Entering a perilous fourth quarter

A tough week concluded a tough month and quarter with all asset classes in the red except cash

AT A GLANCE

• A tough week concluded a tough month and quarter with all asset classes in the red except cash
• Disruptions everywhere: UK policy, Europe energy crisis, and even higher than expected US inflation
• We enter Q4 with a slightly defensive positioning, but some technical rebound cannot be ruled out

Last week was brutal for financial markets, yet again. Apart from cash, and gold up 1%, all asset classes were in the red between -2% to -3%. September and Q3 2022 were among the worst ever times for market returns. Bad news hit everywhere: major turbulence in the UK gilt markets forced the Bank of England to intervene by expanding its balance-sheet. The Nord Stream pipeline between Russia and Europe was sabotaged, with both parties blaming the other. On the inflation front, preliminary data showed that Euro area CPI reached +10% year on year in September, while in the US, the core PCE, one of the Fed’s preferred measure of inflation, came out stronger than forecast on Friday at +4.9% year on year. News from companies didn’t provide comfort, with a series of cautious comments from many major companies, from Apple to Goldman Sachs or Tesla. Despite all these scary global headlines however, our regional markets kept on outperforming, helped by attractive IPOs as well as by the first weekly gain for oil prices in 5 weeks, as OPEC+ could decide a large production cut next Wednesday.

Uncertainty is extreme but the good news is that there is no denial anymore from both market participants, unanimously pessimistic, and from market valuations, which are now clearly discounting more trouble ahead. We are obviously concerned by the current situation, which has led us to decrease our allocations to some risk assets in order to increase our positions in US government bonds. Our positioning is however more neutral than outright bearish: the worst is never certain, many indicators highlight the possibility of a technical rebound, and if we have a clear inflation problem, at least the US economy remains robust for now. We will hold our October TAA Committee this week. Stay safe.

Cross-asset Update

There is lights and shades at the same time in the market outlook. On the one hand inflation, although sticky, seems to be topping out and markets are quite oversold. On the other, the effects of the Fed’s tightening have yet to translate into a fully-fledged slowdown and impact earnings estimates. To put it less nicely, famed investor Stanley Druckenmiller a few days ago said that he “would be stunned” if there was no recession in 2023 as a result of Fed’s tightening. Also, the US dollar will be curbing earnings and economic growth rates as well sometime down the road. So, one has to distinguish between some shorter-term positives and medium-term negatives yet to unfold. Overall, cyclical rallies will provide much needed relief, but are unlikely to be sustainable in view of the mentioned drags.

One of those tactical rallies seems to be round the corner, judging from very oversold equity market conditions as measured by market breadth, and the hint of panic indicated by the inverted VIX curve last week. Some studies also report of some insider buying, executed by people in the know operating in that business, in cyclical sectors like technology, industrials, financials and consumer discretionaries. Stanley Druckenmiller mentioned a recession in 2023, but with no imminent hard landing in 2022 a -24% YTD in the S&P 500 seems to make for an appealing short-term entry point. Of course, one must allow for further high single-digit downside potential as the US benchmark broke below its June lows on Friday. An October bottom would also be in line with seasonal patterns, which usually see a market low before the mid-term elections to be held in early November. So, tactically, times could be ripe to skew portfolios away from a defensively biased allocation.

For more durable rallies one should wait for a Fed pivot, that is either a stop or a pause in the rate hikes. Inverted yield curves, going as far back as the early 60s, in the past always coincided with a peak in the Fed funds rate followed by policy easing. And, if policy was eased too early, hikes resumed and the yield curve inverted again to point to the subsequent stop in the hiking cycle. Today some relevant yield curves have been in negative territory for months, suggesting the Fed could stop tightening in H1-23. This would be already expected by some investors, and the big unknown is whether by that time core inflation will have fallen below the Fed funds rate to warrant a ‘mission accomplished’ claim by the Fed. If by middle 2023 core inflation is still above 4.5%, more or less the maximum level to be reached by Fed funds rates as per current expectations, then J. Powell is likely to push rates in the direction of 5%, or above, to definitely crush price pressures.

Amidst such crosscurrents, buy and hold does not seem to be a tenable investment strategy anymore. Some ability to time the cyclical rallies will be important indeed to enhance portfolio returns.

Fixed Income Update

September could go down in history as the month where fixed income investors abandoned all hopes for an early pivot as they came to terms with the new hawkish central bank regime. Last Friday inflicted more pain on the markets as PCE, which the Federal Reserve uses for its inflation target, rose 0.3% from a month earlier, topping estimates. From a year ago, the gauge was up 6.2%, also higher than forecast and well above the central bank's 2% goal. Core PCE that excludes food and Energy was up 4.9% for August. Both marked acceleration in inflation from a month earlier and exceeded economists' expectations. The US Treasury yield curve bear flattened as the front-end rallied, with the 2 and 3-year yields up by more than 75 bps in September while the 10 and 30-year yields went up by 57 and 41 bps, respectively. The US Govt security liquidity conditions are as poor as in March 2020. Outflows from US HY exchange-traded funds touched $6.4bn for the month, which suggests investors are avoiding the high-yield market, even with the average yield on low-rated corporate bonds surging above 9.5%.

