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Chief Investment Officer's team, 14.02.2022
Last week was another highly volatile one, with riskaversion rising in response to higher inflation numbers everywhere in the West. US CPI for January increased +7.5% year on year, above the median forecast. Some factors are temporary, but the tension is serious and broadbased. The consequence is of course an earlier than expected adjustment of central bank policies, importantly not only in the US. China remains an exception, while India and Japan stick to their accommodative stance. But the West has only one direction: quantitative tightening and rate hikes.
No surprise then that most asset classes were in the red last week, especially in developed markets. Exceptions were gold, benefitting from geopolitical tensions, and stocks from emerging markets, which were closed while Wall Street losses accelerated on Friday. Government bonds were ambiguous: on one hand, they are directly affected by inflation and monetary policies, but on the other, they are a safe haven when risk aversion rises. This is why interest rates were lower on Friday – the US 10-year Treasury yield stabilized at 1.93%.
What is not ambiguous, by contrast, are two facts. First, the Q1 earnings season is great, with double digit sales and earnings growth everywhere and a health proportion of beats versus expectations. Second, the omicron wave is fading almost everywhere, except in Singapore, Korea and China. As a result, equity multiples are more reasonable, while growth should be supported in Q2. Faster growth may be a double edged sword at a time when markets focus on inflation and central banks, but it is fundamentally good news. Our relatively neutral positioning is ready to put more cash at work on a significant correction or if interest rates reach irresistible levels for the long-run. Stay safe.
Although the end-result of the US-Russia confrontation on Ukraine is still unknown, what is becoming increasingly clear is that Biden’s warnings to Putin about the disastrous consequences of a Ukraine invasion are falling on a deaf ear. Unfortunately, as warnings increase, so do the odds of a conflict. The consequences of an invasion would not only be affecting the reputation of the West, incapable of stopping a conflict in its backyard it had been warning about for months, but also heighten inflationary pressures. Should Russia be hit with harsh sanctions and decide to curtail gas exports to Europe, the current energy crisis in the common area would turn into a catastrophe, with prices spiking even higher and reverberating globally as well. Ukraine is also a major food exporter to the EU, which would only be compounding inflationary pressures in case of a war in Ukraine. Although oil and gold prices have been rising in response to the latest developments, there is little appetite for the harshest sanctions. Europe is unlikely to be eager to antagonise Russia by indefinitely delaying the regulatory approvals of the Nord Stream 2 pipeline system connecting Russia and Germany for the delivery of gas; and excluding Russia from the SWITF bank payment system would be hampering the business of Western companies engaged with Russian counter-parties as well. This explains why we would tend to see crude and gold spikes triggered by an open conflict relatively short-lived.
The strength of crude prices has less to do with geopolitical conflicts, than with a strong post-pandemic demand combined with under-investments in the energy sector capping oil supply at the worst of times. While the resilience of gold prices can be put down to investors not expecting much tightening from the Fed. At least bond markets have this expectation, judging from the extreme flatness of the US treasury yield curve, pointing to a more severe slowdown than what anticipated by the consensus of economists. Unfortunately, we expected the outlook for severe tightening to weigh on gold, but it seems now obvious that gold investors are not so much minding Powell’s words, which we did when we set the $1,700/oz price target, as the signal of a significant slowdown from the flattening yield curve.
Equities, on the other hand, remain vulnerable to whatever tightening is yet to come from the Fed. Powell will be forced to squeeze corporate margins by tackling private demand, as high margins mean pricing power and the ability to pass inflation on to consumers, exactly what tightening wants to stop. Even in the absence of aggressive policy, almost record-low unemployment forebodes falling margins to come, if history is any guide, as companies must bow down to rising labor costs, while inflation tends to cause a contraction of stock multiples, which won’t allow for any offset in this respect. After all, even resilient margins during the pandemic were a byproduct of policy stimulus, which is why the US has seen them grow more than in other countries. Either way, it seems to be a lose-lose situation for stocks, at least until a sufficiently negative wealth effect will have curbed inflation.
Fixed Income Update
Last week showed us why our investment outlook for the year is titled “Low Visibility Ahead.” The US Treasury yields crossed 2% for the first time since July 2019 when FED did an about-turn of its 2016-2018 rate hikes and started cutting rates to stimulate growth and jumpstart the economy. The current situation could not be more different from July 2019. The yields increased as a result of the US Inflation surprise to the upside. However, as the geopolitical risks centered around Ukraine rose on Friday, we saw treasuries do a leg back to close the week at 1.94%. As the 10-year treasury yields approach 2% and political risks increase, it is time for investors to rethink their strategy.
