Monthly Investment Review
Long-term macro regime. Towards shorter and risker cycles than in past decades Imbalances, debt, sticky / resilient inflation, and geopolitics argue for more cyclicality and variations in economic cycles
Financial conditions will continue tightening. After plateauing in T4 2021, global liquidity has started to contract in 2022. Higher oil prices and sanctions on Russia (pressuring European banks balance sheets) add to central banks’ action
Stagflation taking-over as 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 rapidly implement a strong fiscal impulse
Geopolitics is back with vengeance. Wars are disruptive and ultimately inflationary. They result in higher risk premium for financial markets
Erratic capital flows. Higher cross-assets’ volatility and wider credit spreads induced forced selling. Markets give signs of oversold conditions. Growing fear is palpable but no capitulation yet
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 restore appeal of duration rich assets
A succession of risk-off / on periods ahead. Forget beta investing, as a nasty combination of fundamental factors will continue next quarters. Unless ¨something¨ breaks in the meantime…
A bad karma – In recent couple of years, the world has clearly had no respite. Perils have followed one another at an unprecedented rate. A persistent pandemic, institutional turmoil in the US, invasion of Ukraine and soaring commodity prices/scarcity shortages. The unhealthy alignment of tragic events is now reaching a critical level. The global landscape has become more hostile to growth and to financial markets.
We must now face the fact that stagflation will persist this year and even next year. This is a particularly difficult environment for the main central banks, which are torn between two contradictory objectives: controlling price slippage (which no one disputes any more) but protecting growth. After deliberately delaying tightening policies, markets are forcing them to pick up the pace. In this context, the risks of a global recession continue to rise. We now estimate them at 50% over the next 12 months. Europe is unlikely to escape, while the US/China still have a chance of a soft landing.
Apart from the special case of China, overinflated property prices, a major vector of the wealth effect, are resisting the rise in interest rates well for the moment. For how long, without this seriously alerting our major decision-makers, and complicating their stated desire to normalize monetary policies?
The Chinese economic situation is worrying. Seriously. Residential property and the zerocovid policy are weighing on the short-term outlook. The timid rebound in credit, orchestrated by the central bank, is not benefiting the private sector. In the absence of a much more pronounced and rapid fiscal stimulus, growth will dangerously slow down. A reflation package is likely to come quickly, given the imminence of the 20th Party Congress in November, which is of political interest to the leadership.
Inflation will remain uncomfortably high in 2022 and 2023 for central banks, consumers, and politicians.
The odds of stagflation morphing into recession have significantly increased.
Asset allocation conclusion – Signs of cracks are multiplying. The feverishness of the interest rate markets has now also reached the equity and currency markets. The immense – downward – pressure exerted against the Yen reflects on the one hand the inanity of the extreme monetary policy conducted by the BoJ, but also the shortcomings of international coordination. The fever of agricultural prices and the extreme strength of the dollar, in the middle of a monetary tightening phase, are hurting indebted emerging countries that are major importers of raw materials. Doubts about their solvency will increase. The entrenchment of inflation, which is more serious and deeper than was feared at the beginning of the year, (re)poses the question of investment regimes and
the correlation between major asset classes.
Peak USD may not be far off – It is hard to go against the current USD strength given the continued Fed re-pricing. We caution against extrapolating current trends too far. The Fed may have only started the hiking cycle, but a lot of rate hikes have already been priced in. In addition, the DXY is overvalued based on fair value estimates. Furthermore, a lot of negative news have been priced into the EUR.
The USD continues to trade strongly and looks on track to test a key topside resistance level in the near term. The war in Ukraine drags on and its economic effects will be felt globally. The IMF downgraded global growth for 2022 and significantly raised its inflation forecasts for advanced and emerging economies. The focus is on how aggressive the Fed tightening cycle will be. Market pricing is now expecting 2.60% by year-end.
Fed officials sound hawkish, with a 50bps hike in May looking like the baseline case and multiple 50bps hikes. This constant re-pricing of the Fed is a key driver behind USD strength. The peak Fed hawkishness may mark the USD top. Past Fed tightening cycles have tended to see the DXY declining following the first hike. Of course, each cycle is different and, while a more aggressive Fed is certainly behind the buoyant USD, there are also other drivers.
