Confidence levels fall

• Inflation stabilised in May but the total count rose to 8.6%, or above expectations
• The Fed’s priority is to beat inflation
• We remain cautious on equities

Investors started the week with the previous Friday’s inflation and consumer confidence data in mind. Underlying inflation stabilised in May but the total count rose to 8.6%, or above expectations. Moreover, in the Michigan University consumer confidence print, 5-10 year inflation expectations among households rose to 3.3%, or above the key 3% threshold. This means that inflation has not peaked and that long-term fears are becoming more entrenched. The data, released just before the FOMC met, sent risk assets sharply lower. To cap it all, consumer confidence tumbled in May to historically low levels, auguring badly for future consumer spending trends. US retail sales in May also fell.

The crucial Fed meeting resulted, as expected, in a 75bp rate hike. Jerome Powell ruled out a 100bp move but said another 75bp was possible in July. Growth forecasts were revised down and unemployment revised higher. The FOMC now sees benchmark rates at 3.8% by end 2023, a level that is clearly restrictive. The Fed’s priority, as evidenced in the press release’s wording, is to beat inflation and get it down to target levels rather than to work towards a strong labour market.

In Europe, government bond yields moved sharply higher after the ECB's announcement in the previous week that it wanted to start raising rates. Italy’s 10-year yields pushed above 4%, widening the spread with the German Bund to the sort of levels seen in 2018 and 2020. The ECB was forced to call an emergency meeting on Wednesday as the risk of eurozone fragmentation resurfaced. The bank said it would call on flexible PEPP (Pandemic Emergency Purchase Programme) reinvestments while rapidly designing a new tool to stop spreads getting out of control.

Various central banks met during the week amid a global rise in rates. Switzerland’s national bank surprised markets by raising its interest rates by 50bp, the first move since 2007. Inflation in May was 2.9%, not as high as elsewhere in the world but still above the bank's target. The Bank of England raised its rates by a comparatively modest 25bp even if inflation was running at 9% in April. The bank's excuse is that the economy is weaker than elsewhere. The Bank of Japan is the only bank to remain accommodating and it intends to supply more liquidity if required.

Risk assets suffered a second week of sharp falls and interest rates shot higher. The US dollar and the yen, the usual safe havens, failed to appreciate and volatility only rose a little. With industrial production data coming in better than expected in May thanks to the economy reopening, Chinese equities fell a little less than developed country markets.

We remain cautious on equities, with a preference for China over other geographical zones and Europe in particular. We also think government bonds are still risky as inflation has not yet peaked anywhere in the world.

EUROPEAN EQUITIES

Recession fears continued to dominate sentiment as surging inflation forced central banks to adopt measures to cool the economy. Against this background, concerns mounted over a possible replay of the eurozone fragmentation scenario as peripheral country spreads widened. The ECB was obliged to declare its commitment to the most debt-laden countries. Recession worries caused prices of commodities like aluminium, copper, steel to fall but oil and gas stuck to lofty levels due to supply side constraints, often due to geopolitical factors. European gas prices soared 50% over the week after Russia reduced deliveries.

Highly cyclical sectors like energy and base products, previously beneficiaries of high commodity prices, were affected. Heavily leveraged companies are now beginning to look suspect because of the cost of borrowing and possible difficulties in getting access to credit markets. Unsurprisingly, defensives like agrifoods, telecoms and healthcare proved resilient. Insurance and banks posted the best sector gains as higher interest rates are considered to be good for their business.

In this stressful environment, industrials were the worst performers, notably Faurecia, which is in the middle of an increase of capital, Saint-Gobain, Covestro and Akzo Nobel which warned on its decorative paints business, a victim of commodity supply constraints and China's lockdowns. The first signs of wage inflation began to feed through. In Belgium, wages are indexed on inflation and Colruyt issued a profit warning and reduced its dividend.

However, some stocks managed to end the period higher, for example Euronext, which, stands to gain from rising volatility, Munich Re and Belgian property company Cofinimmo.

