"Second-derivative" hopes

Chief Investment Officer's team
31 October 2022
quotSecondderivativequot hopes
Most asset classes were positive last week, with growing hopes of decelerating central bank hikes

AT A GLANCE

  • Most asset classes were positive last week, with growing hopes of decelerating central bank hikes
  • Tightening is not about to end, but the tone has started to shift from Canada to Europe
  • In the week ahead, both Fed and BoE will deliver jumbo hikes and Q3 earnings season will continue

“Looking for equilibrium” was the title of our publication last Monday. We thought that the raft of economic, policy and corporate events of last week was the perfect opportunity to gauge what was really priced-in in valuations and expected by market participants.

The week was eventful, and most asset classes were positive. Inflation remains elevated from the US to Japan. GDP growth was robust in Q3, but flash PMIs indicated a global slowdown. The first third of the Q3 US earnings season didn’t deliver as much outperformance as in Q2, and even included some big misses and low-ball forward looking statements. A large and troubled Swiss bank came with a radical restructuring plan, which certainly safeguards it but didn’t convince investors. A comparable situation at a country level took place in Egypt. Finally, central banks: the ECB delivered a large 75 basis points hike, but their communication was materially less hawkish than a month ago. A day before, Canada’s central bank even surprised with a lower than forecast rate increase. This was markets’ focus.

The Fed should hike by 75 basis points this Wednesday and be followed by the Bank of England on Thursday. The tone will matter more than ever, as investors will look for any confirmation that tightening ahead may be less aggressive. This is not a given, with high inflation and strong employment, but it’s not impossible. The Fed may want to avoid market trouble into the mid-term elections next week, and UK fiscal pressure is easing.

A deceleration is not a pivot, but last week showed that markets welcome any kind of good news from central banks, even at the “second-derivative” level. Volatility and unpredictability should remain extreme, hence we keep our positioning close to risk-neutrality. Stay safe.

Cross-asset Update

US stocks put in sizeable gains in the five days through Friday, with the Dow Jones Industrials recording one of its best weeks since 1976. The Q4 rally we have been highlighting for quite some time, initially driven by extremely oversold conditions, is unfolding and being supported by a low earnings growth hurdle, that has been easily overcome in the current reporting season. To be sure, markets even ignored the dismal outlook for IT mega caps, and indeed the S&P 500 equal-weighted index has been outperforming its cap-weighted peer, a reminder that value stocks and smaller caps are back in vogue. One legitimate question in now whether the rebound could be the beginning of a longer-lasting bullish trend. We think that to be very unlikely, as bottoming processes are hard to come by so much before the end of a Fed’s tightening cycle.

The previous bear-market rallies came to an end as yields started to rise again, each time making new highs for the year. So, the answer to most of our concerns related to the fate of equities lies in the future direction of Treasury yields. And longer-dated yields could be close to putting in a peak, as more yield curves in the United Stated are entering inversion territory. The last one to join in, just last week, was the 10yr3m, preceded many months ago by the 10yr2yr and the 30yr5yr. Inverted yield curves, whereby shorter rates sit above longer-dated ones, are infrequent occurrences pointing to harsh slowdowns ahead, if not recessions. And rising yields at the long-end of the curve are at odds with slowdown phases. Macro data in the United States have also started to weaken, at least the so-called soft ones at survey levels, which has historically meant hard data eventually following suit. And we do not see how it could be otherwise this time as well, as not only monetary policy now is tight, but also fiscal policy is. Government transfers to households in the United States have basically been stopped, so fiscal momentum, so forceful after the pandemic, has turned negative and is expected to remain a drag into 2024.

But even though an interim peak in yields could spark glimmers of hope about this monetary cycle being in its last innings, investors may be underestimating how long the Fed could keep rates at higher levels for longer. And in the past tightening cycles since 1994, real Fed policy rates ended up landing on average 200bps above inflation. Unless PCE inflation does indeed settle in 2023 at 3.1%, as per the latest Federal Reserve official projections that remain overly optimistic, even rates at 5% could not be enough to tame price pressures. So, sooner rather than later Fed hawkishness is likely to be reinstated, easily killing investor exuberance.

We stick by the advice that in the current environment clients should prefer stock selection to broader market exposure, and also that they should avoid chasing junk credits higher and continue to prefer higher-quality bonds.



