Retrospective

Central banks are fighting inflation
Central bankers tell us that failing to restore price stability is currently a bigger risk than generating recession. Following the surprising higher than expected inflation data in the US in June at 8.6%, the Fed has raised Fed Funds rates by 75bps, a rare move.

More surprisingly, the Swiss National Bank has acted and taken the lead in Europe. It raised rates, for the first time in 15 years, by 50bps to counter inflationary pressures which reached their highest level since 2008 at 2.9%. After years of fighting deflation, inflation is now too high and the SNB has decided to act quickly. This rapid shift is also explained by a mindset change. After being seen as overvalued for years, the CHF is no longer seen as highly valued. By raising rates before the ECB, the SNB indicates that a stronger CHF is no longer a problem. It is possible because the strong CHF has allowed inflation to be more moderate than in Europe.

On the opposite, despite the ECB held an emergency meeting only 6 days after its June regular one in response to higher Italian bond yields, it did not act. However, the ECB has already pre-announced a rate hike for July by 25 or 50bps.

 

Bond shock has continued
The larger than expected Fed move in June has triggered a new wave of volatility on the bond markets. The US 10 -year government bond yields has continued its move higher and spiked to its highest level since May 2011. Even more surprisingly, the US 2-year yield reached its highest point since 2007. The Swiss Confederation 10-year yield have visited the 1.0% mark for the first time since 2013.

Credit markets have been shaken too. The spreads have sharply widened across the board. The US and EU investment grade credit have widened by 60bps and 100bps respectively in 2022, of which 30bps and 50bps in June. In the High yield space, US and EU spreads have both skyrocketed by 300bps in 2022, included 180bps in June.

 

Largest equity market de-rating since 1970
The first half of 2022 has gone down in history as a period when we saw the fastest rise in US yields, inversion of the yield curve with the first rate hike and one of the fastest de-rating of US equities on record. World equities have lost 12% over the 2nd quarter according to MSCI. Most of developed markets have delivered very close performance. However there were some exceptions. The most negatively impacted index has been the Nasdaq which has lost 18% in Q2. The main reason is the highest sensitivity for Big Techs to higher yields. The most resilient market has been once again the UK due to its high exposure to the energy and healthcare sectors.

 

Gold disappoints
In a context of risk aversion, gold price has gradually slipped to $1’800 from $1’900. However, it has remained resilient to rising expectations of aggressive rate hikes and a stronger USD, which historically was painful for gold prices. However, equity market weakness and ongoing geopolitical uncertainty would have support investor demand. It has been a relevant diversifier once again in a balanced portfolio to mitigate equity market losses.

 

Currencies - Q2 2022 performance

Currencies - Q2 2022 performance

A hawkish Fed, hiking rates aggressively to curb inflation, has pushed the USD to its highest level since early 2000s. In the developed world, the JPY has been the big looser due to a reluctant central bank to tilt to a more restrictive stance to fight inflation.

Emerging currencies have remained under pression, except the RUB., in a context of economic slowdown risks and lower commodity prices.

 

Bonds - Q2 2022 performance

Bonds - Q2 2022 performance

Another awful quarter for bonds. Higher inflation, hawkish central banks and fears of economic slowdown have pushed yields and spreads up. Bonds have delivered their worst semester in history.

The only exception, once again, is the Chinese market which has confirmed its lower correlation with international bond markets.

 

Equities - Q2 2022 performance

Equities - Q2 2022 performance

Another quarter of loss on equity markets. A prolonged war in Ukraine, elevated energy prices, higher yields and risks on corporate margins have pushed global equity markets down.

Emerging stocks were once again the biggest losers. China has been an exception thanks to easing Covid restrictions.

 

Commodities - Q2 2022 performance

Commodities - Q2 2022 performance

A big reversal happened in Q2. Excluding energy prices, most of commodities are down. Energy prices remained supported by the lack of supply to compensate the Russian offer. Other commodities have been penalized by the growing recessions fears.

 

Macroeconomy

Growth concerns

Manufacturing output

Global macroeconomic leading indicators nudged lower in June to their lowest levels since mid-2020. The deterioration took place despite an easing of COVID-19 restrictions in China - which allowed mainland manufacturing activity to rise at the fastest rate for over a year - and reflected weakened factory trends in the US, Europe and across much of Asia.

More encouragingly, the alleviation of China's pandemic restrictions contributed to a further easing of supply chain delays, which - alongside a stalling of global demand growth for manufactured goods - helped cool price pressures, albeit with energy providing further upward pressure on costs.

 

Improvement limited to China

Manufacturing trends excluding China

Production trends varied markedly around the world. Of the major economies, only mainland China reported an improving production trend, with output rebounding sharply from three months of lockdown-induced contraction, to register the strongest expansion since November 2020. It was also one of the strongest expansions seen for over a decade.

In contrast, output fell into decline in the eurozone for the first time in two years and came close to stalling in both the United States and United Kingdom, where steep slowdowns led to the worst performances for over two years. Japan likewise reported near-stalled production growth, its worst performance since January's Omicronrelated restrictions.

Growth of new orders likewise generally deteriorated, with declines registered in the eurozone, US and UK. Even China only saw a modest revival of demand, and near-stagnation was seen in Japan and across the rest of Asia as a whole. Notably, in all cases, new orders growth fell below that of output.

Excluding the rebound recorded in China, the global factory trend therefore looked less impressive. In fact, excluding China, factory output growth came to a near standstill in June, registering the weakest performance since June 2020, while new orders fell for the first time in two years..

 

Strategy

Suffocation

Equity to Bond correaltion

The magnitude of the inflation surge in G10 and its stickiness has impacted major asset classes in depth. Global equity and bond markets fell in synch, in a crucial challenge to the two decades’ prevailing - negative - correlation.

A global recession seems inevitable, putting a definite end to the current unusual business cycle. The question of its magnitude and intensity will gradually take over the fears of an unbridled inflationary regime change.

We consider that equity to bonds correlation will remain highly volatile this year but should not remain durably in positive territory. From a cyclical perspective, the left tail risk of a deflationary shock, due to the confluence of the durable energy shock and inevitable consumers’ retreat, not to mention the huge debt burden, is rising. It is becoming at par with the right tail risk of a runaway
inflationary regime as in 70/80’s.

Markets have now rebuilt a risk premium consistent with the - dangerous - G-Zero landscape.

The ongoing brutal repricing of risky assets’ valuation is well underway. The necessary drying up of excess liquidity and the onset of the severe economic downturn will continue to weigh
on risky assets.

 

Investment landscape

Central banks balance sheet

Stagflation is entrenching in G10. Such a landscape hasn’t prevailed since about 5 decades. Markets have acknowledged for that in suffering: both equities and bonds have cratered, for two quarters, in sync. Not only are these framework conditions difficult for investors to cope with in themselves. Worse, they are completely new to almost two generations of investment professionals
and further overshadowed by the pandemic and geopolitics. Making forecasts in this environment becomes particularly uncertain! A future return to some form of calm / neutrality is illusory.

The range of possible outcomes for the economy and markets has become particularly wide and opaque.

 

Currencies

Central banks tackled the pandemic head on but are now fighting inflation

Dollar trade weighted

With higher yields, elevated volatility and wider spreads, the bond market is sending warning signals that the FX market is listening. The global economy is hit by supplychain shocks, China zero-COVID policy, higher energy prices and the war in Ukraine. Recession fears are growing, and the USD has been the principal beneficiary of the longest period of high volatility we are living in
since early 2010s.

The USD is reaching its 3rd peak in 40 years. The first episode in 1985 was straightforward, the Fed tightened aggressively to cool down strong growth and accommodative fiscal policy, just before the Plaza Accord. The 2001 peak came after a lengthy period of heightened volatility. The USD was boosted by the Asian crisis, the Russian default, the LTCM collapse, the Dotcom burst, and the 9/11 attacks. The 2008 peak followed the global central banks easing to counter the Global Financial Crisis.

Dollar performance (weeks around recession)

Since then, the investment environment has been a secular stagnation (low growth and little inflation). Looking ahead, a more permanent stagflation (low growth and elevated inflation) seems a more likely scenario. The focus may move towards elevated energy prices winners, or predictable cash flows such as profitable tech, healthcare, and energy sectors. The US economy looks well positioned than any other (industry, banks).

According to history, there is no consistent USD pattern when the US enters recession. In contrast, there is a very consistent pattern when the market has fully priced in the recession: the USD has historically always weakened when the equity market has troughed, around the midpoint of the recession.

The next large move is likely to be down but not until tangible signs confirm that inflation is peaking, growth slowing, Fed tightening taking a break and markets calming down. Until then the USD will stay firm.

 

Bonds

Global central bankers hawkish shift

Central banks and CPI rates changes in 2022
The Fed remains unconditionally committed to bring inflation down but recognized that without price relative calm, macroeconomic or financial stability are unlikely. If inflation remains high, the Fed will be reluctant to cut rates in respond to deteriorating macro context. The Fed target of reaching 2.0% inflation and a strong job market would be challenging. Achieving a soft landing is not
going to be easy. The Fed has no intention to cause a recession but acknowledged that is a possibility. This contrasts with the previous testimony when achieving a soft landing was more likely than not.

The Fed remains committed to reduce its $9.0trn balance sheet by 30%. More importantly, Powell pushed back on the possibility of the Fed raising its 2.0% inflation target. Several Fed officials are promoting another 75bps hike in July. Although 75bps hikes are rare, it was not the first time the Fed implemented such moves. Since 1971, the Fed has raised rates 5x by 100bps, 4x by 75bps and 9x by 50bps.

Most central banks are still behind the curve, with very few still dithering. The world hawkish twist will last at least until a recession starts.

 

High Yield market passiveness

Economic activity indicator and HY spread

Since the GFC, investors have been conditioned to buy on the dips across risky assets, including HY. The pandemic reinforced this practice and thanks to fiscal stimulus, monetary intervention, and Fed facilities. That promoted complacency and raised questions as to how investors would react to a real recession. Logically, default rates increase, and issuers are less likely to cover interest payments and debts.

Spreads have always widened in a higher macro uncertainty and equity volatility environment. Their spikes occurred when volatility suddenly jumps. For now, US HY spreads at 500bps are pricing in a moderate economic slowdown. In a recession (ISM Manufacturing below 50), the US HY spread should be closer to 700bps and above 900bps in a deeper one (ISM below 45). The probability of a protracted slowdown and even a true recession is much higher now than before the war in Ukraine and the rapid unwinding of Fed stimulus.

 

Equities

A Bear market, from inflation to recession

S&P500 earnings and recession periods

The 1st phase was the compression of multiples, the second should be the correction of profits. Over the past 12 months, stock market valuations have contracted by around 40% with the sharp  upturn in inflation. Multiples contract when inflation rises. See graph below. In the two oil crises of the 70s and 80s, US inflation had risen above 12% and the PE ratio of the S&P 500 fell to 7x.

The Growth segment and disruptive stocks with high PER generally do not withstand these periods when inflation returns and interest rates rise; in relative terms, their stock market valuations have fallen much more than those of the Value segment, characterized by low PE ratios. This explains the outperformance of the Value segment vis-à-vis the Growth segment in recent months. Since 1975, we have witnessed the largest decline in stock valuations on an annual basis.

The downward readjustment of multiples due to rising inflation is coming to an end, as we believe that inflation peaked mid-year due to falling demand caused by the rising prices and consumer caution in the face of an uncertain future..

Macro models show a decline in profits

According to the correlation model between the PER of the S&P 500 and US inflation, the PER of the S&P 500 should be between 10x and 12x if inflation were to remain between 8% and 10% in the coming months. Today it stands at 16x, which is high and inappropriate based on the model below; unless, as we think, the market is anticipating a return of inflation towards 5% by the end
of the year. Otherwise, PERs will continue to contract.

Since its peak at the start of 2022, the MSCI World index has lost more than 20%, validating its entry into the bear market, through the drop in PERs. Indices could continue to decline with the contraction in profits. Equity indices never rise when profits fall. By a bottom-up approach, which is lagging, US profits are expected to rise by 10% both in 2022, 2023, and in 2024, which seems (very) optimistic given the probable recessionary orientation of the economy in the coming months. By a top-down approach, which is leading, profits should fall by 20%.

If the US economy were to go into recession, profits would fall, even in an economic downturn.

 

Commodities

Cyclical pause in the Supercycle

Bloomberg Commodities Index

The global recession is becoming more threatening and inflation of energy prices is pushing consumers to reduce their demand. With the sharp decline in Russian gas exports, Europe is on the verge of a major energy crisis; measured rationing could allow gas reserves to be filled to 100% for the coming winter and reduce pressure on prices. The sharp decline in industrial metal prices signals that the Chinese economy and its real estate sector are not doing very well, despite the authorities' optimism and supporting measures.

We will therefore move from a historic supply shock, due to Covid, then to the war in Ukraine, to a gradual process of falling demand due to the economic slowdown/ recession and alternative measures taken by consumer countries. In this major energy disruption, coal is regaining “color”, with a reactivation of coal-fired plants to produce electricity in Europe, India and China.

We believe in high but stable energy prices. Demand is expected to weaken in the coming months and OPEC may add capacity to the market, but the market remains tight and a problem at a major producer could push prices higher. For some years now, experts have been warning of a lack of investment in production capacity. These crises show that the green transition will have to be done in a more coherent way and have very solid alternative solutions to fossil fuels before doing without oil and gas.

 

Industrial metals

Long term gold price dynamic

Industrial metal prices have fallen significantly since March 2022: -35% for Bloomberg Industrial Metals, dominated by copper, aluminum, nickel and zinc. Metals are suffering from Chinese Covid lockdowns and the restrictive monetary policy of the Fed which prefers to sacrifice economic growth to control inflation.

Nobody talks anymore about the great needs of metals which are arising for the energy transition. Yet they are very real and huge. Energy and Industrial Metals sectors could be less attractive in the coming months, as investors are focused on the risk of recession. But China and the green transition remain two major factors for a resumption of the Commodities Supercycle after this economic pause.

 

Allocation

Allocations - Julliet 2022

 

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Global vision

LT macro regime. Shorter and risker cycles than in past decades. Imbalances, debt, resurging inflation, and geopolitics result in more cyclicality and variations in economic cycles

US and China financial conditions (FC) on their way to neutral. Deceleration of global liquidity from late 21 continues. Concomitant rise of USD, correction of risky assets and widening of spreads have - already - brought FC on the verge of neutral in the US. Early signs of more accommodative FC in China

Stagflation is 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 accentuate its fiscal impulse

Geopolitics remains critical / hectic. Wars are disruptive and ultimately inflationary. They result in higher risk premium for financial markets

Fear and realized volatility spelled significant capital outflows. Higher cross-assets’ volatility and growing fear have induced margin calls and forced selling from retail investors

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 has lately restored appeal of duration rich assets

Repricing / correction mode is resulting in less expensive valuation. The combination of nasty fundamental factors will generate a succession of risk-on/off periods over next quarters. Unless ¨something¨ breaks in the meantime…

Markets’ action has - by far - preceded the Fed’s - The U-Turn of Powell triggered an unusually quick and sharp tightening of US financial conditions. All components of FI actually contributed to the rise: a stronger dollar, higher rates, wider spreads and a corrective equity market. According to its historic relation with developments of financial conditions, US ISM could soon visit a level below 50, featuring odds of a serious slowdown, if not a recession. The housing market is giving signs of exhaustion because of the dual action of higher Treasury bond rates and more cautious
banks, triggering larger spreads. This sector is a significant contributor to growth and an important vector of wealth effect.

