Authors: Yuxuan Tang, Julia Wang, Global Investment Strategy team
Cross Asset Strategy
Fed statements dominated market moves this week. Equities started the week shedding some of their recent gains following comments by New York Fed President John Williams and St. Louis Fed President Jim Bullard that the fight against inflation could “last into 2024”. Sentiment was turned around by Chair Powell’s speech on Wednesday, which drove a 3% rally in the S&P 500 and a 15bps decline in 10-year treasury yields.
For the most part, Chair Powell’s remarks were not too different from his communications at the November FOMC meeting. The message is that the pace of policy tightening will likely moderate as soon as December (a 75 to 50bps stepdown was fully priced in before the speech); the fight against inflation is not over yet; and the Fed needs to see labor market demand cooling substantially before changing its policy stance. The optimism likely came from the fact that he did not push back on the easing in financial conditions driven by a risk asset rally and lower interest rates. Since the November FOMC, the S&P 500 climbed ~10% and the 10-year yield dropped ~50bps. As shown in the below chart, the tightening in financial conditions notably reversed, running the risk of encouraging future growth and pushing inflation higher. In our view, it could increase the odds of a higher terminal Fed funds rate or a terminal rate that stays high for longer. Risk assets could see further challenges from here. In this environment, core bonds are still our favored way to earn reliable income, add downside protection in portfolio and potentially benefit from capital appreciation.
Strategy Question: what’s our take on the recent market drivers?
Upside surprise in economic data across the U.S. and Europe
U.S. consumers turned out to be more resilient than expected. The positive 1.3% month-over-month change in October retail sales was the largest monthly gain in eight months. With inflation much more muted in October, that means real retail sales were firmly positive. While we expect tightening financial conditions to ultimately weigh on consumer spending, the lags could be longer than expected.
In Europe, following better than expected Q3 GDP numbers, the November flash composite PMI again beat expectations (47.8 vs. 47.0 consensus, 47.3 prior). Despite that, the data still pointed to a continued contraction in the region, with manufacturing at 47.3 (vs. 46.0 consensus) and services at 48.6 (vs. 48.0 consensus), the prints could imply a shallower downturn in the region. This trend of stronger-than-anticipated European data can also be seen in the economic surprise indicator, as shown in the below chart.
In the U.S., the bright spot in the PMI release came in the form of easing price pressures, as firms’ input costs rose at the slowest rate since December 2020, and firms raised their selling prices at the slowest rate in nearly two years. This reaffirms our view that U.S. inflation could trend down from here following the softer than expected CPI and PPI data in October.
The upside surprises in data were welcomed by the market. However, the loss in growth momentum in both regions is clear. In the U.S., new orders fell at the fastest pace since May 2020, and with the exception of the onset of the pandemic, the decrease in total new sales was one of the sharpest since the Global Financial Crisis (GFC). As for Europe, activities are broadly in contraction and high uncertainty reigns supreme as the war persists. We continue to believe that Europe is headed for a recession this winter. Under this backdrop, it’s unlikely that risk assets are “all clear” from here.
Updates in Covid measures in China
In China, easing of the policy appears to be more fully underway. At the November 29 press conference the National Health Commission (NHC) stated that Omicron and its sub-variants have asignificantly lower mortality rate, and hence the threat to the population is also meaningfully lower. The NHC followed on by encouraging the elderly population to get vaccinated. The press conference came two weeks after 20 new measures for tackling COVID were announced, which already marked a shift towards an approach that balances social and economic considerations against the cost of infection. The NHC explained that close contacts would no longer be traced, to remove a costly practice.
There is clearly now more visibility, and confidence, that a fuller and more sustainable reopening would be feasible. Over the last few days, in several cities, including Guangzhou, mobility restrictions and PCR tests have been further relaxed.
From an economic perspective, an easing of policywill likely put a floor on various mobility metrics this winter. At the same time, given rising cases, some degree of mobility and testing rules could remain in place until the current wave passes. As such, Q4 2022 to Q1 2023 could still see weaker economic activity growth. When thinking about the consumption recovery, we need to take into consideration the impact of the housing downturn and the global economic slowdown. Balancing these factors (which will likely impact consumer income) versus the impact of re-opening (which may lift sentiment), we have penciled in a 0.3ppt GDP boost for 2023. We see a fuller recovery in 2024 (around 1ppt). An upside risk to our base case (3.3% GDP for 2023, and 4.9% for 20241) will be possible if we see further monetary and fiscal easing in the December Central Economic Work Conference and the NPC in March.
A sell-off in commodities
Energy commodities sold off over the past weeks. Drivers of the tumble came from both supply and demand factors. On supply, the market has been waiting with anticipation to see how Russia will react to the European price cap that will be announced before December 5th. On this point it appears markets are losing faith on an end to material OPEC+ production cuts, with the realization that price caps proposed at $60-65/bbl for Russian oil (which typically trade at a $22/bbl discount to Brent) could be largely a non-event at the current price levels. Elsewhere, the Biden administration granted Chevron a license to resume oil production in Venezuela after sanctions halted all drilling activity almost three years ago, which could lead to an increase in shipments to 1M barrels of crude by late December. On the demand side, dampened expectations for a smooth reopening in China and fear of ever higher terminal Fed rates seem to have also overwhelmed the bulls for now.
This has created a significant divergence between the price of crude, which has meaningfully pulled back, and energy equities, which are hovering near their highs. Over the last 20 years, this divergence usually implies an unattractive risk reward profile in the sector. Over the medium term, rising recession risks in the U.S. and Europe would be a dampener on oil demand, which could bring further downside risks to energy equities. Given the sector has outperformed the S&P 500 by 72% year-to-date, we favor profit taking of energy equities into yearend at current levels.
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Index definition:
The Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.
The U.S. Dollar Index (DXY) is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies.
Goldman Sachs financial conditions index (FCI) is defined as a weighted average of riskless interest rates, the exchange rate, equity valuations, and credit spreads, with weights that correspond to the direct impact of each variable on GDP.
Standard and Poor's 500 Energy Index is a capitalization-weighted index. The index was developed with a base level of 10 for the 1941-43 base period. The parent index is SPXL1. This is a GICS Level 1 Sector group. Intraday values are calculated by Bloomberg and not supported by S&P DJI.
JPMorgan's economic activity surprise index (EASI) tracks the recent history of economic data surprises (rather than looking at fundamentals on an absolute basis). It helps predict short-term currency moves triggered by shifting expectations for the economy.
