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Chief Investment Officer's team, 21.02.2022
Markets have had little respite so far in 2022, buffeted by less friendly central banks and rising geopolitical risks. We do not see volatility settling down in the shorter term, with the Fed’s tightening process still in its early stages and the extremely low visibility on the Ukraine crisis. Although DM equity valuations are more appealing, we would need positive catalysts for markets to regain their footing, hence we are back to square one looking to the removal of liquidity, the geopolitical factors and the strength of the economy in order to be able to assess when markets will settle down.
A resolution of the Ukraine crisis would be a major positive, but we suspect that only once the effects of the winding down of asset purchases have been fully discounted we could start to breathe a sigh of relief. The US administration has repeatedly called a forthcoming conflict in Europe, a view reinforced by the latest declaration of the Vice President Harris on a diplomatic tour in Europe, who said that :”Putin has made his decision. Period”. In the backdrop inflation remains at multi-decade highs in the West, but it is less concerning in China, where it is “generally mild”, as per the PBoC governor.
In this uncertain environment investors are advised to play offense and defense at the same time. In equities a combination of growth at reasonable price and value, in credit a preference for EM debt alongside some safer bonds now more appealing, in alternative assets hedge funds to mitigate portfolio volatility and gold as a hedge against rising geopolitical risks, should help investors navigate these stormy waters.
Last week we reduced our large global treasury underweight, considering the recent rise in yields and the ongoing geopolitical risks.
In spite of the rising volatility and the confluence of negative factors weighing on markets, the Ukraine crisis and the tightening cycle, we remain moderately constructive on the outlook. We acknowledge it won’t be an easy ride, in keeping with our theme of ‘low visibility’ for this year as compared to ‘easy money’ in 2021, while at the same time considering the supportive factors of the still strong economy and the unwillingness of the Federal Reserve to tackle inflation at the cost of generating a recession. Upside on equities is limited from the starting levels of the year, but more appealing right now versus our year-end fair values. Although the combined effects of the withdrawal of stimulus and the slowdown in the economy could drive markets to new lows, we would be considering such an event as a buying opportunity.
The Ukraine crisis is the worst in a decade, and in case it had to do more with NATO’s continued expansion, as Putin complains, rather than simply with “Russia bullying Ukraine”, it would be much more complex to solve than initially thought. Although it seems that the West would avoid a direct intervention, an invasion would still cause a spike in energy prices sharply affecting markets and the economies. As long as uncertainty persists, negative sentiment is going to weigh on risk assets, compounding the effects of the withdrawal of central bank stimulus. So far equities have been the clear losers, alongside Ukraine, while gold the winner, alongside both Biden and Putin.
Markets should have fully discounted the impact of the Fed’s policy moves in 2022, anticipating more than six full hikes in the next twelve months, as compared to the four or five 25-basis-point hikes the consensus of the board members should be gravitating towards, according to the January FOMC minutes. Yet, the winding down of asset purchases, only to be completed in March, has yet to make itself fully felt, and no past episode of the end of a round of Quantitative Easing has so far failed to cause significant bursts of volatility. Also, investors should keep in mind that this monetary cycle is unlike any other past one, being an asset, not a credit cycle. This time there is no excess lending to curb, as the private sector’s balance sheets are healthy, but rather the wealth effect caused by high asset prices must be tackled, playing a role in boosting the demand that drives inflation. Indeed, price pressures are driven by supply chain issues as well, but central banks cannot do anything on that front. Since the Fed has set itself the task of taming inflation, but not at the cost of causing a recession, we think that there will be a pain threshold in terms of negative market performance it will be sensitive to.
Overall, both the challenges of the security crisis and the withdrawal of stimulus should be manageable, as long as the economy remains resilient. So fare there is no growth scare in the offing. Retail sales for the month of January were strong, supported by a healthy labor market. Once the long-drawn-out process of the removal of accommodation has played out, markets should stabilize and offer better risk-adjusted returns.
Fixed Income Update
The volatility in the US Treasuries continued last week, with the 10-year yield crossing the psychological 2% mark for the first time since July 2019. We talked about this mark for quite some time and seized the opportunity to cut our large underweight in the developed market govt bonds by 50%. We still have overall underweight in the segment, but the move benefited from the subsequent leg down in treasuries as the Ukraine crisis dominated the newsflow. Our conviction is driven by the flatness of the yield curve, which suggests the market still doesn’t believe that the Fed can go the whole way.