The mid-term elections in November will take place in a poisonous internal political climate. The President is at a low ebb in the polls, the Democrats are certain to lose control of the Senate and even the House of Representatives. At best, we are headed for a cohabitation, and thus the paralysis of the Biden administration's budget initiatives. At worst, we are headed for an institutional crisis if the Republicans, led by Trump, continue their institutional defiance. This is not a climate conducive to raising policy rates, let alone if the economy takes a nosedive.
The Fed is likely to back-off from its hawkish rhetoric in H2
It may even pause around mid-term elections

Asset allocation conclusion - The very important selling flows and the extremely pessimistic psychology of private investors is rather reassuring: the first phase / wave of re-pricing / return to normal is well underway. The valuations of financial assets, which were sometimes exuberant, are also beginning to return to normal, particularly with the gradual disappearance of negative rates. However, the macroeconomic component will remain poorly oriented in H2. The inflationary irritation is not over.

It is difficult to see how the financial markets could sustainably return to the upside in this still very disturbed context. Geopolitical uncertainty will prevail and will also maintain pressure, in depth. We confirm our cautious bias.

 

Currencies

The end of USD bull run - On mid-May, the USD index reached its highest level since December 2002 of just over 105. It had gained 7.5% in Q2, 9.8% in 2022 and 17% in one year. Given such strength, it will be hard to pull the USD even higher without the US monetary policy outlook and yields moving further in the currency favor, or another deterioration in risk appetite supporting haven demand for the USD.

The Fed policy outlook should remain hawkish. It should hike rates at a fast pace, with a 50bps hike in June and July before switching to 25bps in the remaining 2022 meetings. Powell warned that the Fed will continue to raise rates until there is “clear and convincing” evidence that inflation is receding.

The neutral interest rate is estimated to be close to 2.5%. However, as the market expects the Fed funds to reach 2.75% by year-end, a restrictive Fed policy is already priced in. There is less scope for an even more hawkish tone to pull the USD higher. In addition, the policy divergence that had supported the USD against most of its peers is being whittled away as other central banks continue to hike rates. By the way, US yields have peaked in early May, just before the USD index reached its high. So, USD bulls may be left dependent on risk appetite to keep the currency elevated.

The USD has slightly slipped from its 20-year peak. Momentum behind the long USD position should fade
Only periods of weak risk appetite and uncertainty could boost haven demand for the USD. However, it has now priced in the full Fed tightening. The prospect of other central banks hiking rates should eat into the USD gains

An EUR catch-up is underway - The EUR spent the first half of May underperforming the safe-haven USD and JPY and reached a 20-year low. This has been a trigger for the FX market to rethink whether there is much more value. The USD is already very high and the ECB signaling that it is very close to hiking rates. The policy dynamics should be moving in the EUR favor.

Most ECB members rhetoric has grown increasingly hawkish over the last couple of months. The next ECB policy announcement will be made on June 9th and is expected to signal that a rate hike will be made at the July meeting. The ECB will exit negative rates by September. The first ECB rate hike since 2011 should be EUR-supportive.

 

Bonds

Market mindset is clearly switching - The MOVE, the US yields implied volatility index, reached its lowest level since the start of the year. This stabilization is a positive sign. The US Treasury market posted its first positive monthly return since last November. After focusing on inflation for the past several months, the market is dealing with a potential deep and faster-than-expected recession risks. Inflation expectations are on track to post their largest drop since March 2020. The markets now seem convinced that the Fed, or any other factor, will be able to contain inflation over the long term.

Bond volatility will decrease with lower long-end yields

 

Central banks determination - Chair Powell recently stressed that the Fed needed to see inflation coming down in a clear and convincing way and that a slight unemployment rate rise is the price to pay to achieve price stability. Recent activity indicators have disappointed expectations with a larger than expected drop in the PMI and a sharp decline in real estate data. This is fueling fears that a recession may be coming sooner in the US.

After having expected more than 75bps Fed Funds hikes in 2023, investors have sharply backpedaled. The bond market is now expecting the end of the Fed tightening cycle, or at least a pause, by mid-2023.

Various ECB members confirmed the need to move quickly away from negative rates. All of them are pre-announcing a lift-off in July, following the end of net asset purchases. The market is fully pricing it and is now expecting faster rate hikes but with the same overall hikes adjustment.

Lagarde and other ECB members continue to stress that policy normalization should be driven by the principles of optionality, gradualism, and flexibility. It is key to anchor longterm inflation expectations with a credible normalization of the monetary stance. The pace of normalization will have to be calibrated to reduce the uncertainty on future inflation. So, the speed of rate hikes could depend on the degree of economic slack. Unlike the US, which is in a situation of excess demand, it will justify a slower adjustment in the euro area. Most ECB members confirmed that the euro natural interest rate is well in the positive territory, in between 1% and 2%.

While we favor a total of 100bps of hikes, we exclude steps other than 25bps. A 25bps hike at every meeting in July, September, October, and December, while far from a done deal, would be in line with the idea of gradual normalization of ECB policy.
Shifts in risk sentiment are dictating the price action. ECB rate hiking expected to be faster but not higher
Long-end yields could redirect higher only if both risk sentiments and economic surprises strongly improve

 

Challenging moment in credit market - Investment-grade (IG) and highyield (HY) bonds have been both under pressure all year long, but a large part of that distress has stemmed from higher interest rates and wider credit spreads rather than deteriorating corporate fundamentals.

Surprisingly in such a context, the size of the IG bond market has continued to grow,  hitting $4.9trn in April, with new debt issuance holding up relatively well. Upgrades to IG from HY have positively contributed to market growth since Q4 2021, rising star companies adding $72bn.

Through now, IG issuance is down 14% while HY is down 75%. New issuance is normalizing near the 2019 level, after $1trn issued in 2020 to bolster liquidity at the pandemic onset. IG total maturities will reach $156bn in 2022, $272bn in 2023 and $302bn in 2024. The market will still have to digest large additional issuance amounts without the buyer of last resort intervention, central banks.

The BBB-rated companies dominate the IG bond market (60%). Downgrades to HY - given the current economic slowdown risks - will reduce the size of the IG market and push lower rated bonds spreads wide. IG will outperform HY

 

Equities

Rally in a bear market or correction in a bull market ? - We came close to a bear market for the global American and European indices, according to the classic definition of a correction of more than 20%. The Nasdaq entered it cheerfully with a decline of 32% between the highest (end of November) and the lowest (mid-May). To define a bear market, the magnitude of the correction is not the only factor, there must also be a notion of duration. In March 2020, the 35% drop in the MSCI World was a violent correction, rather than a bear market.

The rally, which began on May 20, is the result of a combination of favorable factors: 1) Technically, the indices were oversold and a double-bottom configuration had taken place with the appearance of support, 2 ) The fall in interest rates, the fall in the dollar and a possible peak in US inflation in March eased selling pressures on equities, 3) Indicators of investors’ sentiment were in the (very) pessimistic zone, in generally a good signal for a rebound in stock market indices and 4) China had started to ease health restrictions, particularly in Shanghai.

The results for the 1st quarter of 2022 turned out to be much better than expected, with a 9.2% increase in profits (4.6% expected at the start of April) and 13.6% in revenues for American companies, and 11% and 25% respectively for European ones. Despite problems of disruption and inflation, the outlook remains surprisingly good. Chinese economic growth will be an important element of the health of Western companies' results; after targeted measures, the Chinese government could launch broader stimulus programs with the end of the lockdowns.

The decline in the Goldman Sachs financial conditions index also explains the rebound in equities. The Chicago Fed Adjusted Financial Conditions Index is also turning around.

The week of May 25 saw the first net purchases in equity funds since early April, mainly in favor of the US and Asia.

All these points favor to a continuous rally, but we remain cautious on the future economic growth. We believe the rebound is an opportunity for a shift in sector allocation towards defensive sectors, Consumer Staples, Pharmaceuticals and Power Producers. And in a world of West-China/Russia confrontations and protectionism/ economic nationalism, commodities and defense are two sectors to focus on. Historical studies show that in times of stagflation (high inflation/low economic growth), such as in the 1970s, energy and agricultural commodities perform well and are the only traditional asset classes to deliver positive returns in real terms. Fighting inflation with a sharp rise in interest rates will be difficult due to a very high level of public debt.

We are maintaining our neutral stance on the US, an underweight on European equities, while we overweight Swiss equities.

The weakness of the dollar and the drop in US interest rates offer a window of opportunity to return to emerging equities. But it is a very tactical move, because emerging stocks are the weak link in this current environment: various disruptions, Covid, high energy and food prices, climate change, regional globalization, protectionism/ nationalism, weak global economic growth, energy transition. We avoid emerging countries that import energy and agricultural products. Outflows from funds invested in emerging assets are at the highest in 30 years. Emerging equities should become more attractive when central banks focus more on growth than inflation.

China is a great unknown. The economy is slowing and the real estate sector is under stress. Chinese equity funds saw the largest outflows. The Communist Party has taken control of Chinese society to return to the great principles of communism and control of the “perverse” effects of technology, online games and social networks on children. China wants to impose a new world security order, with Russia, with the Global Security Initiatives (GSI) to counter NATO and the Quad. The fate of Taiwan returns to center stage with the Russian invasion of Ukraine. For US and European institutional investors, Chinese equities represent a risk.

 

Commodities

Global rise in raw materials - The pandemic, then the war in Ukraine, have shown the fragility of the globalization and the harmful interdependence of economies, and rekindled tensions between the US/Europe/Japan/Australia and China/Russia blocs. India is for the moment apart, since it receives its fossil fuels and its weapons from Russia and relies on the United States to counter China.

This complicated environment, accentuated by climate change, translates into higher prices for energy and agricultural goods. Industrial metals are down due to China and its confinements which partially stopped the economy and the real estate crisis; China accounted for 25% to 50% of global demand. Investors lack visibility on a Chinese economic recovery to return to metals, but they could be interested again if China announces major support plans.

Brussels announced an embargo on Russian oil of up to 90% by the end of the year, with a temporary exception for the Druzhba pipeline (the remaining 10%) which supplies Hungary, Slovakia and Czechia. This embargo caused an increase in oil prices due to a tight world supply. 36% of European oil imports came from Russia and 75% of Russian oil came by ship. If OPEC+ does not increase its production and Chinese demand picks up again this summer, we may well see oil prices rise sharply. It is not certain that this embargo is harmful for Russia, because the fall in volumes is compensated by a rise in prices, but the European Union and the UK have provided an answer to hurt Russia: they have just prohibit insurers from insuring vessels carrying Russian oil, closing the door to Russia's access to the world's largest insurance and reinsurance market at Lloyd's in London.

A major event could ease crude prices: some OPEC members would seek to exclude Russia from the OPEC+ agreement. The North American and European embargo on Russian oil could force Russia to produce less and force Saudi Arabia, the United Arab Emirates and other producers to produce more.

We therefore remain invested in oil and gas stocks, in particular Americans, which are the big winners for the coming months, before other LNG suppliers appear later such as Qatar, Algeria, Australia and Japan.

 

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Global vision

Asset classes - 10 5 22

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?

outright stagflation - 10.5.22

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.

 

Currencies

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.

large fed repricing

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.

 

Bonds

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.

credit fed vs fed funds

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.

Equities

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.

SnP 500

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.

classic cycle

 

Commodities

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!

gold vs US Dollar

 

Disclaimer - Ce document est uniquement à titre d’information et ne peut en aucun cas être utilisé ou considéré comme une offre ou une incitation d'achat ou de vente de valeurs mobilières ou d’autres instruments financiers. Bien que toutes les informations et opinions contenues dans ce document ont été compilés à partir de sources jugées fiables et dignes de foi, aucune représentation ou garantie, expresse ou implicite, n'est faite quant à leur exactitude ou leur exhaustivité. L'analyse contenue dans ce document s’appuie sur de nombreuses hypothèses et différentes hypothèses peuvent entraîner des résultats sensiblement différents. Les performances historiques ne sont nullement représentatives des performances futures. Ce document a été préparé uniquement pour les investisseurs professionnels, qui sont censés prendre leurs propres décisions d'investissement sans se fier indûment à son contenu. Ce document ne peut pas être reproduit, distribué ou publié sans autorisation préalable de PLEION SA.

Retrospective

The Russian invasion triggered a risky assets sell-off
The pandemic is not even over as the latest lockdowns in China illustrate, and the war in Ukraine started. It is putting global supply chains through another test. Distortions in supply because of the destruction of war and disabled supply chains, sanctions, and voluntary self-sanctioning all hit trade.

Although Russia and Ukraine’s global trade share in exports and imports does not exceed 2%, both countries are crucial commodity exporters. In addition to energy exports, Russia and Ukraine export agricultural products such as wheat, corn, and sunflower oil and large amounts of industrial commodities such as steel palladium, platinum, and nickel, amongst others. Delays and congestion suggest longer-lasting problems for supply chains.

The Russian invasion has triggered a sharp spike in volatility and risky assets have collapsed
Global equities (MSCI World) have experienced a fall of c. –14% between early January and early March. Concomitantly, safe even assets have spiked. Gold price has jumped by +16%, and the USD by +4%. Energy prices have benefited from geopolitical tensions and sanctions to reach new highs: oil and natural gas up by +65%, industrial metals by + 40% and agricultural goods by +25%.

Since March 8th, risk appetite has resurfaced. Most of those segments have dropped from the highs.

More surprisingly, the US treasury bonds failed to be the asset of choice. Given high realized and expected inflation, the US yields have strongly moved up to 2.40% form 1.50% on the 10-year. The US government bond index has delivered its worst quarter since 1980. European bonds have followed and printed their worst quarter since the launch of the EUR. 10- year German and Swiss yields are back into positive territory for the first time since 2019 and 2018.

Fed tackling inflation head on
In March 2021, the Federal Reserve told us that inflation was largely transitory. It was primarily the result of postpandemic re-opening frictions, and in an environment of significant labor market slack, it would not need to raise interest rates before 2024.

Fast forward 12 months and the story could not be more different. The economy is now 3% larger than before the pandemic struck, the unemployment rate is below 4%, and inflation is proving to be far more durable, running at 40- year highs and still rising.

The Fed has just started its tightening monetary policy cycle with a 25bps rate rise at its March meeting and signaled that 50bpswb rate hikes are firmly on the table at upcoming meetings.

All equity markets and segments are equal
In such a complicated environment, the US equity market has once gain outperformed peers. The Dow Jones dropped by –4.1%, the S&P 500 by –4.6%, and the Nasdaq has lost –8.9%. The latter being more sensitive to interest rates moves. Euro equities have lost –8.9% and Japan –4.3%. The UK market has been the most resilient given its exposure to pharmaceuticals, oil & gas and metals & mining companies, which have been the main gainers in this context. It was up by +2.9%.

