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Chief Investment Officer's team, 06.06.2022
Last week provided a broad update on the global economy with monthly leading indicators (ISM and PMIs) as well as inflation and employment gauges. The picture was unambiguous: with regards to activity, the West is doing fine, with all leading indicators firmly in expansion territory, meeting or beating forecast from the consensus. Looking East, China keeps on struggling with the Omicron wave, however, the May manufacturing PMI got closer to the expansion zone at 49.6. Employment is strong, with a multi-decade low in the Eurozone unemployment rate. In the US, the labor market continues to be tight, with a record low in layoffs and 390k new jobs being added in May. This was less than in April but still 70k more than the median expectation. Finally, but importantly, inflation is still very much with us. The Euro area flash CPI increased 8.1% year-on-year and as we write, the price of Brent crude oil is above $120 again, despite the OPEC+ approving a higher hike in production.
This combination carries a clear message for central banks: they can, and have to, continue to tighten financial conditions by hiking interest rates. This explains why last week was negative for almost all asset classes, the only exception being stocks from emerging markets which benefitted from good news on China’s COVID front. This may be important: China’s economy is so far underperforming the rest of the world, but stock valuations are very attractive and the authorities have the power to stimulate activity with many levers if they decide to. This is one of the topics we will discuss in our upcoming tactical asset allocation committee. For the time being, we remain slightly underweight fixed income, with the intention to add if interest rates materially overshoot, and modestly overweight DM stocks and alternatives. Stay safe.
Gauging where markets stand can now be particularly difficult, even as we avail our customary framework based on macros, valuations and sentiment. The economy is slowing down, but still resilient, and strong in particular in the United States, valuations are more or less back to longer-term averages and investor sentiment is depressed. This would make for a promising picture for risk assets, which usually rally against a healthy economic backdrop and the prevailing pessimism of market participants. Not so fast, reality is more complex than this. We hold the view that the unfolding equity rally has room to run, but for the time being we see it as a powerful rebound sooner or later meeting the challenges of a relentlessly global tightening cycle - the easing in China remains an exception – leading to a deteriorating economic outlook. Basically, we reiterate once more that not all the bad news is out, so for the time being our assessment is that markets are range-bound at best.
As for the rebound, market internals are improving a lot. Conditions are technically oversold, positioning is quite bearish and now we have the added boon that since equities have started to inflect higher up-volume has been much stronger than down-volume, pointing to the lasting power of the rally. As for the economy, developed markets are proving to be extremely resilient and the US is in incredibly good shape, as evidenced for instance by the latest manufacturing confidence reading. Yet, this is not what the Fed quite wants, and therein lies the rub. In his usually prescient Bloomberg column Bill Dudley, ex New York Fed Governor, has recently observed that ‘financial conditions are the means by which higher short-term rates work to slow economic growth’, meaning in plain English that the slowdown is achieved by pushing markets lower and the dollar higher alongside policy rates. But he unequivocally adds that ‘the Fed’s job is far from complete’, that investors ‘underestimate the level of short-term rates’ necessary to bring inflation back to target, and that the ‘risks of a hard landing’ are ‘understated’. What is even worse, is that, should financial conditions start to ease again, meaning in plain English that the economy would still be resilient and markets would continue to rebound, Fed officials would have to push policy rates ‘higher than currently anticipated’. Could one spell it more clearly? Any strong equity rebound is on borrowed time, as it would be undoing the tightening the Fed is aiming to achieve. Not only this, consider that as the Fed keeps on pushing until price pressures are contained, earnings are very likely to be materially hit as the economy slows in line with Powell’s goals. So far price-to-earnings ratios have contracted due to the numerator coming down, but what about the denominator? For how long will earnings be left unscathed?
As markets rally, investors should reposition portfolios with a bias towards defensive equities and higher-quality bonds. Rebounding equities are welcomed by investors, but maybe not that long by the Fed, so de-risking would be wiser than the chasing of returns in markets that should be range-bound until the monetary cycle is more advanced.
Fixed Income Update
QT started pretty quietly last week amid volatility in various asset classes dominating the news headlines. We might see slight bearish trends in the treasuries this month after the volatile, yet ultimately positive month of May for the asset class with +0.2% returns. The US Treasury curve bear flattened last week post the robust US Jobs data. The front-end yields rose by 10-15 bps, driven by higher expectations of an aggressive Fed to reign in the wage growth spiral. The markets now price in a 43 bps hike for the September FOMC meeting. This follows lots of industry big wigs who sounded cautionary alarms on the future state of the economy.
