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Chief Investment Officer's team, 27.06.2022
Risk assets in developed markets shone last week, with DM stocks up 5%, followed by REITS, while all segments of fixed income added between +0.2% and +1%. The reason? As always when all asset classes move in the same direction, it’s about central banks. If anything, their narrative hasn’t changed: ballistic tightening to fight inflation. What has evolved however is their explicit acknowledgment about recession risk. Fed chairman Powell said it would be “challenging” to avoid a downturn, but also that the war against inflation is “unconditional”. Meanwhile on the data front, a consumer inflation expectation index printed a bit lower, and so did most of flash PMIsin developed world.
This doesn’t sound like the greatest news of all times, but this was enough to trigger a holistic market relief. This illustrates the weird moment we are in: when central banks’ action dominates markets, it’s not unusual to see economic weakness support markets. In this instance however, the nuance is that bad news on growth is good news for markets if and only if it implies some easing of inflation. This duality is less straightforward, and another layer of complexity comes from regional differences. Inflation in Europe is about energy, so seeing consumer confidence there approaching a 40-year low is a concern with no positive side-effect. On the opposite end of the spectrum, China’s rebound is certainly disinflationary in the medium-term for the world, but undoubtedly energy intensive in the short run. And of course in the middle, the war keeps on raging in Ukraine.
With so many moving parts, we keep on expecting extreme volatility in the coming months. Pessimism is high, but we may be tempted to fade the rallies in case it reverses too quickly.
A growing number of analysts is conjecturing that US inflation should have peaked or should be close to. Confidence in such a prediction would be of paramount importance, as major asset classes historically have exhibited turning points when inflation inflected lower. From a macro point of view there is the expectation of a downturn in US activity, especially in consumer data, alongside a slowdown in wage growth. Retail sales posted their first drop in five months in the last release and wage growth showed some signs of softness. Also, global supply chains eventually unclogging would be helping lessen price pressures. There is concerns of an impending US recession, but these seem to be overblown as confirmed last week by the biggest hawk on the FOMC, Governor Bullard, who said that it is “a little early” to talk about recession probabilities. Overall, the direction of travel of the cycle for now is down, more bad news should come out as business confidence readings still sit comfortably in expansion territory, while central banks globally are just pushing in the opposite direction. If that is the case, inflation at some point should be capped. How fast it will come down, is an entirely different matter and harder to quantify.
Growth jitters are almost palpable in the market, with commodities on track for their first month in the red since November last year and long-dated yields pulling back fast. Copper, particularly sensitive to macroeconomic conditions, fell in bear market territory, and the high-velocity rally of the overall commodity complex to the June high matched past enduring peaks. The fall in global yields was noticeable as well, as only once in the past decade did bond yields fall faster than they did on Wednesday and Thursday, and that was right after the Fed’s March 2020 pandemic rescue. Are commodities and treasuries telling us something? Most likely that, assuming a recession will be avoided in the very near future, a sharp slowdown will be playing out. Indeed, rates came down following the underwhelming release of the flash PMIs and the US business confidence measure undershot estimates by a wide margin as well.
Once the slowdown-recession puzzle is solved in investor minds, requiring more underwhelming hard data, hence more volatility, equities should find a bottom. From this perspective last week’s equity recovery, technically driven by very low market breadth readings, alongside falling yields and a “little early” talk of recession, should again be seen as a rebound. Coming back to the main point, while equities historically tended to fall into rising inflation, they did rise after it topped out, provided no recession followed. Also, commodities on the other hand deflated, as it is the case now. In our view investors should not chase the commodity rally now entering a pause, while adding significantly to equity risk preferably on renewed weakness. Beefing up positions in high-quality bonds seems the way to go, as we have been advising for a while and in keeping with the unfolding of the slowdown phase.
Fixed Income Update
There seems to be a growing optimism in the market that H2 2022 will not be as bad for the fixed income markets as the first half. This has resulted in a risk-on mood in the markets as US Treasury yields stabilized and moved down some notches. Front-end treasury yields moved down by 7 to 10 bps last week. Traders have also brought down the rate hike expectations, with only one 75 bps rate hike expected in July and bringing down the expectations to a 50 bps hike in September. This indicated that the FED had communicated well with the markets. The FED has successfully avoided a spike in bond market volatility post the largest rate hike since 1994 that happened in the June FOMC meeting. The million-dollar question is if the series of rate hikes currently priced in would be enough to reign in inflation numbers. If investors fail to see a proportional decrease in those numbers, we will see another leg of rising bond volatility.
