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Chief Investment Officer's team, 14.11.2021
Last week was all about October inflation numbers and they were spectacular. In the US, the Consumer Price Index printed a +6.2% year-on-year increase, a level not seen since 1990. In China, while the CPI was a very contained +1.5%, the Producer price gauge, i.e. the factory-gate prices, gained +13.5% in a year, another two-decade record. US officials didn’t change their view that the pressure is transitory and doesn’t require immediate action. However, markets clearly questioned it, with interest rates adding more than 10 basis points on average across the curve. The US 10-year Treasury yield ended the week at 1.56%. Stocks were however resilient: up in emerging markets, and only marginally down in developed ones with the US ending flat.
This was not a bad week for our positioning, overweight stocks and underweight bonds, especially as gold, our latest overweight from our November TAA committee, also glittered, sharply up to $1864 an ounce. Our view on inflation remains somewhat aligned with that of central banks: the primary cause is unleashed pent-up demand meeting constrained supply and logistics, and this should normalize over time. Having said that, timing the normalization could be tricky, and in the meantime, demand itself could be affected by rising infections. The trend is actually not good in Europe nor in the US.
Another inflexion is coming, from the East. China’s 19th Communist Party Plenum confirmed last week that President Xi has full support, virtually forever, to implement policies toward a “modern socialist country”, where socialist is probably the most important word. This is an interesting prelude to the virtual meeting with Biden this Monday. With regards to economic data, we will get the important US retail sales numbers on Tuesday. Stay safe.
The October inflation release in the United States saw the CPI reach a three-decade high, and gold break out of a four-month range, reawakening investor animal spirits in what has so far been a flattish year for the yellow metal. The relationship between gold and inflation is not a straightforward one, with the rally in the decade following the dot-com bubble marked by muted price pressures, yet gold’s almost five-fold gains. In the same period the US 10-real Treasury yield, that is the nominal yield minus inflation, collapsed into negative territory from an initial value of almost 4%. So, it is obvious that the link between the yellow metal and inflation is best explained via real rates, a more complex one and harder to grasp for laymen. The price breakout, then, seems to be telling us that investors believe the Fed will be falling behind the curve in containing inflation pressures, allowing inflation to rise faster than yields. Most likely Fed officials will want to avoid the 2017-18 policy mistake, when they raised policy rates only to see inflation eventually go nowhere. And, after all, Jay Powell at the last FOMC meeting was careful to delink the end of the tapering from the start of the tightening, if anything conveying the clear message that policy would not change unless the winding down of asset purchases is over. In the end, this leaves investors with a time window, extending at most until June next year which is the current deadline for the completion of the tapering, when inflation should stay elevated, while longer-dated yields would be capped by the Fed holding back on policy moves. Real rates would continue to be under pressure, boosting gold to new all-time highs.
Indeed, there is room for the CPI to stay firm or grind a bit higher in the next few months, as shelter inflation is calculated based on a theoretical measure lagging real prices, the Owner’s Equivalent Rent, crude demand is deemed to peak only early next year as per EIA projections, and supply-chain constraints are seen persisting in 1H22. On the other hand, visibility on growth is much less assured, with the central bank liquidity impulse fading in 2022 and lots of uncertainty around the strength of the Chinese recovery. Putting this all together, it seems that gold strength could be more front loaded versus our original assumptions, with the potential for further positive surprises if the market starts to price in delayed hikes as an economic slowdown materializes. The longer inflation and growth continue to diverge and the Fed stays put, the better for gold, which stands a good chance of extending its rally beyond new all-time highs. Although the sustainability of such move is in doubt, its likelihood seems to have grown substantially of late.
Investors have recently flocked to cryptocurrencies, deemed to be the new gold with the promise of accelerated gains alongside inflation protection. We think that this views is simplistic, as the inflation-hedging properties of crypto-assets are as limited as those of equities, both cyclical macro assets, and their outsize returns are also predicated on the exceptional liquidity wave triggered by super-loose central bank policies. As much as gold would be negatively affected by shrinking liquidity, we think that digital currencies would be as well, maybe giving perennial digital bulls a new kind of headache.
Fixed Income Update
The plumbing system of the Fixed Income markets has come under pressure for the first time since the post-pandemic times of Q2 2020. The higher than expected inflation numbers released last Thursday threw ripples across the world’s largest bond market, the US Treasuries. The three-year treasuries marked the largest movement in yields with an 18 bps increase last week. Last Wednesday’s 30-year bond auction was very weak, with the new issue pricing at 1.94% versus an expected 1.88% pre-auction level. Bloomberg Barclays US Govt securities liquidity index is at its tightest levels since March 2020. The MOVE index is at its highest point, indicating that the core treasuries market is in a state of flux and still in a price discovery mode. Markets are at odds with the Fed and are pricing in two hikes before the end of the next year. It remains to be seen who blinks first. But the above indicators suggest the volatility will spill over to the credit markets. Our advice to investors is to stay put with a diversified allocation to High Yield and EM Debt along with remaining underweight duration, which will reduce the effect on their daily MTM movements.
