Blog

By Tim Sharp

It has been a testing month for global bond markets, despite inflationary pressures from Central Banks and the Ukraine Crisis market pessimism has been running on stretched levels. When bond yields go up there is an inverse relationship on the price which will go down. An inverted yield curve, when short-dated bonds yield more than long-dated bonds, could be a sign that a recession is coming under normal circumstances. Central Banks look to combat inflation by raising interest rates. Some would argue that Central Bank intervention since the global financial crisis has blunted the signalling skills of the bond markets, but we believe history suggests that the US Treasury yield curve remains the most accurate predictor of recessions. During March, the US Treasury yield curve has flattened considerably with the yield differential between two-year and ten-year benchmarks have reduced to 0.02%, while the five-year to ten-year part of the curve has inverted 0.11% as at month end. The speculation continues and time will tell if central banks can engineer a soft landing.

In the Eurozone, growing investor uncertainty over future ECB (European Central Bank) rates have boosted fixed income volatility, which is assisting the rise in bond yields. Eurozone benchmark bond yields have been soaring recently, with 10-year Bund yields rising by about 75bps so far in March, which is cheapening Bunds. This rising trend in eurozone bond yields reflects the growing investor uncertainty over the future trajectory in ECB policy rates[i]. Price pressures intensified substantially within the Eurozone in March, headline inflation hit 7.6% in Germany and 9.8% in Spain, both statistics were well above expectations, and both at 40-year highs. Pressure on policymakers to act will rise as the market prices in almost three quarter-point hikes from the ECB by the end of the year. The story of inflation within the eurozone is mainly being led by the increase in energy prices and supply disruptions[ii].

In the US, the 10-year U.S. Treasury yield hit a fresh two-year high Friday 25^th March as investors anticipated a more aggressive Federal Reserve tightening cycle. The 10-year rate hit 2.50%, its highest level since May 2019, having started the week near 2.15%. The yield on the 30-year Treasury bond jumped 8.1 basis points to 2.59%. “If we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so,” Powell said in a speech to the National Association for Business Economics. The increase in Interest Rates comes as Powell has said “inflation is much too high” [iii]. As we have previously seen from January this year, there could be as much as seven interest rate hikes this year by the Fed.

Europe has started to feel the effects of the Russia-Ukraine crisis for which unfortunately no end is currently in sight[iv]. Investors have grown increasingly convinced that the fallout from Russia will have a lasting effect on the region’s economy. We see that output has suffered in countries with a greater supply exposure to Russia, with Germany seeing the largest declines. We have already seen rising energy prices and firms passing on higher costs to consumers. This has also been reflected in stock markets with the Italian MIB Index down 1.02%; the Dutch AEX down 0.48%; The German GDAX down 0.14% and, while the French CAC40 was up 0.30% over the course of the month.

We see that the stocks that have performed the best in March have been quality stocks with good cash flows and low debt profiles. Tech stocks that are predominantly software based have very little debt and are typically asset light. A few examples would include Alphabet, up 3.0% on the month, and Microsoft up 3.2% from the start of March.

Global stock markets have had a late month surge on the possibility of a possible ceasefire in Ukraine and a Russian announcement that its military was cutting back operations around Kyiv and Chernihiv in the North of Ukraine that looks like signs of progress[v]. The MSCI World Index has increased 9.1% since March 8^th, 2022.

In Japan the Yen is generally considered to be a safe haven in times when geopolitical and financial tensions are raised, and as an example strengthened against the dollar during the years of the Global Financial Crisis[vi]. However, that is not the case this time as the Yen has weakened against a strengthening dollar by around 6.5% due to its position as a significant energy importer. The Nikkei 225 has been equally disappointing having fallen 5.58% over the course of the year.

Commodity prices have also rallied this past month amongst the growing uncertainty with the Russia-Ukraine Crisis and the resulting disruptions to supply. Russia and Ukraine are two of the world’s largest suppliers of wheat/grain (around 30%) and Russia has temporarily put a ban on grain exports to ex-Soviet Countries (March 14^th) [vii]. US retail gas prices ‘at the pump’ have reached all-time highs due to concerns about supply which has been reflected in OPEC reports and US ban on Russian Oil imports[viii], with oil prices reaching $130 a barrel, almost double their price in early December! Prices of Energy have been increasing and energy related stocks have seen surging share prices. Good news for existing commodity investors with the WisdomTree Enhanced Commodity ETF 10.8% stronger in dollar terms in March.

To summarise, March has seen significant rises in volatility and market turbulence driven by the knock-on effects of the Russia-Ukraine crisis. The S&P closed at 4530, and the UK FTSE 100 closing at 7515 both up 8.6% and 8.0% respectively from Month lows on March 8^th. There has been a late rally in market prices on hopes of Russia reaching an agreement with Ukraine, however the war is not yet resolved, and it is too early to say that markets will not revisit lower prices. The Wisdomtree Enhanced Commodity ETF has been a strong performer in March hitting all-time highs (1596 up 15.8% from the start of March in sterling terms) while the S&P 500 hit its lowest in March albeit ending the month 6.3% higher than at the start. The iShares Physical Gold was up 8.6% on March 8^th although ending the month only 1.4% higher. There will undoubtedly be a knock-on effect due to the restrictions on Russian exports which markets probably still need to factor into pricing. We are in a highly inflationary environment that still needs to be addressed by central banks while attempting to avoid a global recession. The Bank of England has increased UK interest rates in March to 0.75%, the Federal Reserve is still aggressively approaching US Interest Rates, and the ECB is still contemplating its position. Finally, the Japanese Yen once considered a safe haven in times of uncertainty has not lived up to its reputation.

 

[i] Absolute Strategy Research – EUR bond yields’ shifting drivers – March 30, 2022

[ii] Absolute Strategy Research – Eurozone inflation surge continues – March 31, 2022

[iii] https://www.cnbc.com/2022/03/25/us-bonds-treasury-yields-flat-friday.html

[iv] Absolute Strategy Research – Europe starts to feel Russia-Ukraine effects – March 25, 2022

[v] Bloomberg Points of Return – Be Warned – A Piece of Paper – John Authers – March 30, 2022

[vi] Bloomberg Points of Return – Be Warned – What a Time for Japan to Matter to Markets Again – John Authers – March 28, 2022

[vii] https://www.reuters.com/business/russia-may-suspend-grain-exports-until-june-30-interfax-2022-03-14/

[viii] https://www.reuters.com/business/biden-bans-russia-oil-imports-us-warns-gasoline-prices-will-rise-further-2022-03-08/

By Tim Sharp

In a world that is suffering from high inflation due to supply disruptions, the tragic Russia – Ukraine conflict represents another supply shock for the global economy, the impact of which will depend largely on the length of the war and the effectiveness of the sanctions imposed upon Russia. The European Union does not have a good track record for decisive action but the implementation of the policies against Russia have probably surprised many, particularly the historic changes in foreign policy by Germany in support of Ukraine. Higher commodity prices are likely to have a global impact with oil, industrial metals, and agricultural commodities all impacted by the conflict, but the effects of European gas prices will ensure that Europe is hardest hit putting pressure on prices that will squeeze household incomes, and likely depress European growth. Europe is also likely to question its energy policies going forward with the long-term implications to growth and strategy that will cause. Higher commodity prices can correct lower through changes in supply, and although the US announced that it would use its strategic oil reserves to bolster supply shortages, this coupled with the uncertainty regarding the ongoing conflict, and the effectiveness of sanctions, has so far failed to pause the rising price of crude oil. The alternative potential headwind to higher commodity prices is lower demand caused from tightening central bank policy response, and an unwillingness from the consumer to spend in uncertain times when household incomes are under pressure. Absolute Strategy Research (ASR) point out commodity price inflation tends to fade with world trade growth[i].

