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Chief Investment Officer's team, 21.03.2022
No doubt, the action of central banks is as difficult as ever, in a world where growth slows and inflation rises, with the war in Ukraine amplifying both trends and adding uncertainty. The Fed however took a clear stance last week. The central bank delivered its first quarter-point hike in interest rates, which was widely telegraphed. More importantly, while acknowledging slower growth and higher inflation ahead, the Fed expressed confidence in the resilience of the US economy. They thus guided for a total of 7 rate hikes in 2022 and 3 to 4 more to come in 2023. They are confident that the most aggressive policy change in decades should not derail growth and unemployment.
Markets loved it. Stocks gained +6% in developed markets and +3.5% in emerging regions, the latter being boosted by China’s authorities expressing a clear support for growth and financial markets, including technology and real estate. Gold and government bonds were logically underperformers, but didn’t panic. The Fed’s confidence is welcome, but their guidance is seen as a maximum rather than as an irrevocable path.
A good week, coming after a very negative one, doesn’t mean the end of volatility. The war is a major uncertainty, and while we hope for de-escalation in the coming weeks, visibility remains extremely low. Bottom-line, we think that central banks will remain flexible in case the war, or any other adverse event such as a resurgence of covid, would hit the outlook and financial stability. On the latter, the fact that Russia found a way to avoid defaulting on US-dollar denominated bonds was also taken as a positive. In any cases, raising interest rates without impacting the economic outlook remains an ambitious challenge to say the least. Stay safe.
One could have hardly thought of a harsher transition in 2022, from a market-friendly to an unfriendly Fed, from above-trend growth to talk of recession, from peace to war. The consequence of war is a less benign growth-inflation trade-off, in line with the CIO-Office expectation expressed in the 2022 Outlook publication that this decade would be increasingly dominated by scarcity, hence rising commodity prices. Talk of recession is the logical concern about the macroeconomic impact of a stagflationary-leaning scenario. Stagflation is in turn further pushing central banks to hike rates, so that they preserve their credibility about their mandates and price pressures do not spiral out of control. All of this does not add up, at first sight: how can one reconcile the willingness to tighten policy with the contemplated prospect for a recession? We cut to the chase by saying that we do not expect a forthcoming recession in the United States, though odds for one in Europe have risen substantially in the shorter-term, being the euro area more exposed to the negative consequences of the Russia-Ukraine conflict. And even in North America, probabilistic models now ascribe a higher than 50% probability to the event three years out. The missing elements for a US recession now are private-sector precarious balance sheets and overly tight Fed policy, even taking into account the planned hikes. Yes, renowned investor Bill Gross expressed the view that a policy rate above 2.5 or 3% would break the economy, but the Fed is planning to get there only at the end of 2023, when the median projection for the Fed funds rate sits at 2.8%, hence the possibility of an economic contraction in 2024, but presumably not very much earlier.
What is less favorable for a prompt financial market recovery is that we are running straight into a massive Fed’s tightening aimed at containing inflation, compounded by an existing conflict fanning its flames. Maybe investors were inspired by Powell’s words last week, about an exceptionally strong labor market, giving the impression that equities can go through any degree of withdrawal of stimulus unscathed from the recent lows. Maybe that view is somewhat complacent. Powell is bent on defending the Central Bank credibility, so he will have to tighten financial conditions substantially even from the current levels, as they are nowhere near being very tight, for instance as per the Goldman Sachs Financial Conditions Index. Two components of the index are equity valuations and credit spreads. So, there is the possibility that equity multiples temporarily fall below average levels and credit spreads widen further, in order to accommodate the forthcoming removal of liquidity.
Yes, we remain reasonably constructive for the year, which should deliver buying opportunities, though on further weakness. While even the most growth enthusiasts may now be accepting the idea that value stocks are back, many pockets of the technology sector reached quite oversold territory and should offer growth at reasonable price, quite a rarity only some months ago.
Fixed Income Update
It finally happened. The Fed increased the policy rate by 25 bps last week. This is the first rate hike since December 2018. The dot plots indicated a more hawkish path for the rates with seven rate hikes in 2022 and the terminal rate around 2.75%, which is higher than the neutral rate of 2.4%. If the Fed does achieve 2.75%, it would be restrictive for the overall economy. Post the rate hike decision, the 10-year and 30-year yields decreased by 3-4 bps, highlighting lower future growth and inflation expectations. The 5s10s part of the curve inverted for some time before turning flat. As we write, there is less than one bps difference in this part of the curve. We believe the Fed will face many challenges to follow with the rate hike path indicated by the dot plots given the current turbulent background. However, they will remain flexible and should be guided by incoming data.
