Week ended April 1st 2022
There were several news items that influenced global financial markets last week, any of which in isolation could have been downers on their own, certainly for most of the first quarter. However, sentiment seems to have stabilised since mid-March as investors have apparently grown accustomed to the visible risks that rattled investor sentiment for much of the first quarter. The world is watching an unexpected (and uncalled for) war evolve in Ukraine; inflation is raging in the US, the Eurozone and UK; and oil prices remain at severely elevated levels. I have not forgotten about COVID although the new BA.2 omicron variant seems substantially less dangerous, albeit more contagious, than prior variants. In fact, it feels to me that the pandemic is winding down, with one exception perhaps being in China. Bloomberg (article here for subscribers) reported this week that China’s zero-tolerance COVID policy could now come back to haunt the country, as Hong Kong has recently experienced a massive outbreak of the virus and Shanghai is currently shut down in two phases to undertake massive testing. The global economy needs China to fire on all cylinders, so ongoing COVID disruptions there are concerning.
A far as inflation, the Eurozone followed the US and UK by reporting substantially higher expected inflation for March. According to Eurostat (here), preliminary March inflation is expected to be 7.5% in the common currency bloc, up sharply from 5.9% in February and well above the ECB’s 2% target. The major culprit is energy prices, which soared 44.7% in the Eurozone in March. Whilst the Bank of England has raised its base rate three times since December and the Federal Reserve just raised the Fed Funds rate in March with more increases on the way, the ECB has so far taken a slightly more cautious approach to tightening monetary policy. The reason is that the Eurozone is experiencing more damaging collateral effects of the ongoing Ukraine-Russia war, most notably because of the bloc’s reliance on Russian gas. Nevertheless, pressure will be on the ECB to act more aggressively and quickly now because waiting too long substantially increases the risk that inflation could become entrenched. Compared to the US and the UK, I believe that the Eurozone is at substantially higher risk of settling into an economy characterised by stagflation, meaning high inflation and slower growth simultaneously. The US – further removed from the effects of the Ukraine-Russia war and much less reliant on Russian oil and gas – is less likely to experience the economic drag of the conflict. Still, higher global oil prices and plenty of other global supply chain disruptions (including some agricultural / food products) are continuing to push prices higher in the US. The longer these concerns persist, the more likely that inflation could becoming embedded in US wages, too, especially since the Fed has been slow to address steadily rising inflation.
The US jobs report in March (see BLS data here) showed an economy that is still firing on all cylinders, even as inflation continues to increase. 431,000 jobs were added in March, and US unemployment fell to 3.6%. As a reference point, US unemployment was 3.5% in February 2020, prior to the pandemic, peaking at 14.7% in May 2020 as the US economy was voluntarily shut down to combat the virus. As might be expected given ongoing inflationary pressures in the US economy and a tight labour market, US wages rose by 5.6% in March, increasing the risk that the US could be in store for a wage-price spiral. Although late, the Federal Reserve is now turning decisively hawkish, so much so in fact that the US Treasury curve – measured as the difference between 2- and 10-year UST yields – actually inverted following Friday’s strong jobs report. Increasingly, this might be viewed as a harbinger of a pending recession in the US, although in spite of these signals, investors seem to believe otherwise as risk assets continue to move steadily higher. The focus will (or should) be on how equity investors react to the Fed Fund rate increases that lay ahead, as well as how the strong US real estate market digests sharply higher mortgage rates.
Let me touch quickly on the price of oil. OPEC+ just decided again to stick to its production quotas (400,000 bbl/day increase in April), either because they are incredibly disciplined (doubtful) or because they simply don’t have much capacity to increase supply anyhow in the short run. Clearly, the world is beholden to Russia oil and gas (much more so to gas in Europe), given that Russia accounts for around 10% of annual global oil supply (and 25% of OPEC+ supply). The overhang of uncertainty around Russian oil and gas is keeping severe pressure on oil prices. President Biden’s decision to “drip-feed” one million bbls of oil/day from the Strategic Petroleum Reserve into the US market over the next six months to soften “prices at the pump” will work as usual in my opinion – it will provide a very short-term benefit of a few days, and then will be set aside and forgotten as larger macro forces retake control. To provide perspective, the US consumes around 20m bbls/day of oil, or nearly 20% of global consumption of 97m bbls/day. The SPR has around 570m bbls of oil (see here), so the release of 1m bbls/day from the SPR over six months will consume around one-third of the total SPR. Both the US government and investors need to encourage more US domestic production to provide some relief for oil prices. President Biden has said as much, and you can find the White House’s “Fact Sheet” released on Thursday here.
As far as the ongoing Ukraine-Russia war, this conflict is settling into a routine, or at least this seems to be the view of risk investors. Nonetheless, I believe that there remain very real and material risks around this conflict, including the risk that the war could linger on, escalate to include non-conventional weapons, or spread outside of Ukraine. In a world already feeling the harsh effects of higher energy prices and other supply chain disruptions, sanctions on Russia are inevitably exacerbating these problems, creating supply-push inflationary effects that are beyond the scope of central banks to influence or control. Trying to make a call on when or how this conflict will end is a fool’s game, but clearly, it remains a very important factor in the determination of risk sentiment.
