Monthly Investment Review
Long-term macro regime – Growth below potential and more volatile inflation. Demographic and debt undermine potential growth. Coupled with digitalization, it fuels secular disinflationary pressures which collide with – cyclical – inflationary tensions.
Ample but decelerating liquidity – Liquidity is ample, but its momentum is fading. Tapering will reinforce this trend. Global interest curve flattening acknowledges for a less friendly liquidity environment ahead.
Soft patch in H2 21. Expansion delayed, probably not derailed – Global soft patch featuring China sup-par growth and rising inflation. Firmer global expansion in H122. Entering a particular monetary cycle where the US lags the emerging and other Anglo-Saxon countries.
Geopolitics. A complex G-Zero landscape – Afghan failure raises doubts about the reliability of US strategic guarantee. Threatening alliance of China and Russia. Indo-Pacific as the new World epicenter (Taiwan).
Buoyant capital flows – Renewed institutions inflows in passive ETF, compensated by somewhat lower retail frenzy.
Scarce and expensive quality assets – Financial repression to continue in the foreseeable future. US long rates to stay in the (1.5% – 2.0%) range H122.
Somewhat lower risk appetite – Reflation trade losing steam. Needs renewed Fed moves and growth rebound to resume.
Global macro sweet spot – Lately, global growth has been decelerating and inflation rising. It will continue for a while. US will soft land by year-end, because of Covid resurgence, escalating disruptions and hesitant back to school process. China traction and contribution to world growth will be tamer. The odds of stagflation are rising with Producer Price Index jumping 10.7% in September, its fastest pace since October 1996. China transformation spells a lower medium-term contribution to global growth. It will no longer export disinflation.
But a global transition from brown to green spells that both private and public investment in renewable sources of energy will provide a secular boost. Pandemic is turbocharging digitalization and automation, paving the way for an acceleration in productivity growth.
Global growth will approach potential in H1 2022, thanks to G7 countries.
The dog has started to bark – The key risk to a – central – kind of benign macro scenario is runaway inflation. For sure, the pace in price rise exceeded what developed central banks forecasted and expected. It is essentially due to prolonged supply chain disruptions. But a rampant rise of wages and the delayed catch up of housing price / rents will prolong it far into 2022. Up to now, central banks managed to mitigate the concerns of fixed income markets. But the regime of – deeply – negative real rates is likely to face renewed attacks. Runaway inflation remains remote, as it would require a serious dose of policy errors or adoption of MMT. Still, inflation will be durably higher than the historical threshold (2.0%) of tolerance of the central banks of developed countries. It is also threatening to China, which nevertheless has an exclusive weapon, the authoritarian administration of certain prices (cf. its interventions in the summer to calm domestic commodity prices).
Inflation will remain sticky if not pervasive over the next quarters. Fortunately, it is not high enough to compromise solid consumption.
Asset allocation conclusion – We still consider that the current transition towards an inflationary boom landscape is the most likely scenario towards 2022. We maintain a fully invested allocation.
But the duration of this journey will play an important role in maintaining financial conditions very supportive for markets. Further significant rise of inflation expectations from the recent high level would trigger more difficult times for risky assets. Rising stagflation risk only disturbed fixed income markets for now. Resurging volatility (as measured by the MOVE index) neither spilled over to equities (VIX remains very low), nor to credit (High Yield spread remain extremely low). This bears careful watching.
Back from extreme – Over the past month, the USD has consolidated after testing a key resistance. Commodity currencies have rallied strongly and low yielding commodity importers bore the brunt of the weakness. The market is pricing a more sustained price cycle into commodity currencies and an earlier start to the interest rate cycle across most countries. Looking towards year-end, there is more risk of consolidation. Several overbought and oversold currencies have already started and will continue to come back into neutral area.
Carry trades to restart – The Fed will shortly start its asset purchases tapering shortly and complete the process by mid-2022. A less loose monetary policy should be USD-positive, but the currency reaction has been less clear. First, even as the Fed tapers, its policy should remain supportive. Second, the taper was well flagged and is expected, potentially to dull its impact on the currency. Third, some other G10 central banks have jumped above the Fed in the hawkishness ranking. The Norges Bank and RBNZ have already hiked rates, BoE rate hike expectations have significantly risen recently, and the Bank of Canada just stopped its QE program and brings forward guidance on a first rate hike by mid-2022. Hence, whilst US yields have jumped higher over the last month, the support this could have given to the USD has been undermined by a general rise in G10 government bond yields.
