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Chief Investment Officer's team, 08.08.2021
The past week saw further gains in global equities, with the MSCI World returning 1% and closing at all-time highs, and losses in longer-duration defensive assets following the strong US jobs report. Financials and materials led US stocks higher, the yield on the 10-year Treasuries note rose by more than 7bps, gold fell 2.7%, Brent crude slumped by almost 8% for the worst weekly decline since last October, and the US dollar advanced.
All eyes were on the US labor report, which came out strong across the board. The economy added more than 940,000 positions in the month of July, the most since last August and way above consensus estimates - the unemployment rate fell to 5.4%. Will the Fed be reassured that the economy is making substantial “further progress” and finally be more outspoken about pulling back stimulus? Other data-points added fuel to the fire of a solid economy, with factory orders, led by non-durable goods, above consensus and the ISM Services Index topping forecasts to print at record levels. In Europe, the final prints of the July PMIs confirmed that growth remains buoyant at the onset of Q3, as Covid-sensitive services catch up from a lower base. This was contrasted with Asian markets marked by a more uneven recovery and China in slowdown mode acting as a drag.
The constructive backdrop helps us maintain our tactical pro-cyclical stance, although we are more comfortable holding a lower equity overweight as against the first half of this year, considering that the bright outlook is priced in and yields should rise into year-end. Less supportive company guidance and rising risks of lockdowns could further cloud the horizon in Q4.
The outlook is bright and nobody can deny it, considering the momentum in the economy, the forecasts, that growth is unlikely to turn on a dime and the extended stimulus. Valuations remain expensive, but they reflect the currently strong backdrop, hence they will not be minded unless we move many steps closer to a contraction phase. So, why worry? Indeed, we should not, if we just look one year from now. If we try to gaze a bit more into the future, we might be wondering if keeping on borrowing from that future can indeed make it a bit bleaker, rather than a bit better. The developed economies at least, are putting an unenviable burden on future generations, from higher debt, to higher taxes, to inflation. In the end, that will be the name of the game, deflate the debt via inflation and make up for what is still missing by hiking taxes. We are getting a flavour of it in the new course taken in the United States by the Fed, trying to run a super-hot economy, and Joe Biden, pushed to ‘go big’ on fiscal spending. The issue is that the large developed economies are following in these same steps. Markets for now remain unconvinced about the blessings coming with the new policies radically breaking with the past, with US long-dated real yields close to all-time lows, a possible indication of stagflation, rather that both high future growth and high inflation.
Concerns along these very similar lines have been expressed by ex-Goldman Sachs billionaire, now hedgefund investor Leon Cooperman, who in a recent interview said that “the market is facing the fact that taxes are going up, interest rates are going up, and inflation is going up”. Of course, nobody knows when this is going to end, so one watches “the things that would normally indicate an end”. The remarks made by St. Louis Fed’s president Bullard last week tie in well too with this kind of narrative on the rates and inflation side. He mentioned that the post-pandemic environment could be one of stronger growth, higher productivity, but higher interest rates and faster inflation as well, advising against extending stimulus for too long. It is quite striking that both Cooperman and Bullard raised similar concerns from very different angles. According to Cooperman “Mr. Powell will be surprised by inflation”, while for Bullard asset purchases should be trimmed soon and policy rates raised if inflation threatens to remain at higher levels.
On our side, we hold the view that the fading of the liquidity impulse in the second half of next year, alongside the starting of tapering and possibly the not so temporary inflation dynamics would all be playing against equities. But, to put it in Powell’s terms, this is still “a ways off”,so we will monitor this and keep a close watch on “the things that would normally indicate an end”.
Fixed Income Update
The past week delivered the message of a still strong global economy, led by the developed markets, where the United States and Europe are ahead of the pack amongst the major countries. Fed officials have acknowledged this in that they have become more outspoken about the partial removal of stimulus via the tapering of asset purchases. The strong labor market is playing a relevant role in guiding the Fed’s assessment of the US economy, and the latest jobs report reinforces the conviction that the deadline for the implementation of the winding down of the bond-buying programs can no longer be put back. Treasury yields promptly responded to the prospect of a more solid outlook and the yield on the 10-year note rose by almost 8bps to settle at 1.3%. Having had many false starts one may wonder why this time bonds should not continue to rise, as they have since March this year. A straightforward answer is that, unless business confidence, for instance as gauged by the Purchasing Manager Index, is soon going to slump in the low 50s, the current level of rates is not compatible with the outlook. US growth is projected to be above 6% in 2021 and still above trend throughout 2022 and inflation could prove to be less transitory than the Fed’s narrative would have us believe. Public figures from Blackrock’s Larry Fink, to JPMorgan’s Jamie Dimon and the ex US Treasury Secretary Larry Summers have clearly said that price pressures could be persistent even after the easing of today’s bottlenecks. We stick with our 2021 fair value of 1.75% for the 10-year Treasury yield, which we recently revised higher.
