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Chief Investment Officer's team, 30.05.2022
Last week was positive for everything, something that hadn’t happen for long. Stocks gained +5.5% in developed markets and +1% in emerging ones (Asia was sleeping when the US rally accelerated on Friday). Fixed income did well, with the US 10-year Treasury yield losing -5 basis points over the week to 2.74%, and spreads tightening. Govies in developed markets gained +0.8%, quality credit +1.3%, emerging debt +1.7% and high yield +2.8%. Within alternatives, gains were more modest but all green with +0.4% for gold, +0.3% for hedge funds and +4% for global REITS.
The big picture remains full of uncertainty and risks, however last week’s flash PMIs confirmed a resilient economy. There are still many concerns for the coming months, especially inflation and responses against it. To that extent, the minutes of the last FOMC were hawkish, but not increasingly hawkish, which was a positive, especially as the PCE deflator, one of the Fed’s preferred inflation gauge, slowed in April. Meanwhile, monthly personal income in the US gained +0.4%, a deceleration compared to March, but spending was up +0.9%. The UK announced a fiscal package to help mitigate the purchasing power squeeze for low-income households. Finally, but importantly, this weekend’s COVID numbers in China showed a materially positive inflexion.
A week is not a trend, and the major catalyst we need for a sustainable rebound is still not there: a shift in central banks’ tightening. Volatility should remain considerable, but last week’s being positive without a major reason confirms that sentiment and positioning are pessimistic enough to be now supportive.
The week ahead will provide an avalanche of monthly economic data, from regional PMIs to the US job report.
The main narrative driving markets continues to be centered on the Fed and the impact of its tightening on risk assets. Although equities are rebounding, since Powell is watching for “clear and convincing” evidence that inflation is coming down, withdrawal of stimulus will proceed apace and for now we would be hard put to saying that stocks have seen a lasting bottom. The latest releases have shown that the US economy is starting to slow down, but is still very strong. The labor market will take center stage in driving the future policy rate path. Next week’s jobs report is expected to show an addition of 325,000 payrolls for the month of May, moderating from previous readings but still well above the 100,000 figure required for a palpable slowdown. The Fed might pause to assess the effects of the firming of financial conditions either after Summer, as per market chatter, or towards year end. With price pressures not expected to recede that sharply, the latter remains well more likely than the former, not constituting a near-term catalyst for volatility to ease. Should the S&P 500 retrace 50% of its downleg from all-time highs, residual upside from current levels would be in the mid-single digits.
The best case in terms of impact of Fed policy seems to be a soft-ish landing, as mentioned by renowned investor Mohammed El-Erian, still quite pessimistic about the possibility of eventually avoiding a policy-induced recession. Such an event seems quite remote in 2022, though its chances two years out have increased significantly of late. Indeed, the FOMC minutes released last week suggest a very low probability of a near-term contraction, considering that the US economy is “very” strong and the labor market “extremely tight”. As for 2023, Powell may still count on being lucky, by importing weakness from overseas and maybe thus avoiding a recession. In spite of the stimulus recently implemented by China, the playbook of measures adopted could fail to work as in the past. The Chinese property sector is debt-saturated and the zero-covid lockdowns, expected to remain a threat for most of this year, are to an extent curbing the positive effects of stimulus. The failure to spark a meaningful recovery would have negative repercussions for global growth next year, but could help the Fed in its inflation fight.
With uncertainty still high as the global economy remains caught in a long-drawn-out and painful slowdown process, we reiterate that investors should manage downside risks by laying more emphasis on income generation and high-quality. Loss of economic momentum should imply that US longer-dated yields have topped out, making investment-grade bonds attractive again. Within equities, cash-rich companies with stable businesses have outperformed year-to-date, an investment theme which partially intersects with that of high-dividend payers.
Fixed Income Update
We probably are saying this for the first time this year that last week witnessed a broad-based rally across different segments in the fixed income. The question is whether this was a relief rally and how sustainable the compression of spreads is. The US Treasury curve bull-steepened with the front-end curves moving down as markets priced in a slightly lesser probability of an aggressive FED. At face value, last week’s strong retail sales and US Manufacturing data indicate a strong growth momentum in April. However, the FED, with its aggressive rhetoric, has turned the focus toward growth. Fedspeak suggests that they are willing to do what it takes to get “clear and convincing evidence” of inflation’s moderation. Further, Chair Powell does not believe that neutral is a “stopping point” or a “looking around point.” Forward-looking indicators, including business surveys, suggest some softening. This corresponds to downward pressure on the near-term inflation outlook leading to markets pricing in a lower probability of FED exceeding policy rates significantly above consensus forecasts. The December Euro-dollar futures now price a FED Funds rate slightly lower than 3% from a high of 3.26% in early May. This week’s Jobs and ISM data would set the tone and direction of yield movements.