Risk appetite has remained a key driver of the FX market. The USD index weakened in October after reaching a new 2021 high as sentiment improved, reducing demand for the safe-haven. However, the USD is no longer just a haven of peace, as it is one of the few high yielding currencies with NZD, AUD, GBP, and CAD. The 5 are exhibiting a 2-year government bond yield higher than 0.5%, while most of their peers are still offering negative yields.
The mixed environment for EM assets is intact – The US 10-year yield rise above 1.5%, coupled with strong USD flows and potential liquidity tightening have created stronger headwinds for EM. Our negative recommendation on EM FX remains broad-based. Energy prices present another challenge as global supply shortages are likely to persist. This begs the question of what can EM central banks do to ease the pain of a growth slowdown and prices pickup?
On the one hand, tightening policies anchor inflation expectations and cools imported inflation, but at the same time, supply side disruptions and energy shortages are exogenous to central banks decisions. Premature tightening could negatively impact demand. Vaccination rates have only started to improve recently.
Tapering is tightening – Wu-Xia Shadow Rate is an econometric model which helps to quantify what QE means in terms of a theoretical implied rate that is unconstrained by the zero bound. As it was the case in 2014, tapering implied a set back to the actual Fed Funds rate level, or a 200bps of tightening over the next 6 months.
Amid record levels of uncertainty around unemployment, GDP, and inflation including a shift in structural inflation drivers (from headwinds to tailwinds), taking out an insurance policy against inflation expectations is entirely sensible and defensible. When core CPI breeched up 2.0% in 1966 it took 33 years to come back to that level. Whilst the 1970s analogue is incorrect, it is nevertheless a cautionary tale.
For the last decade or so, structural factors pushed down inflation. The Fed terminal rate continued to decline in line with medium term inflation expectations. Clearly, this is changing, leading to doubts about whether the terminal rate of the next Fed cycle has shifted upside. At present, the market terminal rate pricing is 1.75%. It has struggle for a while to be above the Fed long-term dot which is at 2.50%.
Central banks wake up – Removing monetary policies accommodation began with emerging market central banks in early 2021. Over the next 12 months the number of basis points of discounted tightening is at decade highs for both G10 and emerging market central banks. The market is discounting a total of 564bps tightening in DM and 3380 bps in EM. This is a dramatic change in pricing compared to early 2021.
Signs of excess in the credit market – The deluge of issuance has pushed the HY bond market value above $1.5trn for the first time. New arrivals have propelled it to a record size. A record of 149 companies, including Coinbase and Medline, have joined the segment in 2021. The companies have extended a trend set by central banks’ historic response to the pandemic. In September, 26 new issuers came to the market, a record equaled just once before in last April. It happened only 3 times that more than 100 new issuers joined the market. It was in 2013, 2014 and 2007. The implied rising financial leverage due to easy financial conditions raised some questions.
Rating actions so far in October remain largely positive. However, there has been a pickup in the number of downgrades, particularly within sectors where recovery is slow or delayed. The Chinese homebuilders and real estate sectors led downgrades over the last month. The downgrade ratio (downgrades as a percentage of total rating actions) increased, as there were only 23 downgrades against 23 upgrades in September. So far this year, there have been 540 issuers that have had a negative rating action and 1’491 issuers a positive action. Over half of the issuers with positive rating actions experienced one or more negative rating actions in 2020. So far in 2021, 317 issuers have been downgraded while 505 have been upgraded. More than 80% of corporate downgrades since the pandemic began involved issuers with High Yield ratings.
Difficult equity markets evolution’s reading – The disruption of supply chains and the shortage of labor make inflation exploding and are weighing on economic growth (flattening of the yield curve). There is a risk of stagflation, a word that is likely to keep investors busy in the coming months. A temporary stagflation due to the pandemic or something more structural? We are in a marked supply deficit: end consumers can no longer find their products, or delivery times become unreasonable, and companies have to decide between reducing their margins or increasing their prices. Q3 results clearly show semiconductor and labor shortages, as well as rising commodity prices, but companies are performing well and margins remain high. Once again and despite a difficult pandemic environment, companies published results above expectations: + 33% in the US compared to 27.5% estimated one month ago and + 52% in Europe compared to 41% estimated.