Fixed Income Update

We enter the crucial FOMC decision week with markets believing that peak hawkishness is behind us. There are some early indicators of a slowdown in place. However, will that be enough for the Fed to sound dovish after the rates decision remains to be seen? The Fed needs to see some weakness in the jobs data before taking their hands off the accelerator. Markets currently price in a 75 bps hike for the 2nd November meeting amid widespread hopes that this would be the last of the jumbo hikes in this cycle. What is more important for the market is to understand the tone of the presser and the Q&A. The US Treasury curve has bull-flattened with the belief growing about a dovish interpretation as the long-end of the curve decreased by 20bps last week. However, this is not the time to put on long-duration bets. The Fed could easily disappoint markets, and the pullback would be swift.

Markets are coming to terms with the inversion of the 3Months-10Year part of the curve. The crucial spread traded within five bps of zero on the back of weak consumer confidence data released last week. Of course, other segments of the curve, like the 10-/two-year and the 30-/two-year, have been inverted for quite a while now. The 10-year/three-month curve has historically proved to be a watertight signal of an impending contraction. However, on average, a recession has followed in about 11 months in data going back more than four decades. This inversion, when it happens, should not come as a surprise since the Fed has been trying hard to put brakes on inflation, and the economy will be collateral damage because of that.

Within credit, themes are appearing which could hold even in 2023. A strong trend is a sectoral yield dispersion compared to rating-based dispersion. According to a JPM report, the duration adjusted spread difference between BB and BBB Non-Financials is 125bp, its tightest level since October 2018. Within IG, sector moves are being driven less by technicals, so earnings and forward expectations about growth are showing through, with non-cyclical generally outperforming cyclical and banks continuing to underperform.

There is relative value appearing in the region's financials. AA/A-rated names such as FAB, ADCB, and DIB now offer 5.5% to 6.5% on their senior notes. Even the sub-ordinated space of solid regional banks such as NBK currently provides 9%. Worldwide TLCA senior bonds from the G-SIBs also offer strong relative play potential for investors. These bonds have Fixed-To-Floating structures and now offer a pick-up of more than 300 bps for a 5-year tenure issued by A-rated Banks.

The Egyptian authorities on Thursday reached a staff-level agreement with the IMF on a 46-month, $3bn Extended Fund Facility (EFF), with another expected regional support of $5bn and $1bn in further IMF funding (via the RSF) should close the near-term funding gap. However, the lower volume means it will be some time before Egypt gains market access, which would be putting pressure on the long-end of the curve. Therefore, we advise investors to move to the front-end of the sovereign curve.


Equity Update

Surprisingly developed markets had a good week, though earnings from tech mega-caps, which are a significant constituent of global and US indices fell short of estimates. These companies were the out-sized beneficiaries of post-Covid gains and investor inflows and some like Meta are now 75% below their peak, from a year ago. However, weakness in the largest index constituents did not spill over to the broader market, with support from lower sovereign yields, stemming from hopes that Central banks may start giving guidance on a slowing pace of increases. For the week the S&P500 was up +4%, the Nasdaq Index however up just +2%, held back by weakness in Google, Amazon & Meta shares. Indexed back to pre-covid March 2020, Meta and Netflix have fallen in value, Amazon is slightly up, Apple is +120% and Tesla +400%. The S&P 500 is +38% over the 2.5 years. Staying invested pays in the medium to longer term.

The Eurozone and UK outperformed last week on the back of what looked like softening Central bank policy. Emerging markets had a down week with the MSCI China falling 9%. India and the UAE were up 1-2%. Globally all sectors were up except communication services. We retain our US preference for the DM space and see the current rally sustaining at least until the next Fed update on 2nd November, expected to be dovish in tone. However, the still strong USD (+17%YTD), higher rates and wage rises remain headwinds to margins. A 10% rise in the USD impacts S&P 500 EPS by 1%.

Whilst we haven’t been optimistic about China equities in spite of low valuations, last week’s sell off was still dramatic. The Hang Seng Enterprises Index, i.e. China shares listed in Hong Kong, is trading at its cheapest ever at 0.5X price/ book. Growth concerns and the political landscape were triggers along with continued COVID lockdowns. The reaction was even more violent in China’s US-listed equities, with the Nasdaq Golden Dragon China Index at one point at a record -21% intraday on Monday. Intensifying US China tensions remain a concern.

For Q3 2022 with 52% of S&P 500 companies reporting, the blended earnings growth rate is 2.2 % and the net profit margin 12.0%. 2023 estimates continue to be revised down and analysts are projecting earnings growth of 6.4% and revenue growth of 3.7%. This week, 167  companies report. Big tech reflects the real economy and a slowdown is worrisome.  Amazon and Microsoft said that growth in their cloud computing businesses is decelerating, as customers lower expenses.  Cloud computing had been thought to be more resilient in a slowdown. Search/ digital advertising also saw pullbacks. Only Apple managed to report revenue growing consistently in spite of USD headwinds and margins at 42.3% - a pillar of stability. Meta profit margins fell as advertising revenue fell and spend increased with plans to double down on AI and the metaverse next year at 19% of the benchmark, Apple, Microsoft, Alphabet, Amazon and Meta hold bigger sway than the utilities, energy and consumer sectors combined.



