Powell’s words boost animal spirits

Chief Investment Officer's team
02 August 2022
Powells words boost animal spirits
Markets ablaze as investors hope for peak tightening by year-end

AT A GLANCE

  • Markets ablaze as investors hope for peak tightening by year-end
  • Earnings exceed lowered bar even as economy slows down
  • The IMF slashes global growth forecasts

In a week packed with the eventful Fed July meeting, and macro and earnings releases, markets rebounded hard from deeply oversold levels. Investors saw the glass half full, as Powell embraced a more data-dependent stance – while hiking rates by 75bps as expected – and Big Tech reported above expectations. US equities outperformed, gaining more than 4%, while EM stocks were little changed with China doubling down both on Covid and Taiwan policies. Long-dated treasuries advanced for the third consecutive week on mounting concerns about the US slowdown morphing into a recession. The 10-year treasury yield ended the week 10 basis points lower as a high inflation reading was overshadowed by a second consecutive quarter of negative growth in the US economy, with a -1.6% expansion rate in Q1 followed by an estimated -0.9% in the three months through June. Although the soft spell is unlikely to qualify as a contraction given the strength of the labor market, the inverted yield curve is offering little room for comfort about the outlook. Concerns were reinforced by the IMF, that slashed global growth forecasts, raised inflation projections and warned that risks are “overwhelmingly tilted to the downside”.

Overall, the United States remains a bright spot, with Europe mired in an energy crisis and verging on recession and China hard put to finding a fix for its beleaguered real Estate sector.

Although the US earnings season generally met or exceeded a lowered bar, future market direction will be dictated by whether investor optimism about future Fed policy will actually translate into a pivot. With the battle against inflation still having a long way to go, we think that excessive optimism has room for disappointment. Stay safe.

Cross-asset Update

Hope dies hard, especially in equity markets if Powell’s words – that they have now reached levels “of neutral interest rates” and that they are “much more data dependent going forward” – are construed as a policy pivot. While as of few days ago the assumption was that policy would be on a preset course till inflation was tamed, now being data dependent amidst a slowing economy can portend in investor minds a softer monetary cycle with a slower pace of hikes. And this was enough for the market price of risk to change dramatically across asset classes, as equities, treasuries and credit rallied in unison, with US stocks retracing almost all of the previous month losses. Sure, some solid set of earnings played a role as well, but without the alleged prospect of a more market-friendly Fed animal spirits would have not stirred that much. Also, bearish sentiment and extremely cautious investor positioning amplified the upswing, that underscored once more that liquidity remains the primary driver of financial assets. And a peek into what is happening overseas confirms that central banks and more in general stimulus still play an outsize role. The ECB has embarked on a tightening cycle even as parts of the euro area are already in recession and in China stimulus remains underwhelming in spite of the structural crisis in the real estate sector. The relative performance of markets has so far followed the diverging liquidity patterns across different regions and we think it will continue to.

So, it is worth wondering whether the Fed is indeed going to pivot, at least in the immediate future as investors are inclined to believe. Fed funds futures now discount peak tightening with a rate at 3.5% by year-end and easier policy after March 2023. That looks very optimistic, considering also that Powell in the press conference made frequent references to the June Summary of Economic Projections -- where the median committee member anticipated a couple more hikes next year. And historical precedents in the inflationary 70s and early 80s, when Fed chairs at the time eased too soon only to see inflation flare up again, suggest that central bankers can get rid of price pressures only by keeping rates at high levels for prolonged periods of time. Yes, the pace of hikes will be softer, but in our view a pivot can only be in sight once the labor market shows obvious cracks. And that in turn will exacerbate the risks of a recession, after all Powell himself called the soft landing “very challenging”. As for policy having already reached a neutral level, ex NY Fed Governor Bill Dudley politely said that he’d “be a bit more skeptical” that neutral was reached, while ex Treasury secretary Larry Summers bluntly called Powell’s statements “indefensible”.

History and reputable commentators point to the multiple risks of a stop to tightening too early, let alone reversing course, risks that would not be concerning investors only, and would once materialized be further denting central bankers’ reputation.



Fixed Income Update

Last week’s 75-bps rate hike at the FOMC meeting means the current rate hike cycle is the steepest since the early 1980s. However, markets took the Fed’s removal of forward guidance as a positive, and risky assets rallied. As a result, yields across the curve have come down significantly. The 10-year yield had a weekly close below 2.70% for the first time since early April. The market is behaving in a pre-recessionary manner where the bonds are rallying, and credit spreads are tightening. The Bloomberg Barclays Agg Index posted its best monthly return since November 2020. However, we believe this would not be the start of any trend, and the current lower expectations in the hiking trajectory could be a mirage. The inflation remains high, job growth is robust, and the Fed is unrelenting. Hence, credit investors should be cautious of any false sense of hope created by such rallies and cut their exposure to the riskier parts of the asset class.

