Yes, we think it’s alright

Chief Investment Officer's team

12 December 2021

Fears over the impact of Omicron on the economic outlook are abating

AT A GLANCE

Fears over the impact of Omicron on the economic outlook are abating
While US inflation reached its fastest level since 1982
We keep our positioning unchanged for the last month of the year

The end of the year is approaching, and it is undoubtedly a volatile one. We just had one of the best weeks of 2021 for global stocks, celebrating early indications of a milder than feared Omicron variant, and taking note of monthly inflation numbers in the US and China. Price increases are spectacular, with an annual pace of +6.8% for the US consumer and +12.9% for Chinese producers. Markets however hope that an inflation peak should not be too far, limiting the impact on both growth and monetary policy.

We held our monthly tactical asset allocation meeting last week, and reviewed our central scenario. Our colleagues from ENBD Research expect two rate hikes in 2022 and a continuation of the economic recovery as control over the virus hopefully continues to improve. Against such a backdrop, we decided to keep our reasonably pro-cyclical positioning unchanged. With regards to next year, our base case follows the same line. We must however admit that our level of confidence is materially lower than it used to be. Alternative scenarios exist, and their probability of occurrence is not as negligible as before. You know that we issue our Global investment Outlook in January – while many of our competitors speak as early as November. They may feel comfortable with not reporting on their full-year performance - we do - and be happy with perspectives which are not aware of the existence of Omicron. We don’t, and are happy to get the additional data from the variant in the coming weeks before finalizing our views for next year.

Our weekly publication will take a two-week break before coming back on January 4th. In the meantime, the week ahead will be dominated by central bank meetings, especially the FOMC. Stay safe

Cross-asset Update

China has been a source of disappointment for investors in 2021, owing to the hardening stance of the authorities minded to render economic progress more sustainable and also inclusive at the expense of big corporations. Forceful regulatory interventions and a sharp credit tightening have severely impacted risk assets in China, with the latter to an extent reverberating across Asia. EM in general have suffered as well, and a stronger dollar and the accelerated tapering by the Fed are not making matters any easier. What would be necessary for EM equities to surprise to the upside in 2022? Once more, it seems that policy divergence, which was at the heart of EM underperformance last year, with the major DM central banks easing aggressively and EM not keeping up or actually tightening to fend off inflationary pressures, could be the answer. And the process could start with China reversing its stance and prioritizing again growth versus stability.

The PBoC said on Monday that it would cut the reserve ratio, a shift in policy and the second such move this year, releasing reserves for bank lending. More economists now expect cuts to policy rates to follow next year, fuelling credit growth more decisively, after the curbing of liquidity in 2021. The latest inflation release could give the Central Bank the necessary breathing room to start the monetary easing process, as the widening gap between the Producer and Consumer Price Index eased for the first time this year. On the other hand, there is less hope that the authorities will backtrack on the zero-tolerance approach against the virus, which is weighing on consumer sentiment and restraining internal demand. Overall, much will also hinge on whether Beijing is just in management mode, doing the bare minimum to avert a hard landing, or rather will try to do much more to spur shorter-term expansion rates. The magnitude of the rebound in Chinese risk assets seems this time more than ever dependent on where Beijing will decide to draw the line in the sand, dividing the shorter- from the longer-term goals.

The credit impulse, which tends to lead economic growth in China, has been falling throughout the year, and its inflection point would be correlating with improved performance in Chinese equities and EM Asia HY credit, and ultimately benefit the whole EM area. The unanswered question is whether this will be enough to counter the degree of tightening that Powell seems intent to deliver next year.

Fixed Income Update

The current week could arguably be the "Most Important" week for fixed income investors and overall markets. This Wednesday's FOMC meeting outcome could solidify the view of rate hikes for the following year. Most analysts think that the Fed will complete the tapering by Q1 next year to leave ample space for a rate hike by the July FOMC meeting. There is arguably less opportunity for rate hikes in the second half of the year due to the upcoming Mid Term elections. The Fed Dot plots could also project more hikes than previous estimates. Markets currently price in 2.5 rate hikes for 2022. Meanwhile, the yield curve is the flattest since mid-2020 indicating the market's pricing of the lift-off. We strongly believe that the yield increase in the longer-end in 2022 would be smaller than in 2021 as projected economic growth is more subdued. At the same time, the treasury market liquidity is arguably the tightest since March 2020. The Fed has to be careful about the impact of its balance sheet contraction on the treasury markets.