While a disastrous scenario is not our base case, we would still advise fixed-income investors to be cautious and cut risks whenever there are relief rallies. It pays to err on caution and stay invested in the high-quality credits. Within High Yield, we prefer the BB segment, as mentioned in our last weekly. We like Asian IG debt and GCC High Yield within the emerging market. Overall, duration recommendation is to be slightly shorter than the average duration of asset classes.
After an all-green performance the previous week, last week saw a more subdued performance from various segments of the asset class. Only Pan-European HY and Asian HY generated positive weekly returns. All the long-duration asset classes suffered, posting -0.6% to -1% returns. Apart from the preferences mentioned above, we continue to see value in the subordinated debt of top financial institutions and believe in locking in 6%+ yields for a duration of 3-4 years. A typical portfolio to tide over the oncoming storm should have the following ingredients: a pinch of floating rate exposure, a large dose of Treasuries and IG credit from developed markets, a dash of subordinated debt, short-duration high quality developed market HY credit, and selective EM Hard currency bonds.
According to the latest GS publication, flows into global fixed income funds turned positive for the first time in nine weeks and only the second time since early January (+$1bn vs. -$7bn the prior week). Demand rebounded notably for HY credit products, and the pace of net inflows into IG credit funds increased. Meanwhile, net inflows into government-only products slowed. EM fixed income products saw continued net selling, especially in the local currency space. The S&P default monitor had ominous warnings last week about emerging markets. By region, emerging markets are the only region where defaults are higher than comparable 2021 levels, with eleven defaults out of the total 31 defaults. The global corporate default tally for year-to-date 2022 is the lowest since 2014. This is in line with our advice to be very selective in Emerging Markets.
A better week for emerging markets with most regions up from the UAE to China and India. UAE markets had recently seen a pullback, but gains in banks and real estate stocks led to both the Dubai and Abu Dhabi Indexes ending the week positively. China equities were up as Beijing and Shanghai eased Covid-19 restrictions. Developed markets had a down week, except Japan. Equity markets have had a challenging 5 months with economic growth outlooks downgraded and whilst earning outlooks have not seen the same downgrades in absolute numbers, expectations are rising that corporates will feel the impact of tightening, slower consumption and higher input costs on profit margins. Hence, while valuations are at 5-to-10-year median ranges, investors are wary as they look out to the E of the P/E getting lower. The first quarter earnings releases beat estimates and margins have been resilient, but the twin shocks of the non-abating Ukraine-Russia conflict and of China lockdowns, which are being eased, weighed down on investor sentiment alongside the Central Bank tightening cycle.
The question on everyone’s minds is at what level to buy the market? What is the probability and timing of a recession? We have seen doom and gloom predictions from major investment houses from meteorological comparisons on stormy weather for the economy to dire predictions on index levels with reference to previous bear markets. However, while previous cycles provide valuable insights, no two market environments are identical. We still have record savings and low unemployment in the developed markets, a springback of consumption in emerging consumer economies such as India and a number of policy measures announced in China to support the corporate sector and stimulate growth. Enterprises are returning to full capacity production and port backlogs are better. Inflation globally, which has been stronger than wage growth and expected to affect disposable income, could fall in H2 as supply metrics improve.
Rather than focus on technical market levels, in these very volatile markets we maintain our year-end fair values till the summer sheds more light on supply chain and inflation data, and highlight investment opportunities that currently look attractive. Valuations are key in a higher rate regime, hence corporates with valuations below global averages and strong balance sheets with growing earnings (to ensure cash flows remain strong) and reasonable leverage would be the outperformers. The energy sector meets these criteria as do the UK and UAE. The common theme besides low valuations is the commodity underlay. We also recommend keeping the US as the underpinning of equity allocation which is 58% of the ACWI Index composition. The US equity market with its bias towards growth has fallen 13% this year with the tech sector (40% of the S&P 500 incl communication services) -23%. Yes, we could see more downside, but this historically has been the market with resilient returns over a century and with growing dividends and buybacks and the strong investment cycle will drive equity returns into the future. On the EM front we like India as the longer term strategy but it’s time to start adding to broader China as the reopening should lead to a rebound.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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A swing of the pendulum
Winds of change
Fear, Uncertainty and Doubt
Slowing, tightening, falling
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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