Monthly Investment Review
LT macro regime. Shorter and risker cycles than in past decades. Imbalances, debt, resurging inflation, and geopolitics result in more cyclicality and variations in economic cycles
US and China financial conditions (FC) on their way to neutral. Deceleration of global liquidity from late 21 continues. Concomitant rise of USD, correction of risky assets and widening of spreads have – already – brought FC on the verge of neutral in the US. Early signs of more accommodative FC in China
Stagflation is the base scenario in 2022. Ultimately, a soft landing remains possible in the US. Europe has little chance to escape recession, like China if it does not accentuate its fiscal impulse
Geopolitics remains critical / hectic. Wars are disruptive and ultimately inflationary. They result in higher risk premium for financial markets
Fear and realized volatility spelled significant capital outflows. Higher cross-assets’ volatility and growing fear have induced margin calls and forced selling from retail investors
Unstable equity-bonds correlation, but no definitive regime shift. The long-standing regime of negative real rates is under growing test / challenge. Risks of a hard landing has lately restored appeal of duration rich assets
Repricing / correction mode is resulting in less expensive valuation. The combination of nasty fundamental factors will generate a succession of risk-on/off periods over next quarters. Unless ¨something¨ breaks in the meantime…
Markets’ action has – by far – preceded the Fed’s – The U-Turn of Powell triggered an unusually quick and sharp tightening of US financial conditions. All components of FI actually contributed to the rise: a stronger dollar, higher rates, wider spreads and a corrective equity market. According to its historic relation with developments of financial conditions, US ISM could soon visit a level below 50, featuring odds of a serious slowdown, if not a recession. The housing market is giving signs of exhaustion because of the dual action of higher Treasury bond rates and more cautious
banks, triggering larger spreads. This sector is a significant contributor to growth and an important vector of wealth effect.
The mid-term elections in November will take place in a poisonous internal political climate. The President is at a low ebb in the polls, the Democrats are certain to lose control of the Senate and even the House of Representatives. At best, we are headed for a cohabitation, and thus the paralysis of the Biden administration’s budget initiatives. At worst, we are headed for an institutional crisis if the Republicans, led by Trump, continue their institutional defiance. This is not a climate conducive to raising policy rates, let alone if the economy takes a nosedive.
The Fed is likely to back-off from its hawkish rhetoric in H2
It may even pause around mid-term elections
Asset allocation conclusion – The very important selling flows and the extremely pessimistic psychology of private investors is rather reassuring: the first phase / wave of re-pricing / return to normal is well underway. The valuations of financial assets, which were sometimes exuberant, are also beginning to return to normal, particularly with the gradual disappearance of negative rates. However, the macroeconomic component will remain poorly oriented in H2. The inflationary irritation is not over.
It is difficult to see how the financial markets could sustainably return to the upside in this still very disturbed context. Geopolitical uncertainty will prevail and will also maintain pressure, in depth. We confirm our cautious bias.
The end of USD bull run – On mid-May, the USD index reached its highest level since December 2002 of just over 105. It had gained 7.5% in Q2, 9.8% in 2022 and 17% in one year. Given such strength, it will be hard to pull the USD even higher without the US monetary policy outlook and yields moving further in the currency favor, or another deterioration in risk appetite supporting haven demand for the USD.
The Fed policy outlook should remain hawkish. It should hike rates at a fast pace, with a 50bps hike in June and July before switching to 25bps in the remaining 2022 meetings. Powell warned that the Fed will continue to raise rates until there is “clear and convincing” evidence that inflation is receding.
The neutral interest rate is estimated to be close to 2.5%. However, as the market expects the Fed funds to reach 2.75% by year-end, a restrictive Fed policy is already priced in. There is less scope for an even more hawkish tone to pull the USD higher. In addition, the policy divergence that had supported the USD against most of its peers is being whittled away as other central banks continue to hike rates. By the way, US yields have peaked in early May, just before the USD index reached its high. So, USD bulls may be left dependent on risk appetite to keep the currency elevated.
The USD has slightly slipped from its 20-year peak. Momentum behind the long USD position should fade
Only periods of weak risk appetite and uncertainty could boost haven demand for the USD. However, it has now priced in the full Fed tightening. The prospect of other central banks hiking rates should eat into the USD gains
An EUR catch-up is underway – The EUR spent the first half of May underperforming the safe-haven USD and JPY and reached a 20-year low. This has been a trigger for the FX market to rethink whether there is much more value. The USD is already very high and the ECB signaling that it is very close to hiking rates. The policy dynamics should be moving in the EUR favor.