Credit products have had their best week in 2021. High Yield and Emerging Market spreads tightened by 24 bps and 18 bps, respectively, as we continued to receive more data about the Omicron variant. More significant is that even though rates volatility indicated by the MOVE Index stays elevated, bond market liquidity in corporate credits has remained normal. Moreover, the Chinese policy pivot has helped the beleaguered Asian High Yield as the sector returned +1.9% last week even though Evergrande and Kaisa officially defaulted on their bonds. The PBOC had sent a strong monetary policy easing signal last Monday by cutting the RRR, which would release c.$189bn for lending in the banking system. As a result, we are now less cautious on the Asia HY than a month ago.

According to Goldman Sachs research, flows into global fixed income funds turned positive last week, but remained muted (+$1bn vs. -$4bn the prior week). HY and EM bonds funds saw another week of net outflows of $1.3bn, taking the last four weeks outflow to c.$12bn from these segments on Omicron variant concerns. On the other hand, money market fund assets increased by $43bn, consistent with other signs of defensive rotations.

Global corporate quarterly defaults continue to show a downward trajectory. With only nine defaults, the fourth-quarter 2021 tally is tied with the lowest fourth-quarter default count since 2008. In addition, S&P expects the 12-month-trailing speculative-grade default rates to decline in November to 1.7% and 2.1% for the U.S. and Europe, respectively. This would continue to support the riskier segments of Fixed Income, keeping spreads relatively tight.

Equity Update

After a month of drawdowns, global equities saw broad gains last week with the S&P 500 back to record-high territory. DM equities have continued their year-long outperformance with indices up over 3% in the U.S. and Europe, a positive week for EM too though less so with gains of just over 1%. The UAE stands out with gains of over 6% for the MSCI UAE index with both Dubai and Abu Dhabi recording a strong weekly performance. More corporates join the potential 2022 IPO list, including district cooling provider Emirates Central Cooling Systems Corporation “Empower”. Amongst global sectors Technology led to the upside +4.8%, while all others saw a broad rally with no sector below 2% last week. There were large daily moves in both directions, demonstrating the multitude of factors driving markets, from monetary and fiscal policy transition to uncertainty around the effect of the Omnicron variant. This week's Fed meeting remains a key driver of future market direction, but markets have set aside temporarily any worries on rates. The U.S. November inflation data showed prices remain elevated with increases in most components of the index, with the larger contributors: being energy, transportation and housing. What remains sticky in cost inputs for corporates is wages, hence the need to focus on corporate margins in 2022 as in 2021 companies have managed to pass on the higher prices to consumers.

Helping the global stock rebound was preliminary data easing concerns about the severity of the omicron variant alongside vaccine efficacy, though transmissibility is high. Pfizer said that according to their initial studies, a third dose of their vaccine should be able to neutralize the new variant. This will have to be confirmed with more data available by the end of this year. Moderna is expected to have similar results from its booster data. There will be more pronounced differentiation between countries in the short-term based on booster progress and DM countries are best equipped in booster roll outs as of now. Volatility is however likely to continue amid uncertainty regarding the ultimate impact of the omicron variant and the degree of Fed tightening. We recommend a bias toward quality and not trying to time the market. There is uncertainty into 2022, but investing should always be a disciplined process over time.

In company news: Moderna lost its title as the highest S&P gainer as the Covid-19 vaccine maker’s shares dropped 16% last week. The first human trial results from its experimental seasonal flu shot fell short of expectations, as the Moderna shot raised antibodies against influenza as much as a high-dose vaccine from Sanofi that’s already on the market. Seasonal flu shots could become a valuable new revenue stream for Moderna, which gets all of its sales from its Covid vaccine. Elon Musk continues to offload shares in Tesla and jokes about becoming an influencer as he now has 66 mn online followers. In Europe, Daimler AG’s trucks division gained in its first trading day as the German auto manufacturer completed a spinoff. In China, Evergrande Group, the real estate developer was officially labeled a defaulter for the first time.

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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