful of a resolution to the Russian invasion of Ukraine and improvements in the supply chain. However, key supply hubs such as China still have Omnicron and other Covid variants at play. It’s also the start of demand destruction as rising prices are reducing purchasing power.

Equity markets are now showing longer streaks of gains and losses but volatility remains high. Our positioning is mildly constructive with a preference for the US and energy exporters, the GCC and the LATAM countries. The latter continue to add to positive year to date gains now approaching over 20%. GCC corporates have also grown dividends and income remains one of the best investment strategies in an inflationary environment. New issuance from the UAE has been received well and the DEWA IPO as per reports had 37X orders for the number of shares offered. Whilst we are neutral India as we were concerned about the impact of higher oil prices, Indian equities continue to outperform.

There are still plenty of tailwinds for equity performance however earning growth has a straight beta to economic growth. As per FactSet, for the S&P 500 for 2022, analysts are projecting earnings growth of 9.8% and revenue growth of 9.5%. For Q1 2022, the estimated earnings growth rate is 4.5% revised down from 5.7% as at end Dec. However, as some costs are being passed onto consumers revenue growth expectations have been revised up to 10.7%, compared to 9.7% as at end December. Estimated Net profit margin of 12.1% for Q1 is lower than the year before which was 12.8%. Labor costs and shortages are expected to be mentioned frequently in guidance. Over the past five years, actual earnings reported by S&P 500 companies have exceeded estimated earnings by 8.9% on average, so a reasonable 5% upside to the current 4.5% would indicate a 10% Q1 EPS growth. This week sees the big banks reporting including Citigroup, JPMorgan and Wells Fargo and profits are expected to be impacted by a reinstatement of provisions. Q1 2021 had seen a reversal of Q1 2020 pandemic provisions. Lending growth data will be closely watched as consumers face high inflation and reduced support from fiscal stimulus.

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