TUG OF WAR

The antagonism between central banks’ tightening and growth keeps volatility at extreme levels

AT A GLANCE

The antagonism between central banks’ tightening and growth keeps volatility at extreme levels
Inflation stays elevated especially in the US, but economic activity is equally resilient so far
Government support builds in Europe and China, and Q3 earnings will help assess equity valuations better

Volatility remains the name of the game, week after week. Inflation is a slow-moving shock which doesn’t find any quick fix, in sharp contrast to the various crises of the last decade. Last week confirmed broadening inflation in the US, supporting more tightening ahead. This is a simple explanation to another collection of negative weekly returns. But this would ignore the pattern: last Thursday, a few hours after the US CPI came out higher than expected, stocks were actually sharply rallying, wih the SP500 reverting from -2% to +2.6%. Friday was then, more understandably, negative.

As our regular readers know, our strongest conviction for 2022 has always been to expect extreme volatility. Last week’s post-CPI rally, which surprised everyone, is an indication that the current levels of pessimism, and to some extent valuation, start to balance an objectively terrible policy backdrop. Don’t get me wrong: volatility will continue and any form of equilibrium before we see convincing evidence of an imminent Fed pivot will remain unstable. However, uncertainty can move markets in both directions, which is at the end of the day not bad news and the reason why our positioning is close to risk neutrality. With regards to valuation, the Q3 earnings season will bring more clarity on the denominator of equity multiples, and it may be overall positive. Staying on the bright side, early reports from China’s 20th Communist Party Congress emphasize some policy continuity around the concept of “modern socialist country”, with a focus on innovation and security. This doesn’t sound too hostile for markets. Fiscal support is also building in Europe to face the energy crisis, while the UK made a fiscal U-turn, also indicating that markets’ voice can be heard. This is not the end of the tunnel, but we keep going. Stay safe.

Cross-asset Update

Welcome to a new world order where friction between the United States and China is set to continue, and, if anything, increase. Following President Xi’s two-hour speech at a crucial party gathering, we know that China’s priorities have not changed. It is now about two clashing views of the world, one upholding democratic values and the free market, and the other based on authoritarianism and the state driving the economy. And it is also about the unwillingness of the incumbent power to see a competing power rise. President Xi wants the reunification with Taiwan, that was mentioned early in his speech, economic development as a ‘top priority’ though alongside security, and an independent technology sector driving innovation in the country. Xi’s message is that China will stand its ground, and whoever tries to thwart that process will fail. Not only that, he offered China up as an alternative system to the US and its allies. It is very hard to tell who will survive this test. Superpowers tend to last on average 250 years, with America’s ‘expiration date’ and the theoretical start of its decline in set to be in 2026. The divisiveness of the United States, its monetary and debt excesses, and its overstretching on the international scene on many fronts could be causes for concern. The same we could anyway say for China, over leveraged as well, and with structural economic challenges. The main difference between the two countries is the cohesiveness and united Chinese front posed by a society strictly driven by the authorities with clear objectives to achieve.

The consequence of this new geopolitical development, on the one hand, is a more hostile investment environment. The rift between the two superpowers will bring about the dismantlement of the existing supply-chains, a structurally inflationary event. Also, China looking inwards and relying less on exports and more on internal consumption for economic growth, alongside Chinese salaries no longer that competitive with the rest of the world, again have inflationary implications. There are many global forces fostering price pressures, and the China-US confrontation is but one driver of the future trends. But there is also positive forces generating opportunities. According to historian and market researcher Russell Napier we should be in for a capex boom, whereby Western governments will drive credit creation to boost nominal GDP via higher inflation in order to bring down debt-to-GDP levels. This was previously done after World War II, and with financial repression. Yields were kept artificially low by central banks, to avoid higher nominal growth translating into unsustainably higher yields given the large debt levels. And in China the capex boom would shift from the real estate to the IT sector, to ensure that Xi’s vision of technological independence is fulfilled. It is interesting times, and radically different to the previous two decades marked by low macroeconomic volatility and tepid inflation.

Fixed Income Update

Last week US treasuries saw an increase in yields following higher than-expected inflation, a resilient labor market, and release of the minutes of the Fed meeting. The yield on the 2-year US treasury rose by 15bps to 4.46%, and the 10-year UST yield increased by 10 bps to 3.99%. US CPI for September was 8.2% which is slightly higher than the consensus expectation of 8.1% and little changed from August’s inflation of 8.3%. However, core inflation for September remains high at 6.6% vs. 6.3% in August. This higher inflation is indicative of aggressive tightening to combat inflation, i.e., a 75bps rate hike in Nov meeting. Also, Fed’s September meeting minutes released on Thursday showed officials are committed to tightening and keeping the policy in restrictive territory for some time but also conscious of rising risks and the need to calibrate policy accordingly. James Bullard, from his statement, opened the possibility of a 75bps rate hike in Nov and Dec meetings by indicating that the Fed could bring some of the planned hikes for 2023 into this year. Currently markets are pricing in a peak Fed funds rate at around 5% in six months. US corporate spreads remain at three months high, at around 165bps.

