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Chief Investment Officer's team, 16.05.2021
Elevated valuations and more importantly an unanimously bullish positioning generate vulnerability to any adverse news. This has been our permanent behavioral warning and one of the key reasons why we hold cash in our otherwise pro-cyclical positioning.
This vulnerability became apparent last week. The US Consumer Price Index came out much higher than expected, at +0.8% month on month in April. In addition, US employment and retail sales were disappointing, while disruptions in oil supply and semiconductors also fuelled investors’ anxiety. Stocks were down over the week despite some rebound on Friday, gold was up, and interest rates were steady, stretched between inflation pressure on one hand and some moderation in growth on the other.
Our take is unchanged: we are seeing the impact of speculation and optimism rather than a fundamental change. It is interesting to note that the most affected segments have been the most popular, from Bitcoin to SPACs and including clean energy stocks. We keep on believing that inflation should moderate later this year, and welcome the signs of normalization in depressed prices in services. As long as growth is accelerating as quickly, actually faster, than inflation, our scenario remains constructive for risk assets, especially as we do not forecast any change in central banks’ policies.
Flight turbulence is uncomfortable but it isn’t going to crash the plane. We have fastened our seatbelts by keeping a significant position in cash and gold, our preferred defensive assets, along with an unambiguous overweight in stocks versus bonds. If anything, we are getting ready to increase our exposure on a more material correction. Stay safe.
Although markets were taken aback by the degree of last week’s inflation surprise, with earnings and the economy recovering even faster there should be no issues regarding the solidity of the current bull market. Also, the releases following Wednesday’s inflation report were underwhelming, a case in point of bad news being actually good news pointing to bond yields remaining capped. Equities as well as yield-sensitive assets, from the euro to EM FX and Sovereigns and gold, are likely to benefit from a sort of Goldilocks scenario where the economy is in full swing but US rates are not disruptive. It seems that for US real yields to go past the highs recorded in March either a prolonged stretch of impressive growth in the United States is required, or the Fed should start to provide clear indications about the winding down of Quantitative Easing. With expansion rates set to peak in this quarter and Fed officials likely to keep quiet until the late-August Jackson Hole Symposium, Goldilocks should stick around for a bit longer, much to investor delight. Equity market breadth measures have continued to make new highs, in spite of the recent stock gyrations, an indication that the major indices should be headed for record levels. The case for the value-versus-growth equity styles could become less clear-cut, with economic momentum peaking, and growth stocks should also enjoy some respite.
Volatility in US rates has subsided and bond investors could become too complacent about their future direction of travel. The ex FOMC vice-chair Bill Dudley wrote last week in his Bloomberg column that the “days of low Treasury yields are numbered” and foresees long-dated yields twice as high as today. We would observe that this is a reflection of the fact that higher inflation has become a policy choice and a goal to be consistently pursued by central banks. It is not a matter of demographics or productivity which define the macroeconomic setting and are slow-moving variables, but rather of the effects of combined fiscal and monetary stimulus. Bill Dudley’s argument is strikingly simple and effective and based on the longer-run target level of the Fed policy rate, currently at 2.5%, and the so-called term-premium, the compensation bond investors want for future inflation, say 0.5%. One just sums the two numbers to get to a back-of-the-envelope value for the expected 10-year yield of 3%. This is not a surprise for us, being exactly in line with our longer-run estimate based on the growth of US nominal GDP. The point is that this is a conservative projection, not taking into account that the Fed wants at least 2% inflation for some time and that federal debt financing will be a persistent issue in the future. Both would require a higher premium, so eventually even higher yields.
Although the great economist John Maynard Keynes wrote, in a very different context, that “In the long-run we are all dead”, bond investors, usually committed for longer time horizons, should be mindful that the Treasury bull market which started in the 80s could be now over, as implied by Bill Dudley’s analysis.
Fixed Income Update
The volatility in the markets last week has two clear implications for fixed income investors. Firstly, the rates market requires additional catalysts to inflation numbers to break out from the current range. Despite the inflation print beating estimates last Wednesday, the 10-year yields moved up by seven bps and retraced most of the movement by the end of the week closing at 1.63%. We believe employment numbers could be that long-awaited catalyst before the yields have another leg up. However, investors should remember that the yields would retain a bias towards moving higher from the current levels. Secondly, the asset class proves its worth as a diversification tool in portfolios. The drawdown in the asset class has been muted compared to the movements in the equity markets repeating the trends observed in Q4 last year. We believe this change is structural and should persist in the medium term.
