- The Fed will slow the pace of rate rises but expects a higher terminal rate than markets expected, and for longer
- The ECB and central banks in Australia and Canada are being much more sensitive to recession risk and are freely admitting that monetary policy has turned a corner
- We remain slightly underweight equities and neutral on fixed income although the US bond market is finally trading at more reasonable levels
At last Wednesday’s FOMC, Jerome Powell managed to shake investor confidence while pivoting to slower rate hikes in the future.
The Fed will slow the pace of rate rises but expects a higher terminal rate than markets expected, and for longer. Markets are now expecting rates to peak at 5.15% in June 2023. Powell said financial conditions had deteriorated and the property market was under pressure but he was surprised by the resilient labour market and persistent inflation. He recognised that there would be a lag between rate rises and their economic impact but ruled out any pause in monetary tightening. He prefers to do too much rather than too little even if that means triggering a recession.
Other central banks are being much more sensitive to recession risk and are freely admitting that monetary policy has turned a corner. Following moves by the ECB and central banks in Australia and Canada, the Bank of England and the Bank of Norway revised down their terminal interest rates.
The rebound in risk assets following the release of the FOMC communique soon fizzled out. The Nasdaq fell more than 5% after Jerome Powell’s press conference statements.
Elsewhere, opinion polls continued on a downbeat path, suggesting activity is soon to contract. Manufacturing PMI, for example, came in at 46.2 in the UK, 46.4 in Europe and 48.2 in South Korea. In the US, it was 50.2, or close to contraction territory.
Macroeconomic data, however, contradicted the idea of a looming recession. According to ADP, the US created 239,000 jobs and vacant positions amounted to 10.7 million according to the Bureau of Labour Statistics. In Germany, retail sales rose 0.9% when the market was expecting a 0.5% decline.
Nevertheless inflationary pressure is waning judging by the prices paid component in the US ISM (46.6) and a rapid fall in UK house prices. Worsening credit and money supply conditions as well as advanced indicators all suggest inflation gauges will fall in the coming months.
In the circumstances, we remain slightly underweight equities while trying to steer tactically through a market rebound based on a change of tone in central bank comments. We are currently neutral on fixed income although the US bond market is finally trading at more reasonable levels.
European Equities
Bond yields fell after ECB chair Christine Lagarde's less hawkish comments but most of the fall was wiped after European inflation came in higher than expected. The data would seem to warrant a steeper rise in benchmark rates and a longer period before a monetary policy pivot. Yet, despite rising rates and inflation, the economic slowdown is mild for the moment. France and Spain both grew by 0.2% in the third quarter and Germany rebounded by 0.3%. Germany unveiled its €200bn package to tackle the energy crisis with an electricity and gas price cap.
In third quarter results news, BMW and Stellantis released upbeat figures but warned that they had observed the first signs of a drop in demand with worse possibly to come in 2023. At its investors day, auto supplier Faurecia also guided lower on growth and its margins over the medium term. Shipping giant Maersk’s message on global trade momentum was in similar vein. The group lowered its forecasts on container demand this year and said freight prices had peaked with some indications in the third quarter that they were starting to return to normal. BNP Paribas, ING Groep and Société Générale all reported excellent results. The cost of risk remained under control and all three are reaping the rewards of higher margins from rising interest rates. However, the Bank of Italy’s governor struck a dissonant note by warning of a possible recession in 2033 which would damage asset quality.
Geberit and Legrand were also downbeat: volumes fell due to destocking and rising input costs depressed margins.
US Equities
Unsurprisingly, the FOMC decided unanimously to raise rates by 75bp to 3.75-4%, their highest level since 2008. But Wall Street fell when Jerome Powell's comments at the press conference were more hawkish than expected. He refused to say whether the pace of rate hikes would slow in December and added that the terminal rate for the Fed Funds could be above what FOMC member are currently expecting.
Fed Funds futures are now pricing in a peak of 5.15% in mid-2023.
Meanwhile, sentiment was troubled by fresh data pointing to a persistently resilient US economy. Weekly jobless claims fell while composite PMI for October came in at 48.2, or above the 47.3 expected. Services and manufacturing ISM stayed in expansionary territory for the 29th month in a row. In addition, job vacancies rose by 437,000 to 10.7 million in September. The vacancy to unemployment ratio pushed even higher, rising from 1.7 to 1.9, an indicator of a tight labour market and wage pressure.
