The Fed clarifies its rate hike trajectory

Market Analysis

09/05/2022

The Fed chair reaffirmed his determination to beat inflation and rapidly return to neutral interest rates
The FOMC lifted some uncertainties such as the pace of rate rises and quantitative tightening
We have turned tactically more positive on US equities as we see potential for a rebound after the severe falls in recent weeks

After the May 4 FOMC, Jerome Powell announced a 50bp rate hike and the beginning of quantitative tightening (QT) in June for $47.5bn ($30bn in Treasuries and $17.5bn in MBS). This will rise to $95bn in September. The Fed chair reaffirmed his determination to beat inflation and rapidly return to neutral interest rates. This is still a hawkish position but he ruled out the 75bp hikes investors were worried about. He left the door open to further 50bp hikes, notably at the June and July meetings. However, the 50bp markets expect in September is “not certain” and will be “data dependent”.

The FOMC lifted some uncertainties such as the pace of rate rises and QT. As the meeting clarifies the trajectory of short rate increase, we might see government bond yields starting to stabilise when Asian investors return to their desks after the May 1st holidays. We are now neutral on US Treasuries which offer yields of more than 3% on maturities of 5 years and more.

US equities tumbled in April and again after the post-Fed bounce. Thursday's sell-off took the S&P 500’s YTD drop to 13%. The Nasdaq is now down 21% for the year and the Russell 2000 14% lower. Taking already released results and generally upward revisions for 2022 into account, the S&P 500’s PE 12MF is back to end 2017 levels of 18 times and below pre-Covid levels. The Nasdaq 100 is now trading on 24 times and is also back to pre-pandemic levels. Investor positioning and sentiment is now very negative and because share buybacks could resume after earnings reports, so we have turned tactically more positive on US equities. We see potential for a rebound after the severe falls in recent weeks. However, we remain cautious over the medium term. Liquidity is set to fall in the future and growth prospects have dimmed as the risk of recession rises.

Elsewhere, the European commission presented a new raft of anti-Russian sanctions, including oil but with arrangements for countries which are highly dependent on Russia for their supplies. The news sent Brent crude to $113 and there will clearly be an inflationary impact in the eurozone. Several ECB officials are now arguing for rates to be raised in July, or earlier than planned. As inflation will weigh on European earnings and because the shift to more restrictive monetary policy will be quicker than expected, we are still cautious on European equities.

EUROPEAN EQUITIES

Equity markets ended the period solidly in negative territory as inflation remained higher and the Bank of England raised rates. March inflation in the eurozone highlighted the surge and confirmed the underlying trend. In a reflection of the impact from the Ukraine war and lockdowns in China, April's economic confidence indicator missed the 108 expected and came in at 105, down from 106.7 in March. This was followed by a bigger drop than expected in March retail sales in the eurozone. A fresh wave of sanctions against Russia is likely to prolong the situation. That leaves only budgetary measures to underpin consumption.

In company news, Vestas and Siemens Gamesa, the two largest wind farm producers, posted somewhat disappointing first-quarter figures. Both are struggling with production chain problems and soaring material costs, notably industrial metals. In sharp contrast, BP posted excellent operating profits thanks to the surge in oil and gas prices over the quarter. In shipping, Denmark’s Maersk also had an upbeat quarter and sounded a confident note for the future. Nevertheless, the company expects maritime transport growth to slow down from the second half of this year due to consumers moving towards services. Air France-KLM confirmed strong reservation momentum and said it was confident it could pass on higher costs like fuel to travellers. Hugo Boss had a good quarter thanks to sales momentum in Europe and the US but investors were disappointed when management failed to raise guidance for this year. In autos, Stellantis and BMW reported encouraging results which showed they had the pricing power to offset cost inflation.

US EQUITIES

Markets went through an eventful week amid earnings reports and the key FOMC. Jerome Powell ruled out any 75bp hike in the future. Instead, the Fed raised rates by 50bp and intends to shrink its balance sheet to the tune of $47.5bn a month. Markets rallied sharply after the press conference. The S&P 500 jumped 3%, its best session since May 18 2020. It was also only the second time that the index had gained more than 2% back-to-back after an FOMC.

But the enthusiasm had quickly petered out by the following day and indices plunged, leaving the Dow 2.75% lower for the period and S&P 500 off 3.28%. The Nasdaq tumbled 4.3%. Investors had suddenly remembered the Fed chair's comments that controlling inflation could be a painful process. Worries were aggravated by labour costs rising to record levels and a fall in the ISM from 57 to 55.

Oil prices were stable, with WTI around $108.3 on indications that the European Union would approve an embargo on Russian oil. Gold was unchanged at $1,875 an ounce but Bitcoin was savaged by risk-off sentiment and plummeted to $36,500.

Macro data may have been mixed, but company results were still reassuring. With close to 75% of S&P 500 earnings now in, 80% have beaten analysts’ expectations. This is a support factor now that valuations have fallen.