We are cautious on the High Yield credit segment. The US High Yield has been the worst-performing asset class YTD as spreads have widened by 87 bps. With risks growing and investor concerns about the ability of some of the weaker entities to refinance their obligations, the spread blowout would affect investors who have a significant allocation to the high yield segment. Therefore, it makes sense to add safe-haven assets to the portfolios during uncertain times. Our above allocation change is in sync with this idea of lowering volatility.
Within Emerging Market Debt, GCC Debt acts as an island of calm in the ocean of turbulence. We like GCC High Yield oil exporters due to their high energy beta. During these periods, they act as a good hedge while generating decent yields for investor portfolios. We prefer EM Debt over High Yield due to the reasonable valuation metrics and the overall resilient credit environment in the Emerging Market entities.
Asia High Yield remains a cause of worry even though the market has been slowly reacting to the easing measures implemented since the beginning of the year. The latest monthly sales reports indicate that the sales decrease by more than 40% on a YoY basis. However, there is a silver lining in the clouds as home prices seem to have stabilized. Home prices in Tier-1 cities rose by 0.6% month-on-month (MoM). For January, 39 out of the top 70 cities reported falling home prices MoM, 11 fewer than that seen in December. 35 out of the top 40 developers posted MoM decreases, only Corgard and Yanlord emerged as the only two developers that logged MoM gains. Several easing policy measures such as the exclusion of property M&A loans in the calculation of the 3 Red Lines, easing of developers’ access to pre-sales funds in escrow accounts, acceleration of mortgage loan approvals, and standardizing the regulations surrounding the pre-sales funds held in escrow accounts were reported by media outlets since the start of the year.
Market volatility looks likely to continue. It has been a rough start for a year which began with stretched valuations after another exuberant year of returns from developed markets, central banks’ hawkish shift, the bear flattening of yield curves that followed, and rising geopolitical tension. Developed market equities fell close to 2% with the US declining a second week but faring a little better than European markets which will bear the fall out of any Russia Ukraine escalation. EM fared better than DM down just 0.7% on the week and flat year to date. Holding back EM performance is China’s property sector cash crunch and the recent regulations around reduction of fees for online food delivery platforms indicative of the continuing crackdown on highly profitable internet technology companies. Meituan, the leader in food delivery has seen its share price fall 50% last one year, in line with other China tech titans reflected in the performance of the Hang Seng Tech Index. While the European and US tech sector sell off with unprofitable and high valuation companies falling 50 to 60% has been driven by higher 10 year Treasury yields (the discounting denominator for present value calculations) the Nasdaq is flat compared to a year ago and down 13% year to date .Our positioning recommendation for tech is to be invested in companies with resilient businesses and high margins.
A defensive tilt to the market with gold prices up and consumer staples the only positive sector last week. Markets will eventually perform on earning growth and valuation fundamentals once the twin headwinds of inflation leading to quicker monetary tightening and the Ukraine Russia escalation recede. We look to add to US and DM equities just a little lower than current levels. The S&P 500 is trading at 19.5X forward Earnings and 2022 earnings growth should meet our 10% estimate. Demand remains strong and whilst margins could fall 1-1.5% as cost inputs and rates will have some effect.
The UAE and India markets both had positive weeks a continuation of their year to date outperformance. The former’s economy was quick to bounce back from a third covid wave and the latter is benefiting from capital market broadening and resultant increase in trading volumes and higher oil prices aiding government spend. The Expo 2020 has received close to 12mn visitors making it a success in spite of COVID restrictions. The UAE has welcomed foreign investment and is focused on economic growth away from oil. The UAE and India signed a comprehensive economic partnership agreement on Friday, which will boost bilateral trade and investment between the two countries. Investor caution around Asia’s outlook is centred on the impact of China's slowdown, however Asia’s recovery has been fueled by a sharp upswing in exports, growing at four times the pace from 2008-19 reviving the capex cycle. As per Morgan Stanley estimates Asia already the largest economic bloc, nominal GDP is forecast to grow US$5.4tn in 2022-23, higher than US$4.8 tn for the Americas & US$2.9tn for Europe.
Our fair values for the major indices, barring the GCC which has rallied considerably this year led by the KSA, indicate a substantial upside gap to current levels. We would focus on staying invested but look to corrections to add as we will see more of those.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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A volatile transition
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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