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Chief Investment Officer's team, 04.07.2022
Our 2022 Global Investment Outlook was titled “Low Visibility Ahead” to express our perplexity in front of a complex environment: while we were constructive on growth, we acknowledged that the end of magic money would create severe turbulence. We thus recommended to start the year on a cautious tone and be more reactive than proactive.
It wasn’t wrong, but we were far from expecting such a terrible first half of the year for financial markets. Basically, all segments of both equity and fixed income have had negative returns between -15% and -20%, annihilating diversification benefits. Hedge funds and gold limited the damage to a single digit, and cash was the only asset class to deliver a (very small) positive return.
Now that markets have well understood that central banks mean business, the next source of anxiety is logically the consequences of their inflexible tightening on growth – especially as inflation looks very sticky. Stagflation risk is in all conversations, investors’ surveys have expressed a record level of pessimism and all the usual suspects of doom and gloom are as vocal as ever. As always, this sounds like good news for contrarian investors, but as long as we don’t see price pressures convincingly abating, volatility should remain the name of the game. However, we still think that valuations have become decent enough to brighten the perspectives for the medium term: the current inflation is not just about supply, and we believe that a material slowdown would solve most of our problems, and trigger very different policy responses, which in turn could unlock the value we see in selective market segments. We will update our views in our tactical asset allocation committee this week. Stay safe.
Since the Federal Reserve made unequivocally clear at the June meeting that rates would move into restrictive territory, market pricing of a recession has clearly accelerated. The 10-year yield has rallied 60 basis points, equities have remained close to bear market lows, credit spreads have widened and commodities have lost almost 10%. Consumption patterns have materially deteriorated, with a second consecutive reading for real consumption expenditure, and indications from the overall economy have not been any better, as the Atlanta Fed GDPNow model on Friday forecast a 2.1% fall in Q2 GDP. Should the projection turn out to be on track, it would point to a technical recession following the negative GDP reading in Q1. That in and of itself would not match the definition adopted by the National Bureau of Economic Research, which is “a significant decline in economic activity that is spread across the economy and that lasts more than a few months”. It seems markets are headed towards discounting the latter, and in that case as per historical patterns a bottom would be reached when equity valuations are well below their 10-year average, HY spreads are close to 10%, and either macro data inflects higher or policy turns more accommodative. Both valuations and policy are far from anticipating the worse, so investors will still have to wield patience.
Actually, even amidst rife talk of a US recessionary outlook, equities rebounded on Friday, and bitcoin jumped as much as 11% in early trade a day earlier, holding above the June lows as of the weekly close. As a gauge of investor risk appetite, renowned investors have observed that the digital currency tends to lead equities. Could, then, bitcoin rebound and stocks follow through? July has been a winning month for bitcoin in seven of the past ten years, with an average gain of 10.4%. According to Aaron Brown, former head of financial market research at AQR Capital Management, bitcoin can be proxied with IT stocks, exhibiting a directs correlation with the Nasdaq, and gold, which tends to trade in the opposite direction of bitcoin. This makes perfect sense, as we need animal spirits to come back to see a sustainable rally in digital currencies, that is a bull market in IT stocks and lacklustre performance on gold. As the chief strategist at Principal Global investors rightly put it: “If anyone thinks that equities can rally into the back of the year, they are making the assumption that the Fed is going to let go of its entire focus on price stability”. Hence, we are back to square one, as although a bitcoin and an equity rebound can be in the cards, something more sustainable requires, on top of lower valuations across asset classes as argued above, the Fed’s blessings as well.
Once more the advice is to invest with an eye to downside risk until visibility on the outlook improves. That should translate into a preference both for high-quality bonds, first and foremost, and defensive equities. Gold is unlikely to outperform in spite of the stagflationary environment due to the significant tightening of financial conditions underway.
Fixed Income Update
The recession scare is here again. The risk-off scenario last week resulted in bonds rallying. The US Treasury curve bull-flattened, moving down by 20 to 25 bps in the 3-5 year range. The 10-year UST yield came below 3% for the first time since early June. Does that mean the market is not worried about inflation anymore? We don't think so, as evident from the sell-off seen in the European yields this Monday, with bond yields moving up by 5 to 10 bps across the European region. Volatility seems to be the only constant this year. Juxtaposing the second half against the first half, yields rose momentously in 1H22 driven by a hawkish Fed. However, looking at past tightening cycles, we still see modest room for yields to move higher if we compare the current levels with the terminal rate of this cycle. We see softening demand as the main culprit for movements in the second half with weaker fundamentals and anchored real policy expectations. Treasuries still look attractive as a hedge against any real slowdown.
