Whatever it takes

Chief Investment Officer's team
13 September 2022
Whatever it takes
Central Banks took center stage, with hawkish words and policy decisions


  • Central Banks took center stage, with hawkish words and policy decisions
  • DM equities had positive returns, with palpable hopes for a US soft-landing
  • Our TAA Committee didn’t have enough conviction to change our recommended positioning

Aggressive tightening continued last week from all Western central banks. The ECB and the Bank of Canada hiked their policy rates by 75 basis points, which should be mimicked by the Bank of England. Meanwhile, Fed chairman Powell delivered another hawkish speech, saying in essence that tightening will continue until “job is done”, also mentioning a “period of growth below trend”. There is little room for ambiguity, but still, US stocks had a great week with a +3.6% gain, which resulted in a 3% increase for the MSCI World. Interest rates kept on rising however, with DM Government Bonds printing a negative -1% return last week. Put together, while defensive assets acknowledge a ballistic tightening, risk assets, especially stocks and high yield, find some comfort in the current reasonable level of long-term inflation expectations, which helps them entertain hopes for an economic soft landing.

Such a scenario is not impossible. Indeed, we are impressed by the resilience of Western employment, starting of course with the US. Having said that, it should not be taken for granted. There is a lag between monetary tightening decisions and their actual impact. In addition, Europe is undoubtedly in a very difficult place, while China keeps on struggling with Covid and imposing restrictions every week. Uncertainty is wide-ranging, and the US CPI to be released this Tuesday will certainly be important for investors’ sentiment.

We are not outright pessimistic but our level of confidence is not high enough for us to materially change the recommended positioning. We have kept unchanged our underweight in the riskiest segments of fixed income, and our modest overweight in EM stocks. We hold significant amounts of cash for the flexibility it provides to seize future opportunities. Stay safe.

Cross-asset Update

Sentiment improved across asset classes last week, with equities rising, credit spreads tightening and even highly volatile risk assets like bitcoin trying to find a bottom. The Fed’s tightening, alongside accelerating QT, the raging EU energy crisis and the sputtering Chinese recovery are simply being shrugged off. Markets seem set to continue to climb a wall of worry, as long as investors remain convinced about the soft-landing narrative in the United States. Inflation peaking and the resilience of the US economy are upholding investor confidence in a no-recession scenario. Market-implied inflation is indeed falling sharply, be it under the form of prices paid by purchasing managers – the ISM Manufacturing Prices Paid has been sliding since March – or be it TIPS inflation, with 2-year inflation now below the 5- and 10-year. Investors hold the view that the Fed will be successfully taming price pressures, but it remains to be seen whether the economy is going to be the casualty with a hard landing as an end-result, or not.

In this sense the energy crisis in Europe remains a wild card. The West has assumed that Putin will not be able to stop all gas flows completely, as the economics of not supplying energy do not add up for Russia. But should he decide to, then oil could skyrocket to $150, the scenario of a European depression would no longer be so remote and US consumers would be affected as well via record gasoline prices. On the other hand, a quick resolution of the conflict in favor of Ukraine heavily supported by the West would avert a hard landing in the euro area and see a quick rerating of risk assets. If one sticks with the base case of no forthcoming solution, then the Fed is the usual culprit when it comes to recessions. Historically, under the current conditions of low unemployment and high price pressures the Fed has never been able to slow down the economy just enough to tame inflation and to avoid a contraction. But if the process is clear, the timing is much less so, and timing is also important.

We remain agnostic about the possibility of further market weakness, unlikely anyway to be significant under the current soft-landing narrative, which seems to be just about right for our tactical positioning. We are underweight high-yielding credit, challenged by the inverted yield curve and the high rate volatility, both leading to more expensive corporate costs of funding. We are positioned neutral DM and overweight EM equities, given more favorable valuations, hence less downside potential, while our overweight in alternatives, in particular gold and hedge funds, serves the purpose of hedging market volatility.

Overall, with markets not overly cheap and macroeconomic uncertainty high, we think that a barbell approach with allocations not too far removed from benchmark remains appropriate.