Judging by Jerome Powell’s speech to the House of Representatives Financial Services Committee, the US feels far enough removed from the Russia – Ukraine crisis for it not to affect Federal Reserve policy. Governor Powell intimated that policy was likely to tighten 25bp at the March meeting drawing a line under the speculation that the rise might be 50bp or even deferred due to the conflict in Europe[ii]. The speech also confirmed to us that the Fed’s attention has turned firmly to inflation at the expense of growth in the short term. We believe wage inflation is a big consideration for the Fed because the policies used by the US during the pandemic did not furlough workers but offered direct financial compensation. This has led to a much higher flexibility within the employment market, a higher churn rate, and in turn, a boost to workers’ bargaining power as they re-enter or move around the jobs market. Therefore, the fed appears to fear that sustained wage growth through pressure in the labour market may keep inflation elevated. We believe that wage growth and earnings will be key to Fed policy going through this year as balancing upward wage pressure against corporate earnings will provide an indication as to how the economy is progressing. We have been mindful of the possibility of a central bank mis-step due to the delay in quantitative tightening reducing the tightening landing strip and believe that the Russia-Ukraine conflict has heightened the possibility of this occurring. While earnings are growing albeit at a slower pace, it is unlikely that the economy will roll over into recession, but a war that is likely to drive inflation higher and eventually cause global growth to contract will create a more difficult environment for central banks to set appropriate policy.

Following the invasion of Ukraine, equity markets reacted in line with our expectations by selling off on uncertainty before rebounding once the facts of the situation start to be released. There is still much that is unknown regarding the geo-political risk surrounding Russia’s overall intentions, the likely protraction of the conflict, and the fallout from the aftermath. There seems to have been very little evidence of the “buy on dip” mentality that had underpinned equity markets throughout the pandemic. ASR point out that fundamentals suggest that US equities are trading in line with their 10-year average trailing earnings of 21 times, while Europe are trading on a 20% discount to their trailing earnings of the last decade of 14 timesi, so we would argue that there is little need to rush back into risk assets but remain in defensive equity strategies.

The rotation into quality stocks with strong earnings protection and predictable dividend policies suggests that investors are also focusing on high inflation rather than slowing growth. We believe it is unlikely that the global economy rolls over into recession while earnings are growing, therefore, reporting seasons in the second and third quarters will be key to understanding the impact of the current pressures on earnings. This also spreads to the ability of companies to maintain dividend policies in the light of potentially tighter margins, and we feel that the maintaining of dividends will be another touch point for signs that companies are under pressure. The threat of recession and stagflation has seen bond yields fall once more and yield curves flatten putting pressure once more on the banking sector, particularly in Europe where exposure to Russia is inevitable. The iShares Euro Stoxx Bank ETF is now 24.77% weaker year-to-date having fallen 11.61% in February.

This environment seems to favour the mix of companies within the main FTSE UK indices which are dominated by energy, pharmaceutical and domestic banking stocks and possibly explains the outperformance of the FTSE 100 Index when the main indices have been in drawdown. Over the month of February, the S&P500 fell 5.01%; The German DAX was down 6.53%; and the Nikkei 225 in Japan fell 1.76%, while the FTSE 100 fell just 0.08%. Oil prices remain elevated, particularly as US allies discuss adding oil to the growing list of sanctions against Russia, and inventories remain very low, which will continue to support the earnings, and dividends paid by the energy sector. After years of underperformance since Brexit the UK equity markets seems to be rewarding investors with the right breakdown of exposures in the current climate.

We would also draw attention to John Authers Points of Return newsletter dated March 7, 2022[iii] which points out that commodity exporting companies such as Canada, Australia, Brazil, and Norway have also outperformed global indices so far in 2022 and the situation is likely to continue over the rest of this year in the current climate of supply disruptions. More generally we had been researching Emerging Market Local Currency Debt prior to the invasion as a fixed income diversifier but feel that such a move now would add unwanted volatility to portfolios.

China’s policy moves to encourage a more consumer-led economy seem to have been deferred in the latest five-year plan as it looks to boost productivity through manufacturing. This coincides with a need to be more self-sufficient to secure supply chains that have proven frail during the pandemic. Many large consumer countries have suffered from just-in-time delivery problems, and global supply chains that have proven unreliable when challenged by a global event such as Covid-19. An emphasis on onshoring is likely to replace globalisation, in our opinion, to secure manufacturing supply chains, and due to changing views surrounding climate change. This could have implications for growth in emerging markets and the general cost of goods in the future suggesting negative global GDP growth effects.

 

[i] Absolute Strategy Research – Investment Committee Briefing – March 1, 2022

[ii] Powell backs quarter-point rate rise in March despite Ukraine war effects | Financial Times (ft.com)

[iii] John Authers’ Points of Return (bloomberg.com)

By Tim Sharp

We are deeply saddened by the historic decision taken today by Russia to pursue a military invasion of the Ukraine and the humanitarian impact of these events. However, we also wanted to focus on the potential financial impact on investors as market volatility increases. Global investors have initially reacted sharply with broad Russian equity indices falling by c.35%, the price of Crude Oil exceeding $100 per barrel for the first time since 2014, and benchmark Dutch gas futures rose as much as 62%, the most since 2005[i].

After an initial sell-off in developed equity markets of up to 4% the US markets recovered during afternoon sessions to end the day up 1.49% (S&P500) and 0.63% (NASDAQ). European markets have followed suit this morning opening in positive territory buoyed by the perceived lighter than expected impact of western sanctions announced so far on energy markets although this remains ongoing.

Our approach to these types of geopolitical event is to remain invested as the resulting economic effects tend to manifest most acutely at the regional level and less so at the global level (see table below). while we have no direct exposure to Russian equities, and while markets have, at least initially, moved in unison, history would suggest that now would be perhaps the wrong time to take any evasive actions.

Indeed, we believe attempting to do so could materially affect longer term investment returns in a negative way.

Regional Market Returns Following Russian Invasion of Crimea;

Russia remains a relatively small part of the global economy (c.1.5% according to World Bank estimates) and while we do expect to see significant disruption to areas such as energy and food prices, we also feel confident that these are outcomes for which we are already positioned. The threat of greater escalation and the wider impact of financial sanctions suggest volatility will likely remain elevated over the coming days and weeks.

So far this year the rotation from growth and momentum driven stocks towards cheaper value and yield bearing sectors has continued with the S&P 500 Value and Growth Indices down 5.41% and 14.16% respectively. Barclays point out today that falling markets on higher earnings have created a de-rating in European equities that may provide opportunities once the outcome of the Ukraine crisis is more fully understood[ii].

We have always taken a diversified approach toward portfolio construction however, and recently have been focusing on fixed income and alternative investment exposures. This exercise was undertaken to maximise the extent to which these allocations could help diversify risk through periods of equity market stress.

As a result, we favour exposure to carefully chosen assets such as agricultural commodities, precious metals, GBP & JPY denominated government bonds, and a small number of actively managed and genuinely uncorrelated investment strategies. We are encouraged to see these assets having generally increased in value, providing a welcome offset to some of the weakness seen more broadly across the equity markets.

