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Chief Investment Officer's team, 17.01.2022
The second week of the year was not as bad as the first one, but it remained confused.
The most awaited US Consumer Price Index for December came out at +7% year on year, bang in line with forecast. Such a level hadn’t been seen in 4 decades, but of course markets were prepared. Sovereign yields actually moved lower on the news. US Treasury yields on 5, 10, and 30-year maturities are now respectively 1.56%, 1.78% and 2.12%. Equities from developed markets didn’t benefit from this relief: they lost -0.3% over the week, while their emerging markets peers were up 2.6%. GCC continued to outperformed, helped by oil prices steadily rising on supply concerns.
High inflation, policy normalization, and short-term economic challenges from omicron -as seen in retail sales numbers- do not bode well with elevated valuations and optimistic positioning in DM stocks. Having said that, the resilience of bond markets is impressive and early numbers from the Q4 earnings season are not bad. This explains the current state of confusion, which we think may last all year long – with most probably buying opportunities down the road, against an overall constructive backdrop. Emerging markets so far outperform, with more accessible valuation and positioning. The inflation/tightening narrative is of course very different, especially in China where both growth and inflation are slowing, which led the central bank to cut rates. What a contrast. The pace of tightening and the US bond yield direction remains key for DM risk markets and both bear uncertainty. For more details, we will hold our Investment Outlook Webinar on February 9th, and would love to have you with us – unfortunately virtually again. Stay safe.
What a difference a year makes! The previous one was all about American exceptionalism and post-covid stimulus, while this year is starting with US underperformance and the outlook for the Fed’s tightening. It seems that the two, liquidity and outperformance of US assets, are interlinked, and they are in our view. The monster rally engineered by the Fed since March 2020 with unprecedented measures caused a lot of dislocations, with the valuation of growth stocks reaching levels that some market commentators compared to the excesses last seen at the peak of the IT bubble, while the more cyclical pockets within the asset class got the shorter end of the stick as compared to what were perceived to be equity safe-havens. The Fed gives, the Fed takes. At the time it was giving, and valuations skyrocketed, now it is taking, and valuations should come back to earth. Across asset classes excesses will have to moderate. It is not a coincidence that year-to-date EM equities are in positive territory, while DM on the back foot, or that the highest multiple companies within the technology sector have underperformed. We would see this repricing continue, until markets have discounted the bulk of the tightening, or until Powell decides to stop the process, given unintended consequences on markets and the economy.
The US dollar, primary exponent of the fading American exceptionalism, is off to a bad start for the year as well. Monetary policy divergence is priced in - money markets are discounting almost four hikes in the next 12 months - and the growth differential is no longer there, with real growth in the United States seeing this year one of the sharpest slowdowns as per consensus forecasts. It is possible, now that long speculative positioning has reached extreme levels, that the dollar has seen the bulk of the gains and enters a range-trading regime, or one of very moderate returns. If global growth remains strong and the dollar is no longer in the ascendancy, then capital flows should increasingly shift to non-US markets. For instance, EM equities, EM forex and EM sovereign bonds show depressed levels of risk appetite, a contrarian indicator, as per our models. This would again be a repricing towards cheaper markets occurring within the framework of tighter Fed liquidity, which most likely will come with a lot of turbulence and should see gains across risk assets as being more back-end loaded for the year.
The above scenario of markets eventually pulling through the period of shrinking liquidity is predicated on the assumption that global growth remains strong. That could change as well, though it is not our base case. What if the current strength in the economy is just driven by stimulus and the apparent overheating quickly resolves as consumers shift back from goods to services? And maybe alongside that China resumes its slowdown phase at some point this year? The more sudden and brutal these changes, the more likely that investors are taken aback by a growth scare.
Fixed Income Update
The long-end yields continued to react to sound bites by various FOMC members, including the senate disposition from Chairman Powell. The 10-year US Treasury closed the week at 1.78%, the highest point this year, with Friday being a particularly volatile period where yields rose by eight bps. Markets currently price in 3.9 rate hikes with 2022 year-end Fed Funds Target Rate at 1.05%. Credit spreads have relatively been stable, with EM Debt and HY spreads widening by only 15 bps despite the significant increase in yields. We don't expect the spread widening of the last quantitative tightening episode to repeat. However, it pays to be cautious in the most tightly priced segments. As expected, such a large movement in yields YTD has led to negative returns in the long-duration assets such as EM Debt and IG Credit which are down -1.5% to -2.5%.