Written by:

IMPORTANT INFORMATION

This document is prepared by Emirates NBD Bank (P.J.S.C) (“the Bank” or “Emirates NBD”), licensed and regulated by the Central Bank of the UAE (“Central Bank”) and the Securities and Commodities Authority of the UAE (“SCA”) and subject to regulation, supervision and control of the Central Bank and SCA, having its head office at Baniyas Road, Deira, PO Box 777, Dubai, United Arab Emirates. This document may be distributed and/or made available by the Bank and its affiliates and subsidiaries, including Emirates NBD Capital KSA CJSC (“ENBD Capital”) (through its website, its branches or through any other modes, whether electronically or otherwise).

Emirates NBD and its affiliates, subsidiaries and group entities, including its shareholders, directors, officers, employees and agents are collectively referred to Emirates NBD Group.

Any person (hereinafter referred to as “you”, “your”) who has received this document or have access to this document shall acknowledge and agree to the following terms.

Reliance

Data/information provided in this document are intended solely for information or illustrative purposes and are not designed to initiate or conclude any transaction.

This publication may include data/information taken from stock exchanges or other third-party sources from around the world, which Emirates NBD reasonably believes to be reliable, fair and not misleading, but which have not been independently verified. The provision of certain data/information in this publication may be subject to the terms and conditions of other agreements to which Emirates NBD is a party. Opinions, estimates and expressions of judgment are those of the writer and are subject to change without notice. Emirates NBD or any member of Emirates NBD Group makes no representation or warranty and accepts no responsibility or liability for the sequence, accuracy, completeness or timeliness of the information or opinions contained in this publication. Nothing contained in this publication shall be construed as an assurance by Emirates NBD that you may rely upon or act on any information or data provided herein, without further independent verification of the same by you.

The contents of this document are prepared as of a particular date and time and will not reflect subsequent changes in the market or changes in any other factors, including those relevant to the determination of whether a particular investment activity is advisable. Emirates NBD does not undertake any obligation to issue any further publications or update the contents of this document. Emirates NBD may also, at its sole discretion, update or change the contents herein without notice. Emirates NBD or any member of Emirates NBD Group does not accepts no responsibility whatsoever for any loss or damage caused by any act or omission by you as a result of the information contained in this publication (including by negligence).

References to any financial instrument or investment product in this document are not intended to imply that an actual trading market exists for such instrument or product. Certain investment products mentioned in this document may not be eligible for sale in some jurisdictions, and they maynot be suitable for all types of investors. The information and opinions contained in this publication is provided for informational purposes only and have not been prepared with any regard to the objectives, financial situation and particular needs of any specific person, wherever situated. If you wish to rely on or use the information contained in this publication, you should carefully consider whether any investment views and investment products mentioned herein are appropriate in view of your investment experience, objectives, financial resources and relevant circumstances. You should also independently verify and check the accuracy, completeness, reliability and suitability of the information and should obtain independent and specific advice from appropriate professional advisers or experts.

Confidentiality

This publication may be provided to you upon request (and not for distribution to the general public), on a confidential basis for informational purposes only, and is not intended for trading purposes or to be passed on or disclosed to any other person and/or to any jurisdiction that would render the distribution illegal.

Solicitation

None of the content in this publication constitutes a solicitation, offer, recommendation or opinion by Emirates NBD to buy, sell or trade in any security or to avail of any service in any jurisdiction. This document is not intended to serve as authoritative legal, tax, accounting, or investment advice regarding any security or investment, including the profitability or suitability thereof and further does not provide any fiduciary or financial advice. This document should also not be used in substitution for the exercise of the prospective investor’s judgment.

Third Party

This publication is not intended for use by, or distribution to, any person or entity in any jurisdiction or country where such use or distribution would be contrary to law or regulation. It is the responsibility of any person in possession of this publication to investigate and observe all applicable laws and regulations of the relevant jurisdiction. This publication may not be conveyed to or used by a third party without the express consent of Emirates NBD or its affiliates, subsidiaries or group entities distributing this document. You should not use the data in this publication in any way to improve the quality of any data sold or contributed by you to any third party.

