The return of volatility

Chief Investment Officer's team
07 August 2023
The return of volatility

AT A GLANCE

  • Volatility came back across the board last week hitting rates harder
  • All asset classes were in the red and DM treasuries are now the worst performing asset class in 2023
  • We will be holding our August tactical asset allocation this week

Soaring crude prices and rising yields following a Fitch downgrade of the US government debt saw equities fall for the week, with the Nasdaq recording the largest losses. On the corporate side, though earnings surprised, stocks tended to be punished. Amazon rose 8% on Friday as it significantly beat estimates, while Apple fell about 5% following a mixed report.

The Fitch Ratings downgrade from AAA to AA+ - materially a non-event - drew attention to the ever-rising pile of US obligations, adding to the negative sentiment on the Treasury market that was flooded with more issuance aimed at replenishing the Treasury General Account. The yield on the 10-year note touched a new high for the year at 4.2% to settle on Friday at 4.05%, while the 30-year closed at 4.2%. The yield curve bear steepened, with rising expectations for improved growth. Macroeconomic releases saw the divergence between business surveys, pointing to a slowdown, and real activity grow larger. Factory orders came in strong, while the jobs report, though conveying the message of a notable slowing of the labor market, still delivered 187,000 new payrolls in the previous month.

From a seasonal point of view, we are entering that time of the year when equity volatility is more likely than not to rise, that combined with rich valuations and summer-time illiquidity could make for choppy waters. Yet, improved growth prospects – more investment houses are scrapping their call for a recession in 2023 – should see limited downside on risk assets.

We will be holding our Tactical Asset allocation Committee this week and reassess portfolios in light of the evolving scenario.

The return of volatility

Cross-asset Update

The US outlook is ever changing and now JPMorgan has joined Bank of America in scrapping the call for a US recession in 2023, replaced by a continued expansion this year and “subpar growth” in 2024. The hefty post-pandemic government transfers did tide the consumer over the tightening cycle, the US banking crisis was averted with bailouts and a specific funding program, while government outlays grew substantially.

No recession in 2024 would be a sea-change for asset classes. Take 10-year Treasuries, for instance. Let’s assume that the real equilibrium USD cash rate is a mere 0.5%, inflation stabilises at 3%, add a paltry 0.5% term premium and the long-term fair value would be 4%, higher than the 3.4% we had prognosticated, or the 3.5% JPMorgan had worked out for year-end under the previous scenario. Yes, yields could end up being lower versus long-term equilibrium levels, but not by that much if the economy remains so resilient. Credit spreads would stay tight, never mind whether in the lower end of the historical range, as moderate growth would be enough to avoid surging bankruptcies. Equities, though overbought, would not have much downside, and actually we should see the most cyclical stocks catch up with the IT sector. There would be growing chances of a manufacturing rebound, hence of an EM equity rally. And what if the scenario of “subpar growth” comes to pass in 2024? That would be heaven on earth for IT stocks and high-yielding credit, provided inflation stays put.

Therein lies the rub. The main implication of a recovery scenario is price pressures coming back again. In the 2010’s muted growth and inflation were the norm, when globalisation, restrained fiscal policy, and range-bound commodity markets were amongst the factors contributing to keeping price pressures in check. The 2020’s are starting in a different way, with resource scarcity across the board, deglobalisation, aggressive re-industrialisation policies in the United States and Europe, and war-like economies at least so far. Against this backdrop inflation can easily reaccelerate. Indeed, the year-to-date week dollar would be playing in this direction via looser global financial conditions, as well as a Chinese recovery possibly gaining traction on the cumulative effect of countless piecemeal support measures.

Inflation resurgence would keep recessionary risks alive and kicking through further central-bank tightening, that would be coordinated, hence generating an even worse growth slump further down the road. Also, the risk of the delayed effects of past hikes on business activity remains. But for now, the scenario is leaning towards rates high for longer alongside a resilient for longer economy, with positive implications for risk assets. And the growth slump is shifting towards being a tail risk, rather than a base case.

The return of volatility

The return of volatility

The return of volatility

Fixed Income Update

The increase in yields post the US GDP data gained momentum last week as the Treasury announced its upsized auction and Fitch downgraded the credit rating of the USA from AAA to AA+. According to BCA Research, Greater Treasury coupon issuance coming at a time of slowing economic growth and inflation would probably not move yields, but investors get spooked when more bonds are issued at a time when economic growth appears to be re-accelerating. There was an extraordinary bear steepening as long-end yields approached their highest levels since November 2022. The 10-year yields reached a high of 4.20%, and the 30-year yields peaked at 4.32%. Friday's mixed unemployment data reversed the trend slightly, as the report had something both for Hawks and doves. The long-end yields crashed before resuming their increase, as we write.