Fixed Income Update

US Treasury yields have retraced back to their cycle highs, driven by hawkish Fed speak and serial positive surprises in domestic data. Several speakers from the FED, including Chairman Powell, reiterated their hawkish stance on fighting inflation. Chairman Powell's Cato Institute speech said, "We need to act forthrightly, strongly as we have been doing." Again, Powell cautioned against premature loosening while invoking Paul Volcker as his guidepost. He mentioned Volcker acted after "several failed attempts" to get inflation under control in the 1970s and that the FED is working to prevent that outcome straight away so that it doesn't have to act as drastically. On the data front, the US Initial Jobless Claims came in below expectations at 222k, indicating a tight labour market, and ISM services came in at 56.9 higher than consensus estimates.

As a result, The UST yield curve bear flattened with the front-end increasing by more than ten bps last week while the belly and the long-end of the curve moved up by around 5-6 bps. The 10-year treasuries hit a high of 3.36% before coming back to 3.3%. The 30-year traded around the highest levels since 2014. On another note, the 30-year mortgage rates in the US jumped to 5.89%, the highest level since 2008.

On average, September has tended to be the heaviest month for duration supply, driven by increased corporate issuance as the high-grade calendar picks up after Labor Day. This year has been no exception: $54bn of investment-grade issuance was priced last week, and analysts expect supply this month to exceed the recent September average of $137bn. This would make September the heaviest supply month since March. With duration supply expected to remain heavy in the coming weeks, this could exert more upward pressure on yields.

Across the Atlantic, the ECB hiked rates by a jumbo but widely expected 75 bps. This brought the deposit rates to 75 bps, the first non-zero level since 2012, when the ECB cut rates to zero and then embraced the negative interest rate regime. With this, the earlier tiering system to protect banks from the adverse effect of the negative interest rate hikes was also removed. This rate increase makes the ECB part of the club that includes 40 central banks worldwide, which have hiked rates by three-quarters of a percentage or more in one go. Moreover, President Christine Lagarde hinted it could do the same again as part of "several" future moves to escalate the fight against inflation.

We held our monthly TAA last week but did not make any changes to our current positioning as we did not want to make a move before a crucial FED meeting. We are biased toward safe segments such as DM Treasuries and IG credit while shunning the riskier segments, including High Yield and EM Debt. The recent rally had depressed spreads to median levels and should widen from current levels, given that the central banks are ready to inflict more pain to fight inflation and ensure price stability.

Equity Update

We began the year saying that volatility should be expected and have seen equity returns oscillate between positive and negative months since February. After a rough August, the month of September has turned out to be surprisingly good for developed markets, particularly the US and within emerging markets, India. The tech sector has also recovered somewhat though yields have not been kind to the sector. With a few months left into year end and the tightening path clearer and inflation close to peaking there is more clarity around corporate margins, so far resilient and with room to weather a 1 to 2% drop driven by higher labor, transportation and raw good costs.

Don’t press the panic button with much noise around the S&P 500 falling sharply and equities overall. With September historically the worst month for equity performance some nervousness is to be expected. We do not rule out more extreme swings but also see equity markets continue to generate the 6 to 7% returns in the medium term as seen over the past decade and century, implying real returns that are positive even at higher inflation levels. The risks to equity performance remain higher oil prices, wages and labour shortage along with short supply of high end chips weighing on some industrial corporations. But so far the risks have been centred more on the supply than demand side for corporates and not achieved Central banks aim to cool demand. We foresee more volatility, but also support for equity performance from valuation levels that are at or below long term averages and earnings growth for 2022 that has not seen severe downgrades.

The US midterm elections in November are generally a positive period for US equities. The US is expected to lead in terms of lower inflation data, with average gasoline prices down over 20% since the early June highs, while Europe inflation will remain higher due to elevated energy prices. Within DM our OW calls remain the US and UK.

EM central banks could move to a dovish pivot once headline inflation subsides. China risks are centered around an overleveraged real estate sector which sees policy support, but is weighed down by structural issues. The China party congress is Oct 16th and we could see some key measures being taken aimed at supporting consumption. India, in spite of the falling INR, stands out and economic data remains supportive of demand resilient to the higher rates or inflation. India’s upper bound of inflation has always been higher than most countries at 6%. The corporate sector balance sheets are not overleveraged with plenty of room for borrowing and growth and India is in the midst of a strong capex cycle. Our preferences in the EM equity space remain India and the UAE. The UAE has currently another Government divestment in progress: Salik the toll operator which adds to the list of high-dividend-paying companies.

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