Risk Appetite Is Still Under Pressure From Inflation

• Risk appetite is still under pressure from inflation and from the buoyant labour market
• Turbulence on UK markets also hit the headlines. The contentious mini-budget and fears of systemic risk triggered a surge in gilt yields and a plunge in sterling
• Given today’s particularly unstable environment, we are still cautiously positioned on equities and neutral on duration

US consumer inflation once again came in above expectations, rising to 8.2% YoY. Core inflation rose sharply to 6.6%, its highest level since 1982. The energy component decelerated significantly from +32.9% to +23.8% but shelter ex energy remained on an uptrend and now represents 54% of core CPI.

Risk appetite is therefore still under pressure from inflation and also from the buoyant labour market: the previous week’s jobs data confirmed that we are not yet seeing the sort of marked slowdown the Fed wants before it considers slowing the pace of its interest rate hikes. Investors eyed another drop in the unemployment rate to 3.5% when it was expected to be unchanged at 3.7%. Job creations may have slowed but the private sector is still keeping them higher than expected.

The FOMC minutes noted a considerable upward revision in the output gap -GDP is now not expected to move above its potential before the end of 2025- as well as a drop in discretionary spending and an increase in buying of low-cost items among the least well-off households.

Turbulence on UK markets also hit the headlines. The contentious mini-budget and fears of systemic risk triggered a surge in gilt yields and a plunge in sterling. The Truss administration is under heavy pressure from Conservative MPs to postpone the most costly fiscal measures, especially the cancellation of a rise in corporation tax from 19% to 25% which would have brought in £17bn. Before being sacked, the Chancellor of the Exchequer had claimed that the Bank of England's failure to increase rates enough was the cause of market volatility. If the Bank’s ultimatum to UK pension funds fails to get them to rebalance their positions, it would be in a tricky position with the government, another factor that could accentuate financial tensions.

Elsewhere, China’s economy continued to cause worries. Sanitary restrictions caused the services sector to fall back into contraction territory for the first time since May. Due to weakness in new orders, the Caixin Services PMI fell to 49.3 vs. 54.5 expected. Budgetary measures and efforts to boost lending are still moderate and have so far failed to produce the expected results. Meanwhile, the property sector, China's historic growth driver, is still struggling. As long as no efficient vaccine has been developed, there seems little chance of a move away from the zero-Covid policy at the Communist Party's Congress which starts on October 16. Moreover, worries of local lockdowns are resurfacing, especially in Shanghai. 

Another key development during the week was Germany’s step towards EU issuance. At the latest European summit, Olaf Scholz was reportedly in favour of a joint effort to deal with the energy crisis but only on the condition that the money distributed to countries was in the form of a loan and not a subsidy. Peripheral country spreads eased after the news.

Germany also announced a massive €200bn package to help households and SMEs with gas prices in December and to subsidise gas prices for households, SMEs and industry from March 2023 to April 2024.

Given today’s particularly unstable environment, we are still cautiously positioned on equities, especially as companies, apart from those in the energy sector, are expected to report a dip in third quarter figures. We also remain neutral on duration.

EUROPEAN EQUITIES

It was yet another volatile week amid the first third-quarter reports and lots of macroeconomic and central bank news. The Bank of England issued several statements, some of them contradictory, about whether or not it intended to extend its emergency bond-buying programme. The UK government faced down heavy criticism to confirm it was sticking with its mini budget but on Thursday press reports suggested Liz Truss could perform yet another U-turn. Markets are in favour of a climb down as the budget would have meant a rise in the risk premium. The rumour was certainly one of the reasons that helped European markets brush off disappointing US inflation figures. 

In company news BMW (+1.1%) said third quarter sales were stable -they fell in the first half- thanks primarily to a rebound in China and the US which offset persistent weakness in Europe. Givaudan (perfumes) raised prices to maintain sales growth but still fell short of expectations. Germany’s BASF (chemicals) issued a profit warning but managed to reassure markets by unveiling drastic cost-cutting measures. Philips (electronic products) also warned on profits due to supply chain problems and the worsening macroeconomic environment.

