All eyes on the Fed yet again

Chief Investment Officer's team

20 September 2022

All major asset classes were in the red last week with August US core inflation higher than forecast

AT A GLANCE

All major asset classes were in the red last week with August US core inflation higher than forecast
Super-sized hikes from Western central banks continue and Fed is next in line this week
As price pressures concerns shift from energy to core in the US, tightening should ultimately work

With higher than expected core CPI in the US for August, a third consecutive 75 basis points hike is definitely the most probable outcome from Wednesday’s monthly FOMC. Rates markets even allocate a significant 25%+ probability to a 100 basis points move. In any case, the direction is clear, and so was market reaction, with a unanimous drop across asset classes, from stocks to bonds, including everything in between except of course cash in US dollars.

If inflation numbers remain high, it is interesting to note some shift in their drivers in the US. The narrative is shifting from a purchasing power issue, driven by rising commodity prices, to the broader concern of a spiral between prices and wages. Indeed, retail sales have remained strong in the US, with consumers dipping into their savings in a backdrop of high confidence due to a strong job market. Even in Europe, where the energy crisis is the predominant issue, fiscal support from both countries and the EU are providing some resiliency.

For the time being, market participants focus on the clear headwind of monetary tightening. It’s true, but a resilient economy is not bad news. Indeed, rate hikes will have an effect on jobs, demand and prices – ultimately core inflation. It takes time, while markets are not always patient, but it may start to work before the world’s largest economy goes into a recession and shares it with the world. The peak of pain could be now, and it will be interesting to see the update in the Fed’s economic and policy projections.

We keep an underweight in the riskiest segments of fixed income, and a modest overweight in EM stocks. We hold significant amounts of cash for the flexibility it provides to seize future opportunities. Stay safe.

Cross-asset Update

Markets are swiftly shifting from one narrative to the opposite one, struggling to adjust to the idea of accepting higher rates for longer. No sooner had we highlighted at the beginning of last week the prevailing conviction amongst investors of a soft landing, than concerns of a bleaker outlook resurfaced after the US CPI report. Since the start of the year central banks have turned from friends into foes and this accounts for the bulk of the dismal performance across asset classes in 2022, driven by the common factor of rates moving steadily higher. Some reputable commentators have pointed to further downside, or forthcoming conditions causing it. Ray Dalio, founder of the Bridgewater global hedge fund, sees Fed policy rates headed towards the 4.5-6% range and further equity losses to the tune of 20%, while Larry Summers, ex-Treasury Secretary, thinks US unemployment must rise above 5% for inflation to abate. Both views imply a recession in the United States. Goldman Sachs has estimated the downside from current levels to be ranging from 15% to 27% depending on whether unemployment reaches 5% or 6%.

In summary, some of the brightest minds in Wall Street have come to the conclusion that markets are not priced for a hard landing, not even after all the damage suffered so far. Although many predict a global recession, the timing remains as usual hard, if not impossible, to judge. Actually, the rules to gauge that timing are pretty clear, but markets remain fuzzy. In other words, they might not adhere to the rules investors have identified with experience. Usually, for a US recession to occur, the 10yr3m treasury curve must have been inverted for at least three months, then sometime down the road, that is a variable number of months, a hard landing follows. Details apart, the point is that that curve is not even inverted, so broad-based negative economic growth should be a 2023 event, possibly in the first half, rather than a concern for Q4 this year. Also, there is the possibility that inflation has peaked, which historically has meant an equity market bottom. Indeed, leading indicators of inflation, from commodity prices to quite a few business surveys, have rolled over and both CPI and PCE growth rates have failed to make new highs in the last few months.

So, on the one hand, if a hard landing is not impending, and inflation may have peaked, investors could be tempted to look at the glass half full and trigger an equity rally, hence a seasonal bottom could be in place before the mid-term elections. On the other hand, one would be hard put to calling a definite market low before the end of a tightening cycle. So, the odds favour tactically adding to risk in the case of further high single-digit downside, but we would not characterize the ensuing up leg as a fully-fledged bull market yet.

Fixed Income Update

Another crucial week for the markets with all eyes on the FED this time. Last week's negative surprise on the inflation print has significantly ratcheted up the rate hike expectations. Markets currently price in an 80 bps hike for the September FOMC meeting and a close to 1.9% cumulative hike by the year-end that would take the FED Funds rate to nearly about 4.25%. There is a lot of debate on the possibility of 75 bps vs. 100 bps, and market experts vary in their opinion. If the FED goes with a 100 bps hike, it would be a severe jolt to the markets, especially the riskier asset segments.

