Whatever it costs?

Chief Investment Officer's team
12 July 2022
Whatever it costs
The US economy remains strong enough to support an inflexible Fed, as inflation so far doesn’t abate


  • The US economy remains strong enough to support an inflexible Fed, as inflation so far doesn’t abate
  • Growth is at risk from tightening, as well as from a potential energy shock in Europe
  • Volatility will remain extreme, and we have reduced risk within our fixed income allocation

Last week confirmed a resilient global economy, especially in the US. The jobs report was stronger than forecast, with 372k new payrolls being created. It’s close to May’s level and 100k more than the consensus. The consequence is that the Fed will remain aggressive, which in turn increases the risk of a derailing impact on economic growth. Interest rates rose last week, but so did equities, a bit surprisingly, while commodities fell. There was one exception: natural gas prices in Europe kept on rising, reflecting the risk of a de-energizing shock. The fight against inflation and the solidarity with Ukraine: it is about policies and their consequences. Whatever it costs?

Within this fluid context, we keep on expecting extreme volatility -in both directions- until we see convincing evidence that inflation is abating. As monetary tightening is well known, market anxiety should focus on the growth trajectory. We thus decided to adjust our tactical asset allocation by reducing credit risk within the fixed income asset class. We are now underweight in both High Yield and EM Debt, and have increased our allocation to government bonds. We maintained our modest overweight in stocks, precisely in emerging markets, and our preference for alternatives. We stay on the line highlighted in our 2022 Global Investment Outlook: when visibility is low, it’s better to be reactive than proactive. We will remain as nimble as possible as markets will keep on moving erratically.

Many regional inflation indicators will be released this week, the US CPI this Wednesday being the most scrutinized. Median forecast for +8.8% looks...very high. This week is also the start of the Q2 earnings season. Numbers should be good, but CEOs could take the opportunity to deliver cautious guidance. Stay safe.

Cross-asset Update

In spite of growing recession anxiety, markets have year-to-date discounted a sharp slowdown, and only partially a hard landing, with the drawdown in US equities at -24% as compared to a median of -34% over the past 7 recessions. Since the June Fed policy meeting the market pricing of risk has worsened significantly, as investors have not come to terms with the idea that rates will be lifted into restrictive territory. Longer-dated treasury yields have come -50 to -20 basis points off their recent highs, commodities have lost almost -20% peak-to-trough in the last couple of months, with copper recording a -25% monthly drawdown, quite an infrequent event, while the US dollar has reached a 20-year high. Markets do not seem to care much that the US economy is still in good shape, as indicated by the latest jobs report. After all, with a solid labor market all of the recession talk should be in vain. And if the euro area manufacturing activity is already in recession - the output and new order indices of the business surveys fell below 50 in the latest release - this is by far not the case in the United States.

Our base case is still that the US economy will retrench, but manage to avoid a contraction. Not only are households balance sheets still solid, but also corporate margins, though expected to soften, should be facing still manageable headwinds. If as per forecasts inflation remains high enough to support pricing power, hence margins, but not too high to avoid excessive tightening, then the behavioural response of companies should be measured enough to avoid a recession. That is, CEOs should not be firing people to preserve profitability in response to a deteriorating outlook, and central banks would not crash the economy into a hard landing, at least not in the short term.

Downside risks anyway remain, as the current tightening cycle is one of the steepest ones historically, so the speed at which financial conditions have tightened is pretty dramatic. The tail effects of the US fiscal drag could compound the withdrawal of liquidity by the Fed in unsuspected ways, being liquidity after all the most relevant and leading variable in the system. For now, markets seem to assign higher odds to something going wrong, than to all going right within the narrow boundaries of a soft-landing corridor.

The US yield curve, 10yr3m, one of the most relevant recession indicators available, is still in positive territory by a wide margin, at 88bps, although falling fast. It was above 200bps in early May, so it has lost about 100 bps in a couple of months. Should it continue to fall at such a speed, it would be inverting soon. That would most likely signal that, indeed, there was reason to be concerned.

As the outlook remains highly uncertain, investors should wait to add meaningfully to risk, meantime maintaining a defensive bias in their portofolios: towards high-quality versus high-yielding bonds and high-dividend-yielding and cash-producing stocks versus high-beta equities.

Fixed Income Update

Volatility is the name of the game. Last week the strong jobs report alleviated recession fears but cleared the path for the Federal Reserve to keep raising interest rates to fight inflation. As a result, the 10-year U.S. Treasury yield jumped by 20 bps to close above 3% on Friday. Markets now anticipate the Fed to hike by 75 bps at the July FOMC meeting, followed by 50 bps in September, which would drop to 25 bps in October and December meetings, leading to a cumulative rate hike of 2% by year-end from current levels. According to some economists, this would result in a rate upper bound of close to 3.75%, which is well into the restrictive zone.

