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Chief Investment Officer's team, 13.06.2022
Last week was tumultuous for all asset classes with only gold and energy up. Developed markets from Europe to the US fell over 5%, reacting to a combination of a higher than expected CPI print from the US and ECB President Lagarde defining a date for the start of the tightening cycle and the conclusion of asset repurchases. A regime change as the ECB is raising rates for the first time in 11 years. Global growth downgrades continue as the World Bank cut its growth forecast to 2.9%. Emerging market equities did better down just 0.5% last week as green shoots appear around China economic activity recovering though lockdowns continue but less severe. The global tech sector continues to see a fall out with the 10-year Treasury yield up at 3.16% and the gap with the 2 year narrowing and the curve flattening.
Broadly a risk off sentiment as expected this summer, till markets fully absorb the higher rates and inflation shows signs of abating, possible once the Russia Ukraine conflict deescalates and the China factories resume full activity. A heavy week with the Fed meeting in the US and the BOE and SNB in Europe.
The Asset Allocation Committee decided to reposition our EM exposure from bonds to stocks. With China’s reopening as a catalyst, we have added ~1% to EM stocks, taking them to a slight overweight from neutral, funded by a reduction in EM debt, from overweight to ~neutral. Also increased the weighting of EM Asia within the EM portfolio. As always this is not a call to go “all in” but aims at improving medium-term expected return within a risk-controlled, diversified portfolio.
It is a stagflationary environment for now, or at least the best proxy to it that we have seen since the equity secular bear market of the 70s, when the oil crisis hit the developed economies as the OPEC countries steeply raised crude prices. Now of course it is not about OPEC, but rather the rush to build green societies, underinvestments in the old economy and deglobalisation that constitute structural factors exerting upward pressures on commodities. The global monetary cycle is unequivocally in tightening mode, with all the major central banks with the exception of the PBOC frontloading rate hikes to quell inflation, hence wilfully exerting downward pressure on growth. And there we have it, business cycle down and price pressures up, stagflation.
In the 70s the S&P 500 traded in line with business confidence, as measured by the ISM Manufacturing Index, the latter being range bound by construction, so the former was range-bound as well and there was no bull market, but rather broad equity swings up and down in line with the progression of the economy, the whole process lasting about 20 years at the time. Fast-forward to today and the direction of travel of manufacturing confidence is down for the next few months, as suggested by the difference between the New Orders and Inventories components, that is currently headed downwards and tends to lead the manufacturing headline index by three months. We had the view that equities could have a more sustainable rebound being investor sentiment already quite depressed, but for now our hopes are dashed, so the opportunity to de-risk portfolios at more favorable levels is not there. In such a hostile environment investors should be defensive and focus on high-dividend and low-volatility stocks. The S&P 500 High Dividend has YTD outperformed any other S&P flavor of the day, including of course the S&P 500 Growth that ranks last, not the investment style one wants to be in until visibility on future earnings is higher.
As stagflation takes root and catches the attention of the most distracted or unacquainted investors, there should be the opportunity to buy gold and gold stocks. But for a fully-fledged bull market to develop in precious metals we should be past the tightening cycle. Gold does not like rising yields, being a non-yielding asset. Real yields are still rising, so we see gold reaching the upper-end of the range, $1,950-$2,000, due to the stagflation scare, and maybe that is it for now.
There should not be lot of residual upside left in yields, so we would rather take some duration risk than credit risk, even though non-receding inflation will dent returns. It is a matter of picking the lesser evil till markets stabilize, rather than aiming for a positive level of returns.
As much as central banks gave in 2020 and 2021, now they are taking back. Unfortunately, it will be a slow process causing market turmoil and low visibility, where investors will have to allocate capital with an eye to downside risk.
Fixed Income Update
When investors were getting comfortable with duration, the May inflation data from the US came as a rude jolt. Higher than expected inflation numbers dealt a blow to the notion that inflation had peaked. As a result, markets priced in more rate hikes by the FED, with the FED fund rate expected to cross 3% in November this year itself after four back-to-back 50 bps rate hikes in the future FOMC meetings. The markets are still not pricing a 75-bps rate hike even though many analysts across banks think that to be likely. If the FED does a 75 bps rate hike in this week’s FOMC meeting, that would come as a shock and could result in another leg down in the riskier Fixed Income segments. The Euro-Dollar future remains inverted. The sell-off in the bonds accelerated as a result. As we write, the 10-year US Treasury yield has breached the previous high of this year and trades around 3.22%. The UST yield curve has inverted again as the 2 and 3 years moved up by more than 50 bps while the 10-year has increased by close to 30 bps.