 

Currencies - Q1 2022 performance

Currencies - Q1 2022 performance

Currencies have had a bumpy ride. Within developed countries, the EUR is the big loser due to its geographical exposure and its energy and food dependence on Russia and Ukraine.
Within emerging currencies, performance was very balanced.

 

Bonds - Q1 2022 performance

Bonds - Q1 2022 performance

Nowhere to hide. The vast majority of bond segments posted negative performances. The reason is the sharp surge in inflation and the aggressive response from the US Federal Reserve.
Once again the Chinese sovereign market demonstrates its diversification characteristics.

 

Equities - Q1 2022 performance

Equities - Q1 2022 performance

After a sharp correction at the beginning of the Russian invasion, developed markets have recovered. They are slightly down given the context. Europe underperforms the US.
Emerging stocks were the biggest losers. China is the big loser.

 

Commodities - Q1 2022 performance

Commodities - Q1 2022 performance

Unsurprisingly all commodities have delivered strong performance, whether food, energy or metals. The current conflict having a significant impact on the supply side.

 

Macroeconomy

Developed world growth slows

Energy price pressures
Inflationary pressures were sustained, with the number of manufacturing firms worldwide reporting higher prices for raw materials nearly four-and-a-half times higher than normal. A fresh series record of higher prices was reported for semiconductors, while reports of rising energy prices were also at a record high amid surging gas prices.

In the wake of the Russian invasion of Ukraine the cost of energy became especially volatile, with the benchmark for global oil prices exceeding $130 per barrel at the start of the conflict. Moreover, given the dependence of European economies on Russian gas and existing price and supply pressures, reports of rising energy costs and strained supply are likely to continue throughout the year.

 

Pandemic-induced supply shortages ease but remain a driver of global inflation

Semiconductor prices and shortage
As has been the case since 2021, manufacturers globally reported severe disruption in electrical components amid stronger demand. Semiconductor and electrical item shortages have plagued the global manufacturing sector recovery. While there were tentative signs of easing pressures at the turn of the year, the rise of Omicron variant has forced a renewed rise in the number of
companies reporting shortages.

Firms have reported surging price pressures for these inputs have led to sharp rises in costs. Moreover, price and supply pressures for semiconductors especially has had a knock-on effect across the global manufacturing sector. This is most prevalent in key sectors such as automotives, as car production has become increasingly reliant on semiconductor technology.

The outlook for global inflationary pressures appears skewed to the upside due to escalating energy prices and renewed disruptions to international supply chains. While COVID-19 restrictions have been lifted across much of the world, supply chain disruption is expected to continue feeding into purchasing prices.

The pace at which price and supply pressures return to stability will be contingent on how quickly logistical disruptions are resolved and capacity is rebuilt, or in some instances "re-shored" to help resolve supply and demand imbalances.

 

Strategy

Landing with sticky inflation

US Financial conditions
It is a painful reminder: in Q121 the Fed expected average (transitory) inflation in 2021 to range around 1.5%! Twelve months later, even the slightly more realistic G7 central bankers (such as Canada and the UK) are eating their hats and seriously increasing the pace of monetary tightening. They have little choice if they do not want to lose control and the little credibility they have left!
Fortunately, Hyper-inflation is not around the corner.

A global recession is not a base scenario, though its odds have become significant lately (say 30% in 2022, 50% in 2023). But still, removing the ¨patch¨ when the economy decelerates will prove a very delicate path. Even more so considering the unpredictable trajectory of commodities’ prices. If history is any guide, energy shocks of the current magnitude, when they last a couple of quarters, have irremediably provoked hard landings…

Investors’ consensus has rapidly acknowledged for the deterioration of growth perspectives. According to recent surveys, the consensus now expects a macro framework comparable to 2008/9, 2018/20. Interestingly, the wave of pessimism started long before the Ukraine conflict. A geopolitical risk premium has built lately. Fears of nuclear war in Europe have pushed oil and gold to
stratospheric levels.

 

Investment landscape

Investors brutal bearish shift
A premature end of the business cycle is as likely as a soft-landing scenario. Still, negative real rates will prevail. Risk premia will continue to progress, as markets will endure contracting global liquidity. Policymakers have no choice but to tighten financial conditions, until ¨something tentatively breaks¨.

The global landscape for financial markets is becoming gradually more adverse. Uncertainty and volatility will prevail. A lot is already discounted by investors, though a ¨full capitulation¨ did not occur.

 

Currencies

Fed hawkish repricing is no longer the trigger

USD performance around Fed tightening moments

Past price actions have demonstrated that this is not necessarily good news for the USD. In 4 out of the past 5 tightening cycles, the USD has appreciated in the 6 months before the first rate hike. However, it has only once continued to strengthen in the 6-months after. This reflects the fact that the Fed has not always delivered on expectations of promised tightening cycles. The nearterm inflation threat may mean 2022 is different, but at the same time the hurdle to beat current expectations are high, they have already risen above the neutral rate.

For now, all is about inflation, central banks' exit strategies and yield expectations. All those factors are at the benefit of the USD, but the real economy developments could become more of a driver in the year.

Surprisingly, this could support EUR bulls. The US economy will experience a net fiscal tightening this year while the European Union will get another boost from budget spending. A significant help will come from the EU Recovery Fund. It is expected to boost GDP by 0.5% in 2022 and 0.6% in 2023 and 2024.

 

Excessive USD strengthening

Long-term purchasing power parity vs. USD

When the pandemic hit the world in March 2020, the major currencies were all close to their fair values. But the recovery has been very uneven. The USD is at its most expensive level in at least 6 years according to purchasing power parity (PPP) metrics. PPP is an economic theory that compares different countries’ currencies through a “basket of goods” approach. Two currencies are in equilibrium when a basket of goods is priced the same in both countries, considering the exchange rate.

The USD is now more than 25% overvalued against the JPY and almost 10% against the Euro.

The GBP is fairly valued.

Only the CHF is stronger.

 

Bonds

Negative yielding bonds have vanished on aggressive tightening talks

Long-end yields and Fed Funds expectations

Such aggressive pricing Fed tightening in terms of speed and magnitude has never happened. The market expects the Fed to hike rates up to 2.75% by June 2023, in line with the Fed own expectations for 2023, and above the median long-term dot (2.4%). The terminal rate pricing (2.75%) is already above the previous Fed terminal rate (2.50%) and close to the previous market expectations peak at 3.0%. This time the market believes the Fed will have time to reach restrictive area.

Historically, market expectations tend to overshoot what the central bank eventually delivers. This happens in late cycles, and terminal rate expectations tend to peak when the end of rate hikes is in sight. The market is now pricing the end of the Fed tightening in a little more than a year.

 

Challenging credit environment not over yet

Moody’s default rates and 12-month forecast

Emerging Credit markets saw some respite after the first Fed Fund rates hike, due to some buying activity, driven by investors comforted by more clarity on rate hikes and the Fed's decisive action against surging inflation. This relief is expected to be short-lived as uncertainty to engineer a soft landing will weigh on the riskiest part of the fixed income universe.

The current situation shows default rates are very low. Moody’s default study indicates only a mild deterioration in the next 12 months, the US default rate will rise just above 3.0% by January 2023. Their base case looks a bit optimistic. A worst scenario is more likely given the large increase in the CCC-rated bonds.

The bigger issue now is what second-round effects from higher inflation, rising energy costs and supply chains disruptions. We are already seeing some effects. However, we also believe that central banks and governments are much more proactive now than in the past when it comes to supporting the market amid external shocks.

In the current context (war, sanctions, disruptions), HY default rates are set to rise much closer to 2016-2018 levels. Credit spread will follow.

 

Equities

Despite a hostile environment stock market indices are holding up

S&P500 post curve inversion Performance
The stock exchanges have been resilient with corrective phases and rapid rallies because of the algorithms, which are removing the emotional character of investors. The market is efficient: since March 2021, the start of the inflation recovery, the indices PE ratios have contracted by 30%. Now, there remains the profits development. The US yield curve flattening signals a risk of an economic slowdown .

Data from the Dow Jones Market (see chart below) shows that the S&P 500 rises 13.5% on average in the 12 months following an inversion of the 10yr-2yr curve. Some analysts point out that the 10yr–3m curve has a better ability to predict recessions and today we are far from inverted. Historical analysis shows that stock markets can rise up to 18 months after the yield curve inversion.
2022 begins with record US share buybacks, a sign of corporate health and expectations that business conditions will remain supportive.

 

Seasonality

S&P 500 Midterm election year pattern
In terms of seasonality, we are entering a more favorable period. There are 4 periods:

In 2022, the United States will vote for midterm, which usually is a source of higher S&P 500 volatility, particularly between May and October. The US stock market behaves less well when the president is a Democrat. Most of the time (18 of the last 21 midterms), the president's party loses seats in Congress. It is therefore likely that the Democrats will lose the majority in Congress with Republicans led by Donald Trump, reigniting the divide, political aggression, and conspiracy theories.

But history also shows that the S&P 500 rebounds strongly after the midterms: +15% over 1 year vs. +7% in a year without a midterm.

 

Commodities

The Russian war will decisively change the energy market

EU Energy imports by countries

The timing coincides with an already tight oil and gas market. The damage is done, Russia will lose its first customer and Europe will give up its first supplier of fossil fuels.

The European shift will be quick: Germany wants to do without Russian coal from autumn 2022, Russian oil by 2022-end and Russian gas by 2024-end. It signed contracts in early March for the construction of LNG terminals. The United States and Europe have set up a task force to ensure Europe's energy security and significantly reduce its dependence on Russian fossil fuels, mainly with the increase in US LNG exports (doubling in 2022) and the acceleration of the energy transition. Europe will have to reorganize by building LNG terminals for regasification.

The big winners from the Russian shock will be liquefied natural gas, US oil and gas, Qatar, energy transition, and possibly Algeria, Norway, and Australia. The United States is in the process of becoming the 1st LNG exporter in the world.

 

Industrial metals

Long term gold price dynamic
The war in Ukraine and the massive sanctions against Russia have exacerbated the already existing supply shock due to the pandemic. The problems are not only related to Russian production, but also to the domino effect on all global production and transport chains.

Russia is a major producer of nickel, palladium, and platinum, a little less for gold, silver, and copper. On the other hand, Russia is a major producer of (semi)finished metals such as steel and aluminum intended mainly for Europe. As with oil and gas, Russia was THE supplier to Europe. Of course, in the short term, European countries will suffer from such dependence. Neon gas, of which Ukraine accounts for 70% of global production, could cause significant stress in the semiconductor manufacturing process.

For many metals, supply deficit was already the case before the pandemic.

 

Gold
The price of gold follows the evolution of real interest rates. Gold is a good decorrelated asset in this current macroeconomic (inflationary) and geopolitical (war) situation. Will it follow the same path like in the 1970s?

 

Allocation

Allocation

 

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Global vision

Asset classes

Long-term macro regime. Prepare for shorter and brisker cycles vs last decades
Imbalances, debt, sticky / resilient inflation, and geopolitics argue for more cyclicality and variations in economic cycles

Financial conditions will continue tightening. After plateauing T421, global liquidity has started to contract in 22 because of central banks, higher oil prices and sanctions on Russia (pressuring European banks B/S)

Economic recovery will broaden as pandemic eventually becomes endemic. Growth-flation is likely in the US, and possibly in Europe if it can escape an energy crisis. China trajectory is uncertain, as politics dominate (Zero-Covid, deleveraging)

Geopolitics is back with vengeance. The war in Ukraine is a wake-up call for complacent investors. It imposes the installation of a risk premium

Erratic capital flows into financial markets. Speculative investors face higher cross-assets’ volatility. Long only investors did not panic, as wider spreads and oversold conditions refrains massive selling, while uncertainty prevents buying

Unstable equity-bonds correlation, but no regime shifts. Negative real rates will remain in force in 2022. Growing risks of a hard landing restores appeal of risk free / duration rich assets

A succession of risk-off / on periods ahead. A cocktail of complex events is unfolding. Geopolitics, irritating inflation (and a maneuvering Fed), as well as likely delicate US politics in H2 (controversial mid-terms)

War in Europe - The Geopolitical framework has shifted from bad to perilous in just a couple of weeks. Obviously, guessing at this stage the outcome of the Ukraine war is impossible. Still, after one week, experts think that the odds of a ¨Blitzrieg¨ are lower than at first thought. Ukraine’s resistance is raising the bar for Putin. Contrarily to his expectations he coalized the West / NATO against him and restored European unity and its will contemplate - finally - a solid common defense. Indeed, even Germany reversed its longtime policy of not supplying deadly weapons to countries at war and plans to raise defense spending to 2% of GDP.

Did Putin overplay his hand / underestimate Ukrainians’ determination?

At best - i.e. in case of a brief conflict and relatively low impact of sanctions - broad-based shortages of natural resources would prevail for some months. At worst - i.e. in case of a major conflict spill-over - incalculable casualties (human, economic, financial, etc.) would ensue, putting the stability of the whole European financial system at great risks. Most probably, the actual outcome of this crisis will lie somewhere between these two extreme scenarios. But where? In any case, its costs will be of large magnitude, if not of long duration. In a nutshell, Europe is the most exposed, global inflation (cost / input) is reinforced and prolonged, trade / growth will be impaired. For sure, there is no magic formula to predict recessions. But let’s face it, most of them have been preceded by a) a tightening cycle (featuring a policy error) and b) an energy crisis.

Base senario remains fragilely in place

Asset allocation conclusion - Suddenly, geopolitics makes its shattering return. The recklessness of investors, especially those who have ¨abused¨ of the largesse of central banks - thus of free money - is undergoing multiple, adverse, restoring forces. The evaporation of liquidity, the prevalence of volatility, the deterioration of the geopolitical context and of the macro are imposing themselves, in the long run. The mantras that have been in vogue for nearly two years - alignment with central bank purchases, buy on dips, FOMO, TINA, etc. - are going out the window. The investment environment is less supportive.

Since the end of January, we are underweighted equities in the wake of the upcoming interest rate hike and the shrinking of the Fed's balance sheet. We still remain invested in the asset class. The volatility will last.

Rates will remain negative in EUR and CHF. Short USD rates still do not compensate for inflation. We remain overweighted on the US dollar and to commodities, mainly gold and oil.

 

Currencies

Forget the fundamentals, geopolitics has taken over - It has been a long time since conflict has not been the primary driver of currency markets, but the tide has turned. The Russia-Ukraine conflict has become the overwhelming currency market driver. Market participants can forget the usual drivers of the post-Covid world outlook, growth prospects and central banks tapering strategies for now. Increased USD exposure in a global risk-off market context, and at a time when Europe is particularly exposed to the Russia/Ukraine predicament, makes sense. But the USD is not the only short-term winner. The CHF and JPY safe-haven virtues have been confirmed, as well as resilience of commodity related currencies.

Speculative positioning

Positioning alone cannot determine a currency's fate, but extremes can exacerbate price action when sentiment changes. The speculative data from CFTC confirm an exponential increase in USD longs in early 2022. As of mid-February, almost 70% of contracts were long USD, close to recent years tops. The overweight positioning means exacerbated downward USD price action as those contracts unwind, but we could see further extreme USD long positioning first. Europe's high dependence on Russian gas and Ukraine's geography leave it particularly exposed to the situation. The EUR should remain vulnerable to the drop in risk appetite and disproportionately weak European risky assets. The more hawkish than expected February ECB did provide some support but this faded as officials recently clarified that a rate hike remains some way off. With the Fed and other central banks still expected to hike rates over the coming weeks, the EUR looks at risk.