US EQUITIES

In another terrible week on Wall Street, indices lost between 7 and 10% as markets worried about the impact of monetary tightening on global growth. The Fed, the Bank of England and the Swiss central bank all raised rates. Jerome Powell offered investors some reassurance by saying another 75bp hike might occur in July but that such big moves would be rare in the future.

Nevertheless, Fed Fund futures now see rates rising by 200bp by September when the Fed meets (i.e. two 75bp moves and one 50bp rise) and they expect rates to be at 4% by the end of this year.

The Fed sees PCE inflation at 5.2% this year but expects it to fall back to 2.6% in 2023 and 2.2% by the end of 2024. The Fed also confirmed that it would shrink its balance sheet by $47.5bn a month starting June 1st before increasing the amount to $95bn a month in September.

Sentiment was also doused by big macroeconomic data misses. The Philly Fed index came in at minus 3.3 (when it was seen at +5), weekly jobless claims were 229,000 (218,000), housing starts were 1.54 million (1.72m) and building permits were 1.69m (1.8m).

Producer prices for May were in line with expectations, up 0.8% MoM and +10.8% YoY but slightly below estimates ex food and energy: +0.5% MoM vs. +0.6% est.; +8.3% vs. +8.6% est.

The VIX volatility index revisited its year-to-date highs. In company news, Oracle jumped 9% after the bell on an earnings beat due to companies boosting cloud investments.

FedEx jumped 14% (its biggest session move since 1986) on a 53% dividend increase and the arrival of DE Shaw directors on its board. Boeing surged 9.5% on Thursday on news that US and European civil aviation regulators would meet to discuss the 777X. For the moment, the jet has still not received certification.

JAPANESE EQUITIES

The NIKKEI 225 and TOPIX tumbled 6.43% and 5.14% over the period, in tandem with US markets which revisited 2022 lows. The selloff was driven by stagflation fears as prices continued to rise and the Fed raised its rates by 75bp. A slower recovery in China due to lockdown also weighed on sentiment.

Fishery Agriculture & Forestry, a defensive sector in volatile markets, rose 1.05%. Banks edged 0.65% higher as global interest rates rose. Pulp & Paper only dipped 0.20% as it is considered to be defensive because of its low P/B Ratio. Elsewhere, Services sank 8.11% as growth stocks sold off. Machinery tanked 8.06% on fears of a global recession. Oil & Coal Products declined 7.96% on profit taking.

Resona Holdings and Sumitomo Mitsui Trust Holdings rose 4.32% and 3.44%, respectively, on hopes the loan-deposit ratio would improve with higher interest rates. Kansai Electric Power gained 2.42% on news its nuclear power plant operation will restart in August, or earlier than expected. On the other hand, machinery manufacturer Kubota and SMC plunged 14.48% and 13.51% on global recession concerns and China’s slower recovery. M3 fell 12.41% on profit taking.

The Yen strengthened to 132.17 against the US dollar, up from 134.36. On June 14, it had bottomed at 135.47 as US markets tanked on recession fears. Yields on Japan’s benchmark 10-year government bond yield rose to a six-year high of 0.255% on June 13, pushing above the Bank of Japan’s 0.25% upper trading band limit. Concerns over global inflationary pressures, faster US monetary tightening and recovering domestic demand made investors sell Japanese government bonds. The following day, the BoJ conducted an additional, unscheduled purchase of Japanese government bonds for more than JPY 2 trillion, pushing yields back to 0.25%.

EMERGING MARKETS

The MSCI EM Index retreated 4.33% this week as of Thursday’s close, following the Federal Reserve’s largest rate hike since 1994. All major markets sold off as recession fears mounted. India led losers, down 4.56% while China and Brazil outperformed by dropping 4.10% and 3.42% respectively.