We would advise adding more safe-haven assets to the portfolio at the current stage. Investors could also look at extending the duration of their portfolios as the Treasury yields remain around 2%. However, it is essential to note that the longer duration should come from stronger credits rather than the typical beta addition. We especially like Developed market sovereigns for duration exposure. Investment Grade Debt is another source of duration, but with uncertainty around the corner, it behaves more like a spread product. Chinese Government Treasuries (CGBs) are another excellent addition to the portfolios to gain duration without increasing credit risk significantly. Chinese Local currency IG Debt is the best performing asset class this year, and investors should look at it. Floating Rate Notes are another welcome addition to the portfolios. This is a tactical idea till the rate-hikes stop. This segment is flat YTD compared to a drop of - 3% to -4% across other Fixed Income segments
The key areas where investors should avoid adding duration are spread products such as High Yield or Emerging Market Debt. High Yield spreads have widened significantly from their tightest levels since the start of the year. The HY spreads face a double whammy of uncertainty on the monetary tightening and political risks front. We would advise investors to cut their High Yield exposure to below 15% of their overall Fixed Income holdings depending on their risk appetite. An ideal holding for a moderate-risk client should be around 10% of their FI holding. While Emerging Market spreads have been more stable, adding duration in this space would be risky due to the uncertain outlook.
Regarding getting yields for the portfolios, we would like investors to add High Yield sovereigns from the commodity exporter countries. GCC HY oil exporters would be a case in point. The credit spreads of these countries should be stable even during the current political upheaval due to the resilient outlook on oil prices. The primary issuance market has taken a back seat as expected during such turbulence. Year-to-date, we haven’t had any sizeable sovereign issuance from the region. The HY countries such as Oman are turning to the syndicated loan market to tide over such periods where the borrowing cost in the public markets is uncertain.
Last week, equities ended with steep declines as the U.S. warned that Russia could take offensive military action against Ukraine. The S&P 500 fell 1.9% and the Nasdaq dropped more than 3% on Friday, with both benchmarks capping the biggest two-day slides since 2020.
Overall, 72% of the companies in the S&P 500 have reported actual results for Q4 2021 to date. Of these companies, 77% have reported actual EPS above estimates. These above-average growth rates are due to a combination of higher earnings in 2021 and an easier comparison to weaker earnings in 2020, due to the negative impact of COVID-19 on a number of industries.
Stocks are vulnerable to more downside after a biggerthan-expected inflation figure. They remain overbought relative to bonds, while rising consumer prices point to a thinning of margins and a further contraction of PE ratios. U.S. CPI exceeded expectations on Thursday, with the headline measure posting 7.5% YoY (the highest since 1982) against an expected 7.3%.
For European energy stocks, the prospect of higher oil prices, strong earnings and shareholder returns may yet make the sector one of this year’s best performers. Crude oil is trading above $90 a barrel with talk of $100. Global consumption continues to rise and the IEA said an OPEC+ supply shortfall may push prices higher. The price of European energy stocks has lagged crude gains, suggesting there is possibly some catch-up to be expected. Shell posted the biggest annual share-price gain in five years and energy stocks are trailing strong relative earnings. Shell and BP have also boosted share buybacks. Five oil supermajors just generated the highest free cash flow since the start of 2008, when oil first climbed above $100. Plus, spending is much lower, so there’s more money to return to investors. European energy’s 12-month forward dividend yield is c.416%, compared to the Stoxx 600 at 3.15%
Disappointing quarterly reports from Netflix and Meta leave both stocks trading more than 40% below their one-year peaks. For the past few years, many have thought of the tech giants together as a single trade - buy them when you are bullish on risk and growth, sell when you are bearish. The recent decoupling of Meta’s performance from Apple’s and Amazon is a reminder that companies have their own particular issues. Meta’s future prospects rely on the success of its new Metaverse initiative, as well as overcoming competition from Tiktok. Speaking of the future of the Metaverse, Tencent is well positioned to emerge as a leader, as the metaverse develops over the next decade, fueled by its deep expertise in online games and real-time 3D development. Near-term opportunities to increase sales stem from proto-metaverse gaming experiences and virtual concerts, an $800 billion addressable market globally. Longer-term, we expect Tencent to remain a dominant force in China, though overseas opportunities remain murkier amid lingering geopolitical challenges. The regulatory backdrop seems to be stabilizing, as The Cyberspace Administration of China (CAC) engaged companies like Tencent Holdings, Alibaba Group Holding and Tiktok parent ByteDance to discuss a healthy and sustainable development.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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A volatile transition
Low visibility ahead, confirmed
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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