The rise in US markets in March, while the war was raging in Ukraine, was enough to leave one sceptical… From this point of view, market jitters in April are understandable given the flow of bad news to be digested. Between the stalemate of the conflict in Ukraine, high inflation driven by rising commodity prices, less supportive central banks and a drastic rise in long term rates, there are several relevant concerns not to mention the new lockdowns in China following an upsurge in the COVID-19 epidemic there.
On the Russia-Ukraine front, as we enter a third month of the conflict, the spectre of further stalemate is looming. The progress of the Russian forces is laborious, the Ukrainian resistance is fierce, and negotiations seem to be at a standstill. On the Western side, the sanctions escalation continues yet still excludes Russian gas and oil.
After the initial shock following the invasion and the first sanctions, the rouble is recovering, notably with the decision by the Russian authorities to impose payment for gas and oil in roubles. At the end of the month, Gazprom acted on its threat by cutting off gas supplies to Poland and Bulgaria because of their refusal to pay in roubles. The hardening of sanctions between Russia and the Western world was opposed by the neutrality shown by the non-aligned countries, led by China, India and a few Middle Eastern and African nations.
The first economic consequences of the conflict are materialising through inflationary pressures. In the Eurozone, the Consumer Price Index exploded and reached 7.5% year-on-year, a figure that should be put into perspective as it primarily results from imported goods (Commodities) as seen in the modest 3.5% increase for the Core figure which excludes energy and food. Unfortunately, the same observation cannot be made in the United States, where price increases seem more permanent and notably not simply confined to energy and food prices.
Graph 1: Consumer Price Inflation in the Eurozone – Headline vs. Core
Graph 2: US Consumer Price Index – Headline vs. Core
In this context, central banks are faced with a tough choice:
- Do nothing in order to preserve economic growth, at the risk of letting inflation get out of control and undermining low income and/or middle-class purchasing power; or
- Take proactive action to bring inflation back to acceptable levels, at the risk of killing growth and eventually triggering a recession.
In the US, the message is clear: Growth is robust enough, inflation is more anchored and the pressures of the conflict are more distant, so option 2 is the right choice for the Fed.
In the Eurozone, the exercise is more delicate, with a heightened recessionary risk and price pressures more closely correlated to rising commodity prices. Here too, option 2 prevails in order to avoid further collapse of the EUR and being accused of inaction at a time when, as the French elections reminded us, the European project is still being challenged by populists on all sides. It remains to be seen whether this policy will be sustainable over time…
In the meantime, long rates are rising under the pressure of the expectation of a more pronounced rise in short rates and a reduction in the Fed’s balance sheet size. The 10-year rate is now flirting with the 3% mark, and if this threshold is just a return to the pre-COVID level, it is indeed a potential bond market crash that we are talking about, given the historically low starting point. This state of affairs makes it easier to understand the very disappointing performance of most fixed income segments in 2022 and also explains the pressure on long-duration assets such as high-growth stocks.
Central banks are faced with a tough choice: 1. Do nothing to preserve economic growth, at the risk of letting inflation get out of control, or 2. Take proactive action to bring back inflation to acceptable levels, at the risk of killing growth.
This anxiety-provoking environment is also reinforced by fears about growth caused by the failure of the zero-COVID policy in China and the return of mass lockdowns in certain areas. While these fears are justified, it does seem difficult to fear both a marked economic slowdown and continued high energy prices at the same time.
It should also be remembered that China’s self-imposed restrictive health measures – one of the few countries in the world still practising such a harsh “zero-COVID” policy – reinforce the prospects of additional fiscal stimulus and a more accommodative monetary policy – quite a contrast with the Fed’s policy.
We, therefore, remain invested along the lines drawn over the last two months. Without necessarily changing our asset allocation weights, we will continue to adapt our portfolios to this new reality. We stay cautious and selective over Fixed Income markets, even though rising rates and credit spread widening are creating some opportunities in the USD IG segment, at least on a nominal yield basis.
For equities, keep in mind that the upward pressure on interest rates will continue to weigh on the most highly valued stocks, continue to focus on players with pricing power and markets like Switzerland have some of these, and continue to favour areas where inflation is less of an issue and where valuations are already discounting bad news, such as Japan, and China.
Fixed Income Markets: Lael Brainard, the Dove turned Hawk
An aggressive Quantitative Tightening (QT)?
US Treasuries rates continue their march towards 3% and it is not Lael Brainard who has been able to slow down this move. The Fed’s most dovish Fed Chair threw a spanner in the works by stating that the US central bank’s intention is now to tackle the size of its balance sheet more aggressively. Wanting to implement a more aggressive Quantitative Tightening (QT) policy is not in itself a problem, it is probably a good idea in the current environment.
