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Chief Investment Officer's team, 14.03.2022
With an intensifying conflict as a backdrop, last week saw a sea of red across all asset classes, with gold’s modest rise the only exception. In the absence of material progress on the crisis itself, markets are increasingly pricing-in a double shock: a high inflation, through surging commodity prices, and slower growth. Both could combine to form an economic nightmare in the form of stagflation, where damaged purchasing power would lead to falling consumption, depressed sentiment, and ultimately weakening employment and tightening financial conditions.
This could actually happen, and the clear willingness of Europe to materially and quickly reduce its dependency upon natural gas from Russia increases the probability of such a scenario. But we are not there yet. First, as Omicron wave faded, underlying growth remains sound in most of the world. Second, Western consumers had built up excess savings during the pandemic which should help cushion the inflation shock. We will have a clearer picture later this week with US retail sales. Finally, policymakers could act to limit the economic damage from higher prices through fiscal measures.
The Fed will meet and probably start hiking interest rates this week, but also hopefully provide more details on their forecast, intentions, and how the conflict impacts their decisions. Downward revisions to growth and more inflation should not leave them as hawkish as they were in December.
Volatility should remain extreme and the short term as unpredictable as ever in the coming weeks. We keep on thinking that all parties have strong incentives to end the conflict sooner rather than later, and that medium term expected returns are positive. Stay safe.
Let’s face it: the crisis in Ukraine will slow growth and push inflation higher on a global scale. The key questions are of course about the magnitude of the dual shock, as well as about its duration. The worst-case scenario is stagflation, where sustainably higher inflation would trigger a chain reaction for consumers, investments, and financial conditions. This is obviously a headache for central banks: while higher inflation would require counter-measures, tightening monetary policies would fragilize further an already challenged economic outlook.
It is also a headache for asset allocators, especially as it annihilates the usual diversification benefits between defensive and cyclical assets. 2022 year-to-date returns are unfortunately quite an illustration. Global stocks are down close to -12%, understandably hit by growth concerns and rising risk aversion. The fixed income asset class provided no shelter, in a context of surging inflation. With the US 10-year Treasury yield rising from 1.5% at the end of 2021 to 2.04% as we write, government bonds of developed markets are down by almost -5%. There is thus no way corporate bonds could do well, and their return is between stocks and govies, around -8% for both investment grade and high yield indices. There is indeed nowhere to hide. Cash is obviously resilient, but it doesn’t provide any upside potential. Gold is up, but it is highly sensitive to geopolitical developments and there is a limit to the weight one can reasonably allocate to it.
No surprise then, the performance of our three profiles is deeply negative year-to-date, with respectively -6.3%, -7.3% and -8.4%. Stagflation risk has begun to be priced-in, but not an actual worst-case scenario combining economic recession with sustained inflation.
We do not think it’s likely. The current drivers of inflation are linked to two consecutive but still extraordinary crises: the pandemic, which disrupted supply chains in front of an unleashed pent-up demand, and the war in Ukraine, which propels commodity prices and sets additional roadblocks to global trade. Under the pessimistic scenario of a prolonged conflict triggering a downward economic spiral, a collapsing demand would both limit inflation pressure and lower long-term growth prospects. In this case, interest rates would fall, and safe bonds would do well, which is why we reduced our underweight on this segment earlier in February when the US 10-year already reached 2.04%.
Under our current base case scenario of de-escalation in weeks, global growth would be dented, but not derailed. Cyclical assets should benefit from risk appetite and sound fundamentals – which is also why we reconstituted an overweight on DM stocks close to current levels in late February. In any cases, even if commodity prices may be higher for longer, we tend to think that there is a limit to where long-term interest rates can rise. The medium-term picture is not that bad.
Fixed Income Update
Arguably the most crucial week for the fixed income investors starts in the background of a geopolitical conflict that has overshadowed all other fundamental and technical factors. The bond volatility has been staggering, with the MOVE Index touching a high of 140 in the first week of March. The FED rate-hike of 25 bps in March is priced into the US Treasury yield curve as we write. More importantly, the markets will look at clearer guidance about the balance sheet normalization and future rate hikes. The FED will start the rate hike with the flattest yield curve ever before, a rate hike. The 2s10s part of the curve was only 27 bps 7-days before the actual hike, which is expected to be announced on 16th March. Thus the central bank has a tricky balancing act to follow not to spook investors and the economy, which might lead to a hard landing it has been trying to avoid.
