You can’t have your cake and eat it too

Chief Investment Officer's team
24 August 2022
You cant have your cake and eat it too
US recession risk abates, which means that the Fed should remain hawkish


  • US recession risk abates, which means that the Fed should remain hawkish
  • Markets took note with negative weekly returns across asset classes
  • The Jackson Hole symposium should provide more color from central bankers later this week

Last week was negative for all major asset classes, losing between -3% for gold and -1% for emerging market debt, in sharp contrast to a so far very constructive summer. As often, if not always, when everything moves in the same direction, the reason lies with central banks and more precisely to their reaction in times of inflation. In this particular context, good news on the economy, provides reasons to keep a hawkish stance. And market participants don’t want to fight the Fed, especially days before the Jackson Hole symposium provides updates from major central bankers.

Recent economic news was not spectacularly good, but largely points in the same direction: despite inflation and disruptions, consumers continue to spend, and companies continue to hire, especially in the US. Sentiment surveys are less buoyant for both businesses and consumers, but so far there is no factual support for hopes of an imminent pivot from central banks. They have also cautiously kept some distance from forward guidance, leaving market participants in the darkness of “data dependency”. The same action/reaction principle also applies to energy: after the recent drop in oil prices, the Saudi Arabian Energy Minister suggested that OPEC+ may be forced to cut production as future prices look disconnected from fundamentals. Finally, bad economic news is not necessarily good for markets, as illustrated by China, where data confirms softness in activity.

Against such a backdrop, our only certainty is for continued volatility and sentiment-driven markets. The good news is that the fundamental picture is not deteriorating in a brutal way, but the bad news is that investors’ pessimism is not as extreme as it was two months ago, so positioning has less leeway. Stay safe.

Cross-asset Update

Despite a positive summer so far, 2022 continues to be a very tough year for investors. The issue with a change in inflation regime and its consequences on central banks’ action is that it affects all asset classes, which by definition dramatically neutralizes the benefits of diversification.

There is indeed nowhere to hide. Inflation and tightening push interest rates higher, which pressures both the fixed income asset class and equity valuation multiples. Monetary tightening also threatens growth and thus future earnings. The result is that government bonds from developed markets, the quintessential defensive asset class, are down a record -15.5% so far in 2022. But it’s not because of hyperbolic growth that would support equities: stocks are down -13% in developed markets and -17% in EM.

When defensive and cyclical assets behave similarly, especially on the downside, asset allocation becomes more difficult than ever. The most interesting point about the year-to-date returns of our three profiles is not the fact that they are in the red (they are, but marginally less than their global peers) but the fact that the difference between the most defensive and the most aggressive is less than a percentage point. Our Cautious, Moderate and Aggressive profiles are down respectively -11.3%, -12% and -12.1% so far in 2022 as of last Friday.

Paralyzed diversification doesn’t mean that we don’t have active positions. We reduced but retained an underweight in the fixed income asset class where we are cautious on the riskiest segments. Their current valuation may be complacent with the economic outlook. For the same reasons, but inverted, we are slightly overweight on stocks which seem to be more realistic about the backdrop and not ready for any potential good news.

Having said that, as we expect continuous volatility, our active positions are modestly calibrated. Any extreme market movement could be an opportunity to adjust exposure in a more meaningful way to enhance future, longer term returns, which is the only horizon on which one can make a reasonably relevant forecast.

Fixed Income Update

Last week has been as volatile, as we can remember from the recent past, for rates investors. While the FOMC meeting minutes breathed a sigh of relief that the FED would indeed need to slow down at some point in time, subsequently, we have seen traders increasingly pricing in an aggressive FED, among bets that the FED would not fall into a 1970’s kind of trap. Even though Headline inflation came down, the FED's preferred measure of inflation, PCE, remains high at 4.8% and elevated compared to survey expectations of 4.7%. The next release is this week on Friday 26th August, with surveys again indicating a 4.7% print. Given the background, the market will keenly watch the upcoming Jackson Hole Forum to be held from 25th to 27th, especially Chairman Powell's speech on the 26th. We expect this week to remain volatile, with the events outlined above dominating investors' mind space.