 

[i] Europe Natural Gas Prices Jumps 41% After Russia Attacks Ukraine Targets – Bloomberg

[ii] Barclays – Equity Market review – Wartime – February 25, 2022

By Haith Nori 

There has been a significant shift in the world’s mindset of how cars will be fuelled. With many major governments committing to ending the sale of petrol and diesel vehicles consumers are being directed towards Electric Vehicles (EV). For the general public this is causing a dramatic change to their lifestyle, as what was once the quick and easy method to re-fuel a car has turned into a more time-consuming experience. Charging an EV at a Petrol Station will take 20 minutes to 1 hour which isn’t always the most convenient, especially if there are queues!

In the UK it is now compulsory for every new house built to have an EV Charging Point installed which may affect the aesthetics of the building; not what every new homeowner may want. However, the UK Government is providing grants to subsidise the charge point[i] (provided by BP) including free installation. This most certainly helps the public and provides a means for charging a vehicle whilst being in the comfort of your own home even though it can take up to 8 hours to fully charge from empty. Whilst there will be an increase in electricity bills, there will be no petrol bills, no road tax, and no congestion charge for all Pure Battery Electric Vehicles[ii]! Governments and energy companies are working to produce a new structure where EV Charging can be facilitated but there is a long way to go before this becomes the ‘new norm’.

Fast charging hubs are being put into production across the UK and the rest of the world. The ‘fast charge’ addresses the key drawback for many consumers but the wait time is still 20/30 minutes. There are not enough fast charge points available for this to be effective enough and will not be fully available until at least 2023 which makes the shift to electric at this present time more difficult. Companies like Pod Point, who had their IPO in November 2021, are providing innovative ways to aid this shift, for instance having charging points in public parking spaces on roads, in supermarkets and golf courses, and hence whilst the car is charging the owner can do a weekly shop or play a round of golf! This undoubtedly ‘fits’ into lifestyles more smoothly. Pod Point provide electric vehicle charging with a focus on ‘charging the UK’ providing Home Charging, Commercial Charging Points and Workplace Charging Points[iii].

However, whilst in theory this is the correct way forward, there are simply not enough charge points for everyone to enjoy this luxury.

In the annual UK sales snapshot for 2021, the Society of Motor Manufacturers and Traders (SMMT), said carmakers sold 190,000 battery electric cars across the country last year[iv], accounting for about 11.6% of total sales and that Britons bought more electric cars in 2021 than in the previous five years combined.[v]

From the data it is very clear that consumers have been making the added effort this past year to make the jump and ‘go electric’. The pandemic has also shifted consumer mind set as there has been an increase in consumer spending on consumer goods and less on consumer services.

Car companies are racing against each other to produce the most efficient and effective EV to add to their range, setting ambitious targets to achieve all electric vehicle sales. On another level car companies are teaming up with electrical companies that are working to find the most effective batteries to impact the longevity of a journey before the need to re-charge. The battery is the most expensive component of an EV. If a company can reduce the cost of the battery without effecting the efficiency of the battery this can potentially reduce the overall cost to the EV in what is becoming a challenging market. For example, Tesla vehicles have always had the reputation for being the most expensive. Panasonic are working with Tesla to produce the batteries to fuel Tesla’s electric fleet and have recently made a significant investment (January 2022) to produce a battery which is both cheaper to produce and has a 20% increase in energy capacity to be released in 2023[vi]. Tesla has a Gigafactory in Nevada from which Panasonic operates to produce batteries for Tesla vehicles. Along with Tesla many other car companies including Daimler and Stellantis are attempting to produce batteries that will have a longer life and lighter weight, thereby adding to the efficiency of the vehicle. As an example, in January 2022 Mercedes-Benz have released their new prototype called VISION EQXX which will have a range of more than 1,000 kilometres per charge[vii] showing automakers are attempting to address the charging situation.

The UK is currently lagging European competitors in battery production – the crucial link in the EV supply chain. In the global race between countries to secure vital battery production the UK Government has added £100million to an existing fund of £3.8billion aimed at building a new battery Gigaplant in Northumberland called ‘the Britishvolt project’[viii]. Switzerland-based mining giant Glencore have also just invested $54million into BritishVolt (February 2022) in a new round of funding, which highlights both a surge of investment in this field and the additional interest in the British economy[ix].

EV’s are more reliable than the Internal Combustion Engine (ICE) which has over 2,000 moving parts compared to an EV which has as little as 20[x]. As always this is beneficial to any consumer, especially when considering a long-term investment. This will encourage firms like Faurecia, an automotive equipment supplier, to expand spending on making the internal parts of an EV more efficient.

Globally, China is leading the race with the largest EV fleet.

With oil giants like BP and Shell finally making the shift from selling petrol to a greater focus on EV Charging Points, consumers can see a better picture that the world is changing and the need to change with it. Originally, oil giants were reluctant to make the shift as it was a loss-making venture. BP is now gearing up to become more profitable from its electric vehicle charging points than it is from selling petrol and by 2025 their EV charging division will be entirely self-sufficient. What once seemed to be large companies investing for the long term, potentially making a loss, has become a profitable business model[xi]. Shell has converted one of their petrol stations in Fulham, London to be their first all-Electric Vehicle Charging Station (January 2022) with 9 charge points. Whilst some consumers will not be happy initially as change is never easy, the shift with oil giants will be the main catalyst in speeding up the process to electric vehicles as driving a petrol car will soon be more difficult to maintain.

EV’s are expensive to buy outright which puts many people off as they simply cannot afford one. However, there are options including leasing which can be much more appealing and currently the most popular option of vehicle financing[xii].

Overall, the consumer has a great deal to consider before making both the investment and commitment to driving their own EV. Whilst the initial cost may cause a slight sting the shift will certainly benefit the consumer in the long run, and they can be sure that the Electric Vehicle journey will continue.

 

[i] https://www.gov.uk/government/collections/government-grants-for-low-emission-vehicles#electric-vehicle-homecharge-scheme

[ii] https://www.gov.uk/vehicle-exempt-from-vehicle-tax

[iii] https://pod-point.com/

[iv] https://www.smmt.co.uk/vehicle-data/evs-and-afvs-registrations/

[v] https://www.theguardian.com/environment/2022/jan/06/uk-carmakers-report-booming-sales-of-electric-vehicles

[vi] https://www.panasonic.com/global/corporate/ir/presentation.html=

[vii] https://www.reuters.com/business/autos-transportation/mercedes-benz-unveils-1000-km-per-charge-vision-eqxx-prototype-2022-01-03/

[viii] https://www.gov.uk/government/news/government-backs-britishvolt-plans-for-blyth-gigafactory-to-build-electric-vehicle-batteries

[ix] https://www.reuters.com/business/autos-transportation/britishvolt-kicks-off-funding-round-with-54-mln-glencore-2022-02-15/

[x] https://www.forbes.com/sites/sap/2018/09/06/seven-reasons-why-the-internal-combustion-engine-is-a-dead-man-walking-updated/?sh=e643467603fe

[xi] https://www.reuters.com/business/energy/bp-car-chargers-overtake-pumps-profitability-race-2022-01-14/

[xii] https://www.rac.co.uk/drive/electric-cars/choosing/electric-car-leasing-explained-ev-financing-vs-buying/

By Tim Sharp

As the US Federal Reserve turns hawkish equity markets have entered a period of heightened volatility. We have warned before that the chance of a central bank policy misstep has risen and the rapid change in rhetoric suggests to us that the Fed and the Bank of England (BOE) are also now fearing that inflation is getting away from them. The earnings season has provided an element of support despite the spike in Omicron in the fourth quarter, however we believe markets are now focused on the possibility of monetary tightening causing significant contraction in global growth. By the end of a January re-pricing in equities, interest rate markets have priced in a potential five quarter point rate hikes by the Fed in 2022. Following Jay Powell’s press conference after the FOMC meeting last week prices also moved to reflect a heightened chance that this will start with a 50bps hike in Marchi.