For now, defensive FX plays could boost the USD and safe currencies

Renminbi, an alternative to the USD - Yuan lack of stress on Russian actions renewed the case for medium-term yuan globalization. The renminbi is holding up exceptionally well and its credentials as a reserve currency continue to grow. Notably, SWIFT payments denominated in CNY rose in January to a 3.2% share of global transactions, breaking out of a multi-year 1.5-2.5% range and outpacing the JPY for the first time.

Sanctions over Russia should amplify the move

 

Bonds

A delicate exercise - The Central banks moving into tightening mode has been a key theme for months. The Russian attack has put central banks and investors off their guards. Policymakers are now in a more difficult position. They must balance an upward supply shock on inflation and a negative demand shock on the economy (increasing the stagflation risk). Market inflation expectations have been pushed up again, but the uncertainty about the economic impact of the war is significant.

The tightening monetary policy outlook jolts fixed income markets - Central banks decisions will remain an important theme and on the top of the agenda. With US 10-year yields recently breaching 2.0%, one wonders how far they might rise if the Fed is determined to get inflation back under control. However recent developments and FOMC minutes suggest that the Fed has no pre-determined path for rate hikes. Given the backdrop of high inflation, geopolitical uncertainty, the timing and size of rate increases, and the potential quantitative tightening, 2022 promises to be challenging.

Money market rates have soared (even if they have receded somewhat) together with short-term government bond yields. As long-term yields rose more steadily, yield curves flattened. Several central banks have continued to tighten their monetary policy despite geopolitical tensions and sell-off in risky assets. The Reserve Bank of New Zealand and the Hungarian central bank made tightening move and sent aggressive signals.

Fed funds expections

The ECB and the Fed are scheduled later in the month. A lesson from central banks that have already embarked on a tightening cycle is that they tend not to inflect it. The context is unlikely to alter tightening by the Fed. The Fed is already “behind the curve” and its favor inflation metrics that high that it can no longer delay its tightening without risking seeing its credibility definitively ruined.

The Ukraine situation will largely affect the ECB reaction function. It will be complicate to adopt a more restrictive stance to fight inflationary pressure while the economic outlook is worsening. Furthermore, European banks exposure to Russian bonds, loans and businesses will significantly weaken banks. The ECB could be forced to innovate again, like buying financial subordinated debts a sort of recapitalization or pushing for EU banks mergers.

Central banks will balance the higher inflation and geopolitical uncertainty and the impact on the economy and financial sector
We will not be surprised to see further drops in government yields in the near term. Yield curve flattening dynamic will prevail

Unloved credit – Well before the conflict, the credit market was already under pressure. The high yield market has its worst start of the year in more than 3 decades driven by higher bond yields and wider spreads. Risk-off stance spurs an acceleration in net outflows from credit markets. Even before Russia/Ukraine tensions reached a new peak, investors had already turned increasingly defensive.

The recent HY credit spreads widening - like Investment Grade ones – did not discount a lot of risk. Since the Q3 2021, HY spreads have increased by only 100bps, while in 2014 following the Crimea annexation they widened by more than 200bps. Furthermore, they remain well below their long-term average.
The specter of higher, stickier, and synchronized inflation is bringing the era of relentless monetary easing coming to an end. Central banks and their asset purchasing programs are no longer the buyers of last resort. Still way too early to come back into HY bonds.

China, an exception in the EM world - The PBoC has been active with liquidity injection and greater net purchases of foreign reserves to shore up the economy. Credit conditions continue to show signs of easing. The PBoC moved towards net liquidity injection throughout 2022 unlike last year. PBoC Governor Yang explicitly stated that support will be maintained, and it would keep monetary policy flexible and appropriate. Admittedly, the PBoC did keep interest rates unchanged in February, but with inflation slipping to 0.9% in January, there is scope for further easing.

Emerging countries 5 years spreads

Most emerging markets have been strongly hit by the risk aversion mindset. The sell-off in the emerging assets has been reinforced by the series of sanctions against Russia. The only island of peace is China. Chinese government bond yields have remained anchored around 2.8%.
China has gained its badge of honor

 

Equities

The Russian invasion in Ukraine - Risk on profit growth and major changes in energy and defense policy in Europe - Profit growth and margins in Europe are obviously at risk with the geographic, trade and financial proximity to Russia. European chemical companies and foundries have warned that results will decline in 2022 due to rising energy costs. Bruno Lemaire, the French Minister of Finance, was clear: support for Ukraine and massive sanctions against Russia will have a cost for Europe. Russia is a key supplier of fossil fuels (oil, gas, coal) to Europe. The United States will probably be better immunized.

The war could create disruptions in some production and supply chains in metals and wheat, adding pressure on prices. Ukraine provides 90% of the world's needs for neon, a noble gas essential for the manufacture of semiconductors, and Russia accounts for 40% of the world's production of palladium, also used in the manufacture of semiconductors.

Remember that stock markets do not rise when corporate profits fall. In addition, an inflationary regime weighs on stock market valuations with lower PERs. We will most certainly see a downward revision to earnings growth in Europe given the relatively large revenue exposure to Russia/Ukraine/Belarus and the energy impact. We monitor Russian and Ukrainian assets held by some banks/insurers, thinking of Raiffeisen International, Erste Bank, Société Générale, Fortum or Unicredit where risks must be assessed not in relation to total balance sheets, but in relation to equity (see financial crisis 2008)! Others will “benefit” from it such as Eramet or ArcelorMittal with the difficulties for Polymetal, Evraz and Severstal. Conversely, the earnings exposure of US S&P 500 companies to Russia and Ukraine stands at 1%. Now it remains to be seen what the central banks are going to do in the current geopolitical situation, fight against inflation or support the economy; it could provide support to financial markets.

oil - Close Euopean ties with Russia

This situation reinforces our conviction to overweight the energy and metals sectors. In Europe, defense and energy transition are making a strong comeback. Total change of doctrine in Germany: increase in military spending with a target of 2%+ in relation to GDP (1.4% today) and end of dependence on Russian gas with investments in renewable energies and in the import terminals of liquefied natural gas (LNG); in the meantime, Germany will be forced to massively use its coal-fired power plants and perhaps extend the life of the last three nuclear reactors. LNG imports from the United States, Qatar and Canada will accelerate. We prefer the US domestic oil and gas companies (Cheniere Energy, Devon Energy, Marathon Oil, Hess) to European companies which will be penalized by their capital links with Russian groups. BP, Shell and Equinor have announced the sale of their stakes in Rosneft and Gazprom, while at the time of writing TotalEnergies, one of the most affected companies, is reluctant to exit. Accounting, we do not yet know the impact. Exxon Mobil, Trafigura and Vitol are other large groups exposed to Russia.

Germany, Sweden and Finland have decided to abandon their export bans on lethal weapons - a policy of neutrality dating back to 1945! - and the two Scandinavian countries are even considering joining NATO. Germany will invest €100 billion in defense in 2022 and increase the share of the military budget in relation to GDP to more than 2%. We are buying European defense stocks, whose share prices have risen sharply on this new doctrine. Germany will increase its military budget to more than €80 billion, which is considerable. On a global level, annual military expenditure fell between 2010 and 2016, but since then it has continued to increase to flirt with $2,000 billion. 62% of military spending includes the US, China, India, Russia and the UK.

World military expenditure in USD Trillion

The UK stock market, posted a clear outperformance. It benefited from the composition of the index with a weighting of 19% for basic consumption (10% in the other indices), 12% for energy (3%) and 10% for mining and metals (3%). But the FTSE 100 was already outperforming at the start of the year, with investors betting on the exit from the Covid, an improvement in relations with the EU and the sterling.

 

Commodities

Oil, Russia is a key supplier for Europe - The massive sanctions against Russia are obviously negative for Europe in particular and for the world in general, since Russia is among the 3rd largest producers of oil (11 million barrels/day, including 5 million for export), with the US and Saudi Arabia, and the world's leading gas producer.

Russian oil and gas are gradually being embargoed by traders, tanker companies and refineries, while they are not (yet) affected by Western sanctions. Trafigura is getting rid of its Russian oil shipments at a significant discount. International traders want to avoid negative publicity. 70% of Russian oil is frozen. If we do not know all the international sanctions against Russia, stakeholders no longer want to touch Russian oil. If this situation were to last, it would not only be hard on Russia, but also on consumer countries and Europe in particular.

At its March 2nd meeting in Vienna, OPEC+ confirmed its policy of gradually increasing production, ignoring the soaring prices that are worrying consumer countries. The alliance is also ignoring the Russian invasion, which is massively sanctioned by much of the world, keeping Russia in the enlarged alliance. OPEC+ considers that the current volatility is not due to changes in fundamentals, but to geopolitical developments. The geopolitical premium is around $20 a barrel, but we could indeed see the price of Brent go beyond $120 if the positions were to harden between Russia and the West.

Faced with such large volumes, the use of strategic reserves of Western countries and a possible agreement between Iran and the West will only have a limited impact. Saudi Arabia and the United Arab Emirates could increase their production by 1 million barrels/day each, but it would take one to two months to achieve this. The situation was already tense before Ukraine with rising demand and producers who were unable to achieve their objectives as for Nigeria and Angola. OPEC's strategy is gradual and renewed from month to month; in April, production will be increased by 400,000 barrels/day and the next meeting will take place on March 31st.

Stagflation risk benefits to gold – The slope of the US yield curve signals a risk of an economic slowdown or even a recession. With high inflation, which will last longer than expected with the Russian madness, the risk of stagflation has increased significantly. By listening to European politicians, Europe is heading for low growth and high inflation. In stagflation, gold is the best asset. Gold also benefits from its safe-haven character with the war in Europe.

If the Fed engages multiple increases in Fed Funds to fight inflation, gold's progress will be slowed, but the trend will remain bullish.

Gold should return to S2060

 

Disclaimer
This document is solely for your information and under no circumstances is it to be used or considered as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. All information and opinions contained herein has been compiled from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy or completeness. The analysis contained herein is based on numerous assumptions and different assumptions could result in materially different results. Past performance of an investment is no guarantee for its future performance. This document is provided solely for the information of professional investors who are expected to make their own investment decisions without undue reliance on its contents. This document may not be reproduced, distributed or published without prior authority of PLEION SA.

 

 

Global vision

 

 

Long-term macro regime. Growth below potential and more volatile inflation. Demographic and debt undermine potential growth. Coupled with digitalization, it fuels secular disinflationary pressures which collide with - cyclical - inflationary tensions

LT macro regime. Inflation durable irritation deteriorates business cycle perspectives Higher and much more volatile inflation will challenge the duration and the amplitude of expansion phases. Especially in the US.

Lower liquidity will fuel tighter financial conditions. Deceleration of excess liquidity is spilling-over across most asset classes and upsetting risk appetite

Pandemic is not over yet, but the odds of herd immunity later into 2022 are rising. Omicron will strain Western growth short-term. It represents a more serious medium-term challenge for China due to its Zero Covid policy

Geopolitics. US in front of a trilemma. Ukraine, Indo-Pacific (Taiwan) and Middle East (Iran) may become three concomitant fronts

Serious unwinding of speculative capital flows. Massive outflows in January, namely from over-leveraged / disabused retail investors

Unstable equity-bonds correlation, but no regime shifts yet. Financial repression is waning, but negative real rates will remain in force in 2022. US long rates to stabilize around 2.0%

A succession of risk-off / on periods ahead. A cocktail of complex events is unfolding. Geopolitics, irritating inflation (and a maneuvering Fed), as well as likely delicate US politics in H2 (controversial mid-terms).

 

Global Macro fog will prevail at least up to next summer - The odds for a decent 2022 year in terms of growth are significant. We expect a ¨growthflation¨ regime to develop in 2022, featuring above potential growth in the US and Europe. Inflation will continue to irritate western countries and clearly stay above central banks’ target up to late in 2023. The capacity of central banks to confront upset financial markets and sensitive governments (US democrats) will be key on the one hand. In an adverse scenario, a serious fiscal drag could unfold in the US if the Biden administration fails to pass even a down-sized Build Back Better plan.

Rarely forecasting economic outlook has proved so delicate. First, the resilience of the pandemic will continue to trigger highly disparate political responses and disturb supply chains as well as labor markets. The timing and the magnitude of China’s eventual reflation is particularly tricky to determine. Risks are growing of an energy crisis linked to geopolitics, not only of natural gas in Europe, but also of oil in the context of Iran. In the past, all serious energy crisis ended-up with collapsing business cycle…

The serious resurgence of inflation, as well as the procrastination of the Fed and the ECB, provide good insurance that the cycle duration will be shorter (say around 4/5 years) than during the last decades (Great Moderation). The bond market, i.e. the relentless flattening of the US yield curve, is adamant about it. The latest forecasts of the IMF (published late-January) provide some insight in this respect. 2022 global growth is revised down half a point to 4.4%, slowing down to 3.8% in 2023. As a reminder, world growth near 3.0% is synonymous of a recessionary framework.

Asset allocation conclusion - But despite recent markets jitters, financial conditions will remain relatively supportive. It would take further USD strength coupled with higher interest rates to render us more cautious. For now, we maintain a fully invested allocation, but with a somewhat more cautious positioning within asset classes. Stay exposed to precious metals. As a hedging asset, US duration is becoming attractive with US 10-year yield nearing 2.0%.

 

Currencies

Since 2015, the USD is going nowhere - Macro investors who tend to gravitate toward momentum trades have lost interest in the USD. The realised volatility over the period is at an all-time low. What appears somewhat at odds is the strength of the USD in the face of the easing of record financial conditions. The sign of correlation suddenly changed. Recently, the USD as a safe haven in times of uncertainty has been backed up by the tight correlation to Global Economic Uncertainty. The higher the uncertainty, the stronger the USD, and vice versa.

The 2021 dollar strengthening was most likely down to the relative overperformance of the US economy to the rest of the world and investors’ appetite for US growth stocks. Those factors are in the rear view mirror. The focus will return to the twin deficits doom loop. For those wondering why this did not translate into more sustained weakness in 2021, possible answers are that the US 2-year yield was much higher and that it works with a 2-year lag.

However, given the still current stretched positioning on the currency, there is not many investors left to buy the USD. Furthermore, it is trading at the top of end of its historical valuation. Even if valuation is a poor timing tool, that does not mean it is completely irrelevant. In terms of the G10, JPY, SEK, and NOK are cheapest with CHF and NZD the most expensive versus their respective 30-year REER averages.

A different story for EM is insight - Historically, at the start of the Fed tightening monetary policy, the first thought is that it is not time to load up on EM FX. Many of the high yielding currencies in the EM basket are cheap and they yield a lot in nominal and real terms. Last year was awful and they underperformed G10 by the most in 20 years. While it seems a silly idea to overweight in a year where risk premiums could head higher, a lot higher, it might prove surprisingly different thanks to the fact that China central bank is easing its monetary policy. China credit impulse lead EM currencies improvement by 6 months.

