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Chief Investment Officer's team, 10.10.2021
Last week saw an avalanche of economic data, which together painted the picture of renewed growth momentum with significant price pressures and mixed employment. The broad composite PMI numbers, which indicate contraction below 50 and expansion above, were as follow: reaccelerating in the US at 60, robust in Europe and India around 55, and back in expansion in China at 51 after a strong rebound in services. Data however keep on signaling inflation and persistent supply-chain issues. Finally, US non-farm employment increased by only 194k in September, way below the expected 500k. This was poor, but not enough to change the Fed’s intention to start tapering next month. US unemployment rate dropped below 5% for the first time since the pandemic (after a peak of 14.8% in April 2020).
No surprise then that interest rates rose materially, with the US 10-year adding 15 basis points to 1.61%. Defensive assets were logically down, while stocks were slightly up in both developed and developing regions. Oil prices gained another 4%. This was not bad for our active positioning: our monthly asset allocation meeting confirmed Tuesday our large underweight in bonds, and recalibrated our overweight in stocks to +3 percentage points across profiles, of which one third on EM. We are aware of the short-term headwinds but EM valuation and long-term growth prospects are clearly attractive.
We hope that the positive turn in global economic momentum will be confirmed in the coming months, in which case equity valuations should be able to stomach higher interest rates and inflation. We will know more in the week ahead, with CPI numbers being released, especially for the US on Wednesday. Stay safe.
Nowadays there is renewed talk, and rife concern, about stagflation, as investors face the tail risk that growth continues to surprise to the downside and price pressures to the upside. The last time when stagflation hit the economy and financial markets was in the 70s, with inflation then strongly anti cyclical, that is skyrocketing with crude prices, growth stagnating, and returns negatively affected across asset classes. Rather than debating whether such a time period is approaching again, and our answer would anyway be: ‘It is unlikely’, we will instead be looking into the stagflation versus inflation portfolio allocations, and what markets are currently implying about those two different scenarios.
There is a bad and a good kind of inflation, the former supply- , while the latter demand-driven. An oil price shock, as in the 70s, or supply bottlenecks and labor shortages as today in the aftermath of the pandemic, contribute to that kind of bad inflation that companies want to transfer to consumers, but eventually they don’t manage to, and that stifles demand. On the other hand, price pressures driven by a strong business cycle are consequential to an expanding economy, hence quite manageable both for corporations and households. While we hold the view that higher prices are here to stay for a while longer, due to various postpandemic bottlenecks in the system and surging commodity markets, we also think that demand should eventually remain solid, given the extra amount of cash held both by businesses, on account of super easy monetary conditions, and consumers, due to government transfers. Hence, eventually it should not only be about supply-related inflation, and with demand reasserting itself concerns should ease. Although the latest jobs report pointing to persistent labor shortages is not reassuring on this front, with 7 million people in September going off unemployment benefits in the US the October report should see an improvement.
Markets so far have not believed in stagflation, but rather in an inflation narrative. Cyclical equity bellwether sectors like banks and industrials would have massively underperformed under a stagflationary outlook, while year-to-date the former has outperformed the broader market by a wide margin on both sides of the Atlantic, while the latter has slightly underperformed the S&P 500, which can be rather put down to its higher exposure to the emerging economies. We do not believe in stagflation either, as in this case an appropriate allocation would be overweight the most cyclical commodities, neutral-to-underweight equities and heavily underweight the highest quality bonds. A pro-inflation allocation on the other hand would be more geared towards equities, overweight commodities and underweight Treasuries, which reflects our current tactical tilts, considering that we are neutral gold, a countercyclical commodity and the only one in our strategic allocation.
Fixed Income Update
The rise in the US Treasury yields has created panic among fixed-income investors. The 10-year yields increased by 15 bps last week, and even though we expected a gradual increase, the pace of the movement had caught markets by surprise. We still believe the yields could go further up as we approach the end of the year. However, we agree that any substantial higher move does require a positive surprise on growth and employment data. Moreover, the credit spreads have widened in Emerging Markets and High Yield leading to a sea of negative returns in the asset class last week.