Most ECB members rhetoric has grown increasingly hawkish over the last couple of months. The next ECB policy announcement will be made on June 9th and is expected to signal that a rate hike will be made at the July meeting. The ECB will exit negative rates by September. The first ECB rate hike since 2011 should be EUR-supportive.
Market mindset is clearly switching – The MOVE, the US yields implied volatility index, reached its lowest level since the start of the year. This stabilization is a positive sign. The US Treasury market posted its first positive monthly return since last November. After focusing on inflation for the past several months, the market is dealing with a potential deep and faster-than-expected recession risks. Inflation expectations are on track to post their largest drop since March 2020. The markets now seem convinced that the Fed, or any other factor, will be able to contain inflation over the long term.
Bond volatility will decrease with lower long-end yields
Central banks determination – Chair Powell recently stressed that the Fed needed to see inflation coming down in a clear and convincing way and that a slight unemployment rate rise is the price to pay to achieve price stability. Recent activity indicators have disappointed expectations with a larger than expected drop in the PMI and a sharp decline in real estate data. This is fueling fears that a recession may be coming sooner in the US.
After having expected more than 75bps Fed Funds hikes in 2023, investors have sharply backpedaled. The bond market is now expecting the end of the Fed tightening cycle, or at least a pause, by mid-2023.
Various ECB members confirmed the need to move quickly away from negative rates. All of them are pre-announcing a lift-off in July, following the end of net asset purchases. The market is fully pricing it and is now expecting faster rate hikes but with the same overall hikes adjustment.
Lagarde and other ECB members continue to stress that policy normalization should be driven by the principles of optionality, gradualism, and flexibility. It is key to anchor longterm inflation expectations with a credible normalization of the monetary stance. The pace of normalization will have to be calibrated to reduce the uncertainty on future inflation. So, the speed of rate hikes could depend on the degree of economic slack. Unlike the US, which is in a situation of excess demand, it will justify a slower adjustment in the euro area. Most ECB members confirmed that the euro natural interest rate is well in the positive territory, in between 1% and 2%.
While we favor a total of 100bps of hikes, we exclude steps other than 25bps. A 25bps hike at every meeting in July, September, October, and December, while far from a done deal, would be in line with the idea of gradual normalization of ECB policy.
Shifts in risk sentiment are dictating the price action. ECB rate hiking expected to be faster but not higher
Long-end yields could redirect higher only if both risk sentiments and economic surprises strongly improve
Challenging moment in credit market – Investment-grade (IG) and highyield (HY) bonds have been both under pressure all year long, but a large part of that distress has stemmed from higher interest rates and wider credit spreads rather than deteriorating corporate fundamentals.
Surprisingly in such a context, the size of the IG bond market has continued to grow, hitting $4.9trn in April, with new debt issuance holding up relatively well. Upgrades to IG from HY have positively contributed to market growth since Q4 2021, rising star companies adding $72bn.
Through now, IG issuance is down 14% while HY is down 75%. New issuance is normalizing near the 2019 level, after $1trn issued in 2020 to bolster liquidity at the pandemic onset. IG total maturities will reach $156bn in 2022, $272bn in 2023 and $302bn in 2024. The market will still have to digest large additional issuance amounts without the buyer of last resort intervention, central banks.
The BBB-rated companies dominate the IG bond market (60%). Downgrades to HY – given the current economic slowdown risks – will reduce the size of the IG market and push lower rated bonds spreads wide. IG will outperform HY
Rally in a bear market or correction in a bull market ? – We came close to a bear market for the global American and European indices, according to the classic definition of a correction of more than 20%. The Nasdaq entered it cheerfully with a decline of 32% between the highest (end of November) and the lowest (mid-May). To define a bear market, the magnitude of the correction is not the only factor, there must also be a notion of duration. In March 2020, the 35% drop in the MSCI World was a violent correction, rather than a bear market.
The rally, which began on May 20, is the result of a combination of favorable factors: 1) Technically, the indices were oversold and a double-bottom configuration had taken place with the appearance of support, 2 ) The fall in interest rates, the fall in the dollar and a possible peak in US inflation in March eased selling pressures on equities, 3) Indicators of investors’ sentiment were in the (very) pessimistic zone, in generally a good signal for a rebound in stock market indices and 4) China had started to ease health restrictions, particularly in Shanghai.