Primary issuance plunged by almost 77% from 2021 levels as YTD bond sales in the US HY bond market touched $87bn, the lowest since 2008. This would start to haunt issuers as refinancing rates climb, and around $400bn bonds come due by the end-2024. According to BofA analysts, credit stress jumped to a critical zone last week beyond which credit market dysfunction starts. Last week banks had to pull a $4bn leveraged buyout financing, and cash spreads widened to the highest levels seen since March 2020. Wider spreads coupled with high UST yields could result in HY borrowers having to pay in low double digits to borrow from the markets, which would deteriorate the credit indicators. The average price for floating rate loans dropped to about 92 cents as the pain spread to different corners of the credit market. Six US-based borrowers tracked by S&P Global Ratings defaulted in August, as signs mount that higher rates are already taking a toll on stretched borrowers' ability to keep issuing new debt to pay off old. Nevertheless, the HY spreads are still sanguine and currently trade 30 bps lower than their widest levels of the year, and we expect the spreads to continue widen further.

Even the high-quality bonds were not spared the market rout. US investment-grade bond funds suffered their third-largest cash exit on record. Investors yanked $10.3 billion out of US high-grade bond funds in the week ended Sept. 28, according to Refinitiv. The benchmark US high-grade bond index is down more than 4.5% in September, the worst total return since April. Currency hedging costs wipe out the advantage of high yields for most non-US money managers. High-grade corporate issuers have only sold about half as much debt as expected in September with soaring borrowing costs, and strategists expect that lag in supply to continue into October. Average high-grade spreads rose to 161 basis points last week, just two basis shy of the widest level this year.

Equity Update

Inflation, supply chain issues, rising rates, European energy shortages and a strong USD, resulted in global stocks ending the week down -2.5%, the month –10% and the quarter -7%. Overall, Developed markets stocks have lost 25% YTD while Emerging Market stocks -27%. The only positive regions are the GCC- i.e. the UAE and KSA and LATAM (commodity exporters). In Q3, US equities fared a little better than most other regions down 5%, the Nasdaq surprisingly down only 4%. However, the S&P 500 had the worst monthly performance in September since the March 2020 sell off, with the Index down 9.2% and at 3586, is trading at a one year forward Price/ Earnings of 14.8X, the lower valuation now in line with rising rates. A strong derating from 1st Jan, when the S&P 500 was at a 21X one year forward earnings multiple. A challenging quarter was anticipated and an even more difficult month, but with an ever-exacerbating conflict and adverse macro conditions, the market downtrend exceeded expectations. A flight to quality and defensives, with healthcare the best performing sector in September. The energy sector continues its YTD outperformance even with falling prices for Brent ($128 in Feb vs. $88 in Sep), as cash flows remain robust and the high dividend policy a positive. If OPEC+ confirms an output cut this week, oil prices should benefit. Strong dividends remains one of our preferred strategies this year.

The Fed remains determined to curb inflation, with PCE data last week not improving. On the ground level, industry giants such as Apple and Meta have been signaling more hardships down the line: employment concerns in the case of Meta, and iPhone production cuts in the case of Apple, which could have repercussions across other industries. Supply chain issues continue, with Tesla's worldwide deliveries missing forecasts, and it warned of challenges in getting its cars to customers. According to FactSet, analysts cut Q3 S&P 500 EPS estimates, the largest in more than two years, with consensus at earnings growth 2.9%/ revenue growth 8.7%/ net profit margin 12.2% and for CY 2022, earnings growth of 7.4% and revenue growth of 10.7%. For CY 2023, earnings growth of 7.9% and revenue growth of 4.4%, looks a bit too upbeat with economic growth projections on the down trend.

UK policymakers are pursuing an unconventional combination of fiscal loosening and monetary tightening with energy price caps and tax cuts., in the face of high inflation and a weakening economic outlook and UK equities fell 11% in September. The BoE stepped in to maintain financial stability with renewed asset purchases. Eurozone equities are down 32% ytd and there is growing evidence for industrial shutdowns on higher energy costs in Europe. Euro area inflation surprised again to the upside in September. While we expect tighter financial conditions and restrictive real rates to continue weighing on activity in the US we continue with our liking for US equities versus Europe and Japan and also for India and the UAE in the emerging market space. China equity performance continues to disappoint at -31% for the MSCI China YTD and the real estate overhang and the regulation of tech giants, though less onerous continues.