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Chief Investment Officer's team, 20.06.2022
Last week was another difficult one across asset classes, hit hard by the combination of monetary tightening and growth scares. With regards to the former, central banks are aggressive, starting with the Fed and last week’s jumbo 75 basis points hike. The forward-looking projections include another cumulative rise of 175 basis points for policy rates in 2022. While the largest inflation problem lies in the US, with a tight labor market and a consumption frenzy, no one is really immune. The ECB confirmed their decision to accelerate its rate lift-off and discussed the need for an “anti-fragmentation” instrument to counter the negative impact on sovereign bond markets. Having higher rates for everyone but indebted governments seem impossible, but for the ECB the solution is always to create a program and an acronym. It confirms anyway that they mean business. Only Japan -who tried to generate inflation for several decades- holds on and left its stance unchanged last week. Even the usually very placid Swiss National Bank surprised with a 50 bps hike and a martial communique. The war against inflation is declared, with no mercy until victory is in sight. It’s a new and very market-unfriendly iteration of the “whatever it takes”. While inflation could take months to abate, growth is already starting to soften, and markets are as always even quicker. The combination forms a downward spiral: asset-classes are all affected by stagflation fears, adding pressure to the economy through negative wealth effect and damage on corporate financials and sentiment.
So what to do? Our central scenario remains unchanged: we expect extreme volatility in the near-term, until a pause becomes credible in the global tightening. This should ultimately unlock the value we already see in asset valuations in a scenario where growth is hit but not derailed. Patience is paramount.
Here we are again with recession jitters. Powell’s message does matter, and it is resounding louder than ever, when he requires that there must be compelling evidence of falling inflation for months before ‘job done’ can be declared. But inflation is a lagging indicator, and monetary policy a blunt and backward-looking tool, so by the time Fed officials have declared themselves happy with price pressures having receded enough, recession is unavoidably going to unfold. Yet, as already clarified numerous times in this publication, however much investors can be concerned about a forthcoming contraction of the US economy, it will most likely be a late 2023 occurrence in our view, rather than a more immediate one. The business cycle is reversing towards trend, but not collapsing. US demand is cooling as per last week’s retail and inventory data, while at the same time households and corporate balance sheets are strong enough to keep the odds of a recession in the next 12 months at very low levels. It will take time before the housing market cools significantly, excess savings are depleted and fading confidence dents hiring.
So, should one buy stocks taking advantage of excess worries for something that will materialize only further down the road? After all, equities have historically topped out a few months before a plunge in the business cycle, not a couple of years in advance, hence current pricing should be good enough. We think that not all the bad news could be out yet, considering the earnings outlook. The Conference Board Measure of CEO Confidence has just suffered one of the steepest sequential drops in decades, collapsing to readings which in the past coincided with profits recessions, that is negative year-over-year bottom-line growth. And this is at odds with bottom-up analyst estimates, pointing to more than 10% YoY earnings growth in 2022. According to Yardeni Research, profitability for communication services, the consumer discretionary and staple sectors is starting to be revised down, while “the others are still flying high”.
In summary, we see the opportunity to add to risk on further volatility driven by an earnings recession. By the time that happens, quite some tightening should have been achieved by the Fed and the early-November midterm elections will have drawn close enough to have been at least partially discounted as a risk event. Bank of America Merrill Lynch strategists wrote in a recent report that history says that the next bull market is just “months away”. We are not ready to settle for that much yet, but a meaningful bottom should at least be seen in our view. Investors should use that time wisely by getting prepared with a sensible investment list, rather than panic and squint for a forthcoming contraction.
Fixed Income Update
What Fed did last week was not entirely unexpected by the market. However, the ensuing volatility post the FOMC meeting shows the state of the market. The 10-year US Treasury yields oscillated between 3.15% and 3.47% before closing the week at 3.23%. There was one major key takeaway from the FOMC meeting statement and the Q&A session. The statement removed a key sentence from the May FOMC related to appropriate monetary policy being able to bring down inflation while maintaining a solid job market. This sows doubts about the Fed’s softish landing theory. Powell mentioned that pathways to a soft landing “have become much more challenging.” This was also reflected in the Fed revising its future growth and unemployment projections. The unemployment rate was seen rising from 3.7% at end-2022 to 4.1% in 2024; growth forecasts were cut to 1.7% in 2022 and 2023, from 2.8% and 2.2% in March.
