Peak US inflation but choppy waters

Chief Investment Officer's team
22 November 2022
Peak US inflation but choppy waters
With persistent inflation and resilient activity, tightening from Western central banks is not over

AT A GLANCE

  • With persistent inflation and resilient activity, tightening from Western central banks is not over…
  • … But its pace should decelerate from next month, which provides some relief to markets
  • The big picture supports volatility until a Fed pivot is in sight, which is the true constructive catalyst

The fourth quarter of 2022 continues to be better than the previous ones, and last week was no exception. The Treasury yield curve was probably the best at telling the narrative: interest rates were higher for shorter maturities, expressing an acknowledgment that monetary tightening will continue and last. Meanwhile, longer maturities were stable, expressing prospects of muted growth ahead. Stocks were up in emerging markets, led by China, and only marginally down in developed ones.

Data released last week provided more color to an already known picture. Consumption remains strong in the US, but industrial production is slowing. It is the opposite in China, still struggling with Covid but with positive growth in industrial production. The US PPI confirmed some moderation in inflation, but CPI in Europe printed double-digit year-on-year progressions, due to the combination of an energy crisis with imported inflation from weaker currencies. All in all, the good news is that inflation is slowing in the US and that the supply shocks are undoubtedly fading. We are not done yet, tightening will continue. However, its impact on demand should bear fruits, and a slower pace is justified and should start in the coming months.

Bottom-line, the big picture is unchanged. With uncertainty in China and a shock in the crypto world, we are not done with volatility. The true catalyst, which is a Fed pivot, probably requires softening in US job market which hasn’t happened yet. Meanwhile, as valuations are reasonable and sentiment still pessimistic, we are more neutral than outright cautious. We own cash, are close to neutral on stocks and favor govies within fixed income. In the week ahead, we will decipher the Fed minutes and look at flash PMIs in the West. Stay safe.

Cross-asset Update

Investors are cheered by the rising odds of peaking US inflation, welcome across asset classes, from equities, to government bonds and gold. The S&P 500 has rallied in the low double digits from the October lows, longer-dated yields have fallen sharply, while gold is trading close to a three-month high. One is now tempted to look at the glass half full, in spite of the failures of the previous bear-market rallies, and look through the current sequence of Fed’s hikes. In the past, inflation peaks preceded equity market bottoms more often than not, and the latest innings of the tightening cycle saw longer-dated yields peak out. Such a combination seems to be quite bullish for risk assets in general, and money markets are yet again discounting looser monetary policy in the United States, specifically towards the end of 2023. Also, China will at some point slowly relax covid restrictions, and the property sector is being supported. But being unconditionally optimistic would amount to be rushing to conclusions, in our view.

Granted, with the worst of inflation and yields’ upward momentum behind us, it would be right to be less pessimistic about the market outlook, but maybe just a little less so. Looking at the glass half empty as well, as the effects of higher rates make themselves felt through the economy, focus will be shifting from valuations, not outright cheap, to earnings, set to slow markedly despite the recent downgrades for 2023. With all of the relevant yield curves inverted, including the one the Fed watches closely basically measuring shorter term rates eighteen months in the future, and the Conference Board Leading Index in negative territory for three months running, the odds of a recession in the next 12 months have increased significantly. Since the Great Depression no equity bull market has ever occurred before a recession even started, hence we hold the view that stock gains should be capped until the outlook has improved. Exceptions were the 1968 and 1987 bear markets, much shorter than twelve months and marked by no contraction in the economy. The Chinese growth impulse may not be strong enough to fully offset the numerous crosscurrents, hence Beijing’s countercyclical policies might only help so much.

In summary, the outlook across asset classes seems to be complex to navigate, with equities range bound until we get to know whether worsening economic conditions will be looming larger; and government bonds and gold moving sideways as well, till it becomes clear, sometime in the first half of 2023, whether inflation is sticky and more hikes are needed, or it is rather going to fall in line with expectations. Higher-quality bonds still offer the best risk-reward ratio across asset classes, with DM investment-grade corporate bond yields close to 5% and the possibility that longer-dated yields are peaking out, as against a still uncertain growth outlook not outright supportive of risk assets. Gold is attempting to bottom out, and we will be warming up to it in 2023, with the yellow metal usually in a bull trend in times leading up to sharp slowdowns.



