Bedrock’s Newsletter for Friday 3rd February 2023

Friday 3rd February 2023

Central banks were back in action this week – and boy did markets know it. Into this fortnight, the market story remained largely as it had been since the start of the year: plenty of green on the screen across assets, with European and emerging markets doing particularly well, dollar softening, and a definite spring in commodities’ step. In sum, a rather different picture than held for much of last year – a difference confirmed by the fact that many of the corners of the market most beaten up by 2022 have been leading the pack since the turning of the year (Exhibit A: Cathy Wood’s ARK Innovation ETF is up +50% over the last month). But one fact remains entirely unchanged from 2022: central banks are still centre stage. After the relative non-event of the Bank of Japan’s January meeting (discussed in our last letter), where Governor Kuroda left his bazooka at home and declared that Yield Curve Control would live to fight another day (disappointing traders who had built up long Yen positions in anticipation of the policy’s demise), focus shifted to the trinity of major Atlantic basin central banks, who took to the stage this week. Even if there are meaningful differences (in both where their benchmark rates stand today and how exactly they are likely to move at the next couple of meetings), it sounded like their scriptwriters had been collaborating: it was not difficult to parse a newly less hawkish message from all three, suggesting that the rates peak is becoming visible on the horizon.
 
First up on Wednesday was the prima donna of the central banking troupe, the US Federal Reserve. As expected, the Fed notched rates up +25bps, a smaller hike again than the +50bps at their last outing, itself down from the +75bps at each of the four prior meetings. This slowing of the hiking velocity was in itself an indication that the Fed believes it is cresting the peak of this latest hiking cycle, after a string of encouraging data prints suggested inflationary pressure was easing back. But a more optimistic-sounding Fed Chair Powell underscored the message in his press conference. He may have insisted the central bank would not be ‘complacent’, despite the promising data, and further rate rises were needed. But he also declared that ‘for the first time the disinflationary process has started’ in consumer goods – explicitly calling a turning point. Crucially, when asked directly, he did not push back on the recent market rally (unlike during surges of market ebullience last year), nor did he push on the need for financial conditions to tighten in reflection of restrictive monetary policy. Financial conditions are now at their loosest since last September, via rising share prices and tightening credit spreads. The ECB followed the Fed out of the wings on Thursday and – on the face of it – gave the most hawkish performance of the three. The eurozone central bank raised rates +50bps – again, as expected. President Lagarde was gloomier than her American counterpart, emphasising that inflation was still ‘alive and kicking’ and ‘far too high’, even though it has begun to come down (eurozone inflation dropped more than expected in January, to 8.5% compared to 9.2% in December; core inflation, however, was stubbornly steady at 5.2%). Lagarde also all but guaranteed another +50bp increase in March. But a more optimistic subtext was not hard to find in Lagarde’s statements that inflation risks are now ‘more balanced’ and disinflation may set in sooner than anticipated. Crucially, the ECB President said that after March they would ‘evaluate the subsequent path of monetary policy’. Clearly a coming peak in the ECB’s hiking cycle is not unthinkable – if the data allow it. Finally as he took his turn on the stage, the Bank of England’s (BoE) Andrew Bailey was more in line with Powell, openly entertaining the possibility that the turning point had come, even if he declared that it was ‘too soon to declare victory just yet…we need to be absolutely sure that we really are turning the corner on inflation’. The BoE raised rates by +50bps to 4% and – amidst the worst economic outlook of any major economy – the UK’s central bank may even stop there.
 
Having already closed out a strong first month of the year – the MSCI All-Country World Index added +7.1% and the Bloomberg Global Aggregate Index (Hedged) +2.3% in January – this week markets took the message that the end of the current hiking cycle was approaching and ran with it, firing a remarkable rally across assets over the last two days. On Thursday, European sovereign bonds enjoyed one of their biggest daily surges in a decade, as the yields on 10 year German Bunds plunged 20.4bps, their biggest fall since the day Mario Draghi became ECB President in 2011. Italian BTPs did even better, their yields coming down -39.3bps on the day. US Treasuries rallied too, the 10Y yield slipping to 3.4%, the lowest level since September. Amidst strong risk-on sentiment, investors piled into equities too. The S&P 500 surged +1.5% on Thursday to clock a 5-month high. The Nasdaq did even better, leaping +3.3% to put it within a whisker of bull market territory (at the close it was up +19.5% from the lows). In Europe, the Euro STOXX 50 index rose +1.7% and Germany’s DAX 40 +2.2%, on top of their already strong January gains; they are up +11.8% and +10.2% YTD, respectively.
 
