On the other side of the economic cycle?

Much has been said about the first half of 2022 – one of the worst for equities and certainly the worst for bonds in the last 30 years – and July will undoubtedly be remembered as well.

Fund Commentary
5 Aug 2022

Much has been said about the first half of 2022 – one of the worst for equities and certainly the worst for bonds in the last 30 years – and July will undoubtedly be remembered as well.

In the United States, those hoping for a respite on the inflation front will have to wait a little bit longer… With the release of a stunning 9.1% YoY surge in the headline Consumer Price Index, its biggest increase over the last 40 years, the Federal Reserve has no other option than to accelerate monetary tightening by delivering consecutively a second massive 75 bp rate hike.

Between March and July, its key rates went from 0-0.25% to 2.25-2.50% and Jay Powell even indicated that another “unusually high” rate hike could not be ruled out at the next meeting, even if starting from now the pace should be “data dependant”. Far from helping, the Q2 GDP first estimate released at -0.9% (real and annualized figure) just the day after the FOMC could make it more complicated for the FED.

As feared in our previous letter, the US could be in a tough spot facing a technical recession – two consecutive quarters of negative growth – even though inflation has not reached its plateau, let alone fallen. No doubt the debate on how to define a recession has only begun and that the controversy is likely to grow and amplify as the mid-terms approach…

The fixed income markets seem to have already chosen their side with a 10-year yield falling from 3.40% to 2.70% in a matter of weeks and with the 2-10yr yield curve inverted.

In such a context, the S&P500 performance in July looks almost unreal, even though the full effects of the rate hike cycle on the real economy are probably far from being entirely reflected. With a 9.1% increase for the month, the S&P500 posted its best performance since November 20 and the best one for a July month since 1939…

First, it is true that the figures from the tech heavyweights were reassuring with still stellar growth for the Cloud business of Microsoft and Amazon, resilient search and advertising business models at Alphabet and rising revenues from the Services at Apple. Secondly, these earnings were released at a time of extremely depressed investor sentiment, which provides a nice backdrop for contrarian investors and a potential inflexion point on any potential positive news. Thirdly, with a recessionary scenario starting to get priced, Quality/ Growth stocks are back in favour, especially after a valuation reset.

Finally, don’t forget that equity markets tend to react in anticipation: Falling in anticipation of an upcoming recession, and rebounding when they are trying to assess the next step, that is to say, the FED pivot and a possible recession exit…

The ECB had no other choice but to follow the FED in raising its main deposit rate by 50 basis points, in a historic move that ends nearly a decade of negative interest rates.

Despite the proximity of the Russo-Ukrainian conflict and the lingering effect of rising consumer prices, the surprise came from the Eurozone as its GDP growth materially accelerated (+0.7% QoQ) – against all expectations – thanks to strengthening economic growth in Italy and Spain and thanks to the positive contribution of Services (tourism for example). If the European Union managed so far to escape recession, the risk is not off the table and a sharp one could materialize if Russian gas supplies were to be cut off in the autumn.

Chart 1: ECB – Deposit Rate
Chart 1: ECB – Deposit Rate

Source: European Central Bank.

Faced with similar inflationary pressures – albeit more commodity-driven – the ECB had no other choice but to follow the FED and most other major central banks in raising its benchmark rate by 50 basis points, in a historic move that ends nearly a decade of negative interest rates. However, it remains very difficult for the ECB to be aggressive, as it must manage in parallel the implosion risk of the Eurozone with renewed political instability in Italy and rising periphery spread.

We are therefore staying “reasonably cautious” with regards to our allocations in Europe and the United States. “Cautious” because a recession may already be a reality or remain a near-term risk, “Reasonably” as the recent earnings remind us the ability to adapt, and resilience even in the most challenging macro environment should not be underestimated for some companies.

While continuing to wait for a pivot in the FED’s attitude, we favour areas such as China and Japan where the economic cycle remains partially desynchronized – potential additional fiscal stimulus, more limited inflationary pressures and accommodative central banks – and where, moreover, valuations remain reasonable…

Fixed Income – Peak Inflation and Peak in Long-term rates

Fed funds at 2.5%, inflation at 9.1%

At the beginning of the month, the release of the last FOMC minutes confirmed the fierce will of the US central bank to raise its key rates in order to kill inflation. The very good payroll figures also validated a 2nd consecutive jumbo hike of 75bp, which did not surprise the markets on July 27. The Fed will fight inflation: further rate hikes are expected as well as an acceleration of its balance sheet reduction program.

In such a context, the US 10-year yield, which was still at 3.25% on June 28, was close to 2.80% at the end of the month, with a marked inversion of the 2-10 year yield curve. Beyond the absolute rate levels, it is above all their volatility that is outstanding, a sign of market players’ nervousness and indecision.

The ECB caught in a trap

Before the ECB had even started any monetary tightening process, it had to calm the storm on peripheral spreads. This did not prevent the ECB from raising its main deposit rates by 50bp on 21 July despite the surge in Italy’s spread created by Mario Draghi’s resignation.

