When inflation comes down…

November was a busy month: Mid-term elections resulting in a split Congress between Democrats and Republicans, a G20 meeting in Indonesia that saw Joe Biden and Xi-Jinping re-engaging, and a rebound in Chinese equities fuelled by hopes of a gradual end to the “Zero-COVID” policies and newly announced support measures for the Real Estate sector. This is without mentioning the major factor that was the release of sequentially lower and better-than-expected inflation figures.

Fund Commentary
14 Dec 2022

November was a busy month: Mid-term elections resulting in a split Congress between Democrats and Republicans, a G20 meeting in Indonesia that saw Joe Biden and Xi-Jinping re-engaging, and a rebound in Chinese equities fuelled by hopes of a gradual end to the “Zero-COVID” policies and newly announced support measures for the Real Estate sector. This is without mentioning the major factor that was the release of sequentially lower and better-than-expected inflation figures.

Without any doubt, a 7.7% increase in US CPI and 6.3% in US Core CPI, albeit elevated, these figures marked a noticeable deceleration and improvement compared to previous highs. That’s all it took for investors to be convinced that inflation has reached its peak and bet on a Fed pivot…

It is also true that the decline in commodity prices over the past six months, against a backdrop of recession fears, represents a more favourable basis for comparison and a good reason to believe that inflation will continue to come down, most notably thanks to a decrease in the energy and food components (Chart 1 below). Let’s take note that West Texas Intermediate is currently trading at around $78 / barrel compared to for reference, $70 a year ago.

This situation is quite different to that at the beginning of the year when oil prices stood at $88 (Jan ’22) compared to $54 (Jan ‘21). Having said that, a deceleration may be harder to come by for the “Core” index.

Yes, with supply chains normalising, the inflationary impacts on some components (such as used car vehicles – a 4% weight in the CPI basket, up to 1/3 of its increase last year) are vanishing. No, it will not easily return to pre-COVID lows as the price / wage loop is well entrenched and as “shelter” – 30% weight in the CPI basket – should continue to weigh moving forward…

If the reasons to believe in inflation peaking are active and real, the Fed’s pivot seems a little premature at this stage. It will take more than one data point for the Federal Reserve to reverse its actions, and the decline could prove laborious in the absence of a recession.

Chart 1: US CPI – Breakdown by Components

Chart 1: US CPI – Breakdown by Components

Source: Bloomberg, Bureau of Labour Statistics, Banque Eric Sturdza.

In the meantime, investors who were negatively affected early in the year due to the positive correlation between fixed income and equity markets, are now seeing the same correlation at play with the two asset classes rebounding together. Few asset classes are excluded from this temporary upturn except perhaps crypto-currencies.

It must be said that between margin calls, cascading hedge funds and crypto player bankruptcies (and what appears to be a massive fraud at FTX, one of the main crypto exchanges), little has been spared in the crypto ecosystem. If the losses are massive and, in some cases, permanent, fortunately, the deflagration remains for now confined to the world of cryptos.

It will take more than one data point for the Federal Reserve to reverse its action, and the decline could prove laborious in the absence of a recession.

China blowing hot and cold

After the pullback experienced by Chinese markets, following the announcement of the new Standing Committee in October, the exact opposite is happening this month: Chinese equities rebounded strongly, helped by unprecedented support measures for the real estate sector (CNY 250bn plan), and by hopes of further easing of zero-COVID policies.

Chinese domestic investors did not miss the boat, as they were the ones that replaced foreign investors who capitulated last month. If significant changes to zero-COVID policies seem inevitable in light of growing social unrest, timing and implications remain unclear as increasing infections may not encourage a rapid end to lockdowns and disruption to supply chains could prove tricky to handle. While the political risk remains high, China is one of the few economies that should grow in 2023 and continues to trade at depressed valuation levels.

The year 2022 is not yet over and already 2023 could also prove quite volatile. Stagflation risk may be followed by Recession risk. All of this must be factored into how we build our portfolios for the year ahead: Increased allocations in fixed income plus hedge funds after years without, more contrarian geographical choices and seeking out trading opportunities. Quite a schedule ahead!

Fixed Income: Inflation? What Inflation?

United States: an encouraging Consumer Price Index

With the inflation index down to +7.7% annualised and “only” +6.3% excluding food and energy for the month of October, the markets began to hope for a pullback at the end of the year, synonymous with a less aggressive Fed. Whatever the reasons for the generalised bull market in risky assets (Fed and inflation, Midterms, China or the FTX debacle), it remains clear that the long end of the curve is now closer to our 3.70% target than to the 4.50% level feared by some investors and expected by others (including ourselves) to increase again in duration.

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The release of lower US inflation figures is a good sign, but there is still a long way to go to get down from 7.7% to 2%.

One last factor emerged at the end of the month and also contributed to good performance in US long rates: the strong rise in COVID cases in China led to large popular protests against the zero-COVID policies being implemented. Some of them were directly targeted against the Chinese leaders and even Xi Jinping was not spared. Over the month, Credit markets also rebounded and the outstanding monthly performance of investment grade, as well as hybrid credit, was seen as a sign that we had probably reached the lowest point.

