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Chief Investment Officer's team, 09.05.2022
Stocks suffered the fifth straight week of losses amidst the withdrawal of Fed liquidity and a still rumbling Russia-Ukraine conflict. Long-dated yields made new highs for the year, alongside the US dollar, further tightening financial conditions. We would be tempted to look at the glass half full, with the US economy still resilient, higher Fed rates ahead now fully discounted and deflating equities with early signs of capitulation. On the one hand we could, but on the other there still is the big unknown of the impact of Quantitative Tightening on markets, with previous precedents, QT1 in early 2008 and QT2 in 2018, all pointing to disruptive effects.
The Fed did not surprise markets, with a 50-basis-point hike, more hikes of the same magnitude lying ahead and the starting of the shrinking of the balance sheet from next month. But it was surprising that Powell said that the terminal rate, the one to be expected at the end of the monetary cycle, sits “between 2% and 3%”. That holds when inflation is around the target level, 2%, but with core PCE at 5.2% YoY, the hiking should not even be done with a policy rate at 3%. This begs the question of whether the Fed is really committed to fighting price pressures beyond the official rhetoric.
While the US economy is barely dented by different sources of volatility as indicated by the ISM manufacturing and the jobs report, Europe and China are faring nowhere near that well, and Europe’s decision to phase out Russian oil imports by year-end will only add to economic woes. As the Western and Russian positions become more and more irreconcilable, investors should be aware of growing downside risks.Stay safe.
There is still nowhere to hide for investors. With the major asset classes in negative territory year-to-date with the exception of gold, one wonders what could prompt markets to inflect higher. Valuations, liquidity, abating geopolitical risks?
Valuations are important and this point only could be debated for long. We cut to the chase and say that, although stocks are now better priced, looking for average historical price-to-earnings could be deceptive. Are we interested in convergence towards the last ten-year average multiples? Not so fast. That was the past decade, which reflected Goldilocks conditions, that is both muted growth and inflation commanding the highest valuations. Assuming with some common sense that we are no longer under a Goldilocks regime, but rather witnessing a derating from a less favorable growth-inflation tradeoff, we should then be expecting lower average multiples than in the past. Valuations are slow-moving, so anyway we won’t be able to use them as a timing factor, but past averages may offer less comfort than usual and from this viewpoint markets are not oversold.
Liquidity is the lifeblood of markets and it is being removed across the G7 countries at the same time, something which may well account for today’s struggling equities. With asset purchases yet to be reduced by $410bn in the Group of Seven, there is a legitimate concern that the struggling will persist until the bulk of the tightening has been carried out. Although the shrinking of the Fed’s balance sheet has not even started, the past disruptive episodes of Quantitative Tightening suggest that at some point the Fed could backtrack. But we are not there yet.
As for geopolitics, the Russia-Ukraine conflict is dragging on with no quick end in sight. The West now wants to achieve a “strategic defeat”, while Russia intends to annex the occupied regions, control the South of Ukraine and landlock the remainder of the country. Over-ambitious plans on both sides could see them in the conflict for the long haul.
It seems fair to conclude that not all the bad news is out yet and we should brace ourselves for more volatility, before at some point investor capitulation kicks in. Meantime, one should put money to work with an eye to downside risk. In this sense we see hedge funds and income generation across both equities and fixed income as viable strategies. The HFRX Global Index, the most followed hedge fund benchmark, is down only 2.5% for the year, while the Shanghai Dividend Index, comprised of high-dividend-yielding companies, has lost less than 1.5% YTD. Even though diversification has for now lost some of its luster, high-income and absolute return strategies play a role in the current market environment.
Fixed Income Update
It was a paradox that the markets took the highest single-day rate hike in two decades as a dovish signal last Wednesday. The culprit was Chairman Powell's confirmation that a 75 bps rate hike was off the table. The Fed is caught between "a rock and a hard place." Either they hike sharply and crash the economy, or they become lenient and let wage growth spiral. They rhetoric seems to be following the first route with the expectation that economy will weather the demand shocks. Markets seem to think otherwise, leading to a bear steepening of the US Treasury yield curve as longer-term risk premia decrease. The price actions resembles the taper tantrum of 2013. This tussle has resulted in the belly of the curve trading near its 2018 highs. We believe slower growth expectations could flatten the curve. Hence, we advise investors to extend their duration in bonds and credits to 7 to 10 year maturity periods.