 

Bonds

Inflation outlook not less of a concern - The headline inflation surged to a 40-year high in both US (7.0%) and Germany (5.3%) while inflation expectations have recently receded. In late 2021, inflation was mostly driven by rising commodity, higher input prices and core components. This uncomfortable truth is addressed by the Fed. In December, it has decided to scale back its bond purchasing program by a further $15bn a month to $30bn and purchases are set to cease by March. The Fed has rapidly stopped purchasing TIPS, and by consequence pushed up real yields and breakevens down . Long-term expectations are no longer pricing in an above long-term average inflation.

Powell added that an extended intermission between the phasing out of QE and the first rate hike was unnecessary. The Fed will hike in March.

Quantitative tightening is coming - The Fed conducted a balance sheet shrinking (QT) from 2017 to 2019 and introduced a cap on its monthly reduction (run-off rate). The Fed will fully or partly refrain from reinvesting the proceeds from maturing bonds, this will reduce excess liquidity. Last time, the Fed started out cautiously with a monthly cap of $10bn, which was gradually raised to $50bn. QT ultimately led to tight liquidity conditions, and then the Fed had to buy T-bills in 2019 to improve it. As the balance sheet is now much higher, tighter dollar liquidity ought to be somewhat less severe, even more if as the PBoC takes over. We are expecting the Fed to reduce its balance sheet by c. $100bn per month (US Treasury + MBS). It will be officially launched during summer.

The initial reaction to QT in 2017 was a decent upward movement in long US yields. Then, as we moved into 2018/2019, yields began to fall as renewed weakness was perceived in the US economy and the markets began to focus on the Fed hiking cycle coming to an end.

The upward pressure on long yields from QT stems in part from the term premium being pushed higher. The idea of QE is to compress the term premium (push long yields down) and to stimulate the economy. The exact opposite is now happening. The term premium will increase in 2022 when the Fed begins to reduce its balance sheet. That would tend to steepen the yield curve – or at least reduce the flattening pressure from rate hikes. Uncertainty on the inflation outlook should also push the term premium up.

The market has already started pricing this scenario. It is currently discounting more than 4 rate hikes of 25bps in 2022, but only a little over 2 rate hikes of 25bps in 2023. We find the 2022 pricing too aggressive; we also see a potential for further rate hikes to be priced into, especially in 2023.

The 10-year German yield has transitory turned positive for the first time since 2019 and US 10-year yield is moving towards 2.0%. We expect yields to continue rising through 2022. While an ECB rate hike in 2022 is not our baseline scenario, we expect markets to increasingly price rate hikes in 2023 and 2024. The US 10-year Treasury yield will hit 2.25% in 2022 and the Bund 0.3%.

EM Inflection point is coming – The light investors positioning in EM local markets is a development that would help EM assets to stabilize and perform this year. Local EM bonds’ foreign holdings are showing signs of nearing or having reached a bottom, following several years of outflows and de-risking away from EM. Foreigners’ exposure has decreased by a third since 2013 peak. Steepest reductions occurred in CEEMEA, while LATAM bond markets have been relatively spared. Asian exposure has remained immune but still lowest at only 14%.

Repricing of EM bond yields toward higher levels has quickly occurred, in response to much higher US yields. An increasing number of EM countries will pivot over the coming months toward a “living with COVID” strategy. This trend will likely help to largely ease market participants’ fears regarding a scenario of stagflation in EM, to be replaced by growthflation.

In addition to the positive technical factor on investor positioning, global developments over recent weeks suggest that several tailwinds may soon be materialized for EM assets. The inflection point for a more positive narrative on EM assets is on the horizon. A stable or weaker USD would be the trigger.

 

Equities

The return of sector and geographic diversification - From 2017 to 2021, the Nasdaq outrageously dominated the markets with a performance of nearly 200% compared to 88% for the S&P 500 Equal Weight, 85% for the MSCI World, 30% for the Euro Stoxx, 50% for the Nikkei and 42% for the MSCI Emerging. During the pandemic, valuation gap has widened sharply between technology stocks (and other speculative companies) and the rest of the market because of the huge liquidity injected to support the economy.

With the tightening of the Fed's monetary policy, we are witnessing a transition from a liquidity market to a fundamentals market, implying a derating – re-pricing - of growth stocks and the return of volatility. And above all, the return of the diversification in sectoral and geographical terms, favoring the Value and cyclical segments - Finance, Industry, Materials and Energy - as well as regions with a predominant Value and cyclical weight such as Europe and Japan with 60% in their indices. The financial sector (see graph below) reacts the most favorably when interest rates rise.

Without coming as a big surprise, the start of the year was difficult for the stock markets due to unfavorable seasonality, a transition resulting in a re-pricing of high PE ratios and fears of more monetary tightening by the Fed, faster than expected. Added to this, there is an extreme tension between Russia, NATO and Europe over Ukraine.

2022 should deliver a positive performance:

The pandemic and liquidity have pushed investors to buy growth stocks and large cap stocks, defensive segments in a destabilized global economy. Liquidity also favored speculative securities - meme stocks - bought by Robinhood investors, stuck at home and receiving checks. The more favorable outlook for the global economy with normalization of production and supply chains, as well as the end of the labor shortage, will make the segment of small and medium-sized companies more attractive.

Commodities

The Oil, between geopolitics and economic recovery - The price of Brent is at its highest since 2014. The breakout of $87 opens the way to $100 a barrel. Demand is stronger than expected and OPEC+ is increasing production step by step, while inventories are falling in the main global hubs. Levels in Cushing, Oklahoma, are at their lowest in 10 years, while consumption in the United States is at its highest for this period in 30 years due to a freezing winter.

Russia-Ukraine-NATO tensions are pushing prices higher. Current prices include a geopolitical premium. Russia accounts for 10% of world oil production. In the event of a military conflict in Europe, there is little doubt that prices would soar; How far? Hard to say. Probably over $100-120. JPMorgan estimates it at $150.

Crossing the $100-120 mark would not be good news for the financial markets, because investors would be integrating a real risk of an economic slowdown. We doubt Russia will embark on a damaging military campaign and producers are aware that a too high barrel price would jeopardize global economic growth. Technically, Brent is in a highly overbought zone and in the short term we expect prices to decline. We would no longer buy oil company stocks, waiting for a correction and buying opportunities. In addition, high prices are accelerating the production of shale oil in the United States, even if it is hampered by the rising costs of transport and steel, as well as the difficulty of buying the equipment necessary for exploitation of new wells.

There are also unfavorable structural factors that explain high prices over the medium to long term, like for industrial metals, which result in poor visibility on the profitability of new projects. These factors are: geopolitics, climate, environmental constraints and energy transition. Oil companies fear incorporating current prices to make investment decisions, as by 2030 demand is expected to decline with the energy transition. The consultant Carbon Tracker has issued a warning to oil companies on the profitability of exploration projects based on current prices; they could waste $2.2 trillion in this decade with the rapid advance of carbon-free technologies. This analysis is valid for thermal coal.

 

Disclaimer - Ce document est uniquement à titre d’information et ne peut en aucun cas être utilisé ou considéré comme une offre ou une incitation d'achat ou de vente de valeurs mobilières ou d’autres instruments financiers. Bien que toutes les informations et opinions contenues dans ce document ont été compilés à partir de sources jugées fiables et dignes de foi, aucune représentation ou garantie, expresse ou implicite, n'est faite quant à leur exactitude ou leur exhaustivité. L'analyse contenue dans ce document s’appuie sur de nombreuses hypothèses et différentes hypothèses peuvent entraîner des résultats sensiblement différents. Les performances historiques ne sont nullement représentatives des performances futures. Ce document a été préparé uniquement pour les investisseurs professionnels, qui sont censés prendre leurs propres décisions d'investissement sans se fier indûment à son contenu. Ce document ne peut pas être reproduit, distribué ou publié sans autorisation préalable de PLEION SA.

 

The return of inflation

Retrospective

Inflation significantly higher than expected
US inflation rose in November at an unprecedented rate in nearly 40 years. The price increase reached 6.8%. Many factors contributed to this surge, whether transitory or more structural.
At the same time, inflation in the euro area hit a record high in November at 4.9%, still propelled by steadily rising energy prices. It reached a level not seen since the launch of the euro.

Bond markets under pressure
The 10-year government bonds yields have globally increased. Continued asset purchases by the main central banks prevented a more pronounced bond correction given the level of inflation.
In the US, 10-year Treasury government yields have risen to 1.5% today from 0.9% at the start of the year. Yields have risen in the euro area and in Switzerland as well, but to a lesser extent. given these developments, bond markets remained in negative territory during most of the year, except for high yield bonds.

Credit bonds were also supported by central bank purchases, investors' search for yield and their fundamental resilience.

Equity markets hit new records
Global equity markets have followed on their 2020 momentum. Regional markets, including Switzerland, hit new highs, driven in large part by strong corporate earnings and TINA (There Is No Alternative) investor mindset.

The appearance of the Omicron variant has caused trouble, causing a sharp rise in global financial markets volatility.

American technology companies have once again outperformed. They posted nearly twice the performance of the market.

The price of gold has been falling steadily since August 2020, briefly dropping below $1,700 an ounce in March 2021. It has since recovered and then moved sideways.

 

Paradigm shifts
2021 will have been a turning point for the auto industry. All groups have announced that they want to turn the page on the combustion engine when until recently they wanted to replace gasoline and diesel with biofuels. But it is too late. Concerns about the climate, China (again) and its market have imposed a radical technological shift. There will still be a lot of talk about the electric car in 2022.

Beijing is becoming more authoritarian in business matters. The authorities are hunting down bosses who are too extroverted and critical of power. In addition, conflicts with foreign investors are increasing. A form of cold war is taking hold between Beijing and Washington. Internally, President Xi Jinping lectures the youth and threatens Western firms that refuse to comply with the specific rules laid down by Beijing. Chinese stocks show the worst performance among the major markets.

 

En - Currencies - 2021 annual performance

Expectations of a less accommodating US Federal Reserve - which materialized at year-end - have been a continued support for the USD. Emerging countries’ currencies have suffered from flawed vaccine policies despite central banks raising almost all of their key rates.

 

En - Bonds - 2021 annual performance

A tricky year 2021 for government bonds. Chinese government bonds confirmed their status as decorrelated securities. While those of developed countries posted negative performance. In the credit sphere, High Yield once again posted positive performances, while emerging countries underperformed.

 

En - Equities - 2021 annual performance

A fantastic year for equity markets, with the Global Index posting a performance of over 20%. In this particular health context, emerging equities underperformed in large part because of China. The measures taken by the central government have failed to encourage investors to favor the region.

 

En - Commodities - 2021 annual performance

A year marked by rising energy prices, but not only. The cobalt has more than doubled. It is the preferred material for the energy transition towards a low carbon economy. Renewable energies and electrical mobility consume a lot of materials.

 

Macroeconomy

Developed world growth slows

En - New orders growth

December's indicators provided a more solemn note to end the year, with growth momentum across the world's largest developed economies revealed to have eased in the final month of the year. That said, overall manufacturing output rose, supported by an easing of supply constraints across Western economies, which also suggested that we may be seeing prices peaking in these regions. Service sector growth meanwhile came under pressure as the growing COVID-19 wave struck the US, UK and eurozone, while Japan saw service sector activity growth slow post the initial reopening boost. The latest COVID-19 Omicron variant developments add further downside risks to the year-ahead outlook.

Flash PMI surveys for December signaled a slowdown in the pace of economic growth in all four of the world's largest developed economies, while still solid. A renewal of COVID-19 case growth in Western economies into the closing months of 2021 has affected service sector activity in December, with the European economies in particular finding their latest flash composite PMIs sliding further from their summer peaks, reached as the economies opened up from pandemic-related restrictions. Eurozone growth notably fell to a nine-month low in December with the German economy stalling for the first time in a year-and-a-half.

 

Supply constraints ease but overall price pressures remain broadly elevated

En Manufacturing supplier delays

Suppliers' delivery times continued to lengthen at a severe rate in December but eased off the November record to the lowest since August, suggesting that we be seeing a turnaround in the situation. The dip had been underpinned by a slower increase in supplier lead times across all but Japan within the G4 economies. The US, UK and eurozone all saw sharp easing in the rate at which lead times lengthened, with UK delivery times extending at the slowest pace since December 2020 and the eurozone reporting the fewest delays since January. US lead times meanwhile lengthened to the least extent since May.

An easing of previously reported COVID-19 related production issues in Asia is likely to have ameliorated the global supply situation, although the COVID-19 Omicron variant's reach into APAC economies continue to cloud the outlook going forward.

 

Elevated macroeconomy volatility
Pandemic and its consequential distortions are here to stay, as long as emerging countries access to vaccines is limited. The increase in macro volatility imposes a delicate change in economic policies. Inflation and the imbalances inherited from the pandemic increase the risks of a shortened and bumpy cycle. Decoupling between the G7 and China is intensifying. China engages in a politically crucial year. The generous valuation of most assets and the resurgence of markets’ volatility represent potential vulnerability, considering the considerable financial leverage of both institutional and retail investors.

 

Two diametrically different models

En - US and China households are quite different

Chinese households' savings are highly concentrated in cash and real estate - more than 50% of them. This gives perspective to the PBoC's orthodox monetary and positive real interest rates policy. Politically, the Politburo could not tolerate the collapse of this sector, which would provoke potentially uncontrollable discontent. The US economy is highly financialized. Liquid and illiquid financial assets (PE, HF) represented more than 60% of household savings in 2020 (27+37). This is the consequence of financial repression. The economy/consumption would not stand a financial crash.

 

Long-term drivers

We consider three secular disruptors. 1) Climate – rapid – changes, which impose hectic transitions towards green(er) economies. This will fuel large investment packages, but also higher inflation, new regulations, corporate requirements, and taxes. Europe is leading the charge. 2) Technology. The relentless shift towards digitalization has a long-lasting impact on labor markets. 3) High Inequalities generate more labor friendly policies to re-gain a higher share of GDP.

 

Investment landscape

En - Most accommodative financial conditions in decades

In H1 22, a transition from stagflation to growth-flation in G7 will gradually take place and China will engineer a soft landing. Inflation and growth fears will continue to temporarily upset markets. Though less powerful, negative real rates / Asset Inflation regime will remain in place in 2022. Leverage players will add to short-term volatility, as they will further endure more adverse conditions with less exuberant liquidity.

Policy normalization imposes less supportive financial conditions ahead.

 

Currencies

Monetary policy divergence is set to remain the dominant theme and driver of currency markets

En - Fed funds futures are driving the USD

Tighter monetary policy is coming to North America/UK and will differ from the rest of the world. An assertive FOMC cemented their hawkish pivot toward mitigating persistent inflation risks with a more aggressive policy normalization profile. Since the start of September, inflation forecasts and Fed Funds market pricing have been revised sharply higher in absolute and relative terms. The US economy positive output gap is amongst the reasons for the Fed move to front-run others developed countries in their policy normalization. The USD strengthening plays its part in tightening US monetary conditions. In a world where the European, Swiss, and Japanese central banks are late to tighten, the USD gains should largely come at the expense of the low-yielding currencies. While Q1 2022 is likely to see further USD strength, the story will evolve as the year progresses. We would not be surprised to see the USD best levels just reached ahead of the Fed first rate hike. By then, a lot is likely to be priced into the US rates curve, and the FX market.

