Goldilocks, reloaded

Chief Investment Officer's team

05 June 2023

AT A GLANCE

Markets climbed the wall of worries last week, printing steadily positive returns…
… Supported by the US debt-ceiling resolution and hints of no June hike by the Fed
The developments are in line with our scenario and our positioning is unchanged for now.

Last week was positive across all asset-classes. The US debt ceiling issue was, as expected, solved, and in addition, speeches from Fed officials expressed doubts about the need for an interest-rate hike at the June meeting to be held next week. Both were not an absolute surprise to us, but markets happily climbed the wall of worries with broad positive weekly returns.

Friday’s monthly US job report was very interesting, and so was market response. The US economy created 339,000 new jobs in May, dwarfing the median forecast of less than 200,000. The April print was also revised higher. This looks like a booming job market, raising serious questions about the future trajectory of inflation. However, importantly, some metrics in the report suggested underlying weakness. The unemployment rate materially increased from 3.4% to 3.7%, meaning a sharp increase in job seekers. The average working week ticked lower to 34.3 hours, and finally, the increase in wages was slower than expected. Bond markets reacted with a rise in treasury yields, especially on the front-end of the curve, but stocks saw the glass as half-full and rallied. Indeed, the possibility of an ideal scenario of moderating inflation with resilient activity is not off the table.

Another interesting event was the OPEC+ meeting held yesterday. The Kingdom of Saudi Arabia announced a voluntary cut in their production of 1mn barrel per day from July, to support stability in the market. Good news for our country: the production limit for the UAE will be increased from next year.

The week ahead will see the release of PMI Services in most regions, including the US ISM. We will also hold our monthly tactical asset allocation meeting. Stay safe.

Goldilocks, reloaded

Cross-asset Update

Markets took a pro-cyclical turn last week, leaving behind recessionary concerns. That was true of US assets that outperformed in the wake of a strong jobs report, while the DM ex-US indices lagged behind. It is notable that cyclical stocks joined the rally, while at the same time smaller companies outperformed and the dollar continued to rebound, suggesting that US exceptionalism is back, with European growth flatlining and the Chinese recovery still having to prove itself in terms of durability. It seems the rally can continue in the next few months, with inflation falling and growth still solid, making for a brief Goldilocks interlude.

A July hike is increasingly likely as per market pricing and this is hurting long-duration trades from gold to Treasuries. But it is not all gold that glitters. Average hours worked in May decreased in spite of solid hiring. Usually, companies increase or decrease hours worked before proceeding to hiring and firing. Also, the unemployment rate increased, in contrast with the payrolls report. All of this suggests a labor market that is turning and finally going to soften down the road.

This provides food for thought for gold. The yield curve should stay inverted for longer, unable to steepen anytime soon given the unwillingness of the Fed to go back to an easing mode on still high inflation pressures. At the same time, an increasing number of central banks is adding to gold in their vaults as a means of exchange to avert threats related to the weaponization of the US dollar, hence creating additional demand that would not be there for purely macro reasons. The US economy should sooner or later buckle under the weight of higher policy rates, as the details of the labor report suggest. Yields would eventually be falling and supporting a rerating of the yellow metal, alongside unabated geopolitical risks, especially on the Russia-Ukraine front. Investors should stand the chance of buying on weakness, with the still strong US economy and the incomplete repricing of a more hawkish Fed acting as headwinds in the shorter term.

As for equities and bonds, the Goldilocks interlude should see the cyclical stocks continue rebound and catch up with the IT sector, while yields could be more resilient than expected against a backdrop of improved economic conditions. Investors can enjoy the Goldilocks interlude, before the delayed effect of the Fed’s tightening makes itself felt in the latter part of the year.

Goldilocks, reloaded

Fixed Income Update

We remain confident about our longer horizon call of lower yields. However, the short-term direction of yields is a puzzle and needs to be analyzed under a dual scanner of positioning versus macro triggers. As mentioned in our earlier weeklies, the positioning in 10-year Treasuries remains moderately bearish. Hence, there is a high hurdle for the 10 Year to sell off sharply. It would require a broad-based acceleration in the global economy.

While US exceptionalism holds so far, four out of five leading indicators used by the erstwhile Chief Economist of GS, Jim O’Neil, currently point to a future slowdown. Moreover, the puzzling US NFP data released last Friday could indicate an inflection point in the labour data. The unemployment rose by 0.3%, with both WARN layoffs data and May Challenger data confirming layoffs have increased, and new hiring has slowed down. This should lead to cooler wage growth, impacting the core services inflation.