Credit investors breathed a sigh of relief as spreads came off their multi-year highs. Most of the FI segments were in the green. We advise investors to take such opportunities to off-load some riskier positions and decrease leverage. With more and more investors raising the specter of a recession sometime next year, we could see a blow-out in the spreads from High Yield and EM Debt. It seems to us that in the current environment, it is better to be prudent and be invested in short-duration high-quality credit than to chase yields. In the coming days, it could be a battle between “Return-on-Capital” Vs. “Return-of-Capital.”
We have seen a revival of the primary issuance market in the GCC region in line with improving market conditions. Last week, MAF issued a $500 Mn perpetual note with a coupon of 7.875% and a yield of 7.95%. The books were covered 2x, peaking at $1bn. The Federal Govt of the UAE came to the market for the first time this year to issue 10- and 30-year bonds with a total tranche size of $3bn. The books were covered 4.5x at $13.5bn, indicating strong demand for high-quality issuers from the region. This week three more issuances are lined up. First of the block is Dar Al Arkan, a regular issuer from KSA, announcing the mandate for a long 3- year $ senior Sukuk. Next was Mashreq Bank issuing a mandate for their inaugural PNC 5 $ AT1 Bonds. Lastly, QIC, the largest insurance company in the GCC by total assets and total equity, will be issuing PNC 6-year Subordinated Tier 2 $ note later this week. What is interesting to note is that most of the issuers, even the regular ones are willing to provide new issue discounts to the investors pricing the new bonds wider than the existing secondary market yield curves. This has resulted in recently issued bonds trading at a premium in the secondary market.
Last week saw a rebound in the growth sectors healthcare and technology, directly linked to the drop in government bond yields. Global equities gained close to 5%, with developed market regions emerging from bear market territory as the initial shock of accelerated central bank hikes began wearing off and the path of tightening became more defined. The US saw the S&P 500 and Nasdaq indices up by 6 to 7%, a welcome change from the last 3 months with a selloff in all weeks except one. Emerging market regions saw China and India both rally and our call on EM Asia has been timely, but with continuing lockdowns in China we wouldn’t say we are out of the woods yet. The UAE had a negative week, (we have been overweight for some time) has almost wiped out its year-to-date gains, as has the KSA. Abu Dhabi and KSA equity performance has a high correlation with oil prices, which fell 5% last week.
June to date, a 6% drop in global equity performance, even after last week’s rally. The S&P 500 has had its worst drawdown in 50 years in the first half of the year. China was the only large market gaining this month. The beaten down China new economy stocks and EV companies listed in the US are finally showing signs of a turnaround after months of falling.
Stocks showed resilience last week in the face of high inflation and the Fed, ECB, RBI and other Central banks getting more aggressive with monetary policy. Though it was broadly a positive week for markets, recession talk has picked up, which we expect will keep market volatility high. Slower economic growth implies lower demand and lower profits for firms. It’s going to be an eventful summer with a shift in earning expectations likely. However, this seems to be somewhat priced in with the 17% drop in equities year to date and with valuations for most indices below 5 to10 year averages. Equity performance historically has a 6-month lead on earnings growth variance, hence the drop in equity values is likely a precursor to a drop in earnings.
The sustainable turning point in equities will be consistent data on supply chain constraints easing and inflation coming down. Some signs of economic activity cooling, which should bring down inflation were seen as positives for the market as the University of Michigan’s index of consumer sentiment dropped in June to its lowest-ever recorded level and the PMI’s (S&P Global) viewed by investors as real-time gauges of business activity indicated that US growth decelerated in June, while eurozone economic growth was at its weakest level in 16 months. PMI data also indicated that input costs were rising at their slowest pace in five months. Also, oil and commodity prices are falling, though US housing data had median prices rising15% y/y . Good for US bank stocks was that all 34 financial institutions that participated in the Fed's annual stress test passed, enabling banks to increase dividends and buybacks.
We retain our overweight energy sector call even though oil prices fell as Brent still trades at $110/ barrel, well above break even prices. Oil producers are benefitting from high cash flows and the high dividend yield remains attractive, especially in an inflationary environment.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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