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Chief Investment Officer's team, 24.01.2022
The third week of 2022 was tough on financial markets, even for those who, like us, expected volatility. All asset classes were in the red, except, a bit surprisingly, gold, supported by rising tensions in Ukraine and reclaiming its safe haven status to battered crypto currencies. Stocks and listed real estate from developed markets were sharply sold off, now down -6% in 2022.
There are several factors combining to confirm (so far) our theme for a year of low visibility ahead. First, we are still very much in a pandemic, with global case counts rising, especially in Asia. This happens at a time when supply chain bottlenecks, one of the key components of current inflation, were only starting to be fixed. While we expect the slowdown to be concentrated in Q1, it will be important to see that Asian factories remain open, and that Western consumers remain resilient in the meantime. This is our base case, but it will obviously be questioned – we will closely watch the December PMIs in the coming days. Second and crucial factor, of course, is the fact that monetary policy normalization has not even started but should not be delayed. The Fed will meet this week and the should confirm in their press conference on Wednesday a first rate hike in March. Finally, the situation in Ukraine spells “sanctions” for Russia, but the West should be cautious to take the risk of disrupting oil and gas markets at this pivotal moment in the growth/inflation mix, especially as energy costs are an important factor for the numerous elections taking place in the coming months.
We had cut risk and adopted a “wait and see” positioning earlier this year. We remain reasonably constructive and ready to jump on the next irresistible opportunity – we are confident it will happen, maybe sooner than we initially thought. Stay safe.
US technology stocks have led the broader market down and now entered correction territory, having lost more than 10% from their all-time highs. Investors must be wondering whether buying the dip is still a viable strategy, or something has changed and further downside cannot be ruled out. One wants to buy the start of a new trend and not just a rebound, and since the outlook for monetary tightening is something new in the picture, we think that this time it is not worth to act on the fear of missing out. Liquidity is a primary market driver, impacting equity flows, as well as earnings more indirectly via the economy. One way to measure the effects of the Fed’s tightening on market liquidity is to check financial condition indices, that are built by investment houses, and are still pointing to maximum liquidity. So, although markets have already discounted quite a lot in terms of the coming monetary cycle, from the number of rate hikes expected this year to the winding down of asset purchases, there is no sign of tightening of financial conditions yet. Indeed, from this viewpoint we are just at the very start of the process, and one may wonder how equities will react once the Fed for instance is well into the tapering process. Maybe the liquidity to be soaked up is so huge that markets are yet barely reacting, or maybe investors are still thinking that the Fed will not go very far with its plan and give up soon. Whatever the reason, we can only acknowledge that the removal of liquidity still has to make itself felt.
Investor positioning and economic growth are other variables one wants to look into to try to gauge market conditions. Positioning seems to be quite bullish, or at best neutral, either looking at equity futures, the amount of short interest on major ETFs, or cash balances held by fund managers. So, on this front we cannot see any kind of capitulation either, which would make for more of a fertile ground for potential upside. On the other hand, economic growth, although slowing, is holding up at relatively high levels, which is comforting and should offer a floor to markets. Yes, uncertainty around economic forecasts is high, and the Fed will be tightening in a slowdown phase, but for now there is no sign of yield curve inversion at the shorter maturities, as was the case in late 2018 when investors saw a policy mistake in the making as Powell said that the shrinking of the balance sheet was on ‘autopilot’.
Overall, while markets can rebound from current levels, we cannot sound the all clear given the degree of tightening ahead and the market vulnerability due to valuations, although economic growth is still solid and should provide support. In terms of investment choices in this more volatile year, we hold the view that portfolios should not forget shorter-duration, cheaper and more cyclical assets. For instance, EM stocks offer more value and are more pro-cyclical versus DM peers, so they should offer upside as long as global growth holds up. Gold, the longest duration asset one can think of, for now is not responding to the outlook for higher rates. We still think that it will weaken, once the cumulative effects of the withdrawal of liquidity by the Fed make themselves felt.
Fixed Income Update
Last week showed us why “diversification” is essential even within single asset classes such as Fixed Income. After a frantic leg up till Tuesday, when the 10-year US Treasury yields closed at 1.87%, the highest closing level in two years, rising geopolitical tensions resulted in a pullback. The risk-off sentiment drove the yields down to 1.74%.
With the all-important FOMC meeting set to start tomorrow, the market is struggling for direction. There are various rate hike estimates, but the market is pricing in four rate hikes for the year. The consensus is that the Fed doesn’t mind some steam off the inflated asset prices. Germany’s 10-year Bund yield briefly became positive last Wednesday before returning to below zero. The negative-yielding debt in the world has nearly halved since December 2020.
