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Chief Investment Officer's team, 18.04.2022
A longer than expected conflict in Ukraine only amplifies the trends pointing to slowing growth and rising inflation. While the economy is so far resilient, especially in the US, Western central banks have all confirmed their intentions to reduce their extraordinary support at an accelerated pace, combining hikes in interest rates with action on their balance-sheets.
We have thus officially changed our central scenario for 2022 and our year-end fair values, to reflect this new reality. While the backdrop is undoubtedly challenging, the good news is that valuations are improving in several asset classes, and that investors’ sentiment has turned pessimistic which is not adverse for the medium term. We have also made changes to our tactical positioning. We have further reduced our underweight in the safest segments of fixed income: we added to government bonds in our Cautious and Moderate profiles, and to investment grade credit in the Aggressive. The current level of yields is close to our new fair value and a large underweight is not justified anymore. This was funded by a combination of cash, now slightly underweight, and stocks: we have reduced our overweight to DM stocks to +1%, with a preference for the US. We have also cut EM stocks to neutral. Their valuations are compelling but we lack a catalyst to unlock this value. Some recovery in DM stocks is probably a precondition. We keep on favoring alternatives: we hold a modest overweight on all three components, hedge funds, real estate and gold.
The near-term should remain extremely volatile, driven by developments in Ukraine as well as by economic data and central banks’ action. However, we see upside potential into the end of the year. Stay safe.
Apprehensions about steadily rising inflation across the globe were reinforced by the CPI release in the United States at a forty-year high last week. An 8.5% print is something most investors have never seen or have long forgotten, and this tells us a lot about the regime change underway, whereby the growth-inflation tradeoff is expected to remain more unfavorable in the longer term versus the past decade. Call it a commodity super cycle, a push towards a green economy creating demand for materials via commodity-intensive investments, with the current conflict only exacerbating preexisting trends, in the end price pressures are much more persistent than anybody could think of. The Fed is reacting strongly to this new state of affairs and going for a very steep tightening cycle, and yields have skyrocketed. It is hard to resist the tendency to extrapolate and not think that we could have more of the same for the rest of 2022. But with inflation projected to peak soon and the economy on a slowdown path, looking in the rear-view mirror to get the future direction of yields might not be the best strategy.
Actually, US core inflation printed a whiff below consensus in March, and from the current release base comparisons will become more favourable, as price pressures started to accelerate one year ago. Mechanically future readings should come down, although there is high uncertainty about how fast. At the same time, noise about recession concerns is only getting louder. We do not subscribe to that kind of noise, though in any case the direction of travel for the US economy should be towards deceleration, not acceleration in the current year. Hence, we can only come to the conclusion that longer-dated yields should not be far from topping out. We would need to see some more evidence of moderating price pressures and not-so-strong macro releases for yields to start stabilizing. All of this should take some time to come to pass, but the odds support that yields in the second half should be somewhat lower versus H1 2022.
In turn, as the economy slows down but remains resilient and momentum in yields becomes a tailwind, volatility in risk assets should be coming down. There is still one big known unknown, and that is the effect of Quantitative Tightening, the shrinking of the Fed’s balance sheet. The previous precedent, in 2018, when Powell announced in December that the balance-sheet wind-down was on autopilot, did not end well for markets, which crashed and then rallied only when the Fed backtracked. QT lasted for about two years, from 2017 to 2019, so its shock waves to markets were not immediate, but this time the monthly QT run-rate is twice as high and multiples make equities more vulnerable. So, although the bulk of the movement in yields should be behind us, the starting of QT planned for next month may well keep us on high alert.
Fixed Income Update
When we had predicted our fair values for different segments and the 10-year US yields year-end 2022 at the beginning of this year, the market was pricing in four rate hikes by the Fed and QT to begin sometime in the second half of the year. The terminal rate priced in was less than 2%. Since then, inflation has been rampant, and the Fed's rhetoric to fight inflation has only increased. The hawkish pivot in March led to the change in the terminal rate projections to slightly above 3% and a possibility of additional nine rate hikes in the remaining six FOMC meetings through the end of the year. Moreover, there are changes in the economic growth projections and the shape of the yield curve. This is a change in the scenario for us and has led us to review our year-end fair values in our April Tactical Asset Allocation Committee meeting.