The future rate path repricing was driven by easing concerns of external banking risks, and we believe that the Fed would be pausing in the June meeting. Moreover, the credit tightening has had some impact on small businesses. The May NACM credit survey indicates that the combined services and manufacturing bankruptcy filings have reached the highest levels since Covid and GFC, with an expectation of a worsening outlook in Q3. Therefore, the Fed should pause and judge the impact of the cumulative rate hikes before taking a decision.

The different segments within fixed income look very tight in terms of OAS spreads. On an YTD basis, the spreads are slightly below the median. The High Yield spreads compressed by 35 bps for the US and 26 bps for the European Bloomberg indices. High Yield still leads the returns chart with a YTD return of 3.4%, slightly ahead of the 2.8% return of the IG index. JPM’s recent HG fundamental research highlights the deteriorating trends in revenue, EBITDA, leverage, and interest coverage and the conservative steps companies are taking in this environment, including slow debt growth and less money going out to shareholders. This would also hold for the High Yield companies and makes us cautious.

Here, we would like to highlight the opportunity in the GBP fixed-income space. The UK has the biggest mispricing between a potential fall in inflation and market expectations for rate hikes. The risk-reward looks favourable now when it comes to fading aggressive BoE tightening expectations. Market implied rate hike expectations are 80 bps within the next six months which seem aggressive given that the gap between the UK PPI and UK CPI has increased significantly. Typically, in the past PPI led the CPI by around five months, and we could see markets slowly reprice the BoE future rate path. With many solid credits offering 6% + in this space, we advise clients with GBP liquidity to add these bonds to their portfolios and look for a high total return with a horizon of 12 months.

Goldilocks, reloaded

Equity Update

Markets are not yet tired of everything “AI”. The recent rally is definitely all about AI and its potential implications on boosting productivity and growth and the differential in performance between companies that will be the leaders in generative AI starting from the platforms with large data, to enablers, that is the semis, and finally with the applications in fintech, healthcare, EV’s, robotics, agriculture, climate control, et al. The market for generative AI could be $1.3tn in 2032 from just $40bn last year, (Bloomberg Intelligence). Compound annual growth over the period 42%, driven by systems like OpenAI's ChatGPT and Google's Bard. Advertising, customer service and banking will see the most impact. Nvidia briefly crossed the trillion-dollar market cap, fuelled by AI's growth potential. The tech FOMO continues, somewhat justified with the AI productivity addition to global growth, though rising valuations need to be carefully watched. This is not a dot.com rally as these are high growth profitable companies. However, there is more than just the big seven tech companies that will gain, there are opportunities in the med-tech space and analytics that benefit too.

US equities closed at their highest level in the last 9 months. The S&P 500 was up 2% last week, close to 4300 as was the Nasdaq, holding above 13,000. Whilst yield volatility continues, tech is counting on a diminishing path of future hikes. VIX at below 16 is indicative that equity volatility continues to stay down and wouldn’t disregard that, even the doom and gloom gurus are now more muted after the recent equity rally. We have an underweight positioning on DM equities and overweight EM equities where we see higher growth. However, US corporate margins have exceeded expectations and we have a neutral stance to the US, reiterating a focus on quality – a clear path to growth, profitability and low leverage.

Our overweight in equities is centered on Asia – with India a strategic long-term preference and Japan for the near term as a tactical play. Japan is changing after three decades of weak GDP growth and average ROE of 5%, with gains in productivity growth and corporate profits to take ROE to 12%, in line with the MSCI World by 2025, driving a valuation re-rating. Expect a revival in growth, driven by stronger domestic demand and supported by reopening. There is not yet high inflation and real rates should remain accommodative, helping to catalyse a revival in capex. No tightening in sight. Other factors supporting Japanese equities, which are at a 33-year high are margins and consumption.

China growth looks set to slow, though the 5% 2023 target should be met, with growing indebtedness and once the post Covid rebound is over consumption will go lower. Although China is credited for the luxury sector boom, wide inequalities result in demand constrained by excess savings. Supply remains constrained by a falling productivity trend as the working age population is shrinking.

Goldilocks, reloaded

Written by:

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

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