 

Volatility regime shift

En - Turning volatility regime

After months of successive steady declines and phases of stability, implied and realized FX volatility have just spiked. Over just a quarter, implied volatility has plunged to 5.5 – 5 percentile low of the past 2 decades – just before surging above 7. This is an impressive move in a context of a very-low-volatility regime, but still below its long-term average.

After the liquidity shock in March 2020 due to the COVID crisis spreading out of China, the massive monetary injections of central banks mechanically diluted FX market moves. The Fed having recently started and then accelerated its asset purchasing program tapering, it will remain an underlying force supporting higher FX volatility. Furthermore, the currency volatility is lagging other asset classes, like bonds. Given the wide monetary policy decisions, the volatility will no longer be under the control of central banks.

Fed hawkish pivot

En - Fed long-term dots

The Fed executed a hawkish pivot by quickening the pace of tapering, while also building significantly more rate hikes into 2022/2023 than just a few months ago. Asset purchases will slow to $60bn in January with a target of full wind-down by March. Three rate hikes in 2022 are now implied by the dots (0.875%), another three in 2023 (1.625%) and two more in 2024 (2.125%).
While the change in near term rate expectations appears drastic, there are aspects that the Fed was simply pulling forward expectations, as the 2024 dot increased only marginally, while remaining below the 2.5% neutral rate.

The ECB did not blink. The ECB will continue its purchases under its Pandemic Program at a slower pace than in the previous quarter and will stop them in March 2022. To avoid steep liquidity reduction in Q1, the ECB plans to temporary increase asset purchases under other programs until Q3 2022. The ECB is still expecting inflation to be transitory. A first rate hike will be delivered in early 2023.

The SNB policy rates will remain unchanged. It will continue to intervene in the FX market when necessary. The more inflationary context makes it less concerned about deflation. It should tolerate slightly higher CHF levels given its real term approach. The expected tightening of monetary policy around the world should give the SNB some relief, but not enough to consider tightening itself.

 

Emerging markets’ factors to become more supportive

En - Em central banks early tightening

Emerging assets have been penalized in 2021 due to a very slow vaccination process and to some extend by rising political risks premium. However Turkey and Brazil remain small contributorsto global EM.

The Fed tapering start has left some investors concerned about emerging markets (EM) vulnerability to a repeat of the 2013 taper tantrum episode. EM debt market is in a stronger position to absorb the 2022/2023 US monetary policy tightening. Conversely to 2013, most EM central banks have tightened in advance of the tapering.
Other factors can contribute to this relative resilience:

 

Equities

The gold rule: Don’t bet against stocks unless you think that there is a recession around the corner

En - SnP 500 after rate hikes

We remain positive on equities in 2022. Historically, stocks have performed well at the start of a monetary tightening cycle. Economic growth will support stocks. We will become more cautious in 2023 with a more advanced economic cycle.

In 2021, risky assets benefited from abundant liquidity, low interest rates and a strong recovery in corporate results. We remain positive for 2022. The Fed is entering a monetary tightening cycle, but if history is any guide, stocks do well at the start of such a cycle.

Producer prices have risen sharply due to rising wages, labor shortages, disruptions in production and supply chains, and rising commodity prices. We will monitor the positive base effect from March 2022. We are already observing a process of normalization in logistics (transport prices are falling) and in production.

For bears, the moderate increase in US profits expected at +10% in 2022 and +7% for revenues could explain poor stock market performance in 2022. On the contrary, these growth rates will demonstrate the solidity of profits and revenues, because the base effect will be significant.

Despite rising operating costs (wages, raw materials, logistics), net margins will remain at high levels demonstrating the ability of companies to pass rising costs on to customers and improve productivity.

Driven by the pandemic and deglobalization (reindustrialisation in developed countries), companies are evolving by adopting new behaviors and/or business models, favorable to profits. In 2022, we are counting on a restocking in companies, an increase in household consumption and the positive effects of stimulus plans in the United States and in Europe.

Other positive factors for equities will be: 1) the large amount of cash parked in money market funds ready to revert to equities, 2) share buyback programs, and 3) mergers and acquisitions.

En - SnP 500 bet profit margin

Commodities

Oil and industrial metals have had a good resilience in the pandemic

En - Largest metals suppliers

In the long term, the absence of major projects, geopolitics and energy transition support the Supercycle. In October, the gas crisis in Europe and the coal crisis in China and India show that fossil fuels remain essential.

The prices of petroleum and industrial metals have held up well during this pandemic despite the Chinese economic slowdown, given that China consumes 50% of the world supply of industrial metals. 40% of the oil supply is controlled by OPEC +, while the supply of industrial metals has been disrupted by the pandemic and social crises in some mines in South America.

Demand increased in 2021 with the economic recovery and, for industrial metals, demand from the energy transition (electrification of vehicles, solar, wind) has been added. In 2022 and beyond, US spending on infrastructure will stimulate demand. The gas crisis in Europe and the coal crisis in China and India have shown that it will be difficult to reduce the consumption of fossil fuels at the risk of creating an economic decline through electricity production and/or social problems. In India, coal is a cheap source of energy in a poor country where imposing renewables is impossible.

 

Gold moves with real rates

En - 12200 year history of US real rates

Between November 2018 and June 2020, the price of an ounce of gold increased from $ 1,200 to $ 2,065 due to the fall in US 10-year real rate. Since July 2020, the US 10-year real rate has stabilized, as well as gold price: Gold holdings in financial products fell by 12% in 2021.

Source:
Gold suffers from competition from cryptocurrencies which are also financial assets and decorrelated with other assets. The development of inflation will be an important parameter for gold: an inflationary slippage would favor gold, while inflation returning to 3.5% in 2H22 would be unfavorable.

Allocation

En - Allocations

 

Disclaimer
This document is solely for your information and under no circumstances is it to be used or considered as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. All information and opinions contained herein has been compiled from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy or completeness. The analysis con-tained herein is based on numerous assumptions and different assumptions could result in materially different results. Past performance of an investment is no guarantee for its future performance. This document is provided solely for the information of professional investors who are ex-pected to make their own investment decisions without undue reliance on its contents. This document may not be reproduced, distributed or published without prior authority of PLEION SA.

Global vision

EN - Asset classes -

LT macro regime. More variable business cycles ahead
The long decline of potential growth is exacerbated by pandemic and rising debt. Secular disinflation is under attack. More volatile duration and amplitude of expansion phases.

Lower liquidity profusion
Production of excess liquidity is fading, with recovery and resurgence of cyclical inflation.
This is triggering ¨some¨ spill-over of tensions across more numerous asset classes

Pandemic is not over. Global recovery is further delayed into 2022
The pandemic continues to be disruptive. It will somewhat delay the economic rebound but boost inflation in Q1. Pandemic’s global impact on growth is diminishing

Geopolitics. A complex G-Zero landscape
Threatening alliance of China and Russia. Indo-Pacific as the new World epicenter (Taiwan)

Buoyant capital flows
Massive equity inflows, namely through passive ETF. More volatile retail flows

Scarce and expensive quality assets
Financial repression will continue in the foreseeable future. US long rates to stay in the (1.5% - 2.0%) range H1 22

Volatile risk appetite
Resurgent inflation and pandemic. Bond volatility starting to spread to other asset classes.

 

Further macro uncertainty, despite current optimism - The major supranational institutes continue to forecast vigorous expansion in 2022, almost 5% after 6% for 2021 (IMF October 2021). Growth would be driven mainly by the major developed countries. These figures are clearly too optimistic in view of two factors: the return of the pandemic and the change of course in China. The markets, moreover, do not believe it, just as they still doubted last summer the insouciance of the central bankers. On top of this, there are two significant risk factors: the sharp rise in global inflation and the downgrading of major US stimulus plans.

Stagflation fears are overdone, but consensus for economic growth is too buoyant. Global growth will approach potential in H1 2022, not more, thanks to G7 countries

EN - IMF lastest forecast - 06.12.21

 

Pandemic, a never ending story? - On three last occasions, summer 2020 and 21 and winter 2021, the US suffered more acute rise of infections than Europe. Without much explanation, the latest 5th wave of Covid has been more subdued in the US. For the moment… Collectively, Western countries have raised their guard with mass vaccination. However, it is clear that the virus still has a considerable capacity to cause harm. As long as the world's population, particularly that of emerging countries, is not protected on a much larger scale, it is likely to remain so. This fatalistic observation illustrates the growing political tensions inflicted on our democracies. The pressure of an ultra-divided public opinion continues to grow. The virus exacerbates inequalities. It is, in itself, a factor of deep fracture. In Asia, the pandemic has led to the closure of borders. The pandemic is complicating international trade, disrupting production chains, and contributing, in the long term, to a certain increase in production costs. This will contribute to a resilience of inflation, well beyond the ¨statistic base effect¨ behind which central banks hide.

Asset allocation conclusion - The current transition towards an inflationary boom landscape remains the most likely scenario towards 2022. As a result, fixed income volatility has started to migrate to equities and tensions persist in emerging countries, if not in the periphery of the High Yield sphere But despite recent markets jitters, financial conditions remain very supportive. It would take further USD strength coupled with higher interest rates to render us more cautious. For now, we maintain a fully invested allocation, but with a somewhat more cautious positioning within asset classes

 

Currencies

Still room for a stronger USD - The USD has recently been helped by a strong economy, high inflation, and a more hawkish Fed. Even intermittent periods of low-risk appetite have underpinned the currency as a safe haven. The USD has been the strongest performing developed market currency in November driven by 1) the prospect of higher interest rates; and 2) market uncertainty linked to Covid, stagflation fears, or China property crisis. These drivers will remain into 2022, but their ability to easily pull the USD higher may diminish.

The next FOMC announcement on mid-December should remain USD-supportive. Economic data have rebounded, unemployment has slipped, and forecasted inflation should remain elevated across Q1 and early Q2 before slowing. The Fed is already tapering and expected to finish in mid-2022. A first rate hike will follow in S2 2022. This will help the USD to remain firm. At that time, US rates may offer less support for the USD as we do not expect the Fed to move more quickly.

Furthermore, the G10 central banks stance should become less clearly USD-positive in 2022. By the way, even if all those drivers are well known, the positioning is not as extreme as we should expect in such a context.

EUR vulnerability will persist short-term - The EUR has remained under pressure, and this is likely to continue into Q1 2022. The economic outlook remains robust, but the recent focus on rising Covid infections and restrictions will not help sentiment. A still largely dovish ECB, maintaining all options open and warning that rate hikes are unlikely in 2022, should keep the EUR on a defensive tone in Q1 2022.

Whilst the EUR took German federal election in its stride, the April/May French presidential election may have more impact. Last time, in 2017, the EUR weakened in Q1 amid the uncertainty but rebounded in Q2 once the result became clear. A similar pattern next year should repeat.

EN - EUR-USD ahead of the French presenditial election - 06.12.21

Bonds

The Fed stays on the same path - A continuation theme should be the dominant outcome from President Biden decision to reappoint Powell as Fed Chair. But there will be a more influential Brainard to be considered. However, we cannot ignore this. The Fed will continue to taper, and likely hike rates in S2 2022.

Central bank watchers are having an exciting period. The latest FOMC minutes highlighted the Fed openness to accelerating its tapering. Even several ECB and BoE officials will keep investors relatively busy, the coming comments should be less market-movers. Markets are already discounting a 150bps Fed Fund rate increase over the next 2 years. It is likely that officials have already shared all the elements they intended to ahead of the mid-December Fed/BoE/ECB meetings.

We are back in the 1.6% area of the US 10yr. This is the third time this year. There have been two themes in play. First, inflation is running well above nominal rates. Second, several auctions failed to attract demand in the past couple of weeks. The paroxysm was the last 30yr auction.

The 2.0% on the US 10yr yield remains our target which corresponds to a terminal Fed Funds rate in the 1.50% area plus a spread. We also have a significant Covid spike in Europe with the risk that some of it gets echoed in the US. For now, the lure of elevated inflation is dominating, with even the Bundesbank talking of 6.0% inflation. A 2.0% US 10yr yield looks low in front of that. As the gap between upside and downside scenarios is widening, fixed income volatility will stay elevated. As the past 20 months bias has been towards easing, it is natural that a hawkish message proves a market mover.

EN-Move index - 06.12.21

Even with the 5th Covid wave, central banks will hike rates. The main uncertainty is how soon and by how much. Some BoE communication back and forth on the urgency of policy tightening has not helped investors. We think it will raise rates by 15bps in December. However, we think a lot of tightening is already priced in. So, the potential for further USD and GBP rate rises is more limited.

The Euro area is not on the same path. The ECB looks less in a hurry but the synchronized highlighting of inflation upside risk has not been lost. Year-end distortions in EUR money markets have played a role in keeping a lid on EUR rates. The threat of near-term Covid-related economic restrictions is also on everyone’s mind. If and when both drivers fade, EUR rates upside seems significant.

 

The EM tricky period to continue - The main culprit for softer portfolio and Foreign Direct Inflows is the ongoing narrowing of the Emerging to Developed markets growth differential. According to market forecasters it is expected to be about 1.2% in 2022, down from the 1.2% in 2021, 4% in 2020 and 2.8% on average over the last 5 years. The growth differential will likely remain under pressure.

Moreover, public debt ratios are likely to deteriorate and climb higher in EM according to IMF, whereas they may stabilize in frontier markets and materially improve in Developed markets. This past year, across numerous LATAM and frontier-market economies, we saw increased fiscal pressures translating into materially higher bond yields, weaker currencies, foreign investor portfolio outflows, and disappointing bond auction results.

Still too early to come back on EM local currency bonds while the extra yield offered is compelling.

EN-more improvement out of DM than EM - 06.12.21

 

Equities

Consolidation with a huge 5th Covid wave - Since mid-March 2020, the bull market has been marked by numerous sector rotations according to the curves of Covid infections and the evolution of long-term interest rates. The first phase (6 months) was marked by Covid-proof stocks, then there was an alternation between Value (Banks)/Cyclical segment when long-term rates rose and the Growth segment (Technology, high flyers growth stocks) when rates were falling. These strong sector rotations allowed investors to stay in the market, resulting in minor intermediate corrections of less than 5%.

Analysts expect US companies' profits to rise 21% in 4Q21 and +51% for European companies, and in 2021, by +45% and +90% respectively. For 2022, profits are expected to rise 10% in the US and 12% in Europe. We value the S&P 500 at 4'850 for 2021 and 5'280 for 2022.

We are taking a more neutral approach on equities for the next 2 months. Stock indices could consolidate and generate more volatility due to 1) a return of RSI indicators to a neutral zone (heavily overbought in early November), 2) investor sentiment indicators returning to a more neutral position, 3) a creation of a bubble in a few specific segments (EV and metaverse), 4) upcoming tense discussions on the US debt ceiling in Congress, which expires on December 15th, 5) a surge of Covid in Europe, with its share of health restrictions, and 6) less favorable seasonality for equities in January and February.