Most of the credit segment OAS spreads currently trade slightly above their YTD median levels, helped by the rally in July, especially in the riskier segments. The spreads are off by 75 to 100 bps from their recent highs in early July. With talks of a slowdown, aided by the FED rate hikes getting louder, we can expect the spreads to widen from the current levels. We advise investors to reduce their exposure to Emerging Market Debt and Global High Yield and lower their portfolio duration exposure to Emerging Markets.

According to a recent report by S&P, the YTD corporate default tally stands at 43 through July, well below previous year-to-date tallies of 54 (2021) and 72 (2020). However, these defaults camouflage the underlying weakness and pockets of vulnerability. The downgrade risk is increasing for issuers rated 'B-' as their negative bias (the proportion of issuers with negative rating outlooks or CreditWatch implications) ticked up to 7.8% in June from 6.2% in May. The consumer products and capital goods sectors have the highest numbers of 'B-' rated issuers with negative outlooks or CreditWatch implications, many of which are facing inflationary cost pressures that weigh on margins.

Emerging markets currently account for a high proportion of 2022 defaults at 40%. This is due to Chinese real estate players. China, in recent days, has signaled support to the property sector. This includes plans to offer 200 billion yuan ($29.2 billion) loans to ensure stalled housing projects are delivered to buyers. But unless the sales go up and property prices stabilize, we do not recommend taking exposure to that segment.

Egypt's PM Mostafa Madbouly said they are nearing an agreement with the IMF on a new loan. GS estimates Egypt may need to secure a $15 billion package from the IMF to meet its funding requirements over the next three years. This has resulted in the sovereign bond prices moving up by 1-2 pt points overnight. Foreign portfolio investors have pulled some $20 billion from the local debt market. At the same time, Egypt's Gulf allies have stepped up to support the economy of a country seen as a regional linchpin, pledging more than $22 billion in deposits and investments.

Equity Update

Looks like the summer is ending with some thunderstorms – not unexpected and in keeping with the higher temperatures experienced by most of the world. Global equities fell 1.6% last week, with DM and EM in line and the Dubai market and India amongst the few with positive returns. This follows a brutal first half of 2022 where global equities were down 15-20% on the average and then a turnaround in July and the first half of August, which saw a strong rebound for equities with supportive valuations and strong Q2 earnings. Corporates however in their guidance, talked increasingly of margin pressure, though not yet seen in the numbers. The U.S. dollar, nearing new multi-decade is also a drag, except for commodities. The energy sector was up last week, even though oil prices fell and is the only sector up for the year, along with utilities. European equities fell and power is a huge concern as winter approaches. The German industry is feeling both the shortage and higher prices and many corporates have reduced profit guidance.

We have a close to neutral positioning on equities and retain our preference for the US in DM and for India and the UAE in EM equities. We recommend staying invested and though it is difficult to time the bottom, the continued volatility provides opportunities to add to quality stocks.

After a 4 week positive streak, US equities fell by a percent last week with the Nasdaq (tech) double that. The 10 year Treasury yield rose and growth sectors fell, as their performance is typically inversely correlated. The US markets began August with cooler-than-expected July inflation data and a stronger-than-expected labor report, with consequent economic and monetary policy implications. Early August saw US equities supported by better than expected retail earnings from Walmart Lowes, Home Depot and Target. The consumer resilience theme was largely intact, with some positive takeaways around retailer inventories, with excess stock being reduced. Last week’s FOMC July meeting minutes implied softer eco growth momentum and tighter financial conditions with the impact of tightening yet to be felt by the economy. The Jackson Hole symposium may give more clarity on the rate hike path. What’s clear currently is that inflation is still a huge headwind with UK July CPI numbers over 10% y/y, driven by food price rises and speculation of 18% y/y by January.

UAE markets saw some volatility in May and June but are among the few globally with positive ytd returns in USD terms. The Dubai Index has been the better performer as of late with real estate stocks outperforming.

On China we remain market weight. China GDP growth is being revised down as industrial and retail sales data missed market expectations. Also, Chinese earnings reports appear to weigh on sentiment, amid the impact of regulatory scrutiny and COVID-related lockdowns. We are seeing some green shoots with key lending rates being revised down, a small fillip to the ailing property sector which is roughly one third of China’s economy.

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