US EQUITIES

Thursday’s CPI data precipitated a day of wild swings on Wall Street which resulted in the 5th biggest intraday trend reversal in the exchange’s history. Indices tumbled 2% at the opening when inflation came in 8.2% YoY, or higher than the  8.1% expected. But as the S&P500 and Nasdaq flirted with important technical levels, 3,500 on the first and 10,000 on the second, traders unwound short positions and the indices closed 2.6% and 2.23% higher.

A slowdown in the pace of inflation in goods and products was seen as an encouraging indicator.

The FOMC minutes showed that the Fed is much more concerned about inflation than the impact of higher rates on the labour market. Fed fund futures are now 100% expecting a 75bp rise at the next FOMC meeting on November 2.

In company news, JP Morgan was due to kick off the third-quarter earnings season on Friday October 14. Ahead of the figures, CEO Jamie Dimon said he thought a soft landing was highly unlikely and he now expects interest rates to move above the 4-4.5% most economists are predicting. He also said markets could drop by another 20-30%. 
Intel might lay off several thousand people this month following a drop in demand for PCs. 

Moderna is allying with Merck in a research programme for a vaccine against cancer.
Cruise line companies like Norwegian Cruise Line (+1.6%), Royal Caribbean (+11.5%), Carnival (+10.1%) advanced on a slew of positive analyst recommendations.

Meta unveiled its new virtual reality headset priced at $1,500. The previous headset retailed at $400. Netflix advanced after introducing its cut-price subscription with advertisements. It is to be launched at the beginning of November at $6.99 in the US, a dollar less than a similar bundle Disney+ is about to start.

JAPANESE EQUITIES

The NIKKEI 225 and TOPIX fell 3.93% and 3.53% for the period, dragged down by falls on US and European equity markets. Selling was spurred by generally weaker guidance from the semiconductor sector, stronger-than-expected PPI and CPI in the US and sharp declines in gilts and sterling.

Air Transportation and Land Transportation rose by 1.57% and 0.94% on hopes for a boost to tourism after the Japanese government relaxed border control restrictions and started a nationwide travel discount programme. Machinery, Precision Instrument and Electric Appliances declined 6.90%, 5.85% and 5.67% as cyclicals tanked on global recession worries.

In contrast, East Japan Railway and West Japan Railway gained 4.11% and 3.77% on easier border controls. Aeon, one of the country’s largest retailers, rebounded by 2.93%. SMC, Tokyo Electron and Sysmex tumbled 9.33%, 8.64% and 7.94% on global growth worries.

The yen continued to weaken against the dollar, moving from 145.14 to 147.12, even touching the high-147’s for the first time in 32 years, as US inflation suggested the Fed would continue to tighten aggressively. 

The Japanese government kicked off a nationwide travel discount programme on October 11. It aims to boost the domestic tourism industry. Various media reports said strong hotel bookings had already been observed.

EMERGING MARKETS

The MSCI EM Index was down 4.8% as of Thursday’s close. China (-7.4%) was particularly weak after its week-long holiday amid an increase in lockdowns and Beijing’s reaffirmation of its Covid-zero policy ahead of the Party Congress. India fell 1.5% and Brazil 3.3%. 

In China, the Caixin Services PMI fell to 49.3 in September from 55 in August. September credit data surprised on the upside. The improvement in loan growth was mainly led by stronger corporate loans, thanks to incremental policy easing, while household medium-to long-term loans (mostly mortgages) remained weak. The PBoC is using more tools to enhance policy support by relaunching the Pledged Supplementary Lending (PSL) plan. Domestic tourist trips and tourism revenue during the National Holiday both hit their lowest levels since the Covid outbreak in 2020: 60% and 44% of 2019 levels, respectively. This was mainly due to a Covid resurgence and the government's call to "staycation" during the holiday. 