In terms of seasonality, November is a good month, December starts to deteriorate slightly before entering the first 2 months of the year which are statistically more difficult. But the bull market remains valid for the next few months. Households and businesses have plenty of cash to consume, to raise dividends, or to buy back stocks. Companies are seeing lower tensions in production and supply chains and shipping prices; July-October will probably have been the peak of the stress. Companies have also learned to work differently. 2022 will be characterized by a restocking.
2021 will be a great year for IPOs and share buyback announcements. According to EPFR, we should exceed $ 1 trillion in share buyback announcements in 2021, close to the 2018 record of $ 1.1 trillion during Donald Trump's fiscal plan. 30% of share buybacks are concentrated in 5 technology companies, Apple, Alphabet, Meta, Oracle and Microsoft. Concerns are for 2022 with a planned 2% tax on share buybacks to fund Joe Biden’s big spending plans. With one month to go to the end of the year, driven by central bank liquidity, IPOs rise to $ 600 billion, shattering the 2007 record. The winner is Rivian with $ 12 billion. SPACs strongly contributed to this record with 27% of the total (in billions). But IPOs were no guarantee of success: in 2021, the US IPO index underperformed the S&P 500 by 15%.

EN_IPO global en Milliards - 06.12.21

Conclusion. Stock market consolidation and proximity to a less favorable period for equities. Buying opportunities following a decline in prices and reflation during 2022. In the short term, technology and Covid biotechs / pharmas should perform well with the winter Covid wave. In the medium to long term, we overweight banks and cyclical stocks.

The global emerging index had zero performance in 2021, but performances were also very heterogeneous. The problems of China (economic slowdown and real estate crisis), Brazil (politics), Turkey (dictatorship and central bank), the Covid and the strength of the dollar have weighed on the entire emerging zone. Some countries recorded very good performances such as Mexico (+15% in local currency), Taiwan (+20%), India (+22%), but currencies were rather weak. To fully invest in emerging equities, you need better visibility on currencies. Tensions in the China Sea and between Western Europe and Russia make investors cautious.

China is not immediately investable. The Chinese Communist Party has made a 180-degree turn: control of billionaires who no longer consider the national interest, control in education, control over technology, return to the communist dogma of common prosperity and strategy in self-sufficiency. The engine of Chinese growth, real estate is suffering from its past excesses. The new personal data protection law, the extraterritoriality of the national security law and the relentless tensions over Taiwan do not argue for a return to Chinese stocks, and more to the CCP-controlled BigTechs.

 

Oil, consumer countries react - In a coordinated decision, the United States, China, Japan, India, Britain and South Korea decided to release their strategic oil reserves to stop the rise in crude and gas prices. In the US, inflation is becoming a domestic issue, but it's a surprising move for a US administration that is pushing energy transition and climate change. The US will release 50 million barrels between mid-December and April 2022 and oil companies will have to return 32 million barrels to strategic reserves by 2024. Total US strategic oil reserves are estimated at 715 million barrels.

This summer, the US had asked OPEC+ to increase production, but the cartel maintained its strategy of gradually ramping up production to 400,000 barrels per month, seeking to keep Brent prices above $75.

On the announcement, oil prices fell to recover quickly, as the stocks released are not sufficient to have a lasting impact on prices. Consumer countries wanted to make a psychological announcement aimed at the market and at OPEC+. It could do the opposite: OPEC+, which meets in early December, may reconsider its plan to lower output. Oil prices will remain permanently high: 1) the Gulf countries are in a costly economic and “societal” transition, 2) Russia needs money because of international sanctions and wants to punish the US and Europe, 3) new production capacities are scarce because of the uncertainty of the profitability of new projects (legal, climate, environment, financing) and 4) geopolitics is unstable. We do not exclude a return into the $100- $120 range in 2022.

Gold inseparable from real interest rates - The essential factor determining the price of an ounce of gold is the real US 10-year interest rate. The reduction in monetary stimulus and rising interest rates increase the opportunity cost of holding gold. In 2021, the price of gold fell by 5% and the holdings of gold by financial investors in SPDRs, ETFs or other financial products fell by 8%.

EN - Or et taux d'interet réel US - 06.12.21

But the situation is far from clear with a huge winter Covid wave, already in Europe, which could weigh on economic growth and send interest rates back down.

 

 

Disclaimer
This document is solely for your information and under no circumstances is it to be used or considered as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. All information and opinions contained herein has been compiled from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy or completeness. The analysis con-tained herein is based on numerous assumptions and different assumptions could result in materially different results. Past performance of an investment is no guarantee for its future performance. This document is provided solely for the information of professional investors who are ex-pected to make their own investment decisions without undue reliance on its contents. This document may not be reproduced, distributed or published without prior authority of PLEION SA.

Global vision

Asset classes - November 2021

Long-term macro regime - Growth below potential and more volatile inflation. Demographic and debt undermine potential growth. Coupled with digitalization, it fuels secular disinflationary pressures which collide with - cyclical - inflationary tensions.

Ample but decelerating liquidity - Liquidity is ample, but its momentum is fading. Tapering will reinforce this trend. Global interest curve flattening acknowledges for a less friendly liquidity environment ahead.

Soft patch in H2 21. Expansion delayed, probably not derailed - Global soft patch featuring China sup-par growth and rising inflation. Firmer global expansion in H122. Entering a particular monetary cycle where the US lags the emerging and other Anglo-Saxon countries.

Geopolitics. A complex G-Zero landscape - Afghan failure raises doubts about the reliability of US strategic guarantee. Threatening alliance of China and Russia. Indo-Pacific as the new World epicenter (Taiwan).

Buoyant capital flows - Renewed institutions inflows in passive ETF, compensated by somewhat lower retail frenzy.

Scarce and expensive quality assets - Financial repression to continue in the foreseeable future. US long rates to stay in the (1.5% - 2.0%) range H122.

Somewhat lower risk appetite - Reflation trade losing steam. Needs renewed Fed moves and growth rebound to resume.

Global macro sweet spot - Lately, global growth has been decelerating and inflation rising. It will continue for a while. US will soft land by year-end, because of Covid resurgence, escalating disruptions and hesitant back to school process. China traction and contribution to world growth will be tamer. The odds of stagflation are rising with Producer Price Index jumping 10.7% in September, its fastest pace since October 1996. China transformation spells a lower medium-term contribution to global growth. It will no longer export disinflation.

But a global transition from brown to green spells that both private and public investment in renewable sources of energy will provide a secular boost. Pandemic is turbocharging digitalization and automation, paving the way for an acceleration in productivity growth.

Global growth will approach potential in H1 2022, thanks to G7 countries.

China deceleration will dampen global recovery in 2022

The dog has started to bark - The key risk to a - central - kind of benign macro scenario is runaway inflation. For sure, the pace in price rise exceeded what developed central banks forecasted and expected. It is essentially due to prolonged supply chain disruptions. But a rampant rise of wages and the delayed catch up of housing price / rents will prolong it far into 2022. Up to now, central banks managed to mitigate the concerns of fixed income markets. But the regime of - deeply - negative real rates is likely to face renewed attacks. Runaway inflation remains remote, as it would require a serious dose of policy errors or adoption of MMT. Still, inflation will be durably higher than the historical threshold (2.0%) of tolerance of the central banks of developed countries. It is also threatening to China, which nevertheless has an exclusive weapon, the authoritarian administration of certain prices (cf. its interventions in the summer to calm domestic commodity prices).

Inflation will remain sticky if not pervasive over the next quarters. Fortunately, it is not high enough to compromise solid consumption.

Asset allocation conclusion - We still consider that the current transition towards an inflationary boom landscape is the most likely scenario towards 2022. We maintain a fully invested allocation.

But the duration of this journey will play an important role in maintaining financial conditions very supportive for markets. Further significant rise of inflation expectations from the recent high level would trigger more difficult times for risky assets. Rising stagflation risk only disturbed fixed income markets for now. Resurging volatility (as measured by the MOVE index) neither spilled over to equities (VIX remains very low), nor to credit (High Yield spread remain extremely low). This bears careful watching.

 

Currencies

Back from extreme - Over the past month, the USD has consolidated after testing a key resistance. Commodity currencies have rallied strongly and low yielding commodity importers bore the brunt of the weakness. The market is pricing a more sustained price cycle into commodity currencies and an earlier start to the interest rate cycle across most countries. Looking towards year-end, there is more risk of consolidation. Several overbought and oversold currencies have already started and will continue to come back into neutral area.

Carry trades to restart - The Fed will shortly start its asset purchases tapering shortly and complete the process by mid-2022. A less loose monetary policy should be USD-positive, but the currency reaction has been less clear. First, even as the Fed tapers, its policy should remain supportive. Second, the taper was well flagged and is expected, potentially to dull its impact on the currency. Third, some other G10 central banks have jumped above the Fed in the hawkishness ranking. The Norges Bank and RBNZ have already hiked rates, BoE rate hike expectations have significantly risen recently, and the Bank of Canada just stopped its QE program and brings forward guidance on a first rate hike by mid-2022. Hence, whilst US yields have jumped higher over the last month, the support this could have given to the USD has been undermined by a general rise in G10 government bond yields.

Risk appetite has remained a key driver of the FX market. The USD index weakened in October after reaching a new 2021 high as sentiment improved, reducing demand for the safe-haven. However, the USD is no longer just a haven of peace, as it is one of the few high yielding currencies with NZD, AUD, GBP, and CAD. The 5 are exhibiting a 2-year government bond yield higher than 0.5%, while most of their peers are still offering negative yields.

High yielding currencies outperform low yielding ones - November 2021

The mixed environment for EM assets is intact - The US 10-year yield rise above 1.5%, coupled with strong USD flows and potential liquidity tightening have created stronger headwinds for EM. Our negative recommendation on EM FX remains broad-based. Energy prices present another challenge as global supply shortages are likely to persist. This begs the question of what can EM central banks do to ease the pain of a growth slowdown and prices pickup?

On the one hand, tightening policies anchor inflation expectations and cools imported inflation, but at the same time, supply side disruptions and energy shortages are exogenous to central banks decisions. Premature tightening could negatively impact demand. Vaccination rates have only started to improve recently.

 

Bonds

Tapering is tightening - Wu-Xia Shadow Rate is an econometric model which helps to quantify what QE means in terms of a theoretical implied rate that is unconstrained by the zero bound. As it was the case in 2014, tapering implied a set back to the actual Fed Funds rate level, or a 200bps of tightening over the next 6 months.

Wu-Xia rate Shadow Rate - November 2021

Amid record levels of uncertainty around unemployment, GDP, and inflation including a shift in structural inflation drivers (from headwinds to tailwinds), taking out an insurance policy against inflation expectations is entirely sensible and defensible. When core CPI breeched up 2.0% in 1966 it took 33 years to come back to that level. Whilst the 1970s analogue is incorrect, it is nevertheless a cautionary tale.

For the last decade or so, structural factors pushed down inflation. The Fed terminal rate continued to decline in line with medium term inflation expectations. Clearly, this is changing, leading to doubts about whether the terminal rate of the next Fed cycle has shifted upside. At present, the market terminal rate pricing is 1.75%. It has struggle for a while to be above the Fed long-term dot which is at 2.50%.

Central banks wake up - Removing monetary policies accommodation began with emerging market central banks in early 2021. Over the next 12 months the number of basis points of discounted tightening is at decade highs for both G10 and emerging market central banks. The market is discounting a total of 564bps tightening in DM and 3380 bps in EM. This is a dramatic change in pricing compared to early 2021.

G10 expected rates changes - November 2021

Signs of excess in the credit market - The deluge of issuance has pushed the HY bond market value above $1.5trn for the first time. New arrivals have propelled it to a record size. A record of 149 companies, including Coinbase and Medline, have joined the segment in 2021. The companies have extended a trend set by central banks’ historic response to the pandemic. In September, 26 new issuers came to the market, a record equaled just once before in last April. It happened only 3 times that more than 100 new issuers joined the market. It was in 2013, 2014 and 2007. The implied rising financial leverage due to easy financial conditions raised some questions.

Rating actions so far in October remain largely positive. However, there has been a pickup in the number of downgrades, particularly within sectors where recovery is slow or delayed. The Chinese homebuilders and real estate sectors led downgrades over the last month. The downgrade ratio (downgrades as a percentage of total rating actions) increased, as there were only 23 downgrades against 23 upgrades in September. So far this year, there have been 540 issuers that have had a negative rating action and 1’491 issuers a positive action. Over half of the issuers with positive rating actions experienced one or more negative rating actions in 2020. So far in 2021, 317 issuers have been downgraded while 505 have been upgraded. More than 80% of corporate downgrades since the pandemic began involved issuers with High Yield ratings.

Most downgrades since March 2020 were in HY - November 2021

 

Equities

Difficult equity markets evolution’s reading - The disruption of supply chains and the shortage of labor make inflation exploding and are weighing on economic growth (flattening of the yield curve). There is a risk of stagflation, a word that is likely to keep investors busy in the coming months. A temporary stagflation due to the pandemic or something more structural? We are in a marked supply deficit: end consumers can no longer find their products, or delivery times become unreasonable, and companies have to decide between reducing their margins or increasing their prices. Q3 results clearly show semiconductor and labor shortages, as well as rising commodity prices, but companies are performing well and margins remain high. Once again and despite a difficult pandemic environment, companies published results above expectations: + 33% in the US compared to 27.5% estimated one month ago and + 52% in Europe compared to 41% estimated.

Equity indices view this period of chaos as temporary, by anticipating a post-pandemic restocking and an increase of demand. The two US $ 3.2 trillion stimulus plans (lower than the $ 5.5 trillion initially planned), the various national stimulus plans in Europe mainly destinated for green investments and technology, the COP 26 and a favorable seasonality - out of 15 / 20 years, November and December are statistically positive - allow us to envisage a potential increase in the stock markets (US / Europe) of 5% by the end of the year.

S&P 500. net margin estimates for 2022

The interest rates rise remains a negative factor, but for the moment the Equity Risk Premium is in a neutral zone, with a ratio far away from the levels of 2000 and 2008.

If stagflation were confirmed this winter with an acceleration of Covid infections in the northern hemisphere, implying the return of health restrictions, we would become more cautious by favoring the Defensive and Value sectors. Industrials have warned that the 4th quarter results will be weaker due to problems in supply chains. Unsurprisingly, Apple and Amazon disappointed with 3Q21 results; as we pointed out, the Covid-proof technology companies are in a period of (very) negative comparison with 3Q20 and 4Q20. From mid-December, we will be attentive to the overall situation and we will begin to reassess the results for the 4th quarter of 2021, which will be published from mid-January 2022, if necessary.

For now, we are maintaining our Banks / Cyclical bias, as growth remains relatively good despite weaker than expected US household consumption in September due to a lack of supply and higher prices. The banking sector, which we overweight has withstood a sharp flattening of the yield curve. When releasing their results, US banks pointed out that the pandemic was behind them and that loans and credit card applications were in expansion mode.

US banks index - November 2021

We remain positive on the sectors that will benefit from US spending in traditional and green infrastructure, namely cement, steel, engineering, machinery for the traditional part, and electric cars, batteries, solar, wind power, the Smart Grid and the energy efficiency of buildings for the green part.