No rest for the Fed

The release of lower US inflation figures is a good sign but there is still a long way to go to get down from 7.7% to 2%. The Fed is not going to stop just because one monthly data point is encouraging. The Fed will therefore continue to pursue a restrictive policy by continuing to raise rates.

These rate hikes will probably be smaller than in the recent past, with the steps reduced from 75 to 50 basis points. It will also pursue its second goal of drastically reducing the size of its balance sheet. All of this points to a continued inversion of the US yield curve, dragging in its wake the German yield curve, whose slope had remained normal until now.

Short-term rates are rising, allowing “buy and hold” strategies on senior and subordinated loans to generate substantial returns. Long rates are falling and offer the prospect of capital gains in 2023 for “long-duration” strategies. But 2022 is not over yet: all eyes are now on 14th December and the last FOMC of the year.

Equities: A Winter Upturn

The equity markets continued to rebound in November, by nearly 7.8% (MSCI ACWI). October started with an almost identical increase at first (6.5% for the MSCI ACWI) followed by a slight hesitation phase. On 10th November, sequentially lower and slightly weaker than expected inflation figures (US CPI) won out over the more pessimistic and propelled the main world indices upwards once again.

Total returns for this year are now: MSCI China -29.6%, Nasdaq 100 -27.2%, S&P500 -15.5%, Stoxx Europe 600 -6.7% and Nikkei 225 -1.5%. The recent market moves and market upturn remind us how important it is to stay committed for the long term and not yield to panic.

So, are we in a situation in which the macroeconomic landscape and fundamentals have changed? Or are investors’ expectations resulting from a Fed pivot too high? Or is this just a technical rally fuelled by depressed valuations, seasonality (year-end rally) and technical factors (depressed investor sentiment, “window dressing” before the end of the year)?

The reason for this surge is therefore not unanimously clear. The time for the Fed to adopt a less hawkish attitude will come… But a single data point and the positive inflation surprise clearly do not seem enough to justify such a drastic change in the Fed’s attitude.

From a technical perspective, the indices are now reaching overbought levels according to the Relative Strength Index (RSI). Citi’s economic surprises indicator has been fairly stable since September, and the AA II BULL / BEAR sentiment indicator that collects bullish and bearish readings amongst indicators no longer indicates a situation in which bearish investors are prevailing (contrarian signal), although investors positioning themselves as “Neutral” are making a strong come back towards the end of the month.

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The recent market moves and market upturn remind us how important it is to stay committed for the long term and not yield to panic.

From a valuation perspective, markets were clearly pricing some of the worst outcomes, particularly in Europe as we wrote last month. This valuation factor is one we are keeping in mind, as the one of a change of paradigm by the Fed or the macroeconomic situation seems premature at this stage.

In any case, the winter picture is encouraging and comforting in this very volatile year. On the war front, Ukraine also seems to be gaining ground and pushing Russian troops back to the Donbas and their own borders, though not without difficulty. It is worth noting that Oil is now trading around $80 a barrel (Brent), which should allow for a lull in overall price rises.

Chart 2: CSI 300 Price Level Index (LHS) / CSI300 P/E Ratio (RHS)

Source: Bloomberg, Banque Eric Sturdza.

But China continues to blow Hot and Cold…

The Chinese economy is still paralysed by the Zero-COVID policy enacted two years ago and reaffirmed by the government during the last congress in October. If the important real estate crisis started in 2021 shows signs of slowing down, the Chinese lockdowns continue to weigh not only on Chinese markets but also impact the rest of the world through supply chain disruptions.

While the OECD predicts that global GDP growth will be largely supported by Emerging Markets, most notably Asia in 2023 (nearly ¾ of the world GDP growth in 2023), a marked slowdown in China would have significant consequences at a time when European and American economies are on the brink of recession.

The Zero-COVID strategy has in recent days triggered population revolt with increasingly large demonstrations in many cities. However, one of the provinces has already eased some restrictions in the fight against COVID after major social movements by employees and against a backdrop of rare hostility towards the president.

Xi Jinping is certainly well aware that his country’s economic rise also depends on a form of social tranquillity. The government may therefore take measures to ease the situation on a national scale in order to avoid persistent social disorder, which would most certainly damage the country’s stability and the image of its leaders internationally.

While the Chinese domestic market is undervalued (CSI 300 PE 13.6x), nationwide anti-COVID relief measures could trigger a powerful and rapid rebound. The very low valuation of Chinese equities would amplify this rally, while from a macroeconomic point of view, China still seems to diverge strongly from the situation that the other major world economies are going through and is better positioned for a strong rebound in the coming months.

Contributors: Marc Craquelin, Eric Vanraes, Pascal Perrone, Jeremy Dutiot and Edouard Bouhyer.

The original PDF document: “When inflation comes down…” 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
Director
+44 1481 742380
a.turberville@ericsturdza.com

The views and statements contained herein are those of Banque Eric Sturdza SA as of 04/12/2022 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.