On the geopolitical front, the US announced a set of new export controls to slow China's technological advances, including a measure to cut China off from certain semiconductor chips made with US equipment. US citizens and entities are also barred from working with Chinese chipmakers without explicit approval. The US removed WuXi Biologics from its Unverified List (UVL) but added YMTC along with 30 other firms. CATL announced a third-quarter positive profit alert with earnings up 169-200% YoY, or ahead of market expectations. Moutai’s third-quarter preliminary results demonstrated resilient growth despite a weakening macro environment.

Taiwan’s September exports fell 5.3% YoY, the first drop in two years. TSMC third-quarter earnings beat expectations, and the group cut its 2023 capex spending target by 10% to $36bn. It secured a one-year license to continue ordering US semiconductor equipment for its expansion in China (on 28nm and 16nm). In Korea, Hynix and Samsung Electronics received a one-year waiver on US chip export control measures.
In India, CPI rose 7.4% as expected in September to a 5-month high led by food prices. August industrial production fell 0.8% primarily in manufacturing and mining. HCL Technology reported 2QF23 results with solid revenue growth ahead of estimates. Infosys delivered another strong quarter with significant margin improvement driven by robust deal volume, cost optimisation and currency benefits. TCS also beat on the topline and margins, with steady deal wins.

In Brazil, September IPCA fell 0.29% vs. -0.34%, the third down month in a row, on lower fuel costs. In Mexico, industrial production in August rose 3.9% compared to 2021, and above the 2.9% expected. August total loans continued to accelerate to +11.3% amid improving asset quality. OMA published a strong 30% YoY rise in domestic traffic in September. In Chile, September SQM export data pointed to a significant fall in lithium volumes and prices with China.

CORPORATE DEBT

CREDIT

The week’s big talking point was US inflation (CPI) which came in at 8.2% YoY, or more than the 8.1% expected. With no good news on inflation, corporate debt indices remained firmly in negative territory. Investment grade and high yield ended the period between Monday and Thursday 0.92% and 1.34% lower.

On an active new issues markets, Italy’s Fedrigoni (high-quality papers) raised €875m at 11.5/12% due 2027. The company is owned by private equity funds Bain Capital and BC Partners following the latter's acquisition of 50% in July 2022. German healthcare company Stada launched an offer to exchange its secured 3.5% 2024 notes for new secured bonds at 7.5% due 2026 plus 8% in cash.

To start the third quarter earnings season among high-yield companies, Eutelsat reported a slight dip in sales to €287.4m. The satellite operator has high hopes for sales synergies and improved operating efficiency from its coming tie-up with OneWeb Sales. The UK’s Jaguar Land Rover missed expectations by 16% due to semiconductor supply problems.  
In other company news, telecoms operator United Group advanced in its deleveraging drive and is to sell part of its mobile tower network to reimburse some of its bonds due in 2024 and 2024. 

In financials, CoCo spreads continued to widen in the absence of positive macro news: upbeat individual company reports have had little impact on the market. Credit Suisse stabilised after a tender on its senior debt and signs that several financial groups are interested bidding for its securitisation affiliate. Italy’s Monte Di Paschi was actively traded after announcing that it had secured enough firm interest to go ahead with its €2.5bn capital raising. The bank’s subordinated debt gained 20 points on the news. Moody's downgraded Deutsche Bank by one notch but moved to a stable outlook.

CONVERTIBLES
In new issuance, unconventional producer Northern Oil in the US raised $500 at 3.625% due 2029. The proceeds will go on expanding production capacity from its current 85,000 b/d level. This month, the group spent $287.5m on acquiring two fields in the Delaware Basin. 

In third-quarter earnings news, flagship luxury group LVMH announced a 19% rise in sales to €19.8bn despite a drop in sales in Asia. The figures were boosted by operating performance in its key fashion/leather goods and wines and spirits division.
Package delivery group Deutsche Post made a record €2.04bn before tax (+15%) over 12 months despite the inflationary environment.

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.

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14/10/2022
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