Asia High Yield was blindsided by Fantasia Holdings' choice not to pay the investors even though the company had enough liquidity theoretically, unlike Evergrande. According to a Bloomberg article, "As of the end of June, the smaller developer sat on 27 billion yuan ($4.2 billion). In late August, the company claimed it had about 10 billion yuan in cash. It repurchased $6 million worth of bonds in early September, claiming "good liquidity" after the open market operations." Moreover, Country Garden Holdings had agreed to buy its Property management unit for 3.3 Bn Yuan. Fantasia had received a $700 Mn bridge loan on the back of this acquisition deal on 30th September. As a result, Chinese high-yield dollar-denominated bonds witnessed their biggest selloff in at least eight years. While Fantasia is only ranked 60th in the property sector, this could open Pandora's box for the segment as investors try to assess if this is a case of wilful default. What stops the other entities from following suit if the company gets away with such blatant disregard for contracts? While we were pretty much confident that the Evergrande contagion could be contained, Fantasia default is a potential game changer for our scenario. We have realigned our stance on the segment from Bullish to cautious and would advise clients against increasing their allocation to the asset class till the fallout from this incident can be ascertained.
On a positive development for Emerging Markets, Moody's upgraded the outlook of India from negative to stable last week. While we believe the risk of a downgrade for the country was negligible, the change did come as a pleasant surprise. Moreover, with expectations of the country's local currency bonds being included in the benchmark bond indices last week, investors may have a tactical opportunity here.
The UAE issued its first sovereign USD bonds last week in a multi-tranche offering in a landmark deal. The order books were covered 5x and spreads tightened by 30-40 bps across the three maturities, with the 10-year drawing maximum demand showcasing the investors' aversion to long-dated securities. The pipeline for new primary issuance deals from the region seems pretty thin as we enter the last quarter of the year.
Global indices turned positive for the week after a rally on Thursday despite widespread selling initially as soaring energy prices and the prospect of a sooner interest rate hikes to combat inflation rattled investors. A weak U.S. labor market report however wavered on global equity markets on Friday. The report shows that the U.S. economy created the fewest jobs in nine months to September, with worker shortages and jobs lost after vaccine requirements were imposed due to the Delta variant. The last few weeks showed some uncertainty on the new variant and investors are looking forward to the earnings season.
All three (S&P 500, Dow Jones Industrial, Nasdaq Composite) ended positive the week. The S&P 500 is up 0.82% for the week. The energy and financial sectors were the better performers whereas technology and other high growth shares ended selling off on Friday. Markets have been moving sideways for the past few weeks as investors look forward to the third-quarter earnings seasons which starts next week.
Stocks in Asia were positive for the week driven by advanced in Chinese blue chips (which rose by 1.31% as the nation resumed after the week-long National Day holiday). Also, a private-sector survey showed that sentiment has improved as China’s services sector returned to growth in September. Chinese stocks have struggled for the past three months by regulatory clamp-downs, turmoil in the property sector (Evergrande’s vast debt) and the power shortage issue. In Europe, the STOXX 600 index also ended positive for the week, marking its best week in two months as fears of soaring inflation were tempered.
An update on our positioning on the Tactical Asset Allocation (TAA). We expect DM equities to trade around our year-end fair values and in EM for India to overshoot and China under shoot our fair values. Our global sectoral preference remains for financials on the outlook for higher yields and healthcare as a defensive positioning. We expect elevated earnings to continue to support DM equities, while the lingering of regulatory uncertainties in China to cap upside in the shorter-term. The GCC markets continue to lead to the upside on stronger oil prices and the reopening of the economy. We see rising yields posing no challenge to equities as long as growth picks up again. We have shifted the US to overweight. The US market is most insulated from the current energy crisis and the least dependent on China. Other changes we have made we changed Europe and UK to neutral from overweight and Japan remains underweight.
Progress on the first pill to treat COVID-19 is on its way and vaccine producers are rolling out booster shots in wealthy countries. For investors this next stage of the pandemic could shift the momentum in the vaccine/oral antiviral market. A successful rollout of the CODID-19 pill could quicken and broaden the world’s recovery, opening up a plethora of investment opportunities in stock markets. Merck & Co was the first to successfully treat the virus by an oral antiviral pill.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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An eventful week from China to the US
Stagflation concerns chill markets
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