Reassessing expectations

Chief Investment Officer's team
26 September 2022
Reassessing expectations
Jumbo hikes and hawkish comments from major central banks rocked markets yet again last week


  • Jumbo hikes and hawkish comments from major central banks rocked markets yet again last week
  • Expectations for Western policy rates being revised higher pose larger risks to the outlook
  • We increased our tactical allocation to safe government bonds while reducing EM assets

Last week was brutal for financial markets. Bonds sold off with US Treasury yields adding more than +30 basis points across maturities. Stock markets followed, as higher interest rates demand lower valuation multiples and pose downside risk to growth. Global listed real estate, oil and gold were also in the red. Most asset classes now trade at their 2022 lows.

The situation is terrible, yet simple. Central banks are fighting inflation at any cost, by all means, including lowering asset prices and slowing the economy. This is not new, but there are three issues. First, their action is radical but recent: it has not yielded material results yet, apart from a broad market crash. Indeed, employment remains healthy and activity is not slowing fast enough to bring inflation down. Second, central bankers are getting impatient, thus increasingly hawkish. Third, monetary tightening is creating tensions with governments, as illustrated by the UK countering it with large fiscal stimulus, crushing the pound, or by the Japanese Ministry of Finance intervening on markets to support the yen, while its central bank maintains interest rates at zero and keeps on printing money.

Markets reassess their expectations for more tightening for longer, but also for more unpredictability of, actually, everything: inflation, growth, monetary and fiscal response, geopolitics, market reactions ... This is a recipe for volatility and risk aversion. Within this context, we have decided to increase our allocations to DM Government Bonds (actually US Treasuries of reasonably short maturities) by 2 percentage points across profiles. They are currently the most attractive segment of fixed income. We fund it by neutralizing EM stocks and increasing our underweight on EM bonds, taking 1 percentage point from each. Stay safe.

Cross-asset Update

The Fed’s decision to leave policy rates at higher levels throughout 2023, as per the latest dot plot highlighting the FOMC members’ views, has relevant repercussions across asset classes, and they are not positive. Those implications have not gone unnoticed to investors, hence the accelerated bad performance of bonds and equities since the policy meeting concluded on Wednesday, with the S&P 500 losing more than 4% and Treasuries 0.7% in the last three days of the week. The sort of ‘whatever it takes’ message delivered by Powell not only indicates that the times of abundant liquidity supporting risk assets are gone for the foreseeable future, but also that the times of scant liquidity will last for quite a while. That is, they will last until the Fed has managed to engineer higher unemployment levels conducive to lower inflation rates, no quick work given the exceptionally tight US labor market.

As policy rates rise and investors expect diminishing price pressures, betting on a successful Fed, real rates will tend to rise as well, and equity valuations to fall accordingly. And junk-bond issuers, that could refinance their operations at market yields consistently below 5% in the hey-days of sloshing liquidity, will see those costs more than double at Fed funds rates above 4%. In summary, fighting inflation should bring about cheaper stocks and wider credit spreads until the fight is over. This does not mean that the direction of travel is just for risk assets to move lower, but rather that a fully-fledged bull market cannot unfold under these conditions. So, the times of V-shaped recoveries, a by-product of past Fed’s largesse, are gone as well, with any sustainable rally postponed until Powell declares mission accomplished, or announces a Fed pivot. And focusing on whether there will be a recession or just a soft landing, misses the point that in either case it is going to be a long and winding road to the next bull market.

In this kind of environment investing in safer assets and in quality across asset classes remains the main option to build a resilient portfolio. Also, if buying and holding the broader market is not a viable strategy on the forecast horizon, selection is key. In risk-adjusted terms investing in short duration, solid IG credits seems to be the sweet spot, with yields particularly appealing at the shorter-end of the curve and the possibility of holding to maturity eliminating interest rate risk for the most risk-averse investors. Within equities high-dividend- and high-cash-flow-yielding companies would be offering the best downside protection. Specific themes should also be under the radar. If in the post pandemic period the already expensive IT stocks were all the rage, it may be now time to consider the impact of re-shoring on companies’ profitability as the world tends to get divided in different spheres of influence. As for gold, to-date a ‘false friend’, a supposedly defensive asset with dismal performance, its time will come when the bulk of Fed hikes is behind us, so sometime in 2023. In the shorter term, a rebound is likely, but a sustainable bull market much less so.