It may be tempting to tactically trade these higher yields, but we advise investors to be patient before jumping in as seasonality is not in favor, with Sep/Oct being the worst months for long-dated treasuries historically. In the last 10 years, there have been only 3 instances when Treasuries have given a positive return in September or October, while January and March have been the best months for adding duration. If investors have a longer horizon, then buying the dip makes sense since these levels of yields have only traded sustainably around 2011. If we take the various credit measures and the Senior Loan Officers survey, there does seem to be a credit crunch in the offing. Moreover, provisions increased sequentially at nearly two-thirds of the banks included in an S&P Global Market Intelligence analysis that examined results from publicly traded companies with at least $10 billion in assets that reported second-quarter earnings by July 28. But according to analysts, unless we see Jobs creation come below +100k, the Fed would not move towards lowering rates. That would provide a backstop to yields.

Focusing on Europe, the European Banking Authority recently released its bank stress test results. The findings suggest that most European banks will be able to increase dividend payouts and share buybacks, thanks to their resilient capital buffers, according to analysts. The regulator found that under a hypothetical adverse scenario, the aggregate common equity Tier 1 ratio of the 70 banks examined would drop 459 basis points to 10.38% in 2025 from 14.97% at the end of 2022. The stress tests also show that banks' exposure to the hospitality and construction industries is the biggest asset quality threat. In the adverse scenario, nonperforming exposures in the accommodation and food service segment would total 11% of performing exposures. In the construction industry, exposures would total 8.2%. The EBA believes banks are well-positioned to withstand an unfavorable operating environment. This should give comfort to AT1 bondholders who had every reason to be nervous post the CS AT1 debacle.

The return of volatility

The return of volatility

Equity Update

An eventful week for equity markets with Fitch downgrading US long-term credit rating, mega tech earnings and the BoE raising interest rates. The S&P 500 ended a run of three-weeks of positive returns and finished last week down –2.3%, the FTSE 100 and Eurozone equities fell similarly. A shift seen recently from tech (Nasdaq +33% year to date) to a broader rally (global equities rose c.4% in July), with the tech sector flat last month and energy (with Brent back above $85/barrel) and financials outperforming. Higher yields are benefitting bank stock performance. Emerging markets fared no better, with only the UAE equity indices up last week. China and India equities ended down a percent. China’s central bank said it would increase funding to support the property industry and the policy approach has shifted away from supporting small cities to mega cities. It is estimated the key 14 cities make up 24% of China's GDP.

We are close to neutral positioning on equities (small underweight) with a preference for the emerging markets. We are neutral EM Asia with a preference in EM for the UAE and India. An emphasis within DM, where we are neutral, on staying invested in the US. Positive tailwinds are growth (slowing), a trough in earnings, no further bank collapses and the end of the tightening cycle in sight. Amongst regions Brazil, the first to change direction, and they cut rates by 50bps last week. What remains a worry for the earnings outlook is the higher borrowing rates for corporates, consumers and house buyers.

After downbeat outlooks from most investment houses when the year started, a turnaround from some which see further gains or the S&P 500 holding these levels into year end. Our S&P 500 fair value is at 4,500 for year-end and for the 10-year Treasury yield at 3.4%. Treasuries tend to rally when stocks are falling, but the one-month correlation between the Bloomberg US Treasury Total Return Index and the S&P 500 is 0.82, where a score of 1 is a perfect correlation.

The first week of August has seen a fall in equity returns and that’s not unusual, following a very strong June and July. Total YTD returns still significant at +15% for the ACWI (global equities) and the Dubai index leading at +27% YTD, and the S&P 500 (the largest weight in global equities) +18% YTD. An imminent recession isn’t very likely and that reduces the downside concerns about corporate earnings, but it increases the downside potential for the stock market’s valuation multiple if the bond yield continues to rise. We will likely see more volatility this summer.

Still the year for tech and AI linked updates. Apple, now at $2.8tn market cap, shares+ 40% YTD , saw profits grow last quarter with services contributing. The number of paying subscribers for digital services grew to over one billion users. Amazon revenue and profits accelerated with an 11% increase in revenue, with EPS 65 cents, compared to a loss of 20 cents the year before. Stronger-than-expected online sales along with cost-cutting, and large-scale lay-offs earlier this year helped. Growth at AWS slowed to 12% compared to 29% for 2022. Amazon shares are +66% YTD.

The return of volatility

The return of volatility

The return of volatility

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