Two drivers pertain to the EUR and JPY. First, the conflict in Ukraine has weighed more heavily on the EUR than on any other G10 currency due to the EU greater exposure to the Russian economy, especially its reliance on oil and gas. International sanctions will have a more negative impact on euro area growth, and the inflationary effects of reducing exposure to Russian oil and gas will be more acute. ECB officials continue to talk of raising rates later in the year considering high inflation. President Macron reelection has reduced a source of downside political risk, but the single currency continues to struggle. Any positive resolution to the conflict in Ukraine will spur a relief rally in the EUR towards 1.10–1.12 in the near term. But, by the same token, an extension or escalation of the conflict could also push the EUR weakening below 1.05, especially if the ECB were to lose its enthusiasm for rate hikes.
Secondly, the BoJ commitment to keeping the 0.25% cap on 10-year government bond yields has led to a widening differential with the US. The BoJ confirmed it is comfortable with the current weak yen to reach its inflation goal. Unless the BoJ abandons its yield curve control policy or widens the band, both are unlikely, the yen will stay weak.
Fed rhetoric points for multiple 50bps hikes – Fed Chair Powell backs a 50bps hike at the May meeting. Meanwhile overall Fed rhetoric strongly suggests a string of back-to-back 50bps hikes. The market is pricing almost four straight 50bps hikes at the May, June, July, and September meetings. The hawkish rhetoric from Fed speakers continued with a string of officials calling for the Fed Funds to return expeditiously to neutral or above.
Despite not wanting to comment on market expectations, Powell drew attention to the March FOMC meeting minutes which revealed that many FOMC participants thought it would be appropriate for one or more 50bps hikes at coming meetings. He added that markets are processing what the Fed is saying and reacting appropriately. Fed communication is pointing to a string of 50bps rate hikes in coming meetings. Indeed, Fed officials seem united in returning the Fed Funds to neutral by year-end. Given that the median estimate of neutral at the March FOMC meeting was 2.4%, this implies hikes at each meeting for the rest of 2022. The US 10-year yield is fairly valued. One of the risks for the Fed is coming from the housing market. The 30-year fixed mortgage rate rose to its highest since 2011. Housing activity is easing in response to sharply higher rates.
Is the weaker yen behind the bond market volatility? – The JPY sunk to a 20-year low and is one of the worst performing currencies this year. Much of this weakness has been triggered by a sharp widening in bond yield spreads reflecting the opposite monetary policy stance of the Bank of Japan and the Fed. The former persists with its ultra-loose policy and the latter desires a return to neutrality as soon as possible.
The JPY weakness is raising concern about potential volatility in the US Treasury market. Japan investors are significant Treasury holders having overtaken China as the largest foreign holders in 2019.
Conventionally, a weaker JPY is good for Japanese demand for foreign assets. Certainly, existing Japanese domestic holders of unhedged foreign assets would benefit. However, for new ones into US Treasury there are two concerns: 1) Unhedged investors need to identify the JPY bottom. It is difficult and potentially costly to get wrong. And 2) hedged investors are finding the hedging cost expensive.
Recent BoJ data show that Japanese investors have been trimming their net holdings of US debt since November with over JPY3trn of net sales in February, the most since April 2020. If Japan’s demand for UST weakens as the Fed is shrinking its balance sheet, this could have meaningful implications for the US bond market. However, alternate sources of demand could arise.
No cracking signs within the HY space, surprisingly – High yield segment has been resilient up to now – thanks to solid fundamentals – given the more complicated environment. Fitch US HY default rate projection for 2022 remains at 1.0% despite the increased default activity in March which reached its highest level since July 2020.
Its 2023 default forecast remains at 1.0%-1.5%. One of the reasons is that Russia-Ukraine exposure is low, and issuers have shored up liquidity during the pandemic. Also, higher commodity prices should provide a boost for energy related issuers, which is the largest sector (18%) of the segment according to Markit iBoxx.
However, a prolonged inflationary environment, more hawkish Fed rate hikes and an economic growth slowdown could further stress lower-rated issuers and lead to higher-than-expected defaults in 2023. Some early signs of mounting risks are surfacing. Upgrades are still outpacing downgrades in the segment, but the gap has shrunk. Downgrades just reached their highest level in more than a year.
HY yield segment still leaves in La-La Land, while other credit parts have already suffered. The US HY spread is trading close to 375bps i.e. less than 100bps wider than at the start of the year. Since the GFC, each time we experienced an external shock (2012 Euro debt crisis, 2016 US oil bust, 2018 rate hikes and 2020 covid pandemic) HY spreads have sharply widened to trade between 550 and 850 bps. It seems that yield-chasers do not think that the Fed tightening applies to them. In fact, history shows that it applies to HY bonds a lot more than to any other because it will tighten financial conditions. It will make it more difficult for many of these HY-rated companies to refinance with new debt and/or pay off existing debts. The rating agencies default rate forecasts look unrealistic.