Fixed Income Update

The era of central bank largesse is officially over. Last week, central banks in the developed markets provided a cumulative 350bps hike. Including the Emerging Markets, the total rate hikes touched 1,137.5 bps. The only outliers were China and Japan, which did not change their policy rates, and Turkey, which continues to follow unorthodox policies by cutting rates by an unexpected 100 bps. Markets fell the ripple effects of these moves across asset classes. Bond yields spiked across sovereign benchmarks to touch multi-decade highs. The US Treasury 10-year yields increased by 27 bps last week, and we saw a similar move in German benchmark Bunds. But the dubious crown for the highest increase went to the UK Gilts. The benchmark 10-year yields went up by a whopping 100 bps to cross 4% for the first time since 2009. The movement was seven standard deviations above average. This was, of course, a result of the unfunded fiscal bounty declared by the new government that reached up to 1.5% of the GDP. Bond markets revolted as BoE is not in a mood for QE and is increasing rates to counter inflation. This could sound an alarm that the markets can be unforgiving for any slip-ups.

Coming back to the FED, it was as explicit in its message of hawkishness as it can be. The new dot-plot showed a median dot of 4.625% for the peak rate, which was far higher than anyone had expected. The Dots also showed that the FOMC members agree to keep the rates above 4% for the majority of 2024 as well. Some of the economic projections do look rosy, however. Despite mentioning the word “pain” more than ten times in the presser, the unemployment figures were capped at 4.4% in 2023 and subsequently came down. The FED is trying to make the markets believe that they would be able to bring inflation below 4% without inflicting extensive damage to employment prospects, which frankly seems a fairy tale right now. Hence, we could either see the FED not “Keeping at it” once the unemployment rate creeps up above 5% and the current unanimity of the FOMC members dissolves, or we have not seen the “peak hawkishness” yet and would get a rude jolt when the FED finally revises its projections.

Returning to different Fixed Income segments, all the sectors lost more than 1.5%. The long-duration ones suffered the worst, such as EM sovereigns and USD IG credit. There was no place to hide whatsoever. The credit-sensitive sectors such as High Yield saw OAS spreads widen by more than 20 bps and, as a result, lost more than 2% despite their shorter duration. Last week, we made a crucial TAA change by going overweight the DM Treasuries, where we see a lot of value at current levels. This was funded by increasing our underweight in EM Debt and cutting our EM Equity allocation to neutral. We reiterate our recommendation for clients to keep their portfolio duration short. Asset allocation in Fixed income should be defensive with a focus on quality IG names and very selective HY names. It is time to put the anchor and ride out the volatility storm before becoming aggressive.

Equity Update

Global equities fell 5%, taking losses to 7% in the first 3 weeks of September, keeping up the claim that it is the worst performing month on average. A hawkish monetary stance from 80% of the world’s Central banks to reduce inflation has led to increased fears of recession and corporate earnings downgrades. Multiples are typically lower in higher rate regimes and equity valuations have adjusted accordingly. Last week, all regions fell from c. 2% for Japan, India and the UAE to 7% for Europe. US equities - the S&P 500 & Nasdaq were down 5%, The S&P 500 now trades at a one year forward P/E of 15.2X. YTD global equities are down 23%, a little worse off than at June-end, with emerging and developed markets in synch and within sectors, only energy up. Last week the defensive sectors i.e. utilities, healthcare and consumer staples outperformed and surprisingly tech wasn’t the worst performer, it was energy, in line with falling oil prices.

We are neutral equities after taking the slight OW on EM Equity to neutral. We remain convinced of the longer-term potential of Asia, but in the near term the strengthening of the USD and the global growth malaise could further affect Asia performance. We keep our preference for domestically focused economies, the US and India and also the UAE, which is well valued and with high economic growth. Airline and tourist traffic into the UAE is at record levels, with a rise in expat inward movement and a build up to the Qatar World cup in November. India is an economy hugely impacted by the gas shortage and higher fuel costs, but strong domestic demand and alternate fuel sources are powerful offsets.

While the equity sell-off makes valuations look relatively compelling, any potential weakness in earnings from lower demand and supply chain constraints may limit the immediate upside potential for stocks. We remain cognizant of continued volatility and see markets stabilize, once central bank tightening cycles start to peak. The tightening of financial conditions is having a circular effect on markets. The 10-year yield is at 3.75%, and the Dollar index is at 20-year highs. While monetary policy is the main driver of the tightening of financial conditions, earnings downgrades are also a factor with estimates for Q3 S&P 500 EPS down 5% since the start of Q3 and reflecting margin pressures. On the geopolitical front, headlines about Russia beginning to mobilize its reserves are adding to negative sentiment. The outlooks from FedEx and GE are reflective of a slowing economy.

We reiterate buying quality companies with resilient income streams and strong debt coverage ratios. Companies with negative guidance are quick to see sell offs. Ford shares fell after the automaker said that inflation-related supplier costs during Q3 would run higher. We are overweight healthcare which has been outperforming this year, while the longer-duration tech and biotech sectors have suffered sharp sell-offs. The Nasdaq is down 30% this year as compared to 21.5% for the S&P 500, while the Renaissance IPO index, which tracks US companies that listed in the past two years, is down 51%.

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