China’s economic numbers came in better than expected in May, with industrial production up 0.7% vs. a 2.9% drop in April. Retail sales fell less than expected, down 6.7% YoY or better than the 11.1% plunge in April. FAI for the January to May period rose by 6.2%, topping expectations of 6% growth. The surveyed urban unemployment rate was 5.9% in May, or better than expected while the youth jobless rate continued to climb to a record high of 18.4%. Shanghai Disney resumed its main Disneytown and Hotel operations. MIIT and other ministries released guidance to boost green home appliance demand in rural areas. CATL raised $6.7bn in a private placement after pricing the offering at a 12% discount. Moutai guided on a 15% increase in operating income this year. 

In Korea, LG Energy Solution is to invest $568m in expanding cylindrical cells. Samsung Electronics is reportedly asking some suppliers to postpone or partially reduce component shipments until the end of July due to end demand concerns and growing inventories.

India’s Industrial production growth hit an 8-month high of 7.1% in April, or above expectations of 5% and up from 2.2% in March. May CPI inflation dropped to 7% from 7.8%, or slightly lower than expectations of 7.1%. India is buying Russian oil at a discount. Russia became India's second biggest supplier of oil in May, representing 18% of all the crude Russia exported, up from 1% before the Ukraine invasion. Total will buy a 25% stake in Adani New Industries and will invest $5bn to produce green hydrogen in India.

Singapore-based Sea is planning to cut staff at Shopee, its e-commerce division. Shopee will also exit Spain, after exiting France and India earlier this year.

In Brazil, Natura announced a new CEO and corporate reorganisation, transitioning to a simpler holding company structure. The new CEO Fabio Barbosa is well known to investor.

CORPORATE DEBT

CREDIT

Faced with inflation hitting a 40-year high of 8.6%, the Fed raised its rates by 75bp, its biggest move since 1994. The cocktail of widening risk premiums and rising rates led to a bond market correction. Yields on Germany’s 10-year Bund rose 19bp to 1.85% while 10-year US Treasuries gained 11bp to 3.26%.

Similar moves were seen on risk premiums: the Xover widened by a significant 67bp and the Main by 13bp. As a result, the High Yield index lost 2.92% between Monday 13th and Thursday 16th of June and the investment grade index ended 2.13% lower. There was no action in high yield issuance but lots of news on issuers. Air France-KLM successfully completed its €2.26bn increase of capital. Historic shareholders like the French and Dutch governments took part as did airlines China Eastern and Delta. CMA CGM took a 9% stake as part of the process. Air France-KLM had €10.8bn in cash as of March 31 so will be able to continue paying back French government aid. 

Elsewhere, France’s Orpea (care homes) filed its auditor’s report and consolidated accounts. As indicated on May 13, sales rose 9.6% over a year but net profits slumped by 59.1% due to increased provisioning related to ongoing investigations into alleged mistreatment. In financials, Credit Suisse once again hogged the limelight. Following State Street's firm denial that it was interested in the bank, an FT article said the FCA, the UK’s regulator, was looking into the Swiss bank’s UK affiliate. Credit Suisse then surprised markets by issuing an AT1 on Thursday, raising $1.65bn at 9.75%. The proceeds will go on calling an existing AT1 which nevertheless had a lower coupon. The deal was viewed as a friendly gesture to the bank’s bond holders. Elsewhere, euro CoCo spreads with government bonds shot above 800bp as general risk aversion set in.

CONVERTIBLES

Convertibles suffered the same fate as falling bond and equity markets. Company news was overshadowed by macroeconomic angst but a few items stood out. ATOS is to be split into two distinct entities. At the same time, the group will sell its entire 2.5% stake (valued at €220m) in Worldline. There were also persistent rumours that Just Eat Takeaway was looking to sell Grubhub only a year after buying it for $7.3bn. Bloomberg said private equity firms like Apollo Global Management might be interested. Internet operator Yandex reach an agreement with holders of its 2025 convertibles to buy back 84.9% of the issue at 70% of par plus some shares. In results news, ready-to-wear distributor Asos plunged 25% after slashing guidance for this year due to strong inflation.

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

24/06/2022
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