However, the start of this week has been ominous. There is a clear risk-off tone which has led to developed market sovereign bonds being sought as a safe haven. The U.S. 10-year yields have dropped by 17 bps on Monday and early Tuesday. Core euro area yields have also rallied significantly amidst euro trading near parity with the US dollar. Most government bonds in the developed world now trade around their average levels over the last three months.

Credits behaved better last week as spreads narrowed. However, this relief should be short-lived. The only protection is the low level of maturing debt in the short term for high-yield issuers. Just 5% of the 1,554 North American issuers rated BB+ or lower (non-investment grade) have debt maturing in the second half of 2022. That grows slightly to 16% by the end of 2023 and 33% through 2024. The non-investment-grade-rated debt scheduled to mature in the second half of 2022 is $56.1 billion. In 2023 the total is $172.3 billion and grows to $306.4 billion in 2024.

There are early warning signals on credit, though. U.S. corporate bankruptcies rose in June to their highest monthly total of the year so far, according to S&P Global Market Intelligence data. There were 40 bankruptcy filings in June, up from 30 in May and the highest number since April 2021. The 12-month-trailing speculative-grade default rate of the U.S. was just 1.4% in March, according to S&P. This historically low level is not expected to persist as profit margins are squeezed, economic growth slows, and monetary tightening raises costs. This is one of the reasons we cut our allocation in High Yield and EM Debt to Underweight in the July TAA committee meeting held last week.

In the recently concluded Fed stress test for banks with more than $100bn in assets, the U.S. subsidiaries of Deutsche Bank, Credit Suisse Group AG, Banco Santander SA, UBS Group AG, and Barclays PLC were among the ten best-capitalized banks under a severely stressed scenario. The eight U.S. global systemically important banks, had $2.128 trillion of TLAC, or Tier 1 capital plus long-term debt, as of March 31, according to S&P Global Market Intelligence data. That is $387.21 billion, or 22.2% more than required based on risk-weighted assets and on- and off-balance sheet exposures.

Equity Update

U.S. stocks notched a weekly gain following a strong jobs report. The S&P 500 closed flat on Friday after struggling for direction throughout the session. The S&P 500 Index is up 1.9% last week. The Nasdaq 100 also rose on Friday, scoring its longest winning streak this year. The jobs report reaffirmed the strength of the economy, fueling the Fed to stay aggressive to combat inflation.

Yesterday, U.S. stocks fell, with traders bracing for a key inflation reading and the start of the earnings season for clues on whether the economy is headed for a recession. A slide in mega caps like Tesla and Apple weighed heavily on trading. Twitter sank as Elon Musk walked away from his $44bn deal to buy the company, setting the scene for a legal battle. Elon Musk believes that Twitter misrepresented user data, saying the number of spam bots on the platform is much higher than the company has disclosed. Twitter’s shares dropped 8.8%, on track to erase $2.5bn in market value.

Some believe that the stock market has not already priced in any possible upcoming decline in earnings estimates for this or next year. Some note that there is a strong correlation between the Fed’s rate trajectory and earnings growth, meaning it is common for profits to rise as the Fed tightens and to contract as the central bank switches to easing. This could mean that corporate earnings are to remain resilient to surging inflation and slowing growth, paving the way for battered US stocks to rally in the remainder of 2022.

As big banks kick off the earnings season this week, traders will be looking for clues about the health of consumer and spending trends as well as lending to businesses and corporate confidence. Real estate valuations and lending may also be key for market direction, along with the thoughts on the state of capital markets. Earnings are due this week from JPMorgan, Morgan Stanley, Citigroup and Wells Fargo.

Asian stocks declined yesterday as resurging Covid-19 cases in China dented investor sentiment and raised fears of lockdowns that could hurt growth and corporate earnings. The MSCI Asia Pacific Index dropped as much as 1.1%, erasing an earlier gain of as much as 0.5%. Alibaba and Tencent dragged the gauge the most after China’s watchdog fined the internet firms. All but two sectors declined, with materials and consumer discretionary sectors leading the retreat. Chinese stocks were the region’s notable losers, with benchmarks in Hong Kong slumping about 3% and those in mainland China down more than 1%. Japanese stocks are likely to be supported as the BOJ is expected to stick to its current policy. Over the longer term, current Prime Minister Kishida may tackle important issues such as revising the constitution, restarting nuclear power plants and improving fiscal balance. But they are unlikely to become an agenda in the near term as Kishida has said he would prioritize measures on Covid and the economy. Japan’s benchmark TOPIX index climbed as much as 1.8%, set for the highest closing level since June 10, with energy-related shares among the best performing sectors.

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