The segment returns across the asset class have been a sea of red YTD. The only major asset class that is positive YTD is the China local currency Investment Grade Debt, which has generated a +1.3% return. Last week, the worst impacted asset classes were the long-duration ones except for Emerging Market Sovereign Debt. We had written about dispersions among segments in our last weekly highlighting oversold territories in Pan-European HY Vs. US HY and Emerging Market sovereign Vs. Emerging Market Corporate. Pan-European HY returned -0.1% against -1% by the US HY last week, validating our preference. Similarly, Emerging Market Sovereign debt provided +0.3% return compared to -2.7% by Emerging Market Corporate last week.
We continue to prefer EM Sovereigns over their corporate counterparts primarily for three reasons. Firstly, the sovereign index has lower weightage to Russia and Ukraine than the corporate counterpart and has more weightage to commodity exporters. Hence, a lot of the recent drawdown has been sentiment-driven. Secondly, the index OAS spreads have been higher only twice in the last 20 years, during 2008 and March 2020. Whenever spreads have crossed 400 bps, the next 12 months have generated positive total returns for the investors. Lastly, Even though the asset class has a higher duration of 8.5, with 10-year treasury yields trading at 2.03%, any further loss from the upward movement of the yields remains limited for the year.
It has been another bad week for Asia High Yield as the asset class has lost more than 7% since the start of this month. We want to reiterate our stance that this is not a time to “Buy the dip.” There is no sign of home sales stabilizing, with February pre-sales of top 100 developers down 47% YoY. We anticipate more volatility due to the high refinancing volume that should see an uptick in bond exchanges and negative earnings surprise by the developers in the coming weeks. Even though we anticipate more policy easing indicated by the sound bites from the chairman of CBIRC in early March, the road to recovery will be slower than previously expected.
Broad risk off sentiment, with a 5th week of decline for global equities. The fallout from the Russian invasion of Ukraine continues with the humanitarian toll rising in spite of increasing economic and financial sanctions on Russia. An escalating global shortage in essential agricultural and metals is adding to already high inflation with commodities from nickel to wheat at record highs. US February inflation numbers at 7.9% y/y CPI increase are at a 40 year high. The Fed looks set to proceed with an interest rate hike this month, and the 10 year US Treasury is back above 2% adding to tech sector woes. ECB President Christine Lagarde stated risks to the economic outlook have increased substantially due to the impact of the war in Ukraine. 2022 inflation forecast 5.1% from 3.2%. Inflation expectations in Asian economies as most are oil importers are rising.
We continue to see extreme market movements, the result of rising yields and margin worries. Global equities are -12% YTD with EM and DM in synch. The only positive markets YTD are commodity exporters i.e., the GCC and LATAM. US equities are faring better than Europe but in correction territory with the S&P 500 hovering around 4200. The geopolitical crisis has upset a very resilient growth backdrop with record strong labour markets, retreating COVID lockdowns and an improving China policy stance. Near-term, the Ukrainian War creates a risk-off scenario. However, as long as economic growth remains positive earnings growth should follow and while estimates are being revised down for Europe and other oil importing regions they still indicate above trend growth.
We remain overweight equities, we had added to DM equities recently, we already had a small overweight to EM equities. The selloff has indices now at valuations between 5 and 10 year averages. On the granular level we have added to US equities and lowered Europe ex UK to Underweight. Within EM we took India to neutral as it is an oil importer and added to UAE equities. Expect continued volatility with energy and many essential metal supplies still in flux. The duration and outcome of the war is still uncertain.
A rout in China tech stocks with the Golden Dragon Index which represents China companies listed in the US, down 43% Ytd (18% last week). The US SEC reiterated that Chinese companies will be forced to delist from the NYSE and Nasdaq if the US accounting oversight board is unable to inspect their audit records for three years. Beijing has blocked domestic companies from complying with such requests from foreign regulators. This puts in risk over $2tn Chinese listings in the US. Also impacting tech companies is the lockdown in Shenzhen, China home to some of China’s biggest tech businesses and also a manufacturing base for many Western tech companies. Apple supplier Foxconn halted operations at its Shenzhen sites. Just last week Apple introduced 5G versions of its low-end iPhone SE and iPad Air tablet, and a redesigned Mac desktop.
Coca-Cola, PayPal, Pepsi, McDonald’s, Starbucks are among companies that suspend Russia operations. Shell will stop new purchases of Russian oil. Amazon's cloud-computing unit will stop accepting new customers in Russia and Belarus.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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