Most of the sub-sectors ended slightly negative last week. Emerging Market Local currency and Developed Market Sovereigns were the worst affected with returns of -0.5% and -0.4%, respectively. On the other hand, Asia HY, GCC debt, and EM Corporate were left relatively unscathed by the market volatility. While Emerging Markets have underperformed High Yield this year, we believe the asset class should be part of fixed-income investors' portfolios. With a lack of immediate catalysts to send yields higher, the asset class has got some tailwinds. Mudding the waters is the growth differential between EM and DM which has never been this negative for such long periods since the 90s. With IMF's Special Drawing Rights expected to come into effect in August this year, the EM Sovereign credit risks should be well supported. EM Corporate has low duration and maintains its status as a low beta play this year.
Fixed Income fund flows cooled down to + $7 Bn last week. Both HY and IG funds recorded outflows, while Govt bond funds and short duration funds recorded the highest inflows in the previous three weeks. Emerging Market local currency funds saw the highest inflow of more than $1 Bn for the first time since Jan 2021.
MENA bonds went through a volatile week. Credits moved sideways till the CPI print on Wednesday post, which the credits sold off -1 to -1.5%. There was a swift reversal observed towards the end of the week, with Egypt outperforming other HY sovereigns. Overall, the belly of the curve topped the longer duration last week. Primary markets should see a return of deals in May and June before the summer lull settles in. We expect Financials and GREs to lead the issuance.
The bumper equity performance post the March ‘20 pandemic driven sell off, was driven initially by plentiful liquidity with central bank largesse in play, then by a recovery in economic and corporate earnings growth with businesses and services reopening. The current volatility with possible pullbacks is nothing to be wary of, as that is a norm and provides opportunities. Since the March 23rd low, global equity total returns are 86% and technology 96%. Markets are at elevated levels with higher than average valuations, we are seeing cost inputs and inflation worries causing a sectoral and value vs growth rotation, though not much effect at the broader Index level with many indices in the developed markets, trading near records. We still see inflation as transitionary in line with the Feds views and as long as US 10-year yields are below 2%, we would maintain our equity overweight. Even if the 2% is crossed, the reason for the rise is more important than just a spike in yields. Corporate earnings are the biggest catalyst for further upside with EPS growth for Q1 surprising by over 20%, in both the US and Europe. Earnings growth is at +50% y/y in the US and at +42% y/y in Europe, indicative of strong consumer demand but also inflationary pressures. The percentage of companies beating EPS estimates is the highest in the last decade. Cyclicals i.e. Discretionary and Financials earnings have staged a strong rebound, while Defensives have lagged. Revenue growth of +10% y/y in the US and +5% y/y in Europe mitigates the pressure on profit margins from any cost input increases.
Global equities fell 1.5% last week, with EM down 3%. Though DM equities fell only 1.3%, US equities were in the headlights with a sharp selloff till mid-week followed by a snappy recovery, with the S&P 500 losing just over a percent for the week. Commodity costs and labour shortages driven by a resurgence in demand, led to consumer prices at a 13-year high in April. Prices rose from second hand cars to hotel-room rates. The worry is that a rise in input costs will erode profit margins and a sharp rise in consumer-price inflation could have the Fed relook at monetary policy tightening. Sectoral performance for the US and globally was in line with inflation worries and consumer discretionary fell the most along with high growth tech, with financials and staples the only sectors positive. This was reflected with the Nasdaq and the S&P 500 growth index now down for the 4th consecutive week and tech seeing outflows for the first time this year. Global equities are still seeing strong inflows, with the US continuing to receive the major share. We remain overweight equities and in the near term DM equities should maintain their outperformance as the US and Europe are faster to open up and longer term EM equities performance will accelerate as consumer demand rebounds.
On the EM front starting with the UAE which has the ADX Index at +28% and Dubai Index at +11% ytd gains, valuations are low with the former at 16X and the latter at 11X forward earning multiples, we expect further upside. This is supported by oil prices well over $60 and close to budget breakeven for the UAE. China equities the largest weight in EM, are still falling on tech regulatory and now credit tightening issues. India had a down week but the virus cases are finally slowing.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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