However, following Amazon’s disappointing figures, a number of e-commerce plays released poor results. eBay plunged 6.5% after GMV (gross merchandising volume) fell 17%. Management cut guidance for this year due to the weak economy and the Ukraine war. Etsy tumbled 11% after the company said it expected a slowdown in the current quarter. This was despite a solid first quarter which featured higher tariffs on platform sales.

Following Google’s upbeat comments on tourism, Airbnb followed suite by announcing market share gains. The company also said reservations were running much higher than in 2019 and that visibility was excellent.

JAPANESE EQUITIES

Equity markets were only open on May 2 due to the Golden Week holidays. The NIKKEI 225 and TOPIX fell 0.11% and 0.07% amid falls on Wall St and concerns the Fed would tighten drastically at its monetary policy meeting.

Marine Transportation, Air Transportation and Glass & Ceramics rose 4.54%, 2.01% and 1.43% as investors returned to oversold cyclicals. Other Manufacturing, which includes gaming companies like Nintendo and Bandai Namco, fell by 1.29% as nesting consumption fell along with economies reopening. Construction and Services declined by 1.09% and 0.74% on profit-taking.

Fujitsu Ltd. a vu son titre bondir de 5.03%, après avoir fait part de prévisions supérieures aux attentes de son résultat opérationnel pour l’exercice 2023 et d’un programme de rachat d’actions. ANA Holdings Inc. a progressé de 2.67%, alors que la direction anticipe désormais un résultat opérationnel positif pour l’exercice 2023 et que la demande de voyages a rebondi sous l’effet de la Golden Week et de l’absence de restrictions. Suzuki Motor Corp a grimpé de 2.35%, le yen japonais restant à un niveau inférieur aux estimations utilisées par la société pour ses prévisions. En revanche, Z Holdings Corp a chuté de 9.83% et s’est de nouveau établi à un plus bas cette année, les prévisions de bénéfices pour l’exercice 2023 ayant déçu et s’inscrivant en deçà des attentes du marché en raison des coûts d’investissement stratégique initiaux. Resona Holdings Inc. a reculé de 3.42%, alors que les estimations de bénéfice net pour l’exercice 2022 ont été revues à la baisse du fait de la restructuration du portefeuille de trading exclusif et d’une gestion plus stricte du crédit. Ajinomoto Co., Inc. a cédé 3.16% sur fond de craintes à l’égard d’une éventuelle contraction des marges liée à la hausse des coûts des matières premières.

Fujitsu surged 5.03% as operating profit guidance for FY 2023 came in higher than market consensus and on news of a share buyback. ANA Holdings rose 2.67% as the company guided for a profit in FY 2023 and travel demand increased thanks to the unrestricted Golden Week holidays. Suzuki Motor gained 2.35% as the yen remained weaker than in group guidance. On the other hand, Z Holdings tumbled by 9.83% to a year low after the company reduced guidance for 2023 due to strategic investment costs. Resona Holdings was down by 3.42% after revising FY22 net profit forecasts lower due to a restructuring of its proprietary trading portfolio and tighter credit management. Ajinomoto declined by 3.16% on concerns more expensive commodities would squeeze margins.
The yen strengthened to 128 yen against the US dollar before the FOMC but weakened to around 130 on expectations the Fed would hike by 50bp in the future.

The yield on the 10-year government bond (JGB) was stable below 0.25% thanks to the BoJ’s unlimited buying operations at a fixed yield of 0.25%.

EMERGING MARKETS

The MSCI EM Index was down 1.60% this week as of Thursday’s close. China retreated by 2.69% in USD with the A-Share market closed for Golden Week until Thursday. India was also down 2.5%, hit by the RBI's surprise rate hike, while Brazil (-3.6%) continued to see profit taking.

China’s manufacturing and service activity fell in April as tighter COVID curbs continued to disrupt industrial activities and consumption: manufacturing PMI was 47.4 vs 49.5 in March and non-manufacturing PMI down to 41.9 vs. 48.4 previously. More than 20 provinces announced a total of RMB 5bn in consumption vouchers during the holiday. Express delivery firms will be exempt from paying VAT this year due to the new Covid outbreak. An RMB 100bn ($15.2bn) refinancing facility will be launched to support fundraising in transportation and warehousing. Macau received more than 40,000 visitors on the first day of the Golden Week holiday which started April 30, or double the average daily traveller number YTD. On the corporate front, first quarter earnings at CATL missed consensus due to rapid cost increases and despite price hikes. Moutai’s first-quarter profits beat estimates and preliminary results on accelerated direct sale reforms. BiliBili revised down their first quarter guidance to reflect Shanghai’s Covid lockdown impact. Tesla is to expand its Shanghai factory and is targeting an extra 450,000 in annual car production, or almost double the current capacity of 250,000.

Taiwan is seeing a surge in Covid-19 cases as it gradually shifts from a zero-Covid to living-with-Covid strategy.