It was a positive week for credit in general. The credit spreads tightened across segments generating a mini-rally. EM Sovereign was the top asset class with a +1.6% weekly return, as mentioned in our previous publications. Spreads across High Yield and Emerging Market Debt compressed by 25 and 30 bps, respectively. US High Yield slightly outperformed Pan-European High Yield last week as we had diverging messages coming from the conflict zone.
Asia High Yield continues to be under pressure. Despite the proclamation by top officials for support to the beleaguered sectors of Tech and Real Estate, we haven’t seen a significant uptick in the high yield developer bonds. The Bloomberg Barclays index spreads came down by 100 bps. We did see a rally in the bonds of the BBB-rated issuers such as Country Garden and Sino-Ocean. We would still wait before advising to add to the broader asset class as we expect more negative surprises from the developers as they start announcing their FY 21 results. Selectively adding to strong players is critical.
We have seen a much welcome uptick in the primary issuance space from the region. Last week Turkey issued a $2bn 5-year senior bond with a coupon of 8.6%. Mubadala, rated AA by all the three big rating agencies, has announced a dual-tranche dollar bond issuance with the 5 and 10 years IPTs around 3.33% and 3.68%, respectively. This is 50 bps wider than the underlying curve and should compress by 25 bps to final pricing. Govt of Sharjah has announced a mandate for selling 8-year senior dollar Sukuk. It is one of the few investment-grade sukuks from the region and should garner good investor interest.
A very good week for markets: in the U.S., the S&P 500 rose +6.2% and the Nasdaq +8%. The Fed gave direction to its tightening path and the markets liked the predictability of the rate cycle. Tech stocks rose in spite of the 10-year yield going up and the battered Ark Innovation ETF, Roku (streaming) and Teladoc (remote health monitoring), Covid winners which had gone back to trading at pre Covid levels, gained in the double digits. EM lagged DM gains, however China markets saw a turning point. The MSCI China was up +5% with US-listed Chinese companies, the Golden Dragon Index +26%. There was hope on resolution of the Ukraine Russia talks, though nothing materialized and inflation numbers remain at 40 year highs. Palladium, wheat, sunflower oil and fertilizer shortages with Ukraine and Russia key suppliers are adding to inflation already boosted by oil at over $100/ barrel. Staple food, i.e milk and bread prices, are up in many parts of the world. The need to build shorter, diversified, and de-globalized supply chains, a result of the pandemic and geopolitical risks, is going to lead to prolonged inflationary pressure. Whilst last week was spectacular for most markets, downgrades to global growth and earnings growth are in progress, with European growth estimates the most impacted.
Our positioning into year-end is constructive but return expectations more muted and we expect the volatility to persist near term. We wouldn’t chase the current rally but add at dips. Preference remains for the U.S. in developed markets and the UAE/ GCC in emerging markets. The GCC markets are leading in 2022 with higher energy prices benefiting growth and also from the substantial broadening with quality IPOs, the most recent “DEWA”, Dubai’s utility provider. Their diversification efforts in tourism and infrastructure investment are paying off. On sector preference, renewed investment in traditional and energy efficient assets should continue to buoy energy and commodity producers amid shortages as the Russia-Ukraine crisis keeps oil and industrial metal prices high. Rising rates should support the financials sector performance, along with upward earnings revisions and still low valuations.
Amid a maelstrom of Zero Covid policy with the lockdown of tech hub Shenzen and China ADR delisting risk, China’s top financial policy committee led by its Vice Premier plans to “actively introduce policies that benefit markets”. This comes after a sell-off in China listed US shares, the NASDAQ Golden Dragon China Index which at the beginning of last week was down 70% from a year ago, traded up 32% on Wednesday (led by Alibaba, JD.com and Tencent) as investors were reassured that the crackdown on internet companies was going to end and that a disorderly collapse in the property market would be avoided. China’s banking regulator said they would support insurance companies for increasing investment in stock markets. Though valuations are compelling, we retain our neutral EM Asia positioning, maintaining a market neutral weight for China.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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Going overweight equity
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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