The sunny side of volatility

Chief Investment Officer's team
26 July 2022
Last week delivered positive returns for all major asset classes


  • Last week delivered positive returns for all major asset classes
  • Signs of economic slowdown abound, which in turn should help on the inflation front
  • We keep on expecting high volatility for the months to come

Volatility remained material last week, but on its sunny side. Stocks gained 3% across regions, while segments of fixed income between 1.5% and 3%, following their risk hierarchy.

Such a unanimity is usually linked to generosity from central banks. It wasn’t the case, as we had more rate hikes, from the Bank of Canada and the ECB, and it should continue with the Fed this week. However, nuances matter. First, on the economic front, global flash PMIs confirmed that a slowdown is underway, with a considerable worsening in the Eurozone – where the provisional number is below 50. When it’s all about central banks, bad news is good news: less demand means less inflation, and ultimately less tightening. The ECB went even further. The institution hiked by half a point, which was more than expected and ended the aberration of negative interest rates. But simultaneously, they unveiled a new and creative tool. The TPI, it stands for Transmission Protection Instrument, is here to counter “unwarranted and disorderly market dynamics”. Basically, the possibility to expand the balance-sheet to buy sovereign bonds. Yes, magic money again.

Inflation remains the most important driver. If there is a global recession, inflation vanishes and central banks turn, providing support again. In the meantime risk assets will suffer but defensive ones will play their role. We believe the global economy is dented but not fully derailed. Inflation will abate but not collapse; central banks should pause and hesitate. This means volatility but also upside potential for assets where economic risk is priced-in, like emerging market stocks. This is how we built our reasonably constructive positioning. In any case, volatility will remain high this summer. Stay safe.

Cross-asset Update

The debate about the “full capitulation” of investors is not over. And while last week Bank of America provided support for that view, Bernstein begged to differ, saying that equity flows have not been weak enough for markets to have bottomed, but also that we may “have seen capitulation from bond funds”. We would have sympathy for the latter view. We have recently raised our year-end fair value for the 10-year yield to 3.2%, which implies very limited upside from current levels. Indeed, as activity slows down yields cannot keep on rising. That implies that investors are still better off in high-quality bonds than in risk assets. We would tend to side more with Bernstein on equities as well, as it seems too early in the tightening cycle to sound the all-clear, although some of our tactical indicators point to the continuation of the current rebound. There seems to prevail also some complacency about the willingness of the Fed to quickly reverse policy towards an accommodative path once growth weakens too much. When Fed rates have moved into restrictive territory by year end, the expectation embedded in Eurodollar futures, priced off Libor, is that the Fed will start cutting from March. Not so fast. For inflation to be tamed restrictive policy should last a while more than a very few months, so there is excessive optimism about the final level of policy rates. Also, it is difficult to see pressures on record margins ease beyond the quarter with the dollar at a 20-year high and higher input costs. Once margins are impacted, currently close to record levels and sitting well beyond their 10-year average, further equity derating should follow. In short, not all the bad news seems to be out yet.

It seems also too early to be bullish the euro against the US dollar, and here actually way too early in spite of the 10% year-to-date loss and the dollar overvaluation. Overall, it boils down to how the two economies, the euro area and the United States, are positioned. The latter is currently shifting from overheating to slowdown, while the former is bordering on recession. According to the latest PMI survey corporate sentiment is already pointing to a hard landing, while consumer confidence reached an all-time low. Economic agents in Europe are bracing for a recession. Stagflationary pressures are higher in Europe, driven by the rising costs of importing energy, prospective energy shortages and the bleak outlook due to the ongoing neighbouring conflict. One might wonder how the ECB, trailing further behind than the already lagging Fed, may think of going the full range of tightening. This would not be the first mistimed and then aborted tightening spell of the ECB, if the 2008 hike, on the eve of the Great financial crisis, and the two rises in 2011, during the European crisis, are anything to go by. Either way, the common area currency stands to lose: macroeconomic and policy differentials suggest the euro should weaken and a recessionary scenario would still favor the dollar as a safe-haven. Pullbacks in the world reserve currency should be buying opportunities.