There was a massive bear-flattening in the US Treasury yield curve last week. We saw the front-end 1-2 year US Treasuries moving up by 30 bps last week after the ugly inflation data. The front end of the curve has touched its highest levels since 2007. Belly and long-end moves have been more sedated with less than 15 bps of movement. 2s10s part of the curve remains inverted by 42 bps. For clients interested in investing in US Treasury Bills, the 6-month T-Bills provide a better opportunity than the longer maturity ones. The 6-month yields 3.79% vs. the 12-month yield of 3.95%, while the duration risk is halved. Hence, investing in 6 months and then rolling over makes more sense than going for the higher duration T-Bill for cash management.

With such movements in the yield curve and the 2-year crossing 3.85%, we believe there is an excellent opportunity for fixed income investors in the front-end of Investment Grade bonds to get juicy yields while protecting them from market volatility. Most A-rated bonds currently yield near 5% and have lost less than 5% YTD. Going ahead, they would be very stable. Last Tuesday was a testament to this. While equity markets such as S&P 500 went down by over 4%, the worst one-day sell-offs since June 2020, The USD IG market hardly moved as spreads widened by only one bps from 140 to 141 that day. This substantial relative outperformance is a testament to how well-supported the USD IG market is from a technical standpoint.

OAS spread widened across segments last week, with the HY becoming the worst affected. Even after last week's sell-off, the OAS spreads for most credit segments currently trade around their median for the previous three months. The spread's resilience was driven by two key factors supporting credit indicators. Firstly, most of the companies were able to preserve their earnings. Secondly, due to the high volume of issuances in the last two years, the refinancing requirements remained subdued, leading to a lower cost of debt. However, looking at the difference in the coupons of primary market vs. secondary market bonds across IG and HY bonds, we can safely deduce that the cost of funding for marginal debt will increase sharply next year as the previous bonds come due. Moreover, earnings could come under pressure when economic activity slows down. These do not augur well for the HY and EM Debt, and we remain cautious on both segments.

Equity Update

Global equities ended the week lower, and summer gains have been wiped out with the MSCI ACWI back to a 20% loss year to date. A bit of autumn chill pervades as markets remain edgy with higher-than-expected inflation readings last week amplifying expectations that central banks will remain hawkish. With unemployment at record lows the Fed has plenty of room for raising rates before economic growth and labour get impacted. What’s good for markets is that the risks are now getting more priced in with a clearer tightening path, barring any other black swan events like the protracted Ukraine Russia conflict. Global economic growth estimates have been significantly lowered, (except for India and the GCC) as have earnings growth for Q3 and onwards into 2023, though not into negative territory. However, no flight to safe haven assets was seen with the US 10-year Treasury yield at 3.45%. Rising rates have impacted long duration sectors such as technology and the communication sector and more recently the rise in mortgage rates is impacting housing demand. Returns in USD are lower for the UK, Japan and India with the GBP, Yen and INR depreciating sharply. In local currencies these equity indices are close to flat.

Developed Markets finished broadly lower with US equities down 5% on the week and tech a little worse off. The global energy sector was down 2.5%, less than other sectors all down for the week. Rising rates favoured financials which saw less of a fall. Emerging Markets fared better but still down on the week with the MSCI China Index -4.4%, one of the worst performing markets ytd. Stimulus measures to counter a growth slowdown are being rolled out. However, weighing on stock performance is the US moving away from any reliance on China technology and continued struggles in the real estate industry. Indian equities outperformed, down 2%. Though oil has been trending lower, UAE equities and the GCC overall had a good week, amongst the few with positive returns and the Dubai bourse is expanding with the SALIK IPO currently underway. Volkswagen looks to set Euro 75bn as valuation for the Porsche IPO. The GCC has seen new IPOs come to market as their strong dividend yields remain a compelling factor with investors, especially in an inflationary environment. However, US tech IPOs have dried up, with valuations of private tech companies down 50 to 80% as investors remain unwilling to look at returns beyond 2 years and still a long runway to profitability for many of these.

For Q3 2022, the estimated earnings growth for the S&P 500 is 3.5% y/y, lowered from a June 30 estimate of 9.8%. Revenue growth estimates are at 8.7%,. All 11 sectors are projected to report y/y growth in revenues, led by the Energy sector. Looking ahead, analysts expect earnings growth of 4.7% for Q4 2022, and 7.8% for CY 2022. Our estimate for 2022 is 10% which we still think will be met as earnings usually beat by 2-3%. 2023 consensus earnings growth estimates are at 6-7% , in positive territory and we retain our US overweight and cautiously optimistic albeit with volatility on future returns.

Written by:

Anita Gupta Head of Equity Strategy , [email protected]
Giorgio Borelli Head of Asset Allocation , [email protected]
Maurice Gravier Chief Investment Officer , [email protected]
Satyajit Singh Fixed Income Analyst , [email protected]

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