Winds of change

Chief Investment Officer's team
23 May 2022
Winds of change
The current volatility results from a drastic change in the relation between central banks and markets


  • The current volatility results from a drastic change in the relation between central banks and markets
  • Prioritizing the fight against high inflation means slowing growth and tolerating market turmoils
  • An inflexion in inflation is needed for assets to thrive – it will happen, but volatility reigns in the meantime

The weekly returns of various asset classes last week were particularly interesting. It wasn’t a crash -or a rally- of everything. Risk assets from developed markets suffered again, with the MSCI World and the Global REIT index now at the very bottom of the YTD rankings. By contrast, safe bonds were up, supporting gold, while importantly assets from emerging markets also printed positive returns. This is not totally usual.

At the heart of the current turmoil is a material change in the relation between central banks, especially the US Fed, and markets. With high inflation out of the equation for 4 decades, we were used to having the Fed protecting growth, especially through employment, and to some extent markets, the “financial conditions”. They used to cut rates and purchase assets very aggressively when needed and to be very gradual in reversing course. We are experiencing the exact opposite now: with no control on supply-side issues, from the war to China’s lockdowns, they fight high inflation by crushing demand, which means, intentionally slowing growth and not being too worried by the wealth reduction from falling asset prices. This phenomenon is DM centric, and is not totally bearish for long-term, safe bonds. Last week’s differentiated returns tend to indicate that markets have started to acknowledge what happens.

It’s just a week, and it also means that we need to see a clear inflexion in inflation before exiting this temporary but painful bear market episode. It doesn’t exclude the possibility of rallies in the meantime, but patience is still required. Of course, we believe that the inflexion will happen, we just hope it’s not too distant but the timing remains highly uncertain. Meanwhile, we keep a relatively neutral positioning, with only modestly constructive active deviations. Stay safe.

Cross-asset Update

Opportunities seem to be currently skewed in opposite directions in stocks and bonds. For equities it is very questionable to say that a lasting bottom is in sight. Sentiment remains fragile, as shown by the bearish reaction to Powell’s hawkish message last week, which conveyed that the Fed won’t hesitate to shift policy in restrictive territory, if push comes to shove. It will take quite some time before the overheating US economy can be slowed to levels in keeping with more moderate inflation dynamics, in the meantime with policy almost on autopilot it is difficult that markets settle definitely down. But it is quite a different story in high-quality bonds. There are the first signs that US inflation should have peaked, while concerns hinge now on the potentially recessionary effects of the removal of stimulus. So, with longer-maturity rates topping out, duration risk should be minimal, and investors can once again find some refuge in treasuries and IG corporates, adding some degree of diversification to their portfolios. At least the carnage in the bond and stock markets has produced some value in the former, but for now only the potential for rebounds in the latter, until the tightening process is more advanced and the fear of a Fed-induced recession, that we do not see this year, is more ingrained.

But if restrictive policy is now the root cause of all evil in investor minds, policy divergence should also be a source of relative opportunity. Chinese banks just cut the five-year loan prime rate to boost credit, while it is estimated that the authorities will overall provide monetary and fiscal measures in the order of almost one-third of GDP in the whole of 2022. Yes, this comes in the wake of an unprecedented regulatory crackdown, but this is also why Chinese stocks are sporting multi-decade cheap valuations. It is now well discounted that real growth could drift below 4% this year, which last happened in 1990 if we don’t count the Covid-crisis year, and as much as investors wondered whether China stocks were investable, they may now be wondering why not invest in them. The wild card remains the lockdowns, as people will not be enticed to spend whatever form of stimulus, until they are allowed to get out.

In such an uncertain world gold should be shining more than it has so far this year. We do not see a bull market based on the new normal of higher inflation and more volatile growth. At least not until the global tightening cycle is behind us, which would be more of a 2023-end event than the forthcoming trigger we are looking for to change our stance today. Yet, we would tend to see a gold rebound unfolding from the currently oversold levels, as Powell’s hawkish language pledging more 50-basis-point hikes is nothing new, even as the gap with higher real rates capping returns to the upside remains firmly in place.