Gilts market remain volatile. The 10-Year Gilt yield rallied from 4.33% to 3.98% as tax-cutting policies were scrapped. In Europe, inflation pressure continues to build. Europe's high yield spreads remain wide at around 640bps. As per a Goldman Sachs report, EUR HY issuers have larger medium-term refinancing risk compared to the USD HY bond market, indicating more financial distress in 2023 in the euro HY sector. For 2023 Euro HY is expected to have a net supply of €18 billion and decline of €25 billion in the EUR IG category. Gross issuance in Euro segment is expected to reach €450 billion in the current year and €50 billion in 2023. On the Asia front, Indian bonds saw a rally after the RBI minutes showed that the members are divided on the pace of future rate hikes.

As per the IMF chief’s statement, IMF is close to agreeing on a new deal with Egypt, the bonds are expected to remain volatile in near term. Coming to the MENA region, the ADGB curve bear flattened with two-year yields wider by 8-10bps, while the longer ended was wider by 1bps. High-yield sovereigns like Oman & Bahrain remain flat. Separately, IMF downgraded its global growth forecast from 2.9% to 2.7% for next year, however the Middle East and Central Asia are expected to be global growth outperformers.

Equity Update

Intraday and weekly volatility is getting magnified however, developed market equities are at the same level two weeks into October as at end Sept, at -25% YTD, justifying our neutral positioning into Q4. However bond yields have risen, continuing to affect longer duration growth i.e. the tech sector. Last week saw extreme moves, with the S&P +2.6% on Thursday, an almost 5% intraday move, despite inflation numbers that disappointed, only to fall 2.3 % on Friday, as earnings disappointed. The UK FTSE 100 surprisingly held steady, in spite of unfunded tax cuts much in the news. The UK faces a set of challenges with high topline and core inflation, a large current account deficit and a weak currency driving higher costs on imported items. Also, Brexit has reduced the supply of labor and increased the costs of trade. Emerging market equities, where we recently went slightly underweight, fell 3.8% in the first 2 weeks of October with YTD losses at -28%. China continues to disappoint, whilst the GCC and India remain outperformers. The 20th China National Party Congress is ongoing, and Premier Xi Jinping signaled that growth is the main focus. On the global level, all 11 sectors were flat to negative last week. YTD, only the energy sector is positive in line with the oil price rise.

We recommend remaining invested and adding to equities systematically as the market remains unpredictable for the short term. We reiterate focus on the quality of balance sheets and businesses in selection of stocks. Markets will continue to trade in an up and down pattern as this remains an exceptional year for inflation and accelerated monetary policy impacting the growth outlook. The 3Q earnings season will give guidance not only on cost inputs but the stability of corporate profits. On the political and policy front moving markets are headlines around Ukraine, and the ECB and Fed raising rates and US mid-terms. Whilst an argument for peak inflation can start being made, last week’s US CPI surprise reminded us of broad and persistent inflationary pressure, more so from the services sector. A defensive positioning in markets, with the USD retaining its strength and tighter financial conditions all around.

On the earnings front, weighed against growth are a strong US dollar, high inflation and recession concerns. 7% of S&P 500 companies have reported Q3 results, +01% against estimates, and Q3 earnings growth rate has been revised down to 1.6%. Negative earnings surprises in the financials sector the main contributor to the lower estimate. Revenue growth rate estimate for the S&P 500 for Q3 steady at 8.5%. 9 financials sector companies reported last week, including Citigroup, JPMorgan, Morgan Stanley and Wells Fargo. Despite the recent rise in interest rates, this industry is reporting a y/y earnings decline of -13%, with significantly higher provisions for loan losses relative to 2021. FactSet estimates the blended provision for loan losses for the 18 banks in the S&P 500 at $6.0 bn for Q3 2022, compared to -$4.9 bn for Q3 2021 and to increase further into 2022 H1. The largest five S&P 500 companies (Apple, Microsoft, Google, Amazon and Tesla) earnings are expected to be below S&P median earning growth in the near term and 2023. In 2Q, the group posted EPS growth at 2.8%, and both Amazon and Apple recorded y/y declines.

Written by:

Anita Gupta Head of Equity Strategy , [email protected]
Giorgio Borelli Head of Asset Allocation , [email protected]
Maurice Gravier Chief Investment Officer , [email protected]
Satyajit Singh Fixed Income Analyst , [email protected]

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