Fixed Income Update

October CPI surprised on the downside leading to the largest rally for the US Treasuries in more than a decade. However, Fed officials continue to try to moderate market expectations of a quick pause or a turnaround. From the declaration such as "we have a ways to go" from Waller, to the message by NY Fed president John Williams that restoring price stability is of "paramount importance", we get a clear sense of the Fed’s pushback. Fighting the Fed is never a good idea though investors time and again love to test the hypothesis. Even though yields have come down, we see investors flocking to the long end of the curve. The neglected part of the US Yield curve, the 20-year bond auction last Wednesday saw high demand indicated by the bid/cover of 2.64, which was solidly above average, and indirect allocation of 75.3% was a complete 1.2 sigma above the one-year average. With an expected Fed Funds rate close to 5%, a recession will be difficult to avoid unless the Fed more meaningfully pivots. The inverted 2s10s part of the curve indicates this.

According to a recent S&P report, the number of weakest links, issuers rated 'B-' or lower by S&P Global Ratings with negative outlooks or ratings on CreditWatch with negative implications, increased to 239 in October from 220 in September, boosted by an increase in downgrades to 'B-' or lower. The number of 'B-' rated issuers with negative outlooks or CreditWatch placements is rising and is now higher than at this point in 2021 and currently near 10% of the overall HY-rated issuer universe. The low refinancing requirements are the only aspect keeping a lid on actual defaults. A manageable $262bn of high-yielding bonds and leveraged loans mature in 2023/24, which rises to $427bn in 2025, $502bn in 2026, and $488bn in 2027 in the US HY segment. A JPM report mentions that 1,986 high-yield bond and loan companies (81%) have no maturities before 2025. But there is a heavier debt burden for lower-rated issuers over the coming years. Near-term maturities (2023-24) comprise $84bn of BB bonds and loans, $99bn of Single B, and $79bn of CCC-rated issuers.

After a long break, the Middle East primary markets saw a slew of deals and mandate announcements from the financial sector. Last week, Banque Saudi Fransi priced a 5-year $700mn bond at a 5.58% yield. Mashreq Bank priced a 10.25NC5.25Tier 2 $ bond at a 7.95% yield. Both the deals saw decent investor interest, and spreads tightened by around 25 to 30bps from IPTs to final pricing. In addition, DIB has issued a mandate for a debut 5-year sustainable Sukuk expected to price this week.


Equity Update

The month of November so far, has seen global equities gain with China recently rallying from oversold conditions with 3 consecutive weeks of gains. The MSCI China Index was up last week bringing November gains to +25%, though China remains the worst performing large market at -30% year to date. The Golden Dragon China Index of US-listed China companies rose in tandem as did real estate stocks which have been particularly hit by a slowdown in the housing sector. China equities have been supported by recent Covid travel regulations relaxing, property support measures, a positive Presidents Biden and Xi meeting, expectations for more policy fine-tuning following soft October data and firmer online retail sales data. We remain neutral China as we see a rise in COVID cases affecting reopening plans and also whilst tech companies rallied recently the onerous oversight of monopolistic enterprises or those with large sets of data on China users is not going away even though less onerous. Valuations are attractive, but consumer demand is essential for profitability growth. Also, Presidents Biden-Xi meeting while constructive , saw no resolution of any major issues and Taiwan remains a source of discussion. Our preference remains for the UAE and India in the emerging market space.

Our region saw the KSA and UAE equity indices down last week though new listings continue to see tremendous demand. Empower listed successfully on the Dubai bourse and both the KSA and UAE continue to see issuance. Abu Dhabi’s USD1.4bn IPO Fund shortlisted six private sector companies to potentially receive investment and advisory services for listing their shares on the Abu Dhabi Securities Exchange and is in discussion with 30 other companies to list on the capital’s stock market, expected to come to the market by the end of the first half of next year. The Americana IPO is currently underway. Indian equities fell 1.7% last week and have not seen much upside in November, though still positive year to date in local currency terms.

We are 6 weeks away from the end of 2022, a year that started with elevated valuations and then saw the market battered by higher commodity prices, labour costs, supply chain constraints and rate increases. 2 of these 4 variables are now improving. While the European industry is seeing the effect of constrained energy supply and higher costs, oil and essential commodity prices have fallen 20 to 30% from peaks earlier in 2022. Oil prices declined last week as OPEC revised their forecast for global oil demand lower for the fifth time since April, as uncertainty rose around Chinese demand. Also, the supply chain (shipping) is largely back on track as is production in most parts of the world. However, labour shortages in the blue-collar space are still concerning though tech layoffs while in the headlines, are not really a game changer. Monetary policy is also not yet pivoting and rates will rise till inflation is under control. The US saw the S&P 500 lose some of its recent steam, falling 0.5% last week, giving up gains from earlier in the week as Fed officials commented on the need to bring rates further into restrictive territory. European equities rallied despite fiscal policy in the UK revealing possible future spending cuts and tax hikes. We retain our US preference in the developed market allocation.



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