Various segments have come under pressure due to the whipsaw of treasuries, and spreads have widened slightly in the majority of the sub-asset classes. The tightest segments in terms of valuation, such as US High Yield, were the worst affected, with spreads widening by eight bps. However, in terms of overall asset class returns, US High Yield only lost -0.36%, while long-duration assets such as developed market IG and EM sovereign lost close to 1% last week. China was the only bright spot in an otherwise gloomy atmosphere. China Local currency IG Debt has returned 7% YTD and is the top performer as RMB remains at the highest level since 2018.
Asia HY had the best week in the last five months, gaining 2.2% despite extreme volatility. The OAS spreads have compressed by 154 bps to close the week at 11.16% after hitting a high of 12.55% last Tuesday. The driving forces behind this are a gradual stream of reported easing in the regulatory policies. Market sentiment took on a more positive tone following the report by the Securities Times that several developers are to apply for quotas to issue bonds in the onshore interbank bond market. Furthermore, Caixin reported that mortgage lending has increased by RMB 101.3bn during October, signaling an easier stance towards mortgage disbursement. However, we expect the regulators to prefer the baby step methods to a big-bang approach which means the volatility of the tail risk pricing will remain high as there are sizeable onshore debt maturities in December and offshore maturities in January.
The GCC bond market saw some much-needed new bond issuance as both the KSA and Bahrain issued Sukuk and bonds. Both issues priced around the existing curve and investor demand was skewed towards the shorter-dated Sukuk, indicating caution towards the longer-dated maturities.
Global equities finished flat last week with the U.S and Europe falling 0.3% and most EM indices, China, India and the UAE with strong gains. US equities had the overhang of inflation concerns following the biggest CPI increase in over 30 years in October. The accompanying backup in rates was another big headwind given concerns on elevated valuations, especially on the more crowded growth names. The latest data increased the focus on the Fed and worries about a policy mistake. At the same time, the bullish narrative remain intact and the pullback has so far been miniscule. The S&P 500 has finished higher for five straight weeks prior to last week, with continuing record highs. Tech returns closely follow the S&P not yet impacted by the potential for rising rates.
As per FactSet 92% of S&P 500 companies have reported Q3 earnings, the 39.1% y/y earnings growth rate is ahead of the 27.5% estimate at the end of Q2 and the third highest since Q2-10. Revenue growth is at 17.5% y/y. However, inflation continues to be the biggest theme. 285 S&P 500 companies used the term "inflation" during their Q3 earnings calls, the most going back to 2010 and above the previous record of 222 from Q2-21. The mitigant remains margins which are still healthy at 12.9%, estimates for Q4 are at 11.8%.
The Dubai Index continues its upward move with the DFM stock up a 100% since Nov 1st with real estate stocks and banking also performing well, with trading volumes surging. Potential listings in the UAE see the recent addition of Salik, added to DEWA among the 10 state-backed companies to be listed as part of plans to boost activity on the local exchange Companies that have recently listed on the Abu Dhabi exchange i.e. Fertiglobe, Adnoc Drilling, Adnoc Distribution and Al Yah Satellite have focused on strong cash flows and sustainable dividends – always the best performing strategy in the GCC markets.
India had record Diwali consumer sales and is living up to EM consumer demand expectations. COVID is also currently under control with the normal functioning of the economy. Indian inflation started an extended pickup in October, driven by fuel and food. The rate sped up to 4.48% from 4.35%. The Indian Sensex has been one of the best performing stock markets this year and recent successful IPOs such as Nykaa reflect the shift to ecommerce.
COP26 succeeded in highlighting a bright future for zero-emission vehicles. Bloomberg’s 2021 EV Outlook ‘BNEF” states the total global fleet of passenger electric and fuel-cell vehicles is now 13 mn of which 8.5 mn are true ZEVs, either battery electric or fuel cell. That's up from just 4.6 mn at the time of COP25 two years ago. BNEF raised its forecast for the global ZEV fleet to 677mn by 2040. While Tesla gave up some gains, with Elon Musk and his brother selling stakes, it has risen 46% ytd. New listings in the EV domain are following Tesla’s rise, with Rivian valued at $114 bn, up 60% in 3 trading days. Rivian Automotive, backed by Amazon and Ford, recently rolled out the first all-electric pickup truck, the R1T. Electric Vehicles has been one of our key themes this year as we saw plenty more potential in battery makers and other technologies around the manufacturers.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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