Global equities were mixed this week, with all of the indices I track positive aside from the Nikkei 225. The best performing index was the Shanghai Composite, which received a boost as Bloomberg mentioned in an article on Thursday (here, for Bloomberg subscribers) that Chinese national regulators are considering granting US regulators full access to audit papers for the 200 or so Chinese companies with ADRs trading in the US. In 2019, the US government made it mandatory that foreign-listed companies provide full and open access to audit papers for US regulators by 2024, something that the Chinese government has been resisting for years because of concerns about sharing sensitive information with US authorities. The solid performance of Chinese equities also boosted the performance of the broader MSCI EM index for the week.
US equities were generally better on the week, with the value-oriented Russell 2000 and the tech-heavy NASDAQ Composite serving up the best performances. The more concentrated and arguably cyclical DJIA was the only US index that was negative for the week, although it was only modestly so.
Volatility in equities has settled as the equity market has clawed back some of its first quarter losses during the last three weeks. The VIX fell below 20 mid-week last week for the first time since mid-January, closing Friday at 19.63. The S&P 500 has increased 8.9% in only three weeks as sentiment has stabilised, with the index rising in 10 out of the last 14 sessions. As far as corporate events, TSLA announced om Monday that it was creating new shares in anticipation of a possible stock split in the autumn, and meme-favourite GME announced on Thursday that it would do what appears to be a 3.33:1.00 share split assuming this is approved at its upcoming annual meeting (date TBC). The 1Q22 earnings season is also quickly approaching, with the big US banks kicking things off as usual. Both WFS and JPM report earnings on April 13th.
This commentary feels like déjà vu since the trend remains similar to the one that has characterised this market for months, baring one “flight-to-quality” interruption in early March. The yield curve has been flattening for several weeks now, with the 2-10 year yields actually closing inverted on Friday for the first time since the onset of the pandemic.
The 1Q22 was the worst quarterly performance for USTs in several decades. The ICE U.S. Treasury 7-10 Year Bond Index is now down 6.5% YtD and was down 4.0% in March alone as selling pressure accelerated. As inflation increases and yields rise as a result, bond prices are falling, increasingly more severely at the short end of the maturity curve as investors anticipate well-telegraphed increases in the Federal Funds rate. This is leading to a flatting yield curve, possibly signalling a potential US recession down the road. Supply chain disruptions and higher oil prices will inevitably cause US growth to slow, adding more brakes to a US economy that is already being slowed by higher yields. However, investors also need to remember that the absolute levels of yields across the curve remain significantly lower than during (non-crisis) yield curve inversions in the past. Overall, the US economy remains on fairly firm footing, so a recession is far from a given. Nonetheless, US economic growth will almost certainly slow in the coming quarters as the Fed rate rises start to bite. Perhaps the best outcome might be a reversion to pre-pandemic average annual GDP growth of around 2.25% +/-.
Safe haven and other assets
As risk appetite has returned to markets, prices of safe haven assets (including USTs as mentioned above) have weakened. Gold was weaker again last week (-1.7% WoW), as were safe haven currencies including the US Dollar and the Yen.
Oil prices also weakened, with much of the action on the supply side. You can read more about the OPEC+ April (modest) supply increases and the release of SPRs in the US in the opening commentary. There is of course the great unknown which revolves around Russian oil supplies, and this is impossible to model / predict because of uncertainties regarding the war in Ukraine. However, it’s not just about supply. Higher energy prices globally will eat into discretionary incomes, and this will inevitably slow global economic growth. This is the vicious cycle of oil as demand-supply factors can lead to wild fluctuations in prices over time. In spite of March being a story of two halves, Bitcoin has remained resilient, or in fact, better than resilient as the most visible cryptocurrency delivered a solid 4.3% return in March. Perhaps more importantly given crypto’s severe volatility, BTC is well off its end-of-day low for the year ($36,086 on January 14th) ending Friday at $46,282.
Corporate bonds (credit)
Higher underlying UST yields pushed corporate credit spreads tighter this past week, not unusual given time lags (between spreads and yields). Importantly though, sentiment in the corporate bond market improved sufficiently this past week that yields on corporate bonds – both investment grade and high yield – actually improved. This could reflect the fact that the selloff in corporate bonds has gotten ahead of itself, as there still remain few alternatives where current returns are available (aside from alternative asset classes) of 4% (USD-denominated BBB-rated corporate bonds) to 5-3/4% (USD-denominated high yield bonds). I do not fear rising delinquencies or defaults at this point, at least not yet, but I do believe the price improvement this past week will prove to be an aberration as yields head higher. Perhaps high yield can be used as a placeholder, although a better alternative in my opinion would be to look at floating-rate (leveraged or high yield) loan funds, which provide some protection against the increases in the Fed Funds rate which are inevitable.