Last week was voluminous in terms of central bank actions. BOE hiked policy rates by +25bps as expected (With three dissents favoring 50bps); Swiss National Bank unexpectedly hiked by 50 bps; BOJ continued its policy divergence with global peers; kept rates unchanged & no change in YCC target of 0%.
This change in tone from the Fed has some implications across both the Rates and Credit segments. While the Fed dot plot points to a policy rate of 3.4% at the end of this year, markets price in 3.7%. Moreover, according to the market, the peak Fed rate could be 4.34% in H1 2023. If the Fed is forced to cross the 4% policy rate in the current fight against inflation, the 10-year could easily travel to 3.5%. This tussle between market expectation and Fed’s communication could drive near-term volatility. If more traders start to price higher rate hikes, we may see a further blowout in spreads across credit. This would work out negatively for longer-duration bonds even from the strongest issuers. Hence, we would advise against extending the duration risk of portfolios. The current sweet spot seems to be between 3 to 5 years.
Most credit segments currently trade around the higher range of their YTD spreads. The spread blowout has been severe for the high yield sector, with US High Yield spreads crossing 500 bps for the first time post-October 2020. This is still lower than average recession-era spreads. Similarly, Pan-European HY spreads widened by 42 bps last week, leading to a weekly loss of 1.5%, even though ECB’s emergency meeting led to compression in the sovereign yields from the peripheral Europe sovereigns. The Italy-Germany 10-year spread premium fell from the intraweek highs of 245bps to as low as 188bps by the end of the week. GCC debt has outperformed the broader EM Sovereigns by 5.3% YTD, indicating the resilience due to high oil prices.
The markets reacted adversely to Central bank tightening (though expected), persistent inflation, and higher sovereign yields though the Fed, BOE and ECB did not overly surprise with rate hikes or direction. Global equities were down 6% last week and have fallen 10% in the first half of June, taking year to date losses to 22%. A broad sell off last week, from the US -6%, with tech (usually the laggard this year) performing just a little better, Europe -4.6% and Japan -7%. Emerging markets had the UAE, India and China all trading down. China is announcing new lockdowns, but the fewest cases since February. EM equities have been the better performers as of late, with smaller drawdowns but with still largely negative weekly closes. All global sectors fell last week, with energy, the only sector in the green this year, losing 14% as demand fears and a planned windfall taxation on US oil producers (to provide incentives on fuel purchase to consumers) played on sentiment. Also, the selloff of crypto and unprofitable tech is triggering more liquidations and negative sentiment for the broader market, as well as flight to quality.
At what level and when will the equity markets settle? As central banks’ tightening starts to dampen consumer demand and supply chain issues improve with global logistics going back to pre-Covid levels, we should see equities start to perform better supported by valuations and growth metrics. The 12-month-forward P/E ratio for the S&P 500 is 15.8, below both the 5-year average (18.6) and the 10-year average (16.9). Our year-end fair values indicate upside from here, although this year it’s about often revising where growth will settle, with many opposing forces still in play. So, while we wouldn’t rush, we advocate maintaining a diversified portfolio and adding to quality companies, with steady growth and strong cash flows at serviceable leverage levels.
Whilst margins were resilient for corporates globally in Q1, this could be seen as a lagging indicator. Concerns increase about a possible recession in 2023, amid hawkish central bank monetary policy, aimed at controlling inflation with consequences on economic growth, downgraded by public and private institutions alike. The hawkish policy stance from the Fed is further tightening financial conditions with the US dollar appreciating, a rise in mortgage rates, and a drop in equity prices. The more interest-sensitive sectors of the economy, housing and manufacturing, are seeing the effect of higher interest rates. On the bright side the still-strong labor market is supporting wage income and households have just recently begun to use the “excess saving” from the pandemic stimulus.
Slowing economic growth is finally being reflected in Q2 2022 earnings growth estimates, which have been brought down for the S&P 500 from 5.9% on March 31 to 4.3%. However, according to a FactSet report despite higher inflation, rising interest rates, military conflict in Ukraine, fear of recession, and stock price declines, analysts continue to have an unusually high number of Buy ratings on stocks in the S&P 500. Of the 10,708 ratings on stocks in the S&P 500, 56.9% are Buy ratings, 37.7% are Hold ratings, and 5.4% are Sell ratings. The 5-year average percentage of Buy ratings is 53.3%.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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