The technology heavy NASDAQ index has seen many components move into correction territory as investors rotate aggressively into value stocks. While the headline index was down 8.98% during the month, tech heavyweights such as Netflix (-29.10%); Nvidia Corp (-16.75%); Zoom (-16.11%); Tesla (11.36%); and Twitter (-13.21%) have all experienced bigger falls, with many stocks down over 50% from their 52-week highs. The S&P500 index finished the month -5.26% with the underlying value index (-1.75%) outperforming the growth component (-8.42%) significantly, highlighting the extent of the style rotation despite both indices being in negative territory.

This can also be seen in the outperformance of UK equities where the makeup of the main indices shows a value bias led by banks, energy, and pharmaceuticals. The FTSE All-Share Index finished the month down 0.39% with the large cap FTSE 100 up 1.08% despite the UK CBI survey suggesting UK businesses are facing the tightest labour market conditions since the 1970’s. This may explain why the BOE was so quick to tighten rates at the end of 2021 and, should these conditions continue, it may prove more difficult to contain the inflation threat[i].

The extent of the adjustment in tightening expectations also reversed the direction in the US dollar which had started the year providing support for emerging markets. The US Dollar Index finished the month 0.60% firmer in line with the pricing in of aggressive Fed hiking timeframe and a reduction in the Fed’s balance sheet in the form of quantitative tightening. 2-Year US Treasuries now yield 1.16% as the 2-10yr curve flattens under the weight of tightening expectations which may look attractive to some investors when 2-year Gilts yield 1.04% and 2-year German Bunds are still -0.56%! The sterling trade-weighted index hit its highest level since 2016 during January and should be supported by expectations of further BOE tightening with a second interest rate hike expected this week.

Eurozone inflation registered 5% in December and will come under increasing pressure to address its policy responses at this week’s ECB meeting. Chief Economist Philip Lane has stressed that the criteria for a move in EU interest rates are not in place and are unlikely to be fulfilled this year. The ECB will continue to monitor any pickup in wage growth and household inflation expectations but at this time forecasts are for interest rates to remain unchanged until mid-2023[ii]. We believe that moves to adjust negative interest rate policy and to start quantitative tightening are more likely this year as the ECB maintains a cautious approach.

In the light of such significant prospects for tightening we would have expected corporate bonds to have reacted more negatively, however credit spreads have been resilient so far perhaps guided by macroeconomic developments such as Institute of Supply Management data and earnings results[iii]. Furthermore, we feel markets are also focusing on the likelihood that the implied terminal policy rate will be lower in this tightening cycle than in past cycles meaning less potential pressure on corporate balance sheets.

The tussle between negative real yields and a strong dollar has left gold without its usual safe-haven credentials in the face of rising inflation. Gold has fallen 1.74% so far this year following on from its poor performance last year and is unlikely to attract investors until they are able to better understand the current drivers of inflation plus the likely path of interest rates. The threat of a Russian invasion of Ukraine on top of the already difficult supply backdrop will likely create tailwinds for the oil price which was already up 19.63% in January at $94.03 (Brent). The inflationary environment is invariably good news for commodities and the WisdomTree Enhanced Commodity ETF was 6.40% stronger in January.

To summarise, January saw significant spikes in volatility quite often associated with inflection points in financial markets. The closing levels of many equity indices do not really tell the entire story of the level of market turbulence over the course of this month. The maximum drawdown in the S&P500 was 11.97%[iv] before the bounce into month end and this may prove to be a base. This does not, however, necessarily mean that the market will not re-visit these lows as the turbulence is set to continue, and we feel that it is likely assuming a second leg down into bear market territory does not materialise, that it will be early summer before equity markets recover their poise. The main fear will probably be whether the central bank tightening will bring forward possible recession and we believe future earnings will be a suitable indication of that likelihood. Our base case scenario sees inflation falling as transitory effects unwind and economies reopening following the recovery from Omicron. We believe a major question will be what level of the current inflation proves to be sustainable rather than short term because this will determine the terminal level of interest rates in this cycle and its effect on the global economy.

 

[i] Absolute Strategy Research – After the FOMC, Now It’s Europe’s Turn – January 31, 2022

[ii] Absolute Strategy Research – ECB = Extra Cautious Bias – January 18, 2022

[iii] Absolute Strategy Research – Technicals Essentials – January 31, 2022

[iv] Bloomberg Points of Return – Be Warned – the Turbulence This Time Is Different – John Authers – February 1, 2022

By Tim Sharp

The key questions that are likely to affect investment decisions in the medium-term focus on the effects of the Omicron variant on global growth, earnings growth justifying current equity valuations, and the strength of inflation accelerating changes in monetary policy.

There are many categories of risk within markets and investment management, and we would like to focus on idiosyncratic risks for a moment. Idiosyncratic risks are the opposite to systemic risk as they are uncorrelated to overall market risk and effect individual assets or investments. The risk may come from the macro-environment, including economic, political and society risks, or from determinants within a specific industry. Moreover, the term may be used to refer to non-financial, unsystematic risks within the global economy whose effects on financial markets may be difficult to quantify, such as, natural disasters, pandemics, and geo-political tensions.

We believe the rise in geo-political risks, such as Russian / Ukraine tensions, and social tensions caused by new Covid-19 variants, can be added to supply chain disruptions, continued uneven economic reopening’s, and the short-term spike in energy prices, amongst others, that make up an important list of idiosyncratic risks that could have a material effect on financial markets in 2022.

The present disruptions to supply chains are arguably caused by the rise in the consumption of goods instead of services during the pandemic that continues while complete re-opening is delayed. Furthermore, should companies decide that shortening or onshoring of their supply chain would reduce risks in the long term then this disruption will also influence global growth both at a consumption and a country level. More recently there have been reports of companies over-ordering in fear of continuing component shortages leading inadvertently to the very shortages they hoped to overcome. While China continues with a zero-tolerant COVID response policy and other Emerging countries continue to ramp up their vaccination responses, this headwind could last into 2023 in some instances with the inevitable cost to earnings, growth, and financial returns. Absolute Strategy Research (ASR) has recently cut its equity forecasts for 2022 from 10%-20% to 5%-10% in line with the belief that idiosyncratic risks will constrain risk assets meaning EPS growth will fall to 0-15% as nominal growth slows[i].

The likelihood of a China slowdown in 2022 as the economy transitions to a consumer-led framework could see GDP growth of approximately 5% in 2022 falling further to 4.5% in 2023[ii]. This has significant implications for commodity markets unless another systemic consumer comes to the fore – such as perhaps sustainable energy sources. The EU plans to put EUR1trn to work in sustainable investment over the next 10 years as part of the Green Deal making Europe one of the global leaders in sustainable energy[iii].  We believe the level of proposed investment will allow European to embrace the environmental challenge with innovation that could see European companies at the forefront of green energy technologies.