Quantitative Tightening details were published, and Chairman Powell said that the current rate of balance sheet run-off is equivalent to one rate hike per year. It remains to be seen how the markets react to the liquidity withdrawal once the actual process is underway. The QT will start in June with a $30bn Treasury run-off and $17.5bn MBS run-off, which will gradually increase to a $60bn treasury and $35bn MBS run-off within three months. The current pace will allow the Fed to shave off $2.4-$2.6tn from its current balance sheet within three years.
Credit spreads have widened since the start of the year to reach near their highest levels in the last five years. This has led to YTD drawdowns ranging from 9% to 14% across various segments. Some segments, such as IG credit, now offer a greater than 3.7% yield for a duration of less than 6.75. These levels are starting to look attractive. We advise more cautious investors to add some defensive assets at current levels, should they be worried about rising volatility. Moreover, as yields peak out, developed market IG credit offers a good chance to add duration to the fixed income portfolios. We would also advise clients to stay clear of adding long duration in either emerging markets or High Yield segments.
MENA bonds have been volatile due to the lower interest from the local markets owing to the holidays last week. Investment Grade sovereigns have lost between 2 to 3 points on cash bond prices, while high yield sovereign bonds lost between 1 to 2 pts the previous week. Longer duration bonds have been more affected due to the yield's sell-off. Local sovereign and real estate sukuks have performed much better.
Higher volatility with equities ending lower globally for the week. China and India equities were down almost -7% and -5% respectively. European equities fell 4%. UAE markets fell a percent but retain gains of close to 20% YTD. Whilst the S&P ended at 4123, close to where it began the week, it is now in its 5th week of decline and saw two +/- 3% trading days last week and YTD has fallen -13%. The Nasdaq with the Treasury 10-year yield above 3%, has fared worse with growth sectors affected by the higher discounting factor for present value and is down 22% YTD. The energy sector continues to benefit from higher oil prices and is the only sector up YTD.
A key question is how the rising interest-rate environment is going to affect margins for corporates and consumer demand. From India and Brazil to the US, rates have been recently raised by Central banks. The latest U.S. jobs data showed U.S. hiring advanced at a robust pace in April and affirmed expectations the Fed will remain on its accelerated rate-hike path to combat stubbornly high inflation. A small labour force also necessitates wage hikes to attract workers.
Inflation is a big worry with the UK’s BOE seeing a 10% CPI print by October, the US at 6.6% PCE and over 8% CPI and Indian numbers well over 6%. Supply chains remain in disarray with no resolution in sight for the Russia Ukraine conflict, though China lockdowns will eventually cease as virus cases fall. Currently 345mn people are living in full or partial lockdown in 46 cities. Shanghai the world’s largest port is in lockdown, and many Shanghai subway stations are closed. China’s economic activity contracted sharply in April with PMI (47.4) falling to the second lowest level since 2008, the global financial crisis (only behind the COVID-19 outbreak in Feb 2020). As of end April, 25% of China's GDP was still under full or partial lockdown.
Whilst our year end fair values for equity indicate upside, current market sentiment remains bearish. Bank of America’s flow show report talks of bear market average durations of typically 289 days (though markets will always be dictated by current factors and no 2 situations are the same). And whilst equities are seeing outflows the report has the interesting observation that “for every $100 into equities past year or so, only $3 has been redeemed; and note $1.1tn of inflow to stocks since Jan'21 had average entry point of 4274 on S&P500, under water but only somewhat.”
Keeping in perspective earnings growth and valuation multiples, fundamental parameters for equities are favourable. However, volatility will stay through the tightening cycle. This provides opportunities and over the longer term equities have returned 6% p.a. with the US leading at returns of 7% p.a. and 16% over the last 10 years. Tech, the biggest weight in global and US indices, has seen the Nasdaq rise 450% over the past 10 years, so for longer term investors a 22% fall is not a big dent. But quality matters as 49% of the Nasdaq is more than 50% below their 52-week highs, 58% of Nasdaq is more than37.3% down, and 77% is in bear market, down >20%. Our positioning favours the US in developed markets and the UAE and India in emerging markets.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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Slowing, tightening, falling
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