Top quality credit spreads have already discounted part of the coming Fed aggressive tightening. High Yield segment is lagging. A sharp catch-up will happen.
Stagflation hangs over stock markets – The shrinking liquidity translates into more volatility. The Covid, the war in Ukraine and the climate emergency offer new opportunities in certain sectors – Since February, everything has accelerated: the Fed, the war in Ukraine, inflation and China with the return of strict confinements weighing again on global supply chains.
The two drivers for stock market growth are higher multiples and/or higher earnings per share. The Covid, then the war in Ukraine, pushes inflation, due to a supply shock, to levels no more observed since the beginning of the 80s. This new inflationary regime has been gradually integrated by the stock markets: for the last year, the PE ratios of indices contracted. The S&P 500’s PER fell from 31x to 21x. In the hyperinflationary period of the 70s, the PER of the S&P 500 was between 13x and 7x! There is therefore theoretically a risk of further contraction of stock market valuations if high inflation were to take hold for a long time. We do not think it will come to that, but what is certain is that in the coming months, the indices will not rise by an increase in multiples.
As for the growth of corporate profits, we will no longer experience the high growth rates of recent years, such as +22% in 2018 with Donald Trump’s tax reform and +50% in 2021 with the post-economic recovery. Covid. In 1Q22, the profits of the S&P 500 should grow by 6% and bottom-up analysts expect an increase of around 10% in 2022 both in the United States and in Europe. Despite everything, we note the strong resilience of revenues, profits and margins, which should make it possible to avoid entering a bear market; a scenario that is weakening.
With the rise in interest rates, the equity risk premium has been reduced. Looking at the model on a 14 years period, equities are at their less attractive level on both the earnings yield and the dividend yield.
In a normal economic cycle, sector allocation would now shift to defensive sectors, consumer staples, healthcare, utilities, with the start of a normalization of monetary policy by the Fed. This is what we are doing gradually. For a few years, we had been structurally underweight defensive sectors, with the exception of health stocks during the Covid, in favor of growth stocks, Technology, Communication, disruptive companies, until September 2020, then we were back in the Value segment and cyclical stocks with the Covid vaccination. With the prospect of an economic slowdown, we start to build positions in consumer staples. The good news is the very brief inversion of the yield curve which does not validate the scenario of a recession, from a statistical point of view.
With the Covid, the war in Europe and the climate emergency, we are not in a normal cycle. Covid has shown developed countries its strong dependence on Asian production chains and the need for reindustrialization. The US-China shock, with Taiwan in between, forces a rethinking of production chains in technology. The war in Ukraine has shown Europe its excessive dependence on Russian fossil fuels and above all its weak military capacity. Europe has announced massive investments in its defense, with a major change in doctrine. Meanwhile, the climate emergency will accelerate the energy transition. The United States is in an economy of “war” by investing massively in defense for Europe and Ukraine and considerably increasing its exports of liquefied gas to Europe. Western sanctions against Russia will change the structure of the global energy market.
Oil and gas companies will make a lot of money – Russian invasion of Ukraine will change the energy market. Eventually, Europe will do without Russian fossil fuels, causing Russia to lose its main customer. Gas remains the biggest issue for Europe due to the complexity of transportation. In the short-medium term, there are alternatives with the United States, Norway and North Africa, in particular Algeria and Libya where Italy has excellent relationships, and later with Qatar, Australia and Japan. For Russia, the situation is complex, because all the infrastructure, mainly gas, is oriented from Russia to Europe. China will not be an option in the short term due to transport complexity. Then, China needs to keep strong ties with its Middle Eastern suppliers and Gulf producers are not going to give market share to Russia.
With their huge profits, the oil and gas companies will favor shareholders through share buybacks and a significant increase in dividends. Exxon Mobil has announced plans to triple its share buyback program and Chevron to double it. In the 1st quarter of 2022, Exxon and Chevron generated $17 billion in cash, while they spent only $6.9 billion in capex for production. Important dilemma for Joe Biden who wants to adopt a green environmental policy, while the United States must produce more to help Europe and take market shares left by Russia. The major shift in the global energy market and global rearmament clashes with the climate emergency.
Precious metals at the crossroads – Precious metals, and gold, have stood out from the carnage of the last few weeks and fulfilled their role as de-risked assets. This positive performance is even more remarkable given the headwinds: an extremely strong USD and much higher nominal and real yields. Nevertheless, gold is somewhat of a disappointment. Should not it have ¨exploded¨ in the dramatic geopolitical context prevailing since the invasion of Ukraine and the nuclear risk? We are approaching the epilogue with volatility migrating from bonds to stocks, and then lately to currencies!
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