The rapid rise of ESG investing coinciding with an increase in the fiscal response to climate change as highlighted by COP 26, will continue to shape the investment landscape. Many investors are looking for pure play green energy investments when it seems that many of the existing energy companies are transitioning towards alternative energy sources. Total has changed its name to TotalEnergies in an attempt to highlight its multi-source energy strategy and activist investors are trying to persuade energy companies to split green and fossil fuel businesses[iv]. This has led to many traditional energy companies such as Shell, BP, TotalEnergies, ExxonMobil, and Chevron facing ESG discounts, further highlighting investors unwillingness to invest in carbon intensive industries. We believe that the world’s reliance on fossil fuels during the transition to sustainable energy sources should not be under-estimated and the role of the incumbent energy suppliers in investing in that transition is currently not being fully valued by investorsi.

Although the strength and persistence of the inflation spike means that it is difficult to continue to consider the implications as temporary, some of the pricing pressures do seem to us to be linked to the imbalances from the delayed re-opening of the global economy which is likely to be exacerbated by the Omicron variant. High vaccination rates in the western world could also discourage governments from imposing greater restrictions. Ironically as Central Banks meet this week to implement the beginnings of a change to a tighter policy, the characteristics of the new variant could have a restrictive effect on consumer behaviour and government guidance. In the UK there is a reasonably close link between hospitalisations and people choosing to stay at home[v], however, equity investors have bought the dips over the last week as anecdotal evidence from South Africa suggests that although more easily transmissible, the symptoms are weaker than previous variants.

Scarring of the global economy due to the effects of Covid-19 has been debated throughout the pandemic and much of the evidence will become clear once the economy has re-opened. However, the emergence of the Omicron variant creating another wave of infections may bring the virus closer to its conclusion, but not before many temporary changes in consumer behaviour potentially become the new normal. ASR point to a Gallup poll that suggests approximately 70% of US white collar workers are still working-from-home[vi] suggesting a new hybrid working week could become more likely in the future. This will have an effect on the number of housing bubbles that have inflated during the pandemic as consumers switch between suburban and out-of-town living with consequences for housebuilders, office rental companies, and consumer service providers. The Omicron wave may also be the event that alters business travel behaviour for good with inevitable effects on airlines, hotels, and remote communications providers. We believe the longer it takes for the global economy to emerge from the pandemic the more the likelihood that consumer behaviour will move to a new normal.

If we are approaching the final phase, Absolute Strategy Research are predicting that many of the current inflation causes will prove temporary and the rate will return to 2% over the course of 2022i. Consumption growth would eventually normalise between goods and services alleviating some of the employment shortages and supply chain disruptions. Energy prices would be expected to normalise, and the continued strength of the US dollar would remain a headwind for global growth. Under this scenario of weaker growth and less pricing power leading to lower corporate earnings, we may see the cyclical recovery replaced by a move into more defensive sectors, such as, healthcare, consumer staples and utilities.

In conclusion, we believe there are many transitional events taking place in the global economy, increasing the level of idiosyncratic risk in financial markets that will affect the outlook for sectors, industries, and companies at different levels. As active investment managers we will look to navigate the path to consistent, long-term returns, and anticipate the effects of a changing world on portfolios.

 

[i] Absolute Strategy Research – Asset Allocation – De-Risking in a “Trend Everything” World – December 9, 2021

[ii] Absolute Strategy Research – 2022 Outlook: a test of regime change – November 30, 2021

[iii] Portfolio Adviser – Why European Equities could rise as the US Stock Market lustre fades by Cherry Reynard, October 14, 2020.

[iv] FT.Com – Shell warns hedge funds risk derailing energy transition – October 28, 2021

[v] Absolute Strategy Research – New variant, same activity concerns? – December 3, 2021

[vi] Absolute Strategy Research – Omicron & On – December 14, 2021

By Tim Sharp

November started with an FOMC meeting that confirmed the arrival of balance sheet tapering at the expected rate $15bn per month, although Chair Powell did give himself some flexibility to be able to adjust the pace of the taper in 2022. Mid-month it was confirmed by President Biden, after much speculation, that Jay Powell would retain the Chair for a further 4-year term with the other candidate Lael Brainard being offered the vice Chair position, thereby providing a sense of stability at this time of transition.

The November jobs report was strong with the Covid affected Leisure and Hospitality sectors also seeing some recovery which is encouraging. The JOLTS data[i] also showed that 4.4m people, or 3% of the total US labour force, quit their jobs in September which has been a phenomenon of the second half of this year. Although there are a fair percentage of people leaving the workforce for reasons such as Covid fears, early retirement or lifestyle change many moves reflect a confidence in finding higher paid jobs, suggesting to us that wage inflation may have further to run.

The uncertainty surrounding the response of central banks to inflation will continue to influence investors as the transitory nature of the near-term rate feels increasingly persistent, with wages and rental income looking to have gained medium term momentum. Owners’ Equivalent Rent (OER) makes up about 34% of the CPI basket and the ongoing strength in house prices provides a tailwind for rent rises to remain persistent. Moreover, the market is beginning to price in future rate hikes with 3 hikes now priced in for 2022, making 5 or 6 hikes expected by the end of 2023 we believe, which is more aggressive than speculation in September or October. This also suggests that the market expects tapering to be more aggressive in 2022 if this timetable of interest rate hikes is to prove accurate and this was confirmed by Fed Chair Powell during his testimony to the Senate Banking, Housing and Urban Affairs Committee yesterday. We are surprised by the nature of this turnaround and believe that the markets may be pricing in the prospect of a Fed misstep as much a fear of persistently strong inflation.

In the UK the Bank of England Monetary Policy Committee surprised the markets by leaving rates unchanged in November having guided in October of their intention to hike boosting market volatility at the prospect. As a result, markets had priced in a certain 0.15% hike in November with expectation for an additional tightening during the first quarter. When it came to the meeting, however, Governor Andrew Bailey said the committee needed further clarity regarding employment after the ending of the furlough scheme. This apparent U-turn caused great upheaval in the bond markets and one of the largest one day moves in 5-year gilts since the Brexit referendum. Despite this, markets have still priced in a 1% move by the end of 2022 when growth forecasts are more pessimistic which again suggests to us that the outlook is misaligned.

With bond yields drifting higher but not matching the rate tightening expectations we believe the environment remains more favourable to equity investment. Bond yields remain low versus equity yields which favours the economy and equities from a relative valuation perspective. Absolute Strategy Research (ASR) analysis suggests 10-year US Treasury yields would need to rise above 2.5% (1.5% currently) to pose a significant risk to equities and modestly higher yields can also support a rotation into more value orientated companies without undermining equity markets overall[ii]. Despite the inflation headlines and central bank uncertainty equity markets have largely remained unruffled even though many companies have guided to lower earnings growth in the fourth quarter. Investors may be concerned about supply chain disruption and rising wages squeezing earnings but, at least historically, periods of wage growth tend to be periods when pricing power is rising for companies so that margins also tend to rise when inflation is above trendii.