Our fair value for the year-end 10-year UST yield has been revised to 2.8% to reflect the new scenario, and we believe there is an upside risk to the target in the interim. We think we're at peak hawkishness and have reduced our underweight allocation to DM Treasuries; as a result, to lock in the attractive yields. Investment Grade debt has the longest duration among the different segments we track. The spreads had widened to cross 130 and have come back to the 110s. With two levels of monetary tightening to proceed, we anticipate spreads will not go back below 100. Therefore, we have revised our YE spread estimates upwards to 100-125 bps. We maintain our underweight on the asset class due to its long-duration nature.
We also anticipate similar widening trends for Emerging Market Debt and High Yield Debt. High Yield debt spreads could widen as refinancing costs increase, leading to more defaults as we are currently at peak credit quality. EM Debt spreads will widen as we see more stress in the frontier and commodity importing countries. Our new FV estimates for HY and EM Debt stand at 425 bps to 475 bps and 275 bps to 325 bps, respectively. We are neutral on High Yield and Overweight on EM Debt.
GCC Debt continues to benefit from the favorable sentiment towards commodity exporters. The current spreads are slightly below our current FV estimates. With oil prices expected to remain strong, we revise our spreads estimates to 100-150 bps. This is the only segment where we expect the year-end spreads to be tighter than the start of the year levels. However, we believe that most of the return in this asset class will be delivered from carry rather than spread changes.
Equities sold off last week, between 1 – 2% across most regions, with tech a little worse off. Dubai and KSA s were among the few with a positive week. DEWA’s successful listing and pop on trading cites well for future issuance. High dividend payers remain attractive in an inflationary regime. Barring commodity heavy regions/ sectors i.e. the GCC/ LATAM/U.K./energy/material or domestically focused economies i.e. India, all other equity indices are negative year to date.
In our latest asset allocation committee meeting we retained our equity overweigh on DM equities, but lowered it, and took EM to neutral to reflect slowing growth, rising inflation, amplified by the war in Ukraine, and accelerated tightening from Western central banks. We adjusted our year-end fair values for key equity indices. We still see some upside potential from current levels for the end of the year. We have lowered earnings growth estimates for all regions except the US, as it is less exposed to the Ukraine conflict and the GCC, which is supported by higher oil prices. Inflation and higher rates are expected to affect margins. We have reduced valuation multiples (P/E) except for the GCC. Within DM we prefer the US and the UK, in EM the UAE and India. Valuations are starting to be more reasonable, although more appealing in EM where we still see a lack of catalysts for near term performance. Amongst sectors we like energy, financial, healthcare and select technology subsectors.
We remain neutral Asian equities as China is 30% of the EM Index. China’s GDP rose 4.8% y/y in Q1 compared to 4% in Q4 21. Still below the govt. 5.5% target for 2022. Retail sales for March fell by 3.5% y/y, the first contraction since March ’20, as many cities remain in lockdown. India is better positioned as eco growth has not been revised down which should reflect in strong EPS growth for 2022.
Inflation is leading the market narrative. U.S. consumer prices and producer prices are at 40-year highs. War, inflation, higher oil and gas prices, supply chain disruptions, the virus and monetary tightening are increasing uncertainty for markets. The Fed remains hawkish as it looks to embark on the steepest hiking cycle since the ‘90s. Financial firms in the S&P 500 have led the Q1 earnings, with 10 out of 11 banks beating estimates, but growth lower from the fallout of the Russia Ukraine conflict. Consumer discretionary (Tesla) and communication services (Netflix) earnings are in focus this week. Elon Musk is in the headlines after controversial comments about the SEC in his recent TED talk. Meanwhile, Twitter has adopted the poison pill to shield it from hostile acquisition bids.
Many U.S. companies are raising prices to offset higher costs, as the S&P 500 is projected to report revenue growth above 10% for Q1, double that of earnings growth. “Inflation” on earnings calls is a trend continuing into Q1 this year. Higher costs are having a negative impact on net profit margins. As per FactSet, the S&P 500 consensus net profit margin for Q1 is at 12.1%, lower than Q4 ’21, though estimates are higher for the following quarters.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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Navigating in low visibility
Economy slows down and conflict rages on
Heated by the sunshine of a vibrant recovery, the magic liquidity is evaporating, and turning into fog for investors. While growth remains robust, markets may not be ready for the new uncertainties around central banks, inflation and interest rates, to name a few. We are getting prepared to navigate tactically, in a year of ‘low visibility ahead’.Know More
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