In Korea, April exports advanced 12.6% YoY, the lowest reading since February 2021 mainly because of the Covid outbreak in China. Shipments to China fell 3.4% from a year earlier, compared to a 16.6% gain in March.

In India, April Manufacturing PMI was 54.7 vs. 54.0 in March. Services PMI stood at 57.9, up from 53.6 in March, a 5-month high amid mounting price pressures. Power consumption grew 13.6% YoY in April, showing the impact of the early onset of summer and a spurt in economic activities. Shifting gears to tame surging prices, the RBI surprised the market and raised its policy rate by 40bp to 4.4% and its CRR by 50bp to 4.5%, the first increase since August 2018 and the sharpest in nearly 11 years. India is trying to get deeper discounts on Russian oil and hoping to pay less than $70 a barrel. Maruti Suzuki reported its 4QFY22 results. Margins beat estimates due to lower discounts, a better product mix and moderating commodity inflation. Life Insurance Corporation’s IPO was fully subscribed on the second day of the procedure. The government reduced the size of the stake it is selling to 3.5% from 5% due to choppy market conditions.

In Brazil, industrial production rose by a seasonally adjusted 0.3% in March and fell 2.1% from a year earlier, or better than the 0.2% MoM estimated and minus 4.3% YoY in February. The BCB hiked rates by 100bp to 12.75%. This was in line with expectations and left the door open to reduce the pace of future hikes at next month’s meeting. First-quarter results at MercadoLibre beat estimates, with EBITDA coming in 38% above consensus.

CORPORATE DEBT

CREDIT

Major credit indices started May on the back foot due to rate pressure, widening risk premiums and no joy from macroeconomic data and geopolitical developments. Over the week, the Fed raised rates by 50bp, its biggest hike in 22 years. However, Jerome Powell said 75bp moves were out of the question in coming meetings and investors were reassured, if only for a day. Between Monday and Thursday, yields on Germany’s 10-year Bund rose 9bp while 10-year US Treasuries gained 14bp. Credit spreads widened further with the Xover up 25bp and the Main 4bp higher. This left credit indices down on the period: high yield debt lost 0.79% while investment grade was 0.47% lower. After a deal from Miller Homes in the previous week, CVC Capital raised €2bn with a special vehicle designed to fund Spain’s football championship, La Liga.

In company results, Air France-KLM lost €552m in the first quarter, or 3 times less, and doubled sales to €4.4bn. The group said it would increase fares in the coming months to offset higher commodity prices. Petrol and gas distributor Rubis had an excellent first quarter with sales jumping 49% to €1.47bn thanks to higher prices and volumes. Results at CGG (geoscience technology) were mixed. Quarterly sales fell 24% over a year but margins rose, with EBITDA 19% higher. Despite much higher oil prices, oil majors have not yet increased exploration budgets significantly. As a result, oil service companies are struggling.
Elsewhere, there were increasing rumours of a tie-up between Canadian convenience store operator Couche-Tard and the UK’s EG Group. In a market which is seeing a consolidation wave, EG Group, which belongs to the Issa brothers, had previously tried to buy Asda’s forecourts (Asda is also owned by the brothers). Couche-Tard had tried to merge with Carrefour but had been rebuffed by the French government.

It was another quiet week in financial debt with no new subordinated issues. Credit premium volatility put the focus on the senior segment. Euro Coco spreads widened by 30bp over the week to test the historically high 650bp level. USD CoCos also widened by 30bp to around 440bp.

The first quarterly results to emerge were rather upbeat with a good showing from UniCredit. There were reassuring figures also from SocGen which has managed to quit Russia satisfactorily. Even Raiffeisen, which is highly exposed to Russia, managed to navigate a tricky environment, making a profit despite booking higher provisions. There are more results to come but we have seen no signs of a significant hit to bank balance sheets for the moment.

CONVERTIBLES

With new issuance at a standstill, investors concentrated once again on company results. The trend remained favourable overall for convertible bond issuers despite the difficult macroeconomic picture. In France, Schneider had a good first quarter: sales rose 1.% to €7.6bn despite the Covid resurgence in China. In contrast, German e-commerce company Zalando reported a €52m loss due to inflation and the Ukraine war. The picture was brighter for highly cyclical companies, especially in tourism and leisure. Results at Airbnb and Booking.com rose sharply and both companies said sales prospects were excellent.

In M&A, Belgium’s Umicore (mining and recycling) is reportedly being eyed by South Korea’s LG Chem which is interested in the miner's cathode activity. Umicore also recycles metals and catalysts. French video game developer Ubisoft is also rumoured to be a bid target. The sector is consolidating fast and has seen successful bids on Activision, Bungie and Zynga. Ubisoft could be the next, especially as its share price has fallen back to 2017 levels. To avoid a hostile takeover, the founding Guillemot family is said to be looking for support from private equity groups to maintain control.

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

06/05/2022

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