The Fed will not be able to run two hares at once: it will have to choose between violent rate hikes and aggressive Quantitative Tightening.
The concern is the simultaneous activation of a QT together with numerous rate hikes. Unless the Fed deliberately wants to plunge the economy quickly into a sharp recession, it will not be able to run two hares at once: it will have to choose between violent rate hikes and aggressive QT, and it will not be able to implement both policies at the same time. It will have to adjust the cursor between these two tools at its disposal. So, a little more QT? Why not, but it will be at the expense of Fed funds and we will have to revise our rate hike expectations downwards.
The 5-year, a sweet spot on the curve
We believe that US policy rates will inexorably move closer to 2% and that the Fed’s QT ambitions will inevitably be revised downwards. If we see that the QT numbers, likely to be released by the Fed at the next FOMC meeting on May 4, call into question one or two rate hikes, then it will be time to add duration.
However, it will not be useful this time to go very far up the curve and we will focus on the most interesting point, which we believe is currently the 5-year. This point in the curve seems to be the best place to benefit from a possible downward revision of the key interest rate hikes. We will therefore keep a closer eye on the middle part of the curve, which could hold some pleasant surprises.
If the 5-year Treasury is hovering around 2.80%, this means that the yield on dollar-denominated investment grade debt of the same maturity, issued by solid companies, is closer to 3.50%. Investors should therefore take a closer look at the credit market, as there are already many opportunities available. “Don’t-catch-a-falling-knife” investors may find themselves sitting on the platform watching the train leave without them, as they wait for the lowest point in the market.
A challenging start to the 2nd quarter
After a difficult first quarter for equity markets, the first month of the second is so far proving just as challenging. Little signs of progress around the war in Ukraine and its ramifications for Europe, inflationary pressures that are putting central bankers on heightened alert, and a new round of COVID disruptions in China adding to its underwhelming economic dynamic…
Some investors, particularly in Europe, are voting with their feet as traded volumes have cratered, symptomatic of a market where complexity and risk reduce visibility and discourage risk-taking. Given a difficult macro, all eyes will be on the micro and we expect the earnings season currently underway to be heavily scrutinised and catalytic for repositioning.
Broadly, the impacts of inflation on margins and additional colour on logistical disruptions since the Ukraine invasion will become the centre of management commentaries for most “old-economy” companies, while tech, healthcare and other more tertiary sectors will need to demonstrate their growth and profitability in a world oscillating between a post-COVID hangover and secular changes in consumer habits.
In tech especially, investors, under pressure, will continue to exhibit a high degree of sensitivity to anything but stellar results and will place significant emphasis on the ability to show resilient growth and cash flow generation, to justify valuation multiples which remain often elevated.
The impacts of inflation on margins and additional colour on logistical disruptions since the Ukraine invasion will become the centre of management commentaries for most companies.
To illustrate these dynamics: Air Liquide, a speciality gas giant, demonstrated strong pricing power, handsomely covering input cost pressures, on top of positive growth led by a diverse set of non-cyclical industries. Even if relatively “unexciting”, such companies get the chance to earn their handsome valuations, as they tick the boxes of inflation protection, low cyclicality, and positive expected return.
On the other side of the spectrum, within tech, Netflix announced a decline in total subscribers, likely the result of the COVID boom’s partial unwind, sparking a debate around the long-term economics of the business. The sentence was immediate: -35% for the common stock equating to a 50bn market capitalisation wiped out overnight. Even the mighty Alphabet, showing above 20% revenue growth and a 70bn USD share buyback program, was trading down -5% after-hours given the disappointing growth of YouTube (“only” 14%).
Given the current volatility, short-term focus and asymmetry in market reactions, we believe the coming weeks could prove fertile ground for long-term investors looking for attractive opportunities. Low visibility, volatility and a return of risk-aversion are unfortunately necessary conditions for markets to offer above-average future returns – returns that only eventually materialise when the pendulum starts swinging the other way.
In the current market paradigm, a counter-intuitive source of equity support could be the omen of a slowdown in the US economy, feeding into normalising inflation, interest rate pressures, and Federal Reserve credibility – all likely net positives for equities at this stage!
This only reinforces our conviction that given the current context, quality in equities remains key, and that even after a difficult relative performance year-to-date, well-executed quality strategies limiting valuation risk should regain the relative performance edge from here on out.
As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolios.
+44 1481 742380
The views and statements contained herein are those of Banque Eric Sturdza SA as of 05/05/2022 and are based on internal research and modelling. Please click on BES Disclaimer to view Banque Eric Sturdza’s disclaimers. Please click on Disclaimer Page to view full disclaimers.