It has been a tough week for the Asia HY with no end in sight to the credit woes, even for higher-rated issuers in the Chinese property sector. This time Country Garden, a solid BBB-rated entity, was responsible for the panic as it could not generate enough interest to place a $300 Mn convertible bond. The PBOC reduced two key policy rates on Monday morning and infused roughly RMB 700 Bn liquidity in the market. However, these measures have not given investors any confidence. According to a GS report, Asia HY would provide a negative return if the default rate for 2022 climbs north of 40%. According to most analysts, this year's default rate should range around 20%, translating to single-digit returns. But with $10 Bn bonds due in the next three months and the market closed even to the most highly rated issuers, the volatility will be extreme in the category.
In sharp contrast, Chinese Government Bonds (CGBs) reacted well to the policy rates cuts. We have liked China IG local bonds for almost two quarters now, and after the unhedged Bloomberg China Agg index's eye-popping 8%+ returns last year, the policy easing this year should provide good returns to investors this year as well. Most analysts expect RMB to be weaker as the divergence in monetary policy.
YTD Emerging Market issuance crossed $ 45 Bn last week. However, a notable feature this year has been almost 25% of the bonds priced belong to the ESG category. This is significant after a bumper $ 155 Bn ESG issuance last year. CEEMEA issuers lead the pack with $4.8 Bn ESG related issuance. With new ESG programs being prepared for EM government agencies and corporates for 2022, the total issuance could double last year's to $ 300 Bn. Investors need to keep a lookout for this new sub-asset class even though teething troubles such as "Greenwashing" and "Greenflation" cloud the outlook of ESG issuers.
We remain constructive on market performance for the full year, but reiterate sharp swings, as we start the year with higher valuations post 2021’s strong returns from the US and Europe. Tightening, rate hikes, inflation and the virus impact remain headwinds. Earnings and economic growth mitigate the higher valuations in Developed Markets, however the upward move in Treasury yields has had the expected impact on growth sectors which constitute the bulk of DM equity indices. Last week saw emerging market equities outperforming with India, China and the GCC all up. China growth has been a concern and delisting of companies such as ride sharing firm Didi from the U.S. bourses. With the recent rate cuts, growth should get a boost and valuations remain attractive. We have a neutral stance to China, as we wait for regulations and monopolistic concerns around sectors such as ecommerce to settle. Our EM overweight regions are the UAE and India. After a two-day bounce U.S. equity finished lower, as the recent rebound for Technology reversed. The S&P 500 and the Nasdaq were down 0.3% for the week – a small move but a change from last year’s almost uninterrupted rise. Wednesday’s US consumer prices data with CPI up 7% y/y in December 2021, highlights inflation concerns.
The rotation out of growth sectors, is consequential, of the Fed raising rates, possibly starting in March, to keep inflation in check. Equity markets can tolerate gradual rate hikes however the sharp increase in yields will continue to cause volatility in high growth tech sectors and while the more profitable companies will perform based on their underlying positive fundamentals, highly valued and unprofitable tech will see the deeper sell off.
Energy leads global sector returns in line with the rise in oil prices followed by financials. As global bank earnings get underway with the US large caps, and the banks are at the heart of the market rotation, their outperformance should continue, with bank earnings marked by strong loan growth and future NIM upside. S&P 500 companies are expected to report strong profits for the past quarter even as high inflation, wage pressure, supply chain disruption and the Omicron coronavirus variant cloud the outlook. Renewed pressures on supply chains stemming in large part China's Covid Zero approach leaves its major cities at risk of lockdowns, while port closures and disruptions to manufacturing can prolong transportation delays.
As earnings season kicks, S&P 500 companies are forecast to deliver y/y earnings growth of 22%. The focus will be on future guidance rather than past performance. Banks started earnings season highlighting costs in their guidance. JPMorgan Q4 EPS was better though the bigger reserve release helped. The biggest area of concern was higher expenses. Citi Q4 EPS also better with help from a reserve release. However, loan growth was softer than peers, expenses higher and cost guidance flagged. Labour costs increases are a concern and increasingly cited by US firms as an area of concern. We are overweight financials – year to date the second best performing sector - the key drivers being higher rates, loan growth, consumer spend, attractive valuations, strong economic growth and healthy consumer balance sheets.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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A year of low visibility ahead
Healthy, Happy, Prosperous 2022
Yes, we think it’s alright
Heated by the sunshine of a vibrant recovery, the magic liquidity is evaporating, and turning into fog for investors. While growth remains robust, markets may not be ready for the new uncertainties around central banks, inflation and interest rates, to name a few. We are getting prepared to navigate tactically, in a year of ‘low visibility ahead’.Know More
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