Rarely has the first part of the year been so bad for diversified portfolios, with equity markets down nearly 13% and bond segments posting their worst performances in 30 years, courtesy of inflation and rising interest rates. The movement intensified in May against a backdrop of fears about global growth and the stalemate in the Russia-Ukraine conflict. The ‘flight to quality’ logic that favours safe haven assets such as government bonds is struggling to materialise in such an inflationary context.
At the beginning of May, the Federal Reserve (Fed) delivered its second rate hike and outlined its policy for reducing its balance sheet. On the short-term rates front, if Jerome Powell eclipsed the principle of a 75bp rate hike, he nevertheless showed determination in his intention: 50bp in June, another 50bp in July and 50bp again likely in September.
In the space of a few months, USD short rates should rise to 2% and above. Through Fed fund futures, yield expectations suggest:
- An interest rate cut as early as 2024 in response to a possible recession;
- A likely peak in Fed’s hawkishness.
As for the 2nd point, it must be said that the Fed could be helped by a slowdown in inflationary pressures in the second half of the year.
Despite continued high energy prices, the normalisation in base effects is already suggesting that the contribution of energy to the US Consumer Price Index (CPI) increase is already diminishing. The same applies to the contribution of the used cars (only 3.5% of the US CPI basket but up to 20% of the 2021 CPI increase). Due to the Russia- Ukraine conflict, the surge in food prices also suggests that the CPI could hit first a plateau phase before starting its decline.
Graph 1: Bloomberg Global Aggregate USD – Yearly performances over the past 30 years
Between inflationary fears and aggressive monetary tightening, it is indeed the spectre of a recession that is haunting investors’ minds and explaining the down moves observed in the April-May period. If such a scenario seems premature for 2022, the probability of seeing it materialise in 2023 is increasing and it seems difficult to escape at least a marked economic slowdown next year. These fears seem justified as each of the post-war recessionary episodes has coincided with a decline in the equity markets (with on average a decline of around 30% in the S&P).
It is also interesting to note that the bearish episodes in the stock markets preceded the recession by an average of five months and that they were also followed by strong rebounds. Financial markets have begun to adjust to the new environment and reflect the risk of a marked slowdown in the economy in their prices. All good reasons not to despair completely from the equity asset class, stay selective and continue to work on the geographic and style “mix”.
As for fixed income, with long-term rates’ possibly peaking and a likely easing of inflationary pressures, there is a case building for the medium-term maturity (3 to 5 years) USD investment grade debt segment, which is becoming attractive again for its carry with a nominal yield of around 3.5%.
Looking at Technology and / or growth stocks, they have corrected sharply, initially impacted by the rise in long-term rates and subsequently by concerns about their ability to be profitable and survive a recessionary period. The most blatant example is the Nasdaq 100, with more than half of its components down 50% from their highs.
After yesterday’s excesses, free-cash generation and profitable growth are top of investors’ minds. While it is probably still too early to call for a broad and drastic increase in the sector weight, the attractiveness of specific stock ideas or asymmetrical structures linked to secular growth themes (digital payments, cloud computing) is renewed, particularly after a valuation reset and in a slowing growth period.
In an environment where visibility remains limited, we are maintaining the cautious approach outlined in previous months: strengthening geographic and style diversification in equities, increased focus on medium-term USD IG issues in fixed income and continued active management of currency exposures as well as hedging strategies.
Graph 2: US recessions since the post-war period and S&P 500 performance
Fixed Income Markets – Trend Change
+75bp, the Fed did it!
By raising rates by +50bp and adding 47.5 billion of Quantitative Tightening (QT) to reduce the size of its balance sheet, the Fed has, in our opinion, done a good job of tightening monetary policy by 75bp on 4th May. We are almost certain to see two additional 50bp tightening rounds on 15th June and 27th July. As for the QT, the monthly 47.5 billion will increase to 95 in September.
The latest employment figures will not dampen the central bank’s ardour and it can legitimately feel that it has carte blanche, supported also by good corporate results and relatively sustained growth. But for how long? US inflation has disappointed the markets. Prices rose again by +0.3% this month against +0.2% expected and by +0.6% instead of +0.4% expected if excluding food and energy. The Fed is going to double down on this as it needs tangible results as the Mid-Terms approach.
USD Investment Grade credits are becoming a must-have: corporate bonds’ portfolios rated A/BBB with a 4-5yr maturity are yielding above 3.5%.