Equity indices view this period of chaos as temporary, by anticipating a post-pandemic restocking and an increase of demand. The two US $ 3.2 trillion stimulus plans (lower than the $ 5.5 trillion initially planned), the various national stimulus plans in Europe mainly destinated for green investments and technology, the COP 26 and a favorable seasonality – out of 15 / 20 years, November and December are statistically positive – allow us to envisage a potential increase in the stock markets (US / Europe) of 5% by the end of the year.
The interest rates rise remains a negative factor, but for the moment the Equity Risk Premium is in a neutral zone, with a ratio far away from the levels of 2000 and 2008.
If stagflation were confirmed this winter with an acceleration of Covid infections in the northern hemisphere, implying the return of health restrictions, we would become more cautious by favoring the Defensive and Value sectors. Industrials have warned that the 4th quarter results will be weaker due to problems in supply chains. Unsurprisingly, Apple and Amazon disappointed with 3Q21 results; as we pointed out, the Covid-proof technology companies are in a period of (very) negative comparison with 3Q20 and 4Q20. From mid-December, we will be attentive to the overall situation and we will begin to reassess the results for the 4th quarter of 2021, which will be published from mid-January 2022, if necessary.
For now, we are maintaining our Banks / Cyclical bias, as growth remains relatively good despite weaker than expected US household consumption in September due to a lack of supply and higher prices. The banking sector, which we overweight has withstood a sharp flattening of the yield curve. When releasing their results, US banks pointed out that the pandemic was behind them and that loans and credit card applications were in expansion mode.
We remain positive on the sectors that will benefit from US spending in traditional and green infrastructure, namely cement, steel, engineering, machinery for the traditional part, and electric cars, batteries, solar, wind power, the Smart Grid and the energy efficiency of buildings for the green part.
With dispersed 2021 performances, the emerging bloc sharply underperformed the MSCI World by 20% in dollars. The fault lies largely to China with declines of 6% for the CSI 300, 17% for the Hang Seng China Enterprises and 30% for Chinese stocks listed in the US. China accounts for 32% of MSCI Emerging, followed by Taiwan 14%, South Korea 12%, India 12%, Brazil 4% and Russia 4%. The Brazilian index fell 13% in BRL and 20% in USD. But the other large emerging countries recorded stock market performances in line with the US and Europe. The pandemic partly explains these heterogeneous performances. But the main explanation for the great Chinese stock market lag lies in the Sino-American tensions in trade, technology, finance and geopolitics, and especially the new policy on education, on common prosperity and the takeover on Big techs and billionaires. The difficulties of the second largest Chinese real estate developer may be a boon to stop real estate speculation, but will also translate into lower growth in the next few years, as real estate has been a strong contributor. There is a risk that the rich people will contribute to the redistribution of wealth. In conclusion, investment in the emerging bloc must be targeted and we avoid China for the time being; a new fiscal plan could change our mind.
The energy crisis – The energy crisis, which concerns gas and coal, is mainly due to geopolitics, climate and less to the pandemic, even if shipping is disrupted. Inventories are low as winter begins. The prices of gas, oil and coal are world prices: a problem on a continent and it is all world prices that adjust. The gas concerns Europe, which preferred to buy its gas on the spot market instead of negotiating long-term contracts, which Russia wanted. Russia has taken advantage of its soft power with the new Nord Stream 2 pipeline. Gas prices are falling following Vladimir Putin’s order to increase gas exports to Europe.
India and China are running out of coal: Indonesian coal exports have shrunk due to flooding, and China has halted imports of Australian coal due to a trade war. Australia has banned Huawei and ZTE, following the US, from its telecommunications market and called for an international investigation on the Wuhan Covid virus.
Oil prices continue to rise thanks to a strong alliance between OPEC and Russia. With the sharp rise in inflation, consumer countries are asking OPEC+ to increase its supply. By moving out of the Middle East to reorient itself towards Asia and focus on China, the United States has turned the world order upside down and pushed its former allies, such as Saudi Arabia, to draw closer to Russia.
In the short term, fossil fuel prices are expected to decline thanks to an increase in supply. A severe energy crisis would likely validate stagflation, something that developed countries, China and India cannot afford in a pandemic that has already hitting hard the world. Producer countries cannot bring their customers to their knees either. Technically, we can see the Brent hitting $70 and gas hitting $4.50 per million BTU – $5.40 today and $ 6.50 high on October 6 – even $3.50.
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