Moreover, the effect of the quantitative tightening would be fully felt early next year, according to many analysts. According to a recent Barclays report, Banks have about $3 trillion of reserves parked at the Fed. While the Fed’s balance sheet is on pace to shrink by less than $500 billion by year-end, other factors will contribute to reserves falling to $2.1 trillion during the first quarter of 2023. At that level, financial institutions are likely to start to compete more aggressively for deposits, the effect of which would be to push short-term interest rates higher, including the effective FED funds rate targeted by the US monetary policy. This could result in higher bank lending rates, and the real economy would feel the pinch of the monetary tightening.

Leaving the Fed and coming to the UK, BoE is expected to join the Jumbo hike clubs by raising rates by 50 bps this week in what could be the highest rate hike since the early 1990s. It would also unveil its strategy for unwinding some of the £895 billion ($1.1 trillion) of stimulus it delivered over the past decade.

Turning our focus to emerging markets, there seems to be no end to woes for the holders of offshore Chinese Real Estate bonds. Evergrande failed to come up with the restructuring plan by 31st July. According to a recent S&P report, in a worst-case scenario, the rating agency estimated that 2.4 trillion yuan, or 6.4% of mortgages, are at risk amid a boycott across more than 90 cities. As on 26th July, new homes sales volume declined 37% YoY, and secondary transactions were -6% YoY. Primary GFA sold on average dropped 45% YoY on a YTD basis, and secondary GFA sold on average declined 27% YoY on a YTD basis. S&P Global Ratings now expects national property sales to fall 28%-33% this year. This could further squeeze the liquidity of distressed developers, leading to more defaults. Goldman Sachs has raised its 2022 forecast for the default rate for China's high-yield property bonds to 45% from 31.6%, citing rising stress within the sector. We believe things are going to get worse before turning for the better.


Equity Update

To say that it has been a tough year so far for equities is an understatement: YTD the S&P 500 is down -13.34%, the DJIA -9.61%, and the tech-heavy NASDAQ Composite -20.80%. However, markets did get some much-needed reprieve. The same indices were up +9.11%, +6.73%, and +11.80%, respectively, during the month of July; outperformance last seen in 2020. July saw 86% of the S&P 500 in the green. A chunk of those gains could be attributed to Fed Chair Powell’s comments and decision last week during the FOMC rate hike. With inflation continuing its rise, the market had started seriously mulling a full 100 bps increase in interest rates, but the eventual 75 bps outcome was seen as a positive sign of inflation possibly abating soon in addition to the Fed likely to start slowing the pace of hikes sooner than expected.

On top of July being a rich month for quarterly reports, earnings came in much better than analysts were expecting. Apple beat expectations due to its ability to weather a tough inflationary environment; Amazon outperformed thanks to its AWS cloud service segment, while Google and Microsoft gave positive guidance for the year despite the ongoing headwinds. Given the surge in oil and gas prices, with YTD increases being +41.44% for Brent Oil and +120.64 for Natural Gas, it’s no surprise that Oil & Gas companies have reported record profits during their second quarter; as well as having the best YTD returns among the MSCI World Index sectors at +33.2%, while the others have seen negative returns thus far.

July’s performance could be a sign of better times ahead; especially given that turnarounds have not been unlikely during the second half of economic downturns. However, we may not be out of the woods yet. It is easy to fall into the “this time is different” narrative and navigate the markets with less caution at the first signs of a rising tide. Not only have we seen intense inflationary pressures, supply chain constraints, and a conflict with an unpredictable outcome which has largely contributed to the ongoing economic downturn, but a strengthening US dollar has entered the picture as well. This especially does not bode well for emerging markets, as a rising USD dampens global trade, and makes it difficult for EM countries to service their US-denominated debt. China has been facing its own battles recently, with a staunch stance on COVID hampering economic activity and a real-estate market teetering on the edge. The US dollar gaining steam would only add to its woes by encouraging capital outflows and making it tougher for SMEs to operate.

Our current positioning remains neutral on developed market and a small overweight on emerging market equities. We continue to see gains into yearend as earnings growth data remains supportive though guidance is negative, more so from Europe with companies giving profit warnings around energy prices. The US corporate narrative remains around inflation and labour shortage. Our preferred sectors remain select tech, healthcare, and energy.



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