The results for the 1st quarter of 2022 turned out to be much better than expected, with a 9.2% increase in profits (4.6% expected at the start of April) and 13.6% in revenues for American companies, and 11% and 25% respectively for European ones. Despite problems of disruption and inflation, the outlook remains surprisingly good. Chinese economic growth will be an important element of the health of Western companies’ results; after targeted measures, the Chinese government could launch broader stimulus programs with the end of the lockdowns.
The decline in the Goldman Sachs financial conditions index also explains the rebound in equities. The Chicago Fed Adjusted Financial Conditions Index is also turning around.
The week of May 25 saw the first net purchases in equity funds since early April, mainly in favor of the US and Asia.
All these points favor to a continuous rally, but we remain cautious on the future economic growth. We believe the rebound is an opportunity for a shift in sector allocation towards defensive sectors, Consumer Staples, Pharmaceuticals and Power Producers. And in a world of West-China/Russia confrontations and protectionism/ economic nationalism, commodities and defense are two sectors to focus on. Historical studies show that in times of stagflation (high inflation/low economic growth), such as in the 1970s, energy and agricultural commodities perform well and are the only traditional asset classes to deliver positive returns in real terms. Fighting inflation with a sharp rise in interest rates will be difficult due to a very high level of public debt.
We are maintaining our neutral stance on the US, an underweight on European equities, while we overweight Swiss equities.
The weakness of the dollar and the drop in US interest rates offer a window of opportunity to return to emerging equities. But it is a very tactical move, because emerging stocks are the weak link in this current environment: various disruptions, Covid, high energy and food prices, climate change, regional globalization, protectionism/ nationalism, weak global economic growth, energy transition. We avoid emerging countries that import energy and agricultural products. Outflows from funds invested in emerging assets are at the highest in 30 years. Emerging equities should become more attractive when central banks focus more on growth than inflation.
China is a great unknown. The economy is slowing and the real estate sector is under stress. Chinese equity funds saw the largest outflows. The Communist Party has taken control of Chinese society to return to the great principles of communism and control of the “perverse” effects of technology, online games and social networks on children. China wants to impose a new world security order, with Russia, with the Global Security Initiatives (GSI) to counter NATO and the Quad. The fate of Taiwan returns to center stage with the Russian invasion of Ukraine. For US and European institutional investors, Chinese equities represent a risk.
Global rise in raw materials – The pandemic, then the war in Ukraine, have shown the fragility of the globalization and the harmful interdependence of economies, and rekindled tensions between the US/Europe/Japan/Australia and China/Russia blocs. India is for the moment apart, since it receives its fossil fuels and its weapons from Russia and relies on the United States to counter China.
This complicated environment, accentuated by climate change, translates into higher prices for energy and agricultural goods. Industrial metals are down due to China and its confinements which partially stopped the economy and the real estate crisis; China accounted for 25% to 50% of global demand. Investors lack visibility on a Chinese economic recovery to return to metals, but they could be interested again if China announces major support plans.
Brussels announced an embargo on Russian oil of up to 90% by the end of the year, with a temporary exception for the Druzhba pipeline (the remaining 10%) which supplies Hungary, Slovakia and Czechia. This embargo caused an increase in oil prices due to a tight world supply. 36% of European oil imports came from Russia and 75% of Russian oil came by ship. If OPEC+ does not increase its production and Chinese demand picks up again this summer, we may well see oil prices rise sharply. It is not certain that this embargo is harmful for Russia, because the fall in volumes is compensated by a rise in prices, but the European Union and the UK have provided an answer to hurt Russia: they have just prohibit insurers from insuring vessels carrying Russian oil, closing the door to Russia’s access to the world’s largest insurance and reinsurance market at Lloyd’s in London.
A major event could ease crude prices: some OPEC members would seek to exclude Russia from the OPEC+ agreement. The North American and European embargo on Russian oil could force Russia to produce less and force Saudi Arabia, the United Arab Emirates and other producers to produce more.
We therefore remain invested in oil and gas stocks, in particular Americans, which are the big winners for the coming months, before other LNG suppliers appear later such as Qatar, Algeria, Australia and Japan.
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