Fixed Income Update

As recession worries mount, risk-off sentiments across segments resulted in a rally in the US Treasury bonds. Yields across the curve moved lower, with the US 10-year lower by about 14 bps and 30-year by nine bps. Investors are worried about the implications of high inflation leading to higher interest rates, resulting in a material slowdown next year. The Fed’s “soft landing” theory seems to be up for debate as markets believe this delicate balancing act between controlling inflation and maintaining growth needs a fair bit of luck. The forward-looking indicators suggest some softening, particularly in the most interest-rate sensitive sectors of the economy. The Russia-Ukraine conflict and China’s localized shutdowns remain the unknown factor in determining the long-term yields. The yields moved down despite the most hawkish statement to date by Chairman Powell last Tuesday, where he outlined a whatever-it-takes approach to fighting inflation that had resulted in a temporary spike in the bond yields.

According to a recent JP Morgan study, the high volatility in the treasury markets is exacerbated by low liquidity conditions. Treasury market depth remains severely depressed since dropping notably in the aftermath of the Ukraine invasion. Meanwhile, the price impact of each trade in the market has risen sharply in recent weeks. As per the study, a $100mn trade in the treasury impacts the underlying price by close to 1/32th of 100, markedly higher than the long term range of 0.2-06 x of 1/32th.

Most of the segments except High Yield generated positive returns last week owing to the yield’s downward movement. High Yield spreads continue to widen on the risk of slowdown and growth fears. Asia HY remained under pressure despite dovish measures taken by various banks to boost lending to the real estate sector in China. The lack of growth in property sales and increasing defaults soured the mood of the investors. According to a recent GS report, 22 Chinese HY issuers have defaulted on their obligations YTD. GS has also increased its default rate to 31.6%, which was their bearish case at the start of the year. China IG had a fantastic week, with the Yuan gaining as US recession fears took the front seat and US President Biden’s remarks that the China tariffs imposed by the Trump administration were under consideration.

In line with the US Treasury yield movements, the local GCC long duration IG bonds traded up last week, with 30-year high-grade names from UAE, Qatar, and KSA closing higher by 1-1.5 points, while the 10-year paper was up by about 0.5 points. We like the champion banks’ perpetual from the region and short-duration real estate high yield notes. On the other hand, Turkey and Egypt remain under pressure as the risk-off sentiment holds across various segments.

Equity Update

A seventh week of decline for global equities, taking year to date performance to -17% with mounting concerns around the growth outlook, recession risk and Central Bank hawkishness to combat inflation. DM equities continued a downward trend with US equities dropping 3% last week and briefly entering bear market territory. Key retail sector earnings exacerbated inflation concerns. Other DM fared better as did EM: the UAE, China, India and LATAM.

Equities are seeing outflows but still a small percentage of the inflows seen over the past 2 years. GCC markets have outperformed EM the last one year with increased weight in EM indices. We maintain our UAE overweight but retain our preference for strong and consistent dividend payers i.e. banks. The Fed rate hikes in 2022 and higher oil prices, along with IPO and project pipelines, should aid near-term revenue growth for UAE banks. A real estate rebound provides comfort.

Recession is not around the corner with the possibility of 2023 at the earliest and many economic indicators remain expansionary. However, a deterioration in real income can be felt in almost every region, with inflation and supply chain issues plaguing the world. The Goldman Sachs Financial Conditions Index has been tightening. China retail sales fell 11% y/y in April. Sri Lanka has defaulted on a foreign debt payment. Whilst rising energy costs with energy seen to be 50% of the 7.4% y/y inflation growth in Europe compared to one third of the US 8.3% y/y April number, food is an important component for many lower income economies.

Central banks creating liquidity and the equity market’s rise have been highly correlated and the last 2 years markets rose, with surplus liquidity boosting savings. And now the opposite is happening. Market performance is seen as a leading indicator of where the economy is trending. What could move markets up as fundamentals i.e. earnings and growth are taken off the leader board by investors? We still see earnings growth as an important catalyst, which though lower is still at trend. A benign resolution to Russia/Ukraine and China resumption of activity would dampen inflationary pressures. China has been working on domestic stimulus and last week lowered a key mortgage lending rate. Reopening will drive consumption and productivity. Finally, the Fed and central banks turning less hawkish would boost investor sentiment.

Pulling US performance down last week was surprisingly not technology but the consumer sector. as companies disappointed on profit and guidance. Big cap consumer companies Walmart and Target shares sold off over 20% last week. Rising transportation, warehousing and wage costs along with higher prices of products with supply chains in disarray are hurting retail companies. Not all the costs or higher prices can be passed onto the consumer and with inflation tracking over 8% in the US, consumers have been lowering discretionary purchases. The above-average Ebitda margins due to strong consumer demand paired with lower inventories, led to higher pricing and lower discounting during the last 2 years. This scenario is changing.

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