Overall, there are still reasons to favor a defensive bias across asset classes.

Fixed Income Update

The raging debate between “Recession” and “Inflation” goes on. This week we will see the most critical FOMC meeting that will be held on Tuesday and Wednesday. The markets currently price in a 75 bps rate hike. The Fed’s options are minimal. They will spook the markets if there is a larger than expected rate hike. At the same time, anything lower would dent the Fed’s reputation and claims of being serious about fighting inflation. A 75 bps rate hike will take the Fed rate upper bound to 2.5%, typically considered a neutral range. The Treasury curve twisted flatter, and long-end yields declined over the last week on weak sentiment.

ECB joined the rate-hike group, increasing the rates by 50 bps, the biggest increase since 2000 and the first in more than a decade. Lagarde, however, has a shorter runway for the rate hike than Powell. The current energy crisis and the conflict in the region would be a drag on growth. Similarly, the impact of higher rates on the economies of peripheral Europe is a concern. The bank did come out with its anti-fragmentation tool, aptly named Transmission Protection Instrument (TPI), that seeks to cap the Euro-Area spreads. The activation criteria for the tool are a bit vague, with no cap on the bond purchase limits. The metric that everyone is watching is the spread between Italian and German bonds. Some strategists have speculated that the trigger point might be around 250 basis points. Italian bond spreads have compressed by more than 20 bps post the announcement but would remain volatile given the political uncertainty in the country.

An interesting observation by GS post analyzing data from the early 1970s indicates that during periods of low growth and high inflation, typically growth, rather than inflation, provides a better signal for an inflection point in risk sentiment. Specifically, credit spreads start to normalize and grind tighter after growth hits its trough, as opposed to when inflation passes its peak. Extrapolating the data to the current context, we can conclude that credit spreads will remain under pressure until we see a turn in sentiment about future growth and that we might see some spreads widening from the current levels.

Last week Moody’s downgraded Sharjah’s rating to Ba1 from the previously held rating of Baa3. This makes Sharjah the first fallen angel for a sovereign from the region this year. The rating rationale mentioned deterioration in the fiscal deficit and a rapid increase in government debt to 41% of GDP (622% of revenues) in 2021 from 34% of GDP (486% of revenues) in 2020 and only 13% of GDP (200% of revenues) in 2016. Moody’s draws comfort from the fiscal strength of the Emirate of Abu Dhabi and expects support to be extended if required. The outlook was revised to Stable from Negative. The Govt of Sharjah still has a BBB- rating with S&P. The bonds/sukuks of the issuer came down by 1% to 5%, depending on the duration.

Equity Update

It was a great week for global equities. Both developed and emerging markets gained 3%. Within the latter, GCC continued to outperform, followed by India. Positive returns were homogeneous within developed markets. US stocks benefitted from a somewhat weaker dollar, as well as from overall better than expected Q2 earnings reports. While some misses made headlines, the current scorecard is encouraging. Less than 20% of US companies have reported, however their earnings have been on average 4% better than forecast. The sales growth was also marginally higher than expected. Q2 so far looks good, but it’s important to keep in mind that comments and guidance are cautious.

The earnings season is in its very beginning in Europe, but stocks from the region were supported by the fact that Russia resumed gas deliveries from the Nord Stream 1 pipeline. The decision from the ECB was also welcomed by markets, especially the Transmission Protection Instrument which provided some relief on investors’ risk appetite with regards to some peripheral eurozone members.

Last weeks’ returns were also relatively well spread among sectors. Indeed, all 11 MSCI Sectors were either flat or positive. Cyclicals outperformed overall, especially industrials, consumer discretionaries and to a lesser extent energy.

The week ahead will obviously be dominated by the FOMC meeting from a top down perspective. But bottom-up inputs will be extremely rich with an acceleration of the earnings season. It is Big Tech’s week. Amazon, Apple, Alphabet, Microsoft and Meta will all report their Q2 numbers.

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