However, the reopening story has not followed the expected script in 2020 and much demand has been deferred due to production issues and continuing disruption from the Delta variant of Covid-19. The vaccination roll-out has not been consistent across the developed world and almost non-existent in the frontier markets. Although vaccination rates have picked up sharply in the developing world, we have fears that scarring from the pandemic will have a lasting effect on potential growth rates in the long term. The increased rate tightening expectations in the US have also underpinned the US Dollar – up 2.0% over the month – which creates a further headwind for emerging market investment. The aggressive stance towards Covid outbreaks in China, plus energy shortages and a real estate crisis, have knocked an already slowing economy thereby creating another headwind for global growth, and the developing world. Local government infrastructure spend may provide a much-needed boost to China’s fiscal spending plans, but we feel China as a global engine for growth may take a back seat in 2022.

As we went into the US Thanksgiving holiday equity markets were buoyant, the S&P500 was up 2.1% on the month at 4,701, near all-time highs, and the NASDAQ was similar, although off its peak, as investors undertook another mini rotation out of growth stocks. However, the announcement of another variant of concern, now known as Omicron, first detected in Botswana, caused a significant “risk-off” day when markets re-opened on the Friday with equities, oil, and commodities all significantly lower. Initial investigations suggest the Omicron variant is more infectious than Delta, but there is currently little evidence that it is more lethal, but we live in fear in the developed world that there will come a new variant that is resistant to current vaccines. As global travel routes were closed, many leisure and airline stocks bore the brunt of the sell-off especially as the first signs of the implementation of Covid restrictions in Europe due to the spread of the Delta variant were also hitting the headlines and finding resistance amongst certain elements of their populations.

If the Omicron variant does prove to be vaccine resistant, then we face further social and economic disruption as governments try to persuade the populous to restrict their movements once more. Although it is widely reported that pharmaceutical groups seem confident that they will be able to tweak existing vaccines quite quickly to deal with a new strain. With the weekend to reconsider markets clearly decided that the sell-off was overdone, and many markets and sectors rebounded but remained unstable into month end. Most major equity indices ended November in negative territory as Omicron and Delta met growth and inflation head on, and Chair Powell and Treasury Secretary Yellen offered little comfort during their testimony to the Senate Committee yesterday. The Omicron news also caused markets to move out rate tightening expectations as investors show concern for the implied growth trajectory over coming quarters. Weaker growth may help with the more persistent inflation trends, however, John Authers reports[iii] that according to the San Francisco Fed, pandemic delays and stoppages may drive higher inflation in the goods and services most sensitive to the pandemic, so we conclude that the future path of policy rates in the developed world remains uncertain. Moreover, we do believe that a further wave of Covid-19 will likely affect the developing world harder than the developed world increasing the economic scarring and recovery gap between developed and developing economies. Many economists have shown a degree of optimism regarding the impact of Omicron on the global economy[iv] and, as the data is released, we expect equity market optimism to continue.

[i] The Job Openings and Labour Turnover Survey – https://www.bls.gov/jlt/

[ii] ASR Investment Committee Briefing – November 1, 2021

[iii] Bloomberg Opinion – Points of Return – Risk-Omicr-Off – November 29, 2021

[iv] Financial Time – Economists optimistic on impact of variant – Chris Giles – November 30, 2021

By Hottinger Investment Management 

The subscription economy is a term coined by the Zuora ‘Subscription Economy Index’ which highlights the rise among companies shifting from a traditional product sales model to selling recurring subscriptions in exchange for access to products or services over time. Whilst the idea of subscriptions is not particularly new, we have historically only seen this concept in a small handful of industries such as magazines and gyms. Due to technological developments subscription-based models are now seen across a much wider array of industries including media, groceries, makeup, transportation and even clothing.

 

Over the last seven and a half years the subscription economy has grown by more than 350%[1] as economic, societal, and technological changes have allowed subscription-based business models to thrive. The pandemic facilitated a significant shift toward e-commerce and away from traditional retailers. Subscription services shift the idea of physical ownership towards the provision of services and customer discounts. This type of business model proved to be especially resilient during the pandemic, with the Economist reporting that subscription-based firms saw revenue growth of 9.5% during Q1 2020 while revenues of the wider market (as measured by the S&P 500) contracted by 1.9%[2].  Once a customer has enrolled on a subscription service it typically implies a more continuous stream of revenue, which makes it much easier for a business and its investors to predict future revenues; in comparison to pay-per product retailers which can face huge demand fluctuations due to seasonal factors, evident by the pandemic. Moreover, subscriptions tend to increase brand loyalty, 64%[3] of consumers feel more connected to companies they have a subscription with, opposed to companies they engage with for a one-off transaction. Furthermore, the longer a consumer has been with a service the more value they derive from it, making their demand more inelastic and raising their switching cost.

 

The growth and success of subscription service offerings can partly be attributed to the shift in consumers sentiment away from ownership and towards usership. Recent surveys conducted by Natixis Thematic Asset Management, suggests that 68% of adults no longer value ownership and care more about flexibility and convenience in the products they consume[4]. Why purchase a car and deal with the burden associated with ownership, when you can purchase a subscription and receive a new model monthly?

 

Technological innovation has meant that we are living in an era where we have instant access to any service or product that we desire. Consumers have become obsessed with instant gratification and crave immediacy in the products and services that they consume, the subscription-based model caters perfectly to this new mind-set. Netflix, for example, has capitalised on our desire for both instant gratification and convenience; it has taken away the burden and cost that once came with the ownership of DVDs, and its unlimited media library enables users to “binge-watch” entire seasons in a single sitting, providing instant gratification.

 

Spotify is another successful subscription-based model, however, with a slight twist. Spotify operates on a “freemium model”, offering a basic free ad-supported service and a premium paid membership option. The advantage of a freemium model is that the free service encourages users to join the platform without having to commit financially. However, users quickly become frustrated with the basic plan; ad-breaks and the inability to select certain songs prohibits users need for instantaneous consumption, spurring them to switch to the premium version. This is simply just one factor behind Spotify impressive 46% conversion rate, from free to premium users[5]. The flexibility and convenience of its service has made CDs obsolete, as it provides users access to an unlimited music library, a concept that would have been in-feasible with CDs.

 

Companies that develop a subscription-based service that satisfies our demand for immediacy and provide a convenient and flexible service for users will probably excel. There are reportedly 1.3bn payment enabled smartphones sold annually and currently 6.4bn smartphone subscriptions worldwide[6]. In addition, the significant potential growth from the developing world becoming more tech-enabled should see the total addressable market for the subscription economy continue to expand. We believe technological innovation will only amplify our need for instant gratification and obsession with consuming services on-demand.

 

[1]  John Phillips, general manager, EMEA at Zuora, a cloud-based subscription management platform.

[2] How the pandemic has changed the weather in the technology industry – the Economist – October 30, 2021

[3] Zuora Financial

[4] Thematics Asset Management Subscription Economy Fund, Manager Nolan Hoffmeyer.

[5] The Fader, 2015

[6] https://www.statista.com/topics/840/smartphones/#dossierKeyfigures

By Tim Sharp

The key questions that are likely to affect investment decisions in the medium-term focus on earnings growth justifying current equity valuations, and the persistent level of inflation accelerating changes in monetary policy. Supply side disruptions have been a significant headwind to growth over recent months, none more so than rising energy prices, and the European gas price shock, which impacts both the growth and the inflation outlook. As we approach COP26 which we believe could have a marked effect on future investment planning; we feel the ability of renewable energy sources to provide consistent supply as the global economy transitions away from traditional energy sources will be key to ensuring minimal supply disruption and fewer such incidents in the future.