With EM sovereign spreads at the wides of the year and the US dollar stronger, entry points on EM debt seem to be more appealing now. In our view this holds for sovereigns, but not on local debt yet. The US dollar should strengthen further into year-end, on growing expectations for tapering and the solid US outlook, hence EM local bonds do not seem as a whole a good proposition yet. The tactical views expressed in our latest fixed income report ‘Income generation in Emerging Markets’, where we expressed preference for EM hard currency bonds and corporate debt, are still very much current. Asia high-yield credit has suffered some losses recently on spill-over effects from the regulatory offensive in China. Although a tail risk, the credit market could become a transmission channel for financial contagion, if losses in China credit continue, affecting the region and eventually forcing sell-offs in US HY corporate credit, which has some of the richest valuations recorded both in its history and versus peers. We believe that more short-term pain is in store for Asia High Yield investors, though eventually weakness should prove to be a buying opportunity.
A good jobs report out of the US gave a further boost to the S&P 500 and good earnings data added to European equity gains last week. Europe and US equities have had an uninterrupted trajectory of gains this year and indices are at record highs, total returns +19% for SPX and +15% for Europe YTD. According to FactSet, nearly 90% of S&P 500 companies have reported Q2 results. Blended earnings growth stands at nearly 90%, exceeding expectations by 17%. Blended revenue growth rate is just under 25%. Positive guidance from many companies and as yet no impact of the supply chain disruptions with S&P 500 profit margins at a record 12.1%. Reopening momentum, capital return boosts and fairly sanguine commentary about spread of Delta variant are keeping US equities at records. EPS levels for the S&P 500 for 2021 are on track to be 30% above the prepandemic levels of 2019. Similarly, Q2 earnings are +150% y/y for Europe for Q2 supportive of our stronger DM overweight.
The US market reaction on Friday was in line with good job numbers: the 10 year yield rose, gold fell, S&P 500 up slightly, Nasdaq down as tech (growth) is now inversely related to yields. Cyclical sectors outperformed growth, with Financials the best performers. Cyclical sectors are leading year to date sector performance i.e. Energy in line with higher oil prices as mobility numbers tick up and financials as they are a barometer for economic growth. Technology performance is however not far behind. We think markets will continue to rotate between growth and cyclical factors, from digital COVID winners to reopening trades. The Fed is focused on employment numbers, hence markets are in a Goldilocks regime – exceedingly positive job growth could see a hawkish Fed and an underwhelming one indicate dovishness and that lower rates continue. However, the current spread of the COVID variant favours the Fed continuing its accommodative policy which is good for corporate profits and hence equity performance.
The outstanding performer is the UAE with another up week, with total year to date returns for the Abu Dhabi Index +53% and the Dubai Index +17%. India equities in line with global equity performance are up 16% year to date. India has also recently seen a sentiment boost to foreign investment, with the reversed $ 1 bn tax charge for Cairn energy UK, and Amazon winning its ruling against Reliance Industries takeover of the Future Group’s assets..
Emerging market equities have however lagged, pulled down by China underperformance. China is 40% of the MSCI EM Index. The gap between EM and DM performance is now 15% and China tech now lags US tech performance by 30%. 5 companies Alibaba, Tencent, JD.com, Meituan, Pinduoduo make up one third of MSCI China and each has been a subject of China’s tech crackdown and lost roughly 30 to 40% from peak. We went nt neutral EM Asia last month just before the China regulation crackdown on for profit education and gaming. This was post the Ant Group IPO withdrawal and fine on Alibaba as signs were emerging that hitherto unaffected sectors could see some angst. Also, we advise no specific China bet in portfolios just a broad allocation to EM equities as per asset allocation profile guidelines.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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