- Central bank heads reaffirmed their determination to smash inflation and opt for higher rates over a longer period
- Global PMI data showed activity slowing
- We are negative on equities but with a preference for China and we are still cautious on duration
Europe’s energy crisis has deepened due to soaring gas and electricity prices. The gas December contract is now trading 60% above its price when the Ukraine war began. Imports of Russian gas through the Nord Stream pipeline are still capped at 20% of capacity and another 3-day shutdown for more maintenance is scheduled.
This has all aggravated the inflation outlook in Europe and 2-3 year expectations gained 100bp in August. European rates are rising faster than US yields and the euro has dipped below parity with the dollar.
As energy price caps spread, inflation is being boosted by rising deficits and the falling euro. In addition, Italy is looking fragile ahead of elections, making the ECB’s job harder as the bank wants to avoid triggering a severe recession. Nevertheless, this correlation between government bond yields and exchange rates reflects investor worries over Europe's economy and the possibility that inflation could de-anchor.
Double-digit inflation is becoming widespread, labour markets are robust, financial conditions are improving despite monetary tightening, and economic data are slowly declining although advanced indicators are tumbling. As a result, central bank heads at the Jackson Hole symposium reaffirmed their determination to smash inflation and opt for higher rates over a longer period.
Even if this means a recession, it is an absolute priority for the FED and the ECB and it explains why equity markets have been tumbling since.
Elsewhere, global PMI data showed activity slowing. In the US, the composite PMI index tumbled to 45, its lowest level since 2009 if we exclude the Covid years. It is the same story in Europe, Australia and Japan with indices now under 50, an indication of a looming contraction.
China’s economy has slowed due to successive lockdowns and the property market crisis. Consumers are still wary in spite of stimulus measures like cutting borrowing costs on money and mortgage markets. That said, Beijing’s political determination is so strong that future measures should trigger a rebound on China's equity markets.
We are negative on equities but with a preference for China over other geographical zones, and Europe in particular. And we are still cautious on duration. We prefer the short end of the US yield curve.
EUROPEAN EQUITIES
After rebounding in the first half of August, European equity indices ended the week 2-3% lower. Several macroeconomic factors undermined optimistic scenarios. Electricity and gas prices hit record levels in Europe. Electricity soared to €1,100/MWh and gas stayed above €300/MWh. These levels are more than 140 and 15 times higher, respectively, than normal. Recent rises were caused by widespread droughts which hit hydroelectric dams, low activity in France’s nuclear plants and the temporary shutdown of Nord Stream 1 (with the possibility of further interruptions).
August PMI indicators in the eurozone offered little relief: France’s services indicators was a big disappointment for a summer period, coming in at 51 (when it was expected at 53) and down from 53.2 in July. This took the composite PMI into negative territory, (49.8 vs. 51 expected and down from 51.7 in July) for the first time since March 2021. In industry, PMI stayed in contraction, a sign that any trend change in manufacturing is unlikely at the moment. New orders are down and production costs are still rising because of more expensive energy.
In company news, Carrefour decided to freeze prices on 100 essential products up to November 30, following the example of its supermarket rival E. Leclerc a few weeks ago. In construction, CRH raised its guidance, citing its ability to pass on input price rises without jeopardising volumes. Although residential housing projects are slowing in Europe, the situation is not dramatic. Elsewhere, industrial group Schneider confirmed that it was seriously considering a 100% bid on Aveva. Biotech company Valneva said the WHO had granted provisional approval for its COVID-19 vaccine.
US EQUITIES
US indices moved lower ahead of the Fed chairman's comments at the Jackson Hole Symposium and sold off afterwards. Over the week, the Dow Jones fell 1.39% and the S&P500 4.04%. The Nasdaq fared the worst, tumbling 4.44%.
Markets were on tenterhooks throughout the week ahead of Jerome Powell’s comments. In the end, he came down firmly on the side of tightening monetary policy. The fact is that demand is outpacing supply in the US, particularly on the labour market. Getting inflation back to 2% will require returning to a better supply/demand balance. This means restrictive monetary policy and it will entail problems for households and companies alike.
Powell cited a few lessons learnt from the “great inflation” in the 1970s: central banks are chiefly responsible for keeping inflation in check even if it is partly caused by supply factors; the Fed’s big mistake in the 1970s was to have allowed expectations to increase more and more; central banks should not allow long periods of high inflation.
Fed members James Bullard and Esther George backed up Powell’s hawkish tone.
Elsewhere, Joe Biden cancelled student debt between $10-20,000 but only for those earnings less than $125,000 a year. He also announced two other measures targeted at easing household debt levels.
House prices fell 0.77% MoM in July, the first drop in close to 3 years and the largest monthly decline since January 2011.
In company news, Nvidia fell in after-hours trading when its third quarter sales came in at $5.9bn, or below the $6.9bn expected. The company said lower demand for PCs was responsible.
Nordstrom (-20%) cut its annual revenue guidance to +5/7% from +6/8% and its EPS forecast from $2.30-2.60 from $3.20-3.50. The news also took Macy’s 3.9% lower.
Zoom fell 8% after the bell, taking its year-to-date decline to 55%, when it cut its EPS guidance from $3.70/3.77 to $3.66/3.69.
Warren Buffet, now 82, got the green light from the Federal Energy Regulatory Commission to take his 20% stake in Occidental Petroleum to 50%. The oil company has soared 146% year to date.
JAPANESE EQUITIES
Fed Chairman Jerome Powell's speech at the Jackson Hole Symposium made the Fed's stance very clear: the top priority is curbing high inflation even if this means a slowdown in the US. In Europe, where inflation is still high, the risk of a gas shortage risk in winter is smoldering. In China, there is still a risk that sticking to a zero-COVID policy will be a drag on the economy.