 

COP26 may also indicate a change in the main drivers of future global growth as China’s own change of emphasis in economic development to “common prosperity” could see its prominence as the world’s largest consumer of raw materials superseded by the expected investment in sustainable energy sources. Iron ore and copper have both seen prices weaken as Chinese demand is reduced by its own government directives on energy use and emissions[i] as well as “Dr. Copper’s” ability to react to changes in the global growth trajectory. However, our research suggests copper is likely to be one of the pivotal raw materials in the production of green energy probably ensuring a long-term tailwind for the price.

 

We believe that it is unlikely that the energy crisis will prove to be anything but temporary, but there are other supply side pressures that may well prove more persistent. The imbalances between the reopening of different sector of economies has thrown up unexpected labour shortages not just in the UK where Brexit fallout is also having an impact, but also well reported in the US. US Wage pressures are now notable, and it is still unclear if the significant levels of people reportedly quitting their jobs or not returning to the workplace after lockdowns, especially in lower income roles, will have a more persistent effect on inflation rates. There is little doubt, in our opinion, that despite the debate regarding the temporary nature of many current inflation pressures, the underlying trend is higher which is probably unsurprising following the unprecedented policy support throughout the pandemic and its lagged effect on inflation.

 

The ability of central banks to gauge the tightening of policy rates we expect will be scrutinised by investors keen to see global growth recover unchecked by cautious monetary policy decisions. In our view, the recovery from the Global Financial Crisis was dominated by monetary policy and austerity measures, whereas the recovery from the Covid pandemic has been overseen by massive fiscal support leaving rate setters with the dilemma of when to engage monetary levers without choking the recovery.

 

It is still early in the reporting window for third quarter earnings, but so far reports are above expectations with EPS growth at 32% yoy in Europe and 39% yoy in the US[ii]. Margins are obviously under pressure due to supply side disruption issues which makes the beats the more impressive, and early guidance would suggest that overall firms are seeing demand remaining intact, which could spell good news for the outlook for 2022ii. Absolute Strategy Research (ASR) expect 15-20% yoy global EPS growth over the next 12 months which will continue to drive equity valuations especially if inflation trends lower as the temporary pressures begin to fade, and companies are able to maintain pricing poweri. However, if central bank policy decisions are made too early so as to stifle activity, then we feel investors may start to question valuations once more. Despite recent market trends back into growth stocks when bond yields were unreactive to rising inflation, we remain confident that the reflation trade will prevail emphasised by bond yields that started to move higher in the latter part of the month. ASR point out that rising bond yields tend to favour value over growth, although equity investors really need to see both growth and value perform in a rising market in order to maximise equity outperformance vs. bonds[iii].

 

Technically, the future for gold should be bright as a storer of value in an inflationary world, however, the gold price is negative 5.4% year-to-date with over $10bn being sold down from the major gold exchange traded funds[iv]. Furthermore, the dollar has revived alongside the US economy putting further pressure on the gold price and leaving investors without the traditional inflation protection that gold has provided. The recent issue of an exchange traded fund that invests in the Bitcoin future has once more pushed the cryptocurrency back into the spotlight and potentially opened the door to more traditional investors to gain exposure. This has led to some investors, most notably Paul Tudor Jones, to see Bitcoin as a portfolio diversifier, and a hedge against inflation particularly as the number of coins that can be mined is limited at 21 million against the unlimited printing presses of central banksiv. However, we believe the rather short and volatile history of Bitcoin’s valuation since 2009 may prove to be its undoing, and more persistent inflation could prove a tailwind for commodity prices, including gold, attracting back investors looking for a more predictable inflation hedge.

 

Finally, the banking sector seems to be benefitting from an ideal environment for increasing earnings so could be considered as another long only inflation hedge. Over the last week the 5 largest US banks (JPMorgan, Citibank, Bank America, Wells Fargo and Morgan Stanley) have reported consensus beating earnings results helped by high advisory activity, and lower loan loss reserves. All were also remarkably upbeat on the state of the US economy and the financial condition of the US consumer, while supply chain problems were not expected to de-rail the recovery[v].  Moreover, we find European banks are seeing a similar positive environment, and relative valuations are undemanding with most trading well below book values. Asset quality has significantly improved, and we are seeing the highest capital levels since 2008 underlining the general strength of balance sheets. We still favour banks, financials, healthcare, and industrials in equity sectors, but also include sectors that have the power and presence to set market prices, such as large global consumer staples companies which have also featured well so far in this earnings round.

 

[i] Absolute Strategy Research – October Investment Committee Briefing – October 1, 2021

[ii] Barclays – Earnings beats help alleviate rates pressure – October 22, 2021

[iii] Absolute Strategy Research – The three toughest questions from Q3 marketing – October 14, 2021

[iv] Financial Times – Inflation fears push investors to flee gold for digital currencies – October 22, 2021

[v] Barclays – Earnings to the Rescue – October 19, 2021

By Tim Sharp

The weak September seasonality of financial markets showed up again this year and the world remembered the 20^th anniversary of the 9/11 bombings. Inflation has risen sharply in recent months and although the expectations are that rates in the developed world will be lower next year as many causes prove transitory, we believe it is likely that some prices, such as housing, will remain elevated, and further upward pressure from wages is also likely.  It is probably true to say that the underlying trend in inflation is rising[i] assisted by the expectation that central banks will allow a period of above target price growth to run and the strong recovery of economies following the 2020 shutdowns.

 

The FOMC projections for PCE inflation see inflation ending the year at 4.2% before falling to 2.2% in 2022 and 2023 getting back to 2.1% in 2024[ii]. This underscores the belief that the current high levels will be transitory but shows less confidence in GDP growth being maintained. Looking at US breakeven rates the Fed would seem to be more confident in its inflation forecast than bond markets who price the 6-year breakeven rate at 2.51% well above the longer run projection of 2%[iii]. Markets had built up an apprehension over the Fed September meeting, but despite the frank press release outlining the change in the environment this fear dissipated without a serious threat to risk assets.

 

The reopening of economies has once more shone a light on persistent supply side disruptions and the risks to financial markets. The lockdown in Vietnam appears to have left Nike, amongst others, with major supply headaches, and the semi-conductor shortages have affected many industries most notably automobile production with the knock-on effect to the second-hand car market. Absolute Strategy Research (ASR) believe that the forced reshoring of supply chains would be a net negative for the global economy and the disruption to the global goods economy ongoing. Along with the rise in COVID cases this has caused many forecasts for global growth in the second half of the year to be downgraded, with the Fed itself lowering its US growth target for 2021 to 5.9% from 7% in June ii, which is also very similar to ASR’s global projection of 5.75% for this year[iv]. In our opinion, recent global PMI data has also pointed to decelerating growth, and we remain cautious of the likely weakening in the PMI data during the next couple of months may prove significant.

 

Having been the global engine for growth following the global financial crisis we feel China is now proving to be a drag on its region’s ability to recover and causing instability in both economic and geo-political terms. The credit tightening particularly in the property market has led to a slowing economy and the Evergrande saga that has played out over the past two weeks increased fears regarding the risk of contagion spooking investors. It is also clear that the Chinese government is also worried about the flow of data and money through certain sectors most notably technology and private education. The new data protection laws and regulations for internet companies have seen the tech sector shares weaken significantly as the legislature tries to rein in the power of popular internet platforms by standardizing datai. This process appears to be ongoing and its effect on global data gathering currently unknown but with deeper divisions of trust between China and western economies it is difficult to gauge how far the effects are likely to reach.