Even European Govvies were not immune to the sell-off, with traders now wagering on two half-point hikes by October. As a result, Germany’s two-year government debt yield rose above 1% for the first time in more than a decade. Last week, the ECB had indicated its intention to raise interest rates by a quarter-point next month and suggested another half-point hike was possible in September, which would be the biggest move since 2000.
Again, the different segments were a sea of red with spreads widening significantly in the High Yield space. US High Yield was the worst affected, with yields widening by 32 bps last week. That resulted in US High Yield returning -2.1% getting the dubious distinction of being one of the worst-performing segments. The long-duration segments such as EM Sovereign and Investment Grade Corps also generated more than 1.5% weekly losses. Among this carnage, GCC Debt performed a little better, despite its longer duration as spreads remained range-bound. Apart from the strong oil prices playing a role, supply-side technical support for the segment as sovereign issuance could come down by 40%-50% this year due to the large fiscal surplus generated across the region.
Lastly, in the latest June Tactical Asset Allocation Committee, we decided to cut our long-standing overweight on EM Debt to Neutral as we don’t see any opportunity for alpha generation. Even though EM Debt has performed well in the past rate hike cycles, with growth expected to go down and USD to remain strong, EM Debt could come under further pressure. Therefore, we would play EM Debt selectively as we like certain pockets, including Asia IG, GCC HY, and Champion bank subordinated debt. We also believe the Sukuk segment to be rather expensive and would only invest there if there are no alternatives.
Equity market volatility continued with another strong US inflation print and upcoming monetary policy tightening in Europe. In the US, the S&P 500 finished down –5% and in Europe, markets reacted to the prospect of steady ECB rate hikes, with equities falling 6%. Thursday and Friday’ were particularly brutal for markets. Friday saw global stocks fall 1.6% taking the weekly drop to 4.5%. Emerging market equities did better down just 0.5% last week with China up and India and the UAE down. The global tech sector fared worse than the broader market as yields rose and the US Dollar was stronger. The energy sector continues to outperform as Brent oil remains firmly above $120/bbl with OPEC+ not able to meet the supply gap fully.
We kept our small overweight on DM equities at our recent Asset Allocation committee and a preference for the US and UK. We added slightly to EM equities which have a small overweight now. We also added a small overweight to EM Asia as we think these domestic economies are better positioned to weather global supply chain disruptions. We retained our UAE overweight.
A very good week for China equities, as the China lockdowns and the tech crackdown eased, the equity market rebounded. Another key driver of the up mood was policy tailwinds with incentives and subsidies to sectors hit by lockdowns, while the Central Bank’s looser monetary stance contrasts with aggressive tightening in most parts of the world. The MSCI China bucked last week’s global rout to end the week up 6%. Not completely out of the woods and expect hiccups with lockdowns not over but green shoots as the tech sector is no longer getting a dressing down. The Ant Group IPO revival is still unconfirmed, but the Didi probe looks like it’s ending. Game approvals have resumed after a year.
Global growth downgrades continue but not reflected so much in earning downgrades for corporates. Stocks have fallen this year in the face of rising interest rates with inflation in most regions above 6%. Surveys indicate that consumers are continuing to list inflation as their number one concern and consumer confidence is weakening. Two-thirds of consumers plan to reduce spending over the next 6 months because of inflation, with planned cuts coming from discretionary categories.
Inflation is showing no signs of cooling with the EM region more affected by food costs, Europe by high energy prices and the US corporates talking of the impact of supply chain and the impact on profits. Corporate earnings have seen little revision downwards though the S&P 500 has fallen 19% from its peak, as the Fed increases rates to bring down four-decade-high inflation. Whilst valuations ate now reasonable at 17X forward earnings, profit growth remains the key pillar for the market to regain its footing. Investors are jittery as companies from Target to Microsoft have warned that their profits will be lower. The US has been quicker to taking its supply chain more domestic and the next leg of equity direction will be dictated by Q2 earnings and guidance.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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