Liability

Notwithstanding anything to the contrary set forth herein, Emirates NBD, its suppliers, agents, directors, officers, employees, representatives, successors, assigns, affiliates or subsidiaries shall not, directly or indirectly, be liable, in any way, to you or any other person for any: (a) inaccuracies or errors in or omissions from this publication including, but not limited to, quotes and financial data; or (b) loss or damage arising from the use of this publication, including, but not limited to any investment decision occasioned thereby. Under no circumstances, including but not limited to negligence, shall Emirates NBD, its suppliers, agents, directors, officers, employees, representatives, successors, assigns, affiliates or subsidiaries be liable to you for direct, indirect, incidental, consequential, special, punitive, or exemplary damages even if Emirates NBD has been advised specifically of the possibility of such damages, arising from the use of this publication, including but not limited to, loss of revenue, opportunity, or anticipated profits or lost business.

This publication does not provide individually tailored investment advice and is prepared without regard to the individual financial circumstances and objectives of person who receive it. The appropriateness of an investment activity or strategy will depend on the person’s individual circumstances and objectives and these activities may not be suitable for all persons. In addition, before entering into any transaction, prospective investors should: (i) ensure that they fully understand the potential risks and rewards of that transaction; (ii) determine independently whether that transaction is appropriate given an investor’s investment objectives, experience, financial and operational resources, and other relevant circumstances; (iii) understand that any rates of tax and zakat or any relief in relation thereto, as may be referred to in this publication may be subject to change over time; (iv) consult their advisers on the legal, regulatory, tax, business, investment, financial and accounting implications of the investment; (v) understand the nature of the investment and the related contract (and contractual relationship) including, without limitation, the nature and extent of their exposure to risk; and (vi) understand any regulatory requirements and restrictions applicable to the prospective investor

Forward Looking

Past performance is not necessarily a guide to future performance and should not be seen as an indication of future performance of any investment activity. The information contained in this publication does not purport to contain all matters relevant to any particular investment or financial instrument and all statements as to future matters are not guaranteed to be accurate. Certain matters in this publication about the future performance of Emirates NBD or members of its group (the Group), including without limitation, future revenues, earnings, strategies, prospects and all other statements that are not purely historical, constitute “forward-looking statements”. Such forward-looking statements are based on current expectations or beliefs, as well as assumptions about future events, made from information currently available. Forward-looking statements often use words such as “anticipate”, “target”, “expect”, “estimate”, “intend”, “plan”, “goal”, “seek”, “believe”, “will”, “may”, “should”, “would”, “could” or other words of similar meaning. Reliance should not be placed on any such statements in making an investment decision, as forward-looking statements, by their nature, are subject to known and unknown risks and uncertainties that could cause actual results, as well as the Group’s plans and objectives, to differ materially from those expressed or implied in the forward-looking statements. Estimates of future performance are based on assumptions that may not be realized.

Risk

Data included in this publication may rely on models that do not reflect or take into account all potentially significant factors such as market risk, liquidity risk, and credit risk. Emirates NBD may use different models, make valuation adjustments, or use different methodologies when determining prices at which Emirates NBD is willing to trade financial instruments and/or when valuing its own inventory positions for its books and records. The use of this publication is at the sole risk of the investor and this publication, and anything contained herein, is provided "as is" and "as available." Emirates NBD makes no warranty of any kind, express or implied, as to this publication, including, but not limited to, merchantability, non-infringement, title, or fitness for a particular purpose or use.

Investment in financial instruments involves risks and returns may vary. The value of investment products mentioned in this document may neither be capital protected nor guaranteed and the value of the investment product and the income derived therefrom can fall as well as rise and an investormay lose the principal amount invested. Investment products are subject to several risks factors, including without limitation, market risk, high volatility, credit and default risk, illiquidity, currency risk and interest rate risk. It should be noted that the value, price or income of securities denominated in a foreign currency may be adversely affected by changes in the currency rates. It may be difficult for the investor to sell or realise the security and to obtain reliable information about its value or the extent of the risks to which it is exposed. Furthermore, the investor will not have the right to cancel a subscription for securities once such subscription has been made. Prospective investors are hereby informed that the applicable regulations in certain jurisdictions may place certain restrictions on secondary market activities with respect to securities.

Before making an investment, investors should consult their advisers on the legal, regulatory, tax, business, investment, financial and accounting implications of the investment. In receiving this publication, the investor acknowledges it is fully aware that there are risks associated with investment activities. Moreover, the responsibility to obtain and carefully read and understand the content of documents relating to any investment activity described in this publication and to seek separate, independent financial advice if required to assess whether a particular investment activity described herein is suitable, lies exclusively with the investor.