Nevertheless, the Fed’s favourite deflator for core inflation came in at an annualised 5.1% when it was expected at 5.2%.
As for consumer sentiment, the Michigan University index on inflation expectations over 12 months was 5%, or lower than the 5.1% expected. Over 5-10 years, it was in line at +2.9%.
In company news, Amazon’s market cap fell below $1,000bn for the first time since April 2020.
Airbnb fell 7% after reporting disappointing overnight stay numbers and limited visibility on 2023.
Smartphone chip maker Qualcomm tumbled 9% on disappointing guidance due to softening demand and the impact from China’s lockdowns.
Estée Lauder fell more than 8% after cutting guidance for the full fiscal year on reduced demand among Asian travellers and destocking in US stores.
Paypal declined by 10% after the bell due to results being hit by a slowdown in consumer discretionary spending.
Apple is to freeze hiring except for R&D positions.
Japanese Equities
After a weak start, the NIKKEI 225 and TOPIX ended the week 1.16% and 1.83% higher, tracking US equity markets reassured by stable company results and resilient Chinese equity markets.
Wholesale Trade and Mining rose 4.80% and 4.20%, respectively, as major companies announced solid results on higher commodity prices. Foods gained 3.90%, led by a 15.11% surge in Japan Tobacco after an upward revision in December 2022 fiscal year guidance and an increase in its dividend. Precision Instruments, Metal Products and Marine Transportation fell 2.97%, 2.51% and 1.26%, respectively, on concerns rising inflation would trigger a global recession.
Panasonic ) soared 17.69% on hopes for an additional tax credit under the US Inflation Reduction Act of 2022. Subaru jumped 10.83% after revising FY2023 guidance higher and upping its dividend. Kyocera and Mitsubishi Electric fell 6.47% and 5.47% after FY2023 guidance fell short of market expectations. Sysmex slipped 3.85% as large-cap high-tech stocks came under pressure on fears of a global slowdown.
The yen weakened from 146.29 to 148.25 against the dollar after the BoJ reaffirmed its commitment to accommodating monetary policy at its September Monetary Policy Meeting and diminished expectations that the Fed would slow the pace of its rate hikes.
On October 28, the Cabinet approved a comprehensive economic package to tackle high prices and a slowing economy. The package is worth JPY 71.6 trillion yen with JPY 39 trillion in financial expenditure and a supplementary budget of JPY 29.6 trillion. According to Cabinet Office estimates, the plan will boost GDP by about 4.6% and cut CPI by 1.2%.
Emerging Markets
The MSCI EM Index was up 1.8% as of Thursday’s close. China rebounded 4.2% on reopening expectations. Brazil (+6.1%) outperformed on the presidential election results. India rose 1%.
In China, October’s official Manufacturing PMI was down to 49.2, short of the 50 expected. Non-Manufacturing PMI was 48.7 or lower than the 50.1 expected. Beijing is reportedly working on a reopening plan. The National Health Committee will host a press conference this Saturday to discuss Covid control policies. Foxconn in Zhengzhou is in close-loop production and Shanghai Disneyland also closed during the week due to a Covid outbreak. The authorities resumed Macau E-Visa applications for mainland residents. 13 cities in Jiangsu Province are deploying an inhaled Covid vaccine. Germany's Chancellor had a one-day visit to Beijing. US PCAOB inspectors reportedly finished on-site work in China ahead of schedule. Tencent and China Unicom got approval to set up a JV for a content delivery network and edge computing related business while tech POE and SOE partnerships are being established between Alibaba and China Telecom as well as JD and China Mobile. CATL signed an agreement to expand its cooperation with Vietnamese EV maker VinFast.
In Taiwan, Apple is reportedly trimming 5nm/4nm wafer orders at TSMC.
In Singapore, DBS posted strong 3Q22 results with profit surging more than 30%, or above expectations.