This week’s movement in the yield resulted in longduration assets having the best week of the year so far. Developed Market Treasuries returned a solid +0.2% while Emerging Market Debt generated a +0.16% return last week. Spreads were broadly stable except for High Yield in line with the risk-off episode. Global High Yield spreads widened by 13 bps to return a paltry -0.39% over the week.
YTD China local currency unhedged Agg index has returned a market-leading +1.4% driven by China policy rate cuts and expectation of further easing to continue. This asset class works as a good diversifier and could cushion the blows to investor portfolios during these turbulent times.
Asia HY returned +1.7% as spread tightened by 120 bps last week due to supportive news flow regarding further policy easing directed towards the property sector. The Dy Governor of the PBOC declared that the bank would use all the available monetary policy tools not to let credit freeze across the Real Estate Sector
There are some encouraging signs of asset sales in the discussion. China Evergrande Group showed signs of progress in its restructuring and the appointment of an official from a state-owned distressed debt manager to its board. Agile Group Holdings Ltd. has agreed to sell its 26.7% stake in a Guangzhou property joint venture for 1.84 billion yuan ($291 million). Shimao Group is discussing with state-owned firm China Overseas Land & Investment to sell its stake in the Guangzhou Asian Games City project. Moreover, Country Garden was able to sell $ 500Mn of HKD denominated convertible bonds last week, indicating returning investor confidence. But as we have mentioned earlier, with $10 Bn of offshore bonds due and no signs of the public debt market opening up, the credit stress is still high, and the asset class's volatility will be high in the short term.
Global equities fell -4% last week with EM the better performer, a trend seen well into the third week of January. EM began the year with better valuations and with China now following a different monetary policy path and India not yet showing signs of tightening, have not experienced the volatility that DM have seen. The S&P 500 was down -5.7% last week and the Nasdaq - 7.5%, and though the 10-year Treasury yield is back at 1.75%, real rates rising are a concern. Both U.S. indices are trading below their 200 day moving average, a significant technical level to watch. We expect the S&P 500 will end 2022 at 4950 based on a 10% earnings growth and 21.5X Price/Earnings, however with the shift in monetary policy and post 3 years of extraordinary returns, it’s not surprising to see the current sell off. A - 5 to -10% drop once or twice a year is normal. We would however wait for Fed clarity on its rate hike path and inflation’s course, both of which impact corporate margins and are key to U.S. equity direction.
European stocks also saw a third week of decline but less so than the U.S. We are neutral European equities as we assess the impact of China trade and supply chain challenges on a export oriented economy. Geopolitical tension around Russia and Ukraine are also a concern for natural gas supply and prices. EM has seen broad gains with China, India and the GCC all positive year to date. Energy was the best performing sector last week as was the KSA, in line with the rise in oil prices.
Consumers and corporates are starting to feel the impact of inflation and logistic issues and it looks likely the Fed will tighten at an accelerated pace to fight the inflation overshoot. The major US equity indices are down only 5-10% from their highs, but expensive, unprofitable names, the more speculative parts of the equity market are down 30-50%. Equally punished are stocks which guide below expectations. Netflix disappointed on new subscribers and fell 22% on Friday. Many biotech and tech companies including Moderna which was amongst the top S&P performers last year, have lost 40% from their peak and we don’t expect a knee jerk rebound as investors will wait to see the pace of rate hikes. Earning season has 13% of S&P 500 companies that have reported with an expectation growing from an initial 22% y/y earning growth to 30%. Beats are however lower than the last few quarters. As expected, the updates and guidance have highlighted inflation worries. The big banks who were the first to report Q4 earnings spoke of higher bonuses and wage costs weighing on margins and earnings.
Not all pandemic trends kept their gains – from the 23rd March 2020 low Zoom is -7%, Peloton +15% and Teladoc -56%. These stocks had gained over 200% over a year. However some of the trends that accelerated with the pandemic such as gaming continue with Microsoft acquiring Activision Blizzard for $70 bn making it the 3rd largest gaming company in the world. Next week the trillion dollar club in big tech i.e. Microsoft, Apple and Tesla announce earnings and are expected to declare record revenue and profits. Key will be Tesla’s commentary on the supply chain. Industrials that report GE, 3M and Caterpillar and food giants McDonalds and Mondelez will be heard closely for guidance.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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Low visibility ahead, confirmed
A year of low visibility ahead
Healthy, Happy, Prosperous 2022
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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