 

It is true to say that risk asset markets always seem to be climbing a wall of worry but there seems to have been a number of reasons to cause the additional anxiety in September including the rise of delta variant cases, the persistent rise in inflation, European gas price shock, Fed to start tapering QE, the easing of growth forecasts, continued strength of technology stocks, Evergrande contagion, US government default and shutdown, and the pressure on corporate tax rates to name but a few. However, until this week at least US 10yr Yields remained anchored below 1.40 and the dollar was once more a safe haven, turning TINA into TRINA – There Really Is No Alternative to equities at present despite a mainly negative month for both developed bonds and equities we believe. The S&P500 gave up 4.76% over the month while the more tech-heavy NASDAQ lost 5.31% leaving it negative over the course of the quarter. The Xetra DAX Index (-3.63%) and CAC 40 Index (-2.40%)  followed the US lead while the already underperforming UK FTSE 100 finished the month down only 0.47% but still flat on the quarter. Japan showed some of its safe haven qualities with the Nikkei 225 index up 4.85% on the month against a weaker Yen versus the Dollar.

 

In the last few days, the US bond market has started to react to the surprisingly hawkish FOMC meeting with 10yr yields trading as high as 1.56% rising above its 100- and 200- day moving averages as the curve steepens once more. We feel UK MPC minutes have also been surprisingly hawkish forecasting CPI above 4% into Q2 22 with the Gilt market pricing in two hikes in 2022 with the first in the first quarter. The ten-year Gilt now nominally yields approximately 1%. It is looking increasingly likely that the BOE will take the interesting step of tightening rates before finishing QE. Furthermore, Norges Bank in Norway was the first central bank to raise policy rates by 25bps suggesting that Central Banks have made the first tentative steps to unwinding the accommodative environment that has supported markets for so long[v].

 

We believe this has been an important inflection point in the reopening of economies as markets consider the slowing growth forecasts for the second half of this year and the heightened risk of a correction in equity markets that comes with it. We still believe equities remain expensive in absolute terms but are still supported by their relative valuation to bonds and the strength of corporate earnings reporting over the past year. It is, therefore, unlikely that the medium-term risk overweight positioning will change but we feel it is likely that market volatility will rise as we enter the fourth quarter starting with the most volatile month in the calendar year – October. We have positioned ourselves for the reflation trade and the focus to move more towards Europe away from US growth stocks which has been undermined by the rotation back into Technology over the summer which was reversed as September came to a close. The S&P Growth Index lost 5.95% over the month versus -3.85% for the Value Index. As real rates become negative the search for real, long term growth prospects become stronger. However, rising inflation is a real headwind for growth stocks as it undermines future cashflows and potentially reduces revenue growth opportunities, so we expect the markets to come back round again. We still favour banks, financials, healthcare, and industrials in equity sectors, but our focus remains on alternative revenue streams to bonds and equities through collectives that are looking at real assets, structural growth opportunities, and the strength in IPO and M&A markets.

 

[i] ASR’s Investment Committee Briefing – September 2021

[ii] FOMC Summary of Economic projections – September 22, 2021

[iii] Bloomberg – Points of Return: The Tapir Cometh – John Authers – September 23, 2021

[iv] ASR Economics – Growing Pains – Dominic White – September 14, 2021

[v] Barclays – Global Macro Thoughts: A Rising Wall of Worry – September 28, 2021

By Tim Sharp

Following Ben Bernanke’s 2013 market induced taper tantrum Chairman Powell has been keen not to be responsible for a repeat by carefully planning his press releases since the summer so as not to spook the bond market. The results seem to suggest that he has successfully convinced the market that there is a difference between the reduction or tapering of quantitative easing and initiating a rate hiking cycle. Arguably the press release following the September Fed Open Market Committee (FOMC) meeting pointed to a more hawkish Fed outlook than the market probably expected. However, this failed to trigger a major reaction especially as the global stock markets have been in a state of flux following the anxiety surrounding the potential failure of Chinese property developer Evergrande; rising cases of the Delta variant threatening global growth prospects in the second half of 2021; rising inflation that may become persistent rather than transitory; and an FOMC meeting to discuss the reduction in US bond market support.

Last night’s meeting made the balance sheet the focal point with Powell stressing that no inference should be made regarding the path for rate hikes[1] which have a clear higher hurdle. Powell made an unambiguous statement that barring surprisingly bad economic data over the next month, we should assume that the tapering process will be initiated at the November meeting and will reduce its purchasing of Treasury Securities to conclude around the middle of next year. This translates as a reduction of $10bn per month from November until June which arguably is a much more aggressive taper than the market had expected[2].

The market’s reaction was startlingly benign, we believe a testament to the management of the Fed’s press releases. Bond market volatility has remained low, stock markets ended the day mainly flat while the VIX index hovered around 20.

For the record, the benchmark overnight lending rate was kept in its current range of 0% – 0.25% where it has remained since March 2020. The minutes that are released on October 13 should continue to imply that balance sheet actions are separate from a hiking cycle but the “dot plot” of members interest rate forecasts should show that more members now expect to start raising interest rates next year. Nine, up from seven in June, out of eighteen members, now expect the hiking cycle to start next year leaving only one, down from five, that forecast rates to remain unchanged by the end of 2023. This is a clear indication that the FOMC has grown more hawkish than it was at the June meeting. The swifter pace of interest rate hikes from policymakers’ last set of projections in June comes amid the fastest economic recovery in U.S. history after a brief recession last year, and robust debate at the Fed about balancing its maximum employment and 2% average inflation goals[3].

The FOMC projections for PCE inflation see inflation ending the year at 4.2% before falling to 2.2% in 2022 and 2023 getting back to 2.1% in 2024. This underscores the belief that the current high levels will be transitory and shows less confidence in GDP growth being maintained. Real GDP growth is forecast to be 5.9% at year-end (7% in June), falling to 3.8% by the end of next year, and 2.5% in 2023[4]. Looking at US breakevens the Fed would seem to be more confident in its inflation forecast than bond markets who price the 6-year breakeven rate at 2.51% well above the longer run projection of 2%2.

Although the median interest rate of 1.8% by 2024 is still below the 2.5% level seen as neither stimulating or restricting growth over the long run3 the US Treasury yield curve between 5 years and 30 years flattened 1% after the press release suggesting that the risk of a monetary tightening mistake by the Fed has risen. The Jackson Hole symposium suggested that the Fed would be inclined to run inflation “hot” under its new Average Inflation Targeting strategy but a forecast that sees inflation falling back to 2.1% in 2024 after a decade under target will not feel particularly accommodative to some in the long run and may bring into question the reflation trade. However, the markets reactions show no fear of the taper despite a more hawkish press release than many would have expected, and bank shares as well as the wider stock market seems to be continuing its long term rally after a brief stumble on Monday.

 

[1] Morgan Stanley – FOMC Reaction: A Tidy Taper – Ellen Zentner – September 23, 2021

[2] Bloomberg – Points of Return: The Tapir Cometh – John Authers – September 23, 2021

[3] Hottinger & Co. Limited – FOMC – Quick Summary – Adam Jones – September 22, 2021

[4] FOMC Summary of Economic Projections – September 22, 2021