India’s manufacturing sector growth remained strong with PMI at 55.3. Services PMI stood at 55.1 in October, up from 54.3 previously. Pegatron has begun assembling the iPhone 14 in India, making it the second assembler after Foxconn to produce the model in the country. Samsung Electronics had record Diwali festival sales, selling $1.7bn worth of smartphones.
In Brazil, Lula beat Bolsonaro to return as President in a very tight result. Meli announced solid, better-than-expected 3Q22 results driven by a strong gross margin gain from shipping and other fixed cost dilution.
Corporate Debt
Credit
As expected, the FOMC decided to raise rates by 75bp, taking them to 3.75-4%. However, Jerome Powell’s press conference statements doused market enthusiasm by suggesting that the Fed’s terminal rate could be higher than previously indicated. The only bright spot for market sentiment came from China with hopes that the zero-Covid policy might be eased. The Xover widened by 3bp and the Main by 1bp between Monday and Thursday. But government bond yields accelerated upwards everywhere with Germany’s 10-year Bund up 14bp and 10-year US Treasuries 12bp higher. The high yield index gained 0.25% over the week while investment grade slipped 0.38%.
There was no new high yield issuance but Fedrigoni raised another €56m to top up last month’s €300m issue.
High-yield issuers continued to post upbeat results. As in previous quarters, Selecta continued to benefit from economies reopening and also from its own restructuring plan. Sales rose 14% over a year to €297m. Ebitda was 8% higher, mainly because of price rises over the last two quarters to offset inflation. Duty free shop leader Dufry saw sales jump 57% over a year to CHF 2.1bn as airline traffic recovered. The group still has room to improve as its Asian branch continues to struggle with China's lockdowns.
Financials reported upbeat results as higher margins offset cost inflation and asset quality remained healthy. The issue of early redemptions remained in focus. A South Korean insurance group surprised markets by saying it would not redeem one of its US-dollar denominated perpetual bonds. The bond in question promptly shed 15 points. And Australia’s financial regulator clarified its approach to approving early redemption by reaffirming its insistence on them being “economical.” The statement triggered some volatility on subordinated debt markets both in Australia and across Asia. CoCo spreads widened slightly over the period after Jerome Powell’s stance more than wiped out the tightening seen at the beginning of the week. CoCo premiums are still very high.
Convertibles
There were two new issues, one in Africa and the other in Japan. South African petrochemicals group Sasol raised $750m at 4.5% with a November 2027 maturity. The proceeds will be used in part to refinance existing debt.
In Japan, Cyberagent (digital advertising) returned to the convertibles market with a 2029 maturity for $270m.
Note that with the recent surge in interest rates, new convertible issues are once again attractive for issuers as they can price coupons below straight bond levels.
In third quarter results news, AMS AG reported a 6% annualised fall in sales to €1.2bn and an 8.4% contraction in EBITDA to €206m. The decline was due to lower auto production.
Glossary
- Investment Grade: bonds rated as high quality by rating agencies.
- High Yield: corporate bonds with a higher default risk than investment grade bonds but which pay out higher coupons.
- Senior debt benefits from specific guarantees. Its repayment takes priority over other debts, known as subordinated debt.
- Debt is considered to be subordinated when its redemption depends on the earlier payment of other creditors. To offset the higher risk, subordinated Senior debt has priority over other debt instruments.
- Tier 2 / Tier 3 : subordinated debt segment.
- Duration: the average life of a bond discounted for all interest and capital flows.
- The spread is the difference between the actuarial rate of return on a bond and the rate of return on a risk-free loan with the same maturity.
- The so-called "Value" stocks are considered to be undervalued.
- Markit publishes the Main iTraxx index (125 leading European stocks), the HiVol (30 highly volatile stocks), and the Xover (CrossOver, 40 liquid and speculative stocks), as well as indices for Asia and the Pacific.
- EBITDA: Earnings before Interest, Taxes, Depreciation, and Amortization.
- Quantitative easing describes unorthodox monetary policy from a central bank in exceptional economic conditions.
- Stress Test: a process which simulates extreme but possible economic and financial conditions so as to assess any impact on banks and measure their resilience to these events.
- The PMI, for "Purchasing Manager's Index", is an indicator of the economic state of a sector.
DISCLAIMER
04/11/2022
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