With dispersed 2021 performances, the emerging bloc sharply underperformed the MSCI World by 20% in dollars. The fault lies largely to China with declines of 6% for the CSI 300, 17% for the Hang Seng China Enterprises and 30% for Chinese stocks listed in the US. China accounts for 32% of MSCI Emerging, followed by Taiwan 14%, South Korea 12%, India 12%, Brazil 4% and Russia 4%. The Brazilian index fell 13% in BRL and 20% in USD. But the other large emerging countries recorded stock market performances in line with the US and Europe. The pandemic partly explains these heterogeneous performances. But the main explanation for the great Chinese stock market lag lies in the Sino-American tensions in trade, technology, finance and geopolitics, and especially the new policy on education, on common prosperity and the takeover on Big techs and billionaires. The difficulties of the second largest Chinese real estate developer may be a boon to stop real estate speculation, but will also translate into lower growth in the next few years, as real estate has been a strong contributor. There is a risk that the rich people will contribute to the redistribution of wealth. In conclusion, investment in the emerging bloc must be targeted and we avoid China for the time being; a new fiscal plan could change our mind.

 

Commodities

The energy crisis – The energy crisis, which concerns gas and coal, is mainly due to geopolitics, climate and less to the pandemic, even if shipping is disrupted. Inventories are low as winter begins. The prices of gas, oil and coal are world prices: a problem on a continent and it is all world prices that adjust. The gas concerns Europe, which preferred to buy its gas on the spot market instead of negotiating long-term contracts, which Russia wanted. Russia has taken advantage of its soft power with the new Nord Stream 2 pipeline. Gas prices are falling following Vladimir Putin's order to increase gas exports to Europe.

Energy prices - November 2021

India and China are running out of coal: Indonesian coal exports have shrunk due to flooding, and China has halted imports of Australian coal due to a trade war. Australia has banned Huawei and ZTE, following the US, from its telecommunications market and called for an international investigation on the Wuhan Covid virus.

Oil prices continue to rise thanks to a strong alliance between OPEC and Russia. With the sharp rise in inflation, consumer countries are asking OPEC+ to increase its supply. By moving out of the Middle East to reorient itself towards Asia and focus on China, the United States has turned the world order upside down and pushed its former allies, such as Saudi Arabia, to draw closer to Russia.

In the short term, fossil fuel prices are expected to decline thanks to an increase in supply. A severe energy crisis would likely validate stagflation, something that developed countries, China and India cannot afford in a pandemic that has already hitting hard the world. Producer countries cannot bring their customers to their knees either. Technically, we can see the Brent hitting $70 and gas hitting $4.50 per million BTU - $5.40 today and $ 6.50 high on October 6 - even $3.50.

 

 

Disclaimer
This document is solely for your information and under no circumstances is it to be used or considered as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. All information and opinions contained herein has been compiled from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy or completeness. The analysis con-tained herein is based on numerous assumptions and different assumptions could result in materially different results. Past performance of an investment is no guarantee for its future performance. This document is provided solely for the information of professional investors who are ex-pected to make their own investment decisions without undue reliance on its contents. This document may not be reproduced, distributed or published without prior authority of PLEION SA.

Risky assets’ quarter

Retrospective

Risky assets have experienced varying degrees of success in Q3. The reopening of economies has been hampered and the economic recovery has stalled. After hitting records, the US stock market consolidated in the wake of the Chinese real estate developer Evergrande default.

 

Back to the job market in the United States

The unemployment rate in the United States keeps dropping. After laying off more than 20 million workers in 2020, US companies are still hiring and struggling to find skilled workers. After peaking at over 15% in March 20212, the unemployment rate fell to 5.20%. However, it remains well above its prevailing level just before the pandemic at 3.5%.

Earlier in the year, employers hoped to see the workforce return as early as September, in part because of the end of the payment of subsidized unemployment benefits for 12 million beneficiaries, as well as the reopening of schools.

Instead, the economy slowed in September due to an increase in infections linked to the Delta variant. Some workers prefer not to return physically at work. Schools and daycares have also been forced to send scores of children home to quarantine, which has made the task more difficult. for many parents to consider jobs outside the home.

 

Oil prices continued to hit new post-pandemic highs

Global growth is expected to be around 6.0% this year and 4.5% next year.

Long-term interest rates in the United States and in Europe continued in their downward trend started in April before rebounding in early August on the eve of the announcement by the US Federal Reserve of its wish to reduce the amount of its monthly bond purchases.

The equity markets stalled. The S&P500, the flagship index of the New York Stock Exchange, set a new high at the end of August at more than 4,500 points. It consolidated in September and is back to late June levels. It still shows an increase of over 15% since the start of the year. As interest rates hiked, the technological sector suffered big profit takings.

Gold did not show a clear trend, as industrial metal prices contracted following the Evergrande story and the risks of slowing Chinese demand. The price of oil continues to advance, it appreciated by + 4.5% over the quarter to reach $79 per barrel, gas prices have soared by almost 60%.

 

Currencies - Quarterly performance

Currencies - 10.21

In the wake of a less accommodative central bank, the USD appreciated strongly against all currencies, both from developed and emerging countries.

 

Bonds - Quarterly performance

Bonds - 10.21

Chinese government bonds continue to exhibit a clear decorrelation with those of developed countries. High Yield continues to perform well, while emerging hard currency bonds continue to experience massive outflows.

 

Equities - Quarterly performance

Equities - 10.21

Quarter without a big momentum in developed markets, after reaching new all-time highs in the US market in the summer. Asian emerging markets are not catching up interests.

 

Commodities - Quarterly performance

Commodities - 10.21

Gas was the big winner during this period, as industrial metals were penalized by the Chinese economic slowdown.

 

Macroeconomy

Global manufacturing prices spike higher amid supply constraints

Manufacturing input costs rose at an accelerated rate in September, increasing at one of the sharpest rates seen over the past decade as supply shortages were exacerbated by ever-higher shipping costs. Demand growth cooled, however, alleviating some of the upward pressure on prices, linked in part to less companies building safety stocks compared to earlier in the year. Worldwide manufacturers reported a steepening rate of input price inflation in September, linked primarily to ongoing shortages of components and higher shipping prices.

Manufacturing demand, supply delays and prices - 10.21

 

Price pressures lift higher

The JPMorgan Global Manufacturing PMI, showed average factory input prices rising at the third-fastest rate recorded over the past decade, the rate of increase accelerating from August to equal that seen in July though fall slightly short of May's recent peak.

Higher shipping costs - 10.21

The rise in costs was first and foremost again linked to suppliers being able to hike prices amid widespread shortages, creating a sellers' market for many inputs from electronics components through to basic raw materials used for construction industry products. Average suppliers' delivery times continued to lengthen globally at a rate unprecedented in almost a quarter of a century of survey data, exceeded only by those recorded in the prior three months, underscoring the unparalleled supply chain delays being recorded in recent months as a result of the pandemic.

Not only has the pandemic seen surging demand for many goods, the health crisis and associated lockdown measures has seen production of components and logistical capacity hit hard, with the recent Delta variant placing additional pressure on production capabilities in many important export-oriented Asian economies in particular, notably China, where manufacturing output has now fallen for two successive months .

 

Strategy

Elevated macroeconomy volatility

Macro volatility will continue in the aftermath of the pandemic. Growth will converge from 2022 towards its long-term potential, while inflation will be resilient above Western central banks’ targets. Decoupling between the G7 and China will intensify. The containment of China's housing crisis will require a significant easing of its economic policy. The generous valuation of most assets, the surge in commodities and real estate, the financial leverage represents potential vulnerability in times of macro and economic policy transitioning.

Volatile Macro/Geo-politic will challenge, but not derail the Asset Price Inflation regime.

Disappointing economic surprises - 10.21

Long-term drivers

We consider three secular disruptors. 1) Climate – rapid – changes, which impose hectic transitions towards green (er) economies. This will fuel large investment packages, but also higher inflation, new regulations, corporate requirements, and taxes. Europe is leading the charge. 2) Technology. The relentless shift towards digitalization has a long-lasting impact on labor markets. 3) High Inequalities generate more labor friendly policies to regain a higher share of GDP.

 

Investment landscape

Stagflation fears are taking root. Rising inflation fears have irritated markets and fueled changes in assets’ correlation. The volatility of negative real rates, the global mushrooming of stricter regulation, and perspectives of (US) higher taxes add to uncertainty. The decrease of risk appetite favors a stronger USD. Further strength would accentuate drying-up of investable liquidity and upset risky assets.

Stagflation fears should dissipate by year-end. Supportive financial conditions will continue in H1 2022.

Global investment framework remains relatively supportive, though less so.

Towards a new correlation regime - 10.21

 

Currencies

The almighty USD

The QE tapering will happen in November and a first rate hike in S2 2022 accordingly to the median Fed forecasts. That would coincide with a pickup in cyclical inflation, as opposed to the transitory lift we have seen this year from the combination of base effects and supply disruptions. Clearly, the Fed is looking ahead to a reacceleration in growth in 2022.

Forward Fed Funds rates - 10.21

While a S2 2022 rate hike would not be shocking at this point, it still looks too early. According to historical forecasts, both the Fed and markets failed to predict the first rate hike in the right timing. Investors have usually been more hawkish than the FOMC, this time is the opposite and could cause a big shift in positioning.

Furthermore, the Fed central tendency terminal expected rate, still according to dots, is quite high at 2.5% compared to other central banks foreseeable rates paths. That divergence in policy rates between the Fed and other funding central banks like the ECB, BoJ, and SNB in the coming years will drive USD outperformance.

While the pandemic purchases will moderate, the overall ECB QE envelope will remain unchanged at €1850bn until March 2022 at least. The ECB intents to maintain favorable financing conditions to perpetuate the recovery narrative. Therefore, the central bank will consider pandemic purchases transitioning into the Asset Purchase Program. Although headline inflation risks testing 13-year highs, the ECB will look through short term price spikes, especially as core prices are expected to remain relatively well contained. Alongside expansionary fiscal policy will favor persistently low interest rates, and as a result, a weaker EUR in 2022. This will be the main support for the USD.

EM ex-China monetary policies tightening - 10.21

 

Bonds

Solid credit performance

Rating performance is improving in the corporate sector. The number of issuer upgrades exceeded downgrades in 2021. Most of them are not reversals of rating actions taken in 2020. Last year was a record deterioration in corporate ratings, with the highest number of downgrades in 20 years or 20% of the universe, and with 7% of issuers downgraded by multiple notches. However, as pandemic-related restrictions have relaxed and as many economies return to growth, the most severe credit pressures have abated. Positive ratings actions have started to rise. The ratio of corporate upgrades to downgrades in developed markets is 1.3x in 2021, while the balance is almost neutral in emerging markets.

Improving credit ratings - 10.21
This dynamic is well spread across the bond universe. The number of potential fallen angels (issuer leaving the investment grade space to the high yield) has begun to shrink, and potential rising stars (the opposite way) continue to climb.

The 2022 US High Yield bond default rate will reach 1.0%, down from 2.5%-3.5% original projection, according to Fitch. This will result in just a 7% cumulative default rate for 2020-2022, well below the 22% registered during the 2008-2010 global financial crisis. These forecasts coupled with a very low near-term maturity wall and continuing improvement in fundamentals remain supportive for low credit spreads, even more as refunding remains easy.

Even if defaults risks are lows, the overall HY market is offering the largest negative real yield in history and more than 80% of the US HY market is yielding below the CPI. Higher government yields will not derail credit market, the amount of debt to roll-over in the next 2/3 years is manageable. Even with improving fundamentals  credit spreads remain at unattractive levels

Unattractive real yields - 10.21

 

Equities

Supportive year-end seasonality

Since August, some investors have been worried about a significant stock market correction due to unfavorable seasonality (statistics) in August, September and the first two weeks of October, and expectations of smaller injections of liquidity from central banks. As observed recently, rising interest rates are still shaking the stock markets as they challenge stock valuations. Investors may be more worried now, because the origin of the latest hike is more inflation fears and potential cuts in central bank liquidity than expectations of an economic recovery.

US stock market seasonality - 10.21

 

Stagflation risks are mounting

In the short term, the market has to integrate a possible new paradigm with the return of inflation and the implication of a reduction in liquidity by central banks. Added to this is the brawl in the US Congress over stimulus plans and the debt ceiling, as well as the real estate problems (Evergrande) in China.

In the medium to long term, we remain positive on equities and believe that investors will look beyond this current period of acute disruption.

The positive arguments for 2022-2023 are:
• A gradual normalization of world trade and less pressure on supply.
• Massive restocking, with new demand coming from the energy transition and 5G (involving the use of new applications).
• An acceleration in demand thanks to the savings accumulated during the pandemic and the return of a normalized supply for clients/households.
• US and Chinese budget plans (forthcoming).
• Green investments, with perhaps more visibility after COP26.
• Investments dedicated to increasing production capacities (semiconductors) and new production capacities (electric vehicles, batteries, etc.)

The emerging zone should continue to underperform in a period of Sino-US confrontations - technological, commercial, geopolitical, financial -, questioning the globalization, the strengthening of the dollar and higher US interest rates.

First equity funds outflows - 10.21

 

Commodities

Geopolitics is a source od stress

Geopolitics is becoming more complex, such as the rapprochement of Russia towards OPEC (Saudi Arabia) to control oil prices or Russian pressure on Europe with gas to make the Nord Stream 2 pipeline (Gazprom) indispensable, a great tool for Russian soft power. Gazprom is the only company that Europe can turn to in case of urgent need for gas and the International Energy Agency calls on Russia to ensure sufficient storage for the next winter season. We have to wait until the end of the year for the exploitation of Nord Stream 2 and Russian gas will therefore have to pass through Ukraine, which Russia does not facilitate due to the tense UkrainianRussian relations and international sanctions against it.

Commodities prices - 10.21

Gas and coal prices are skyrocketing. Demand for gas is picking up sharply in a context of an economic rebound, while inventories are at their lowest. Weather phenomena, several breakdowns (in Norway in particular), the Covid and a global maintenance delay on the installations during the year 2020 have contributed to the slowdown in global supply. China is caught off guard - one could even say that it is facing an energy crisis -and must ration electricity consumption.

 

Metals have clear different drivers

In precious and semi-precious metals, production of platinum and palladium for catalytic converters has declined along with that of cars due to the shortage of semiconductors.

Too low Capex - 10.21

The next few years will be marked by a structural increase in demand for metals and a weak supply response. Investments in new mines are slowing down because the profitability of projects is no longer guaranteed due to (geo) political, climatic and legal risks.

Precious metals are not sought after, gold and silver, as absolute protection, but as decorrelated diversification in a portfolio. Their prices moves with US interest rates and/ or the dollar. Gold is a financial asset that can protect in the event of a financial (debt) or monetary crisis. This is not the case today. If rates go down, it favors stocks, if rates go up, it favors bonds. However, a negative real interest rate regime is good environment for gold and offers cheap protection in a diversified portfolio.

 

Allocation

Allocation - 10.21

 

 

Disclaimer

This document is solely for your information and under no circumstances is it to be used or considered as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. All information and opinions contained herein has been compiled from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy or completeness. The analysis con-tained herein is based on numerous assumptions and different assumptions could result in materially different results. Past performance of an investment is no guarantee for its future performance. This document is provided solely for the information of professional investors who are ex-pected to make their own investment decisions without undue reliance on its contents. This document may not be reproduced, distributed or published without prior authority of PLEION SA.

 

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