So rates are no longer in negative territory in the Eurozone, but an antifragmentation tool had to be introduced to put under control the long-term rates in some peripheral countries, led by Italy.

So rates are no longer in negative territory in the Eurozone, but an anti- fragmentation tool had to be introduced to put under control the long-term rates in some peripheral countries, led by Italy. We are still waiting for the details of this plan, but it is highly likely that the markets will not be satisfied with it and will continue to test the ECB’s commitment by attacking Italian debt.

Before the Fed made the same decision on July 27, the ECB abandoned its idea of “forward guidance” to become “data dependent”. This approach change is important to take into account to assess the attitude of the two major central banks in the months to come.

Fixed Income Strategy

We took advantage of the volatility in fixed income markets to refine our strategy by adding duration to our main fixed income investment vehicle up to 4.4, a figure to be compared with 2.7 in March- April and 4.1 at the end of June. Our duration overlay strategy did not survive this turbulent period and we are now clearly positioning ourselves for stabilization in long-term rates this summer before a possible decline by Fall.

As regards credit markets, we are becoming more cautious: the second wave of spread widening is to be feared. The recession risk, and potentially further correction in equity markets, are all spiced up by a dramatic fall in liquidity: all the ingredients are there to provide us with good investment opportunities in the autumn.

In the meantime, we remain invested in corporate bonds, but only on short maturities, with a preference for 3-year maturities issued by top-quality and investment grade rated companies.

Equities – Quality and Diversification

After a historically weak first half of the year, equity markets rebounded strongly in July in an equally notable upward move. Up 9.1% for the month, the S&P500 posted its best monthly performance since November 2020 and its best July since 1939.

This performance also echoes the underperformance of Chinese equities. There is no shortage of reasons to explain it: the fears surrounding Chinese real estate, the deceived hopes of massive fiscal and monetary stimuli, not to mention the infamous COVID stop & go policy.

It is also worth remembering that last month Chinese stock markets were skyrocketing at a time when most developed markets were down. The sequence highlights the diversification merits of Chinese markets. With a less pronounced underperformance of A shares.

It also reveals the growing bifurcation between domestic and offshore listed Chinese stocks. As a reminder, domestic shares or A-shares are these of companies listed on the Shanghai and Shenzhen stock exchanges, which are invested primarily by Chinese investors and are partially accessible to foreigners.

Contrary to common perception, Chinese domestic markets are far from being marginal with more than 1,900 and 2,600 companies respectively listed in Shanghai and Shenzhen and a cumulative market capitalization above USD 13 trillion that places them behind the NYSE and the NASDAQ. Whereas indices that include stocks listed in Hong Kong and Chinese ADRs have a strong focus on internet and financial stocks, A-shares are exhibiting a broader sector diversification with a greater emphasis put on Health Care, Consumer Staples, and so on…

The greater representativeness and sector diversification, as well as the continued commitment of Chinese authorities to open and develop its domestic markets, are among the factors explaining the growing performance gap between A-shares and other proxies to invest in China (see graph below).

As regards the S&P500, the rebound also looks surreal, as it occurred at the same time as the annual Consumer Price Index reached 9.1% a 40-year high, as the Federal Reserve raised its benchmark rate by 75bp, its 2nd consecutive massive rate hike. According to the first estimate of the 2nd Quarter GDP, the United States is already going through a “technical recession”. And yet…

As already highlighted, the debate today has shifted to earnings and less on valuation multiples. From that point of view, the earnings season has been quite encouraging. Of the 300 or so S&P500 companies that have reported, aggregate sales are up 12.3% and earnings per share up 5.8% over one year.

With the exception of Meta, the FAAMGs (Facebook/Meta, Apple, Amazon, Microsoft and Google/Alphabet), the US market heavyweights, also reported encouraging results. Microsoft and Amazon continue to ride on the stellar growth of their cloud divisions. A strong Search business and robust advertising revenues helped Alphabet.

Even if the law of big numbers is making it difficult for Apple to grow iPhone sales, services are growing faster and becoming bigger. Not to mention that it comes against a backdrop of more reasonable expectations and very repressed investor sentiment.

Graph 2: Performances – Chinese Equity Indices
Graph 2: Performances – Chinese Equity Indices

Source: Bloomberg, Banque Eric Sturdza, 31/07/2019 to 29/07/2022.

As recessionary fears are becoming harder to ignore, the recent sequence of events supports our thesis that Quality / Growth companies remain relatively better positioned to face margin pressures and offer a robust growth profile as economic conditions are getting tougher. With the valuation derating experienced during the 1st half, they are coming at a lower price. As we read the rebound in equity markets, this thesis may find new fans…

Contributors: Marc Craquelin, Eric Vanraes, Pascal Perrone, David Haynal and Edouard Bouhyer. The original PDF document of the “Quarterly Outlook – 3rd Quarter 2022” by Banque Eric Sturdza can be downloaded here.

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.

Adam TurbervilleAdam Turberville
+44 1481 742380

The views and statements contained herein are those of Banque Eric Sturdza SA as of 05/08/2022 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.