Intellectual property

This publication has been developed, compiled, prepared, revised, selected, and arranged by Emirates NBD and others (including certain other information sources) through the application of methods and standards of judgment developed and applied through the expenditure of substantial time, effort, and money and constitutes valuable intellectual property of Emirates NBD and such others. All present and future rights in and to trade secrets, patents, copyrights, trademarks, service marks, know-how, and other proprietary rights of any type under the laws of any governmental authority, domestic or foreign, shall, as between the investor and Emirates NBD, at all times be and remain the sole and exclusive property of Emirates NBD and/or other lawful parties.

Except as specifically permitted in writing, you should not copy or make any use of the content of this publication or any portion thereof or publish, circulate, reproduce, distribute or offer this publication for sale in whole or in part to any other person over any medium including but not limited to over-the-air television or radio broadcast, a computer network or hyperlink framing on the internet or construct a database of any kind. Except as specifically permitted in writing, you shall not use the intellectual property rights connected with this publication, or the names of any individual participant in, or contributor to, the content of this publication, or any variations or derivatives thereof, for any purpose. This publication is intended solely for non-commercial use and benefit, and not for resale or other transfer or disposition to, or use by or for the benefit of, any other person or entity. By accepting this publication, you agree not to use, transfer, distribute, copy, reproduce, publish, display, modify, create, or dispose of any information contained in this publication in any manner that could compete with the business interests of Emirates NBD. Furthermore, you should not use any of the trademarks, trade names, service marks, copyrights, or logos of Emirates NBD or its subsidiaries in any manner which creates the impression that such items belong to or are associated with you, except as otherwise provided with Emirates NBD’s prior written consent. You shall have no ownership rights in and to any of such items.

IMPORTANT INFORMATION ABOUT UNITED KINGDOM

This publication was prepared by Emirates NBD Bank (P.J.S.C) in the United Arab Emirates. It has been issued and approved for distribution to clients by the London branch of Emirates NBD Bank (P.J.S.C) which is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority in the UK. Some investments and services are not available to clients of the London Branch. Any services provided by Emirates NBD Bank (P.J.S.C) outside the UK will not be regulated by the FCA and you will not receive all the protections afforded to retail customers under the FCA regime, such as the Financial Ombudsman Service and the Financial Services Compensation Scheme. Changes in foreign exchange rates may affect any of the returns or income set out within this publication.

IMPORTANT INFORMATION ABOUT SINGAPORE

This publication was prepared by Emirates NBD Bank (P.J.S.C) in the United Arab Emirates. It has been issued and approved for distribution to clients by the Singapore branch of Emirates NBD Bank (P.J.S.C) which is licensed by the Monetary Authority of Singapore (MAS) and subject to applicable laws (including the Financial Advisers Act (FAA) and the Securities and Futures Act (SFA). Any services provided by Emirates NBD Bank (P.J.S.C) outside Singapore will not be regulated by the MAS or subject to the provisions of the FAA and/or SFA, and you will not receive all the protections afforded to retail customers under the FAA and/or SFA. Changes in foreign exchange rates may affect any of the returns or income set out within this publication. Please contact your Relationship Manager for further details or for clarification of the contents, where appropriate. For contact information, please visit www.emiratesnbd.com.

IMPORTANT INFORMATION ABOUT EMIRATES NBD CAPITAL KSA CJSC

Emirates NBD Capital KSA CJSC (“ENBD Capital”), whose registered office is at P.O. Box 341777, Riyadh 11333, Kingdom of Saudi Arabia, is a Saudi closed joint stock company licensed by the Saudi Arabian Capital Market Authority (“CMA”) under License number 37-07086 dated 29/08/2007G (corresponding to 16/08/1428H) to deliver a full range of quality investment products and related support services to individuals and institutions in the Kingdom of Saudi Arabia. ENBD Capital is subject to Capital Market Law, and Implementing Regulations in the Kingdom of Saudi Arabia

ENBD Capital’s contact details are T +966 (11) 299 3900 and F +966 (11) 299 3955.

This document may not be distributed in the Kingdom of Saudi Arabia except to such persons as are permitted under the Investment Funds Regulations issued by the Capital Market Authority.

The Capital Market Authority does not make any representation as to the accuracy or completeness of this document, and expressly disclaims any liability whatsoever for any loss arising from, or incurred in reliance upon, any part of this document. Prospective subscribers of the securities offered hereby should conduct their own due diligence on the accuracy of the information relating to the securities offered. If you do not understand the contents of this document, you should consult an authorised financial adviser.