Welcome though it has been, we still counsel caution on the strength and makeup of the recent rally – above all in a complex and uncertain macroeconomic context. In a sign there may be a decent amount of FOMO-fuelled buy-the-dip mentality and momentum chasing to it, more speculative assets have been doing particularly well: YTD, bitcoin is up +40%, the Goldman Sachs Non-Profitable Tech Basket +22%, and so-called meme stocks AMC and GameStop are up over +31% and +18%, respectively. This is not limited to day-trading Robinhood junkies. Leadership of this rally has been firmly in the hands of previously out-of-favour sectors: Communication Services (the likes of Facebook parent Meta) and Consumer Discretionary have been the S&P 500’s strongest performers, while defensive sectors Energy, Healthcare, and Consumer Staples have lagged badly. In the wake of the Fed’s slower rate rise and Powell’s dovish statements, it was the ‘high-duration’ tech stocks of the Nasdaq that led the running and the FANG+ mega-tech group had their best day since November, adding +6.9% on Thursday. Quality has not been a feature of this rally, with measures such as Return on Equity and financial leverage not correlating with share price returns – suggesting corporate management need not worry about deleveraging and cost-cutting after all as reports of the death the era of free money were apparently greatly exaggerated. These are big bets to make on the premise that inflation will continue its downward path, the Fed will not follow through on what remains its stated intention (get the Fed Funds rate above 5% and hold it there into 2024), and the economy will be basically rosy enough to keep consumer discretionary spending – and corporate profits – strong.
 
Do the data justify this? Put simply, the answer remains very uncertain. Hard data look robust, especially in the US, where GDP grew at an annualised rate of +3% QoQ, even as inflation is falling and the jobs market remains tight – together suggesting the Fed may be on course to pull off a soft landing. But the US GDP number was not quite what it seemed; a sharper fall in imports than exports, together with inventory stocking and higher government spending, pushed the number up (while private investment cratered). Moreover, monetary policy works with a lag, so a real-economy slowdown caused by tighter policy may not yet be fully captured by lagging indicators – but still occurring. Sentiment-focused survey data point in this direction and consumer spending has been dialled back from the 2021 highs. Even as the latest rally causes multiples to expand once more, corporate earnings cannot defy gravity if the economic picture deteriorates further. The latest earnings results from big tech – which came after the bell yesterday – should give pause for thought. The A Team of Apple, Alphabet, and Amazon all disappointed, each in their own way: Apple recorded its first revenue fall in almost four years (pinning the blame in part on Chinese supply chain problems), Alphabet’s Google suffered falling advertising sales, and Amazon said growth in key profit-driver AWS had slowed. Their share prices all fell sharply in after-hours trading, stepping back from the strong gains in the normal session.
 
And what of inflation? Today’s US jobs data surprised dramatically to the upside: compared to an expected +185,000, US employers added 517,000 jobs in January – not indicative of a cooling economy allowing inflationary pressure to dissipate. Beyond the US, core inflation in Europe has not fallen back, even as declining energy prices have brought the headline figure down, pointing to possible stickiness. And inflationary risks remain, including the ongoing – and highly uncertain – war in Ukraine, and the potential for surging Chinese demand to push commodity and energy input prices back up. Even as central banks this week allowed investors to entertain the hope that inflation has peaked and rates will soon follow, the markets’ current expectations of cuts before the year is out remain uncertain. In this environment, we continue to hedge our equity exposure, and prefer to move up the capital structure to lay claim to the attractive all-in yields available in fixed income, while also adding long duration treasury exposure for diversification should earnings continue to disappoint and a recession take hold after all.


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