On the other hand in Japan:
- Inflation has been kept under control (YOY Core CPI was 2.4% in July),
- The government is stable, underpinned by a majority in Congress and high Cabinet approval rates,
- As domestic COVID restrictions on mobility have already been lifted, the country is expected to enjoy the benefits of economic normalisation,
- As Yen depreciation against the US dollar, mainly due to the widening interest rate gap between the two countries, will continue, Japanese companies will benefit.
EMERGING MARKETS
The MSCI EM Index ended the period 0.55% higher as of Friday’s close. Brazil (+3.4% in USD) outperformed. China rebounded by 3% on the announcement of CSRC and PCAOB arrangements for ADRs audit inspection. Taiwan and India retreated by 1.9% and 1.1%, respectively.
In China, the PBoC cut 1Y/5Y LPR by 5bp/15bp, effectively lowering mortgage rates. Premier Li announced 19 economic support measures, including a RMB 300bn top-up to the policy and development financial instruments. The CSRC and PCaOB reached an arrangement on audit inspection for Chinese ADRs. The government plans to extend tax exemptions on EV purchases until the end of 2023 and step up the construction of EV-charging facilities. The electricity shortage in Sichuan has been eased with a limited impact on the nation's overall industrial output for the year.
On the corporate front, second-quarter profits at JD.com were ahead of market expectations as the cost-saving strategy kicked in. Meituan delivered another quarter with a strong profit beat with full year guidance unchanged on a robust July and August recovery. Longi results were in line. The quarterly earnings expansion was driven by higher wafer and module output. CATL’s earnings recovered in the second quarter on robust EV sales and the margin improved sequentially with a better cost pass-through. FlatGlas results were in line and management remained optimistic on the demand outlook in the second half where they expect improving downstream orders. PingAn’s operating profit was slightly better than the consensus mainly driven by PingAn Life. The decline of New business value (NBV) narrowed during the second quarter. AIA results were in line with expectations and face-to-face meetings started to resume. In the sportswear segment, both Anta and Xtep delivered stronger-than-expected results. A sequential improvement in July and August was an encouraging sign. Mengniu reported better-than-feared first-half results with full year guidance unchanged.
Taiwan’s July exports contracted 1.9% YoY, driven by a more than 20% drop in orders from China and HK and well below estimates of 6.2%.
The Bank of Korea hiked its policy rate by a further 25bp to 2.50%, after an unprecedented 50bp hike in July. The bank also revised up its inflation forecast for 2022/2023 to 5.2%/3.7% (from 4.5%/2.9% in May). It also lowered its growth forecast to 2.6%/2.1% in 2022/2023 (from 2.7%/2.4% in May).
India’s auto component industry recorded its highest trade surplus of $700m in a financial year in 2021-22, on the back of leading automakers across the world embarking on a 'China Plus One' strategy to de-risk supply chains in the wake of the Covid-19 pandemic. In a similar trend for the smartphone industry, Apple will manufacture its iPhone 14 in India 2 months after its initial release, shortening the lag from the usual 6-9 months. Adani Group launched a hostile takeover of NDTV, one of the oldest media companies in India.
Singapore Telecom announced it will sell a 3.3% stake in Bharti Airtel for $2.25bn.
Indonesia’s Central Bank unexpectedly increased interest rates by 25bp to 3.75%.
Brazil’s IPCA-15 inflation declined by 0.73%, and annual inflation decelerated to 9.6% YoY. Domestic companies reported solid results during this earning season, driven by both decent top and bottom line performance and a better price pass through.
OPEC+ said it would cut oil production if Iran was to reach an agreement with the US and increase its oil output.
Russia has approached several Asian countries to discuss possible long-term oil contracts at a steep discount.
CORPORATE DEBT
CREDIT
Risk aversion jumped after Jerome Powell spoke at the Jackson Hole Symposium. Investors were simply reacting to the Fed’s warlike tone in its focus on fighting inflation. Risk premiums widened by 35bp on the Xover and 10bp on the Main. Long-term bond yields rose 7bp in the US and 16bp in the eurozone. Over the week, high yield indices fell 0.79% and investment grade finished 0.96% lower.
There were no new high yield deals but we saw the latest second quarter results. TAP Portugal, the national carrier, reported sales of €831m, a return to 2019 levels. In spite of commodity inflation, EBITDA was a positive €157m. The group reduced losses by 36% over a year and still stands to receive €990m from the Portuguese government as part of the restructuring plan approved by the European Commission in December 2021.
Results at Modulaire Group rose 21% over a year to €419m but the net figure was still a €38m loss due to the LBO’s financial charges.
In a quiet news week for financials, Bank of Cyprus reportedly rebuffed several approaches by private equity company Lone Star and UK insurance group Rothesay was upgraded by Moody’s to A2 from A3. Although US dollar CoCo and euro CoCo spreads widened by 26bp and 54bp respectively, the new issues market was active. Rabobank sold a T2 bond and BNP and Deutsche Bank issued senior non-preferred debt.
CONVERTIBLES
The new issues market was idle over the week after a good run in the first half of August. Investors were focused on the Jackson Hole Symposium. In company news, Palo Alto Networks (cyber security) had an excellent second quarter with sales up 27% over a year to $2.69bn and EPS sharply above expectations at $2.39. Elsewhere, bid rumours continued to circulate in the gaming sector. Amazon is reportedly about to buy Electronic Arts. The rumours naturally benefited France’s Ubisoft, one of the few remaining independent players in the sector. The company could be of interest to several sector giants, including its own minority shareholder Tencent.
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
29/08/2022
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