We can therefore foresee the risk of seeing the FOMC overdo it, resulting in a stronger and faster recession. Moreover, Jerome Powell did not particularly want to dissuade us by admitting that the Fed will do everything possible to make this anti-inflation policy compatible with a soft landing for the US economy. He added that there is no guarantee that it will succeed and a recession avoided. We have been warned.
Treasuries, credits, hybrids, the embarrassment of riches
Among the market phases that interest us the most, there is one in particular that is resurfacing. It is a kind of alignment of planets between macroeconomics, technical analysis and investor behaviour.
Today, macroeconomics tells us that the risk of recession is growing, while sooner or later inflation will fall. The technical analysis warns us that we are potentially at the beginning of a change in trends: the bear market in rates could be in its final phases. Finally, investors are once again interested in the bond markets with an appetite that we have not seen since 2009 (except perhaps March-April 2020 during the COVID crisis).
Three major investment opportunities are available to us. First, pure duration through US Treasuries is no longer a market to avoid at all costs. We had significantly reduced our duration at the beginning of the year, but in May we switched to neutral and then slightly overweight.
Secondly, USD investment-grade credits are USD corporate bonds’ portfolios rated A/BBB with a 4-5 year maturity yielding 3.5% on a gross basis. Finally, hybrid corporate debt (excluding the banking sector) in euros is achieving very attractive yields, close to 5%.
In conclusion, it would be foolhardy to say that we have reached the rate peaks in all these markets, but the time to rebuild positions has come.
Equities – From Price To Earnings
Equity markets remain under pressure as investors continue to digest the Federal Reserve’s fight against inflation. Signs pointing toward a slowdown in the economy are starting to emerge, raising the counterintuitive question of whether we are entering a market where “bad news is good news”. Put another way: is the current financial tightening slowing the economy and tempering inflationary dynamics, and will this alleviate the pressure on equity market valuations?
Firstly, we would argue that early signs of an inflation stabilisation are appearing in certain sectors. Housing, with new home sales dropping materially below expectations while housing under construction is reaching 20Yr highs, certainly shows signs of a peak. 30Yr mortgage rates moving to 5.3% from 3.3% YTD has had an impact.
With household financial assets having reached their highest proportion in equities for decades, the wealth effect is likely to retreat sequentially as well, leaving inflationary pressures from further acceleration in discretionary spending on a downtrend. While employment, a lagging economic indicator, remains strong, we are starting to see anecdotal evidence of a reversal of trend in what used to be the “hot” job markets, including technology. While hardly representative, it is still instructive to note that large tech companies are increasingly announcing hiring freezes or layoffs, a trend that is catching on among private companies cutting budgets and growth ambitions.
Finally, to muddy the overall picture, energy and food prices remain high and are still increasing, as a number of supply chain issues (including refining bottlenecks) broadly destabilise the equilibrium and impact prices. For energy, it is however hard to imagine year-on-year comparisons remaining on the current trajectory in a context of slowing aggregate GDP growth, contributing to our belief that the inflationary readings are likely to close to their peak.
While multiples might now be fair on current expected earnings a true economic slowdown would force downgrades in earnings.
Will this alleviate the pressure on equity market valuations? As discussed in past commentaries, the current correction has until now largely been an adjustment of the price, or valuation, of financial assets dictated by an increase in interest rates. For the most expensive groups of companies, this adjustment has been dramatic. Any improvement on the interest rates side, as we have seen this month, should thus theoretically help.
The nuance is, we believe, that the monetary tightening’s successful slowdown of the economy shifts the debate to the “E” of the “P/E” ratio. Simply said, while multiples might now be fair on current expected earnings, a true economic slowdown would force downgrades in earnings.
We believe this narrative is a key force behind the month of May’s decline in equity markets, especially given the sensitivity of markets to the earnings announcements by Target, showing slowing sales and compressing margins, and Snap, showing a significant miss on advertising revenue compared to its own recent estimates.
While challenges undoubtedly remain, we do find reasons for optimism. Firstly, while we have arguably not experienced forced capitulation during the ongoing drawdown, many sub-groups of stocks seem to be reaching oversold levels. As a group, Biotech has rarely traded this cheaply, with a record number of companies trading below their cash levels according to experts. US Software, trading above 15x revenues only a few months ago, is now broadly back to a longer-term average of 5-6x revenues. Quality merger arbitrage deals are seeing spreads reach rare widths.
All in all, while the earnings cycle takes over from valuation, we view the environment as approaching levels where defensive, quality-focused, bottom-up strategies could start offering enough risk/reward appeal to encourage re-weighting the equity allocation.
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 01/06/2022 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.