OAS spreads across segments tightened last week. The leader was, of course, US High Yield, which returned 3.13% due to a 63 bps tightening in spreads. This was followed by EM Debt, where the spreads compressed by 12 bps generating a weekly return of 1.6%. According to a recent JPM study, the US Investment Grade spreads currently are just wide of the non-recessionary average and 63bp tight of the average of the recessions ex the GFC. High-yield spreads are only 3% above the long-term non-recessionary average of 519bp and comfortably inside the average in a recession of 971bp. And BB, B and CCC spreads are now 361bp (+8bp w/w, +55bp MTD), 570bp (+30bp w/w, +112bp MTD), and 1098bp (+51bp w/w, +222bp MTD) which is 9% above, 10% above, and 4% above average spreads during non-recessionary periods. Hence, we see value in strong BB names in the US to be added to client portfolios.
Closer home, GCC bond markets rallied with the risk-on sentiments. High-yield names such as Oman and Bahrain closed 4-6 pts higher, while IG names such as Abu Dhabi, Qatar, and the KSA jumped up by 2-3 pts. Emirates REIT rallied post news of the real estate company selling its Jebel Ali property for a consideration of AED 233.5 Mn. We have had a lull in the GCC issuance market. We expect a leading Sharjah-based master developer to issue a benchmark USD Sukuk this week with price expectations in the high 7s. This will be the first Sukuk issuance since March this year.
Global equities are on track to end the month of May flat to positive, with last week reversing the direction of seven weeks of negative closes. Global equities gained 5% with a broad rally across regions and sectors, more so for the DM and US equities. Monetary policy though on a tightening cycle has a clearer path with direction from the Fed, the ECB, the BOE and the Reserve Bank of India. On the EM front, China had a negative week but strong results from Tech bellwethers Alibaba and Baidu and resumption of economic activity is building confidence in a rebound. Also, government support on tech regulation and loosening of credit conditions should start providing confidence to investors.
The tech sector got support from falling yields and a less Hawkish Fed and had a strong week. We are cognizant of changing trends in tech specially on lowered spend on discretionary activities such as streaming and a digital advertising revenue slow down. We remain positive on exponential ecommerce growth in EM (outside China already heavily penetrated). But we note that buying patterns are changing and the consumer discretionary sector is -25% ytd. High inflation is expected to impact the margins of retailers and rising rates and higher prices will lower the buying power of consumers. Retail earnings from Best Buy, Abercrombie & Fitch, Ralph Lauren, Nordstrom, highlighted that Americans are still shopping, but more selective about what they are buying and the divergence between higher and lower income shoppers.
UAE indices have seen a recent pullback but it is one of the few regions with ytd gains. This is a yearly pattern as investors become complacent post dividend payouts in April and May. We stay positive on further gains into year-end as oil prices remain over $100/ barrel supporting government spend and new issuance is well received, broadening the capital market. Dividend growth is strong specially in the banking sector. The UAE remains one of the most digitally advanced, adopting technology and spending on state of the art infrastructure and transportation.
Are markets finding trading ranges after the extreme volatility we have seen recently? While equity valuation and growth metrics have been supportive of future equity returns, concerns on margins post guidance from key corporates on supply chain, labour and input costs has led to falls of 20 to 40% on some stocks i.e. Walmart, Target, Snap, Facebook, Netflix to name a few. . Also rising inflation, rate hikes, and the Russia-Ukraine conflict have contributed to growing recession fears. However, while inflation in the US remains close to its highest level in forty years, market expectations of longer-term inflation have begun to ease. PMI’s are still in expansion mode, though April numbers are lower than March.
Expect volatility to continue into the summer but start settling down into Q3. Looking at forward P/E multiples, the S&P 500 is trading at 18X FY 22 and 16.8 X FY23 indicative that earnings are expected to grow 8-10% annually. FactSet has the 10-year average at 16.9x and 20-year average at15.5x. With valuations supportive we need to look through the current inflationary impact on markets and look out to the medium to long term.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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Winds of change
Fear, Uncertainty and Doubt
Slowing, tightening, falling
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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