Consistent with the above risk-off scenario, credit spreads widened significantly last week. The High Yield segments worldwide were the worst-performing segments last week as HY spreads widened by 75 bps. Even though the yields look attractive, we still believe another 150 to 200 bps of widening is yet to be priced in. Once US HY spreads cross 750-800 bps, it would be wise to relook at the positioning and take decisions based on the slowdown outlook. But for the time being, it is better to be cautious and be very selective in High Yield and EM Debt. A case in point is our recommended bonds list. The YTD median return on our HY names is -5.39%, which looks respectable compared to the Global HY return of -16.7%. Similarly, Our EM names have returned -5.92% YTD vs. -16.7% in the Bloomberg Barclays EM Index. Going ahead, this plays a crucial role as more and more slowdown risks are priced in.
Recently, GCC primary markets saw as many as five deals in the last couple of weeks. All of these are part of our list. While MAF, UAE, and QIC deals generated an enthusiastic response from the investors, DARALA received bids from its loyal base. Mashreq's maiden AT1 drew a lukewarm response. Due to the wide pricing of the new issuance, the secondary markets have been crushed. We expect the high coupons of some of these HY issuers would protect them against rising volatility. Last week's moves in GCC credit felt nothing short of a roller coaster ride. The week started on a backfoot for most IG names due to high US treasury yields, followed by a sudden jump in bonds (in cash), as yields retreated from their levels. In terms of overall GCC bonds performance, the sector has outperformed the broader EM Debt by 6.5% YTD, and this outperformance should carry on till the end of the year, supported by robust oil prices.
We’re halfway through the year, with global equities down 20% and emerging market equities just a little better off. June saw continued volatility with sharp daily moves and most regions traded down, barring China. Our recent overweight on EM Asia has been advantageous as the less onerous Covid restrictions, opening of the economy and lowered tech oversight, were the necessary catalysts to boost the China market. Erstwhile leaders in performance the commodity exporters the UAE, KSA and LATAM followed the global trend trading down in June, as oil prices fell with recession fears increasing. There is however no data supporting this as air travel and freight transportation numbers continue to grow. We recommend adding to oil E&P companies and LNG refiners as the recent pullback provides opportunity to invest in these high cash flow and strong dividend payers. We have been reiterating the outperformance of dividend payers in an inflationary environment.
Whilst global markets largely fell last week, the UAE had a flat week. Tecom lists this week and the dividend yield of 6% and a steady income as a real estate facility operator adds it to the list of already successful high dividend IPOs this year i.e., DEWA and Borouge.
The first six months were full of surprises: Tightening financial conditions with sticky inflation over 8% in the US and Europe, over 6% in India, Sri Lanka in crisis and most global economies barring China and Japan with over 5% CPI y/y. Rising yields with the 10 year US Treasury touching 3.5% leading to the worst performance of bonds in four decades and tech stocks falling 30%. Add to this the implosion of crypto and sell off of unprofitable tech and COVID favourites i.e. streaming and biotech companies.
The biggest concern now is corporate margins and next week the Q2 earning season starts and guidance will be closely watched. Margins can be impacted by both the higher rates (avoid investing in highly leveraged companies) and higher inputs cost as supply chains are still not back to pre-pandemic efficiency. Labour is still in short supply as slowbalization has led to reduced cross border worker flow and wages are higher as a result. Inflation is also eating into the consumption baskets, more so in the case of the lower income cohort of the population which have a higher proportion of food and energy. Higher rates are also going to increase consumer and real estate financing costs with a related impact on demand.
Whilst recession talk has increased, equity markets have somewhat priced this in with global indices trading close to 10 year average P/E multiples. The S&P 500 has fallen by the most in the first 6 months since the 21% loss in 1970, when the economy was in recession. JP Morgan compares market falls with the average peak-to-trough fall of past hard landings. The average fall in the last 11 recessions was 26% for the S&P500 , that suggests an almost 80% chance that recession is priced. Though analysts have started cutting earnings forecasts, estimates remain at earnings growing over 10% for global stocks, so we remain mildly constructive but cognizant of slower growth.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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The good, the bad, and the weird
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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