Market Insights Podcast – 19 APR 2022
Since 2022, the hot words for global investors are to cutting QE and raising interest rates, but recently the Federal Reserve has come up with another word that makes the world extremely nervous. That is QT (quantitative tightening). At present, the market has fully digested the expectation of rising interest rates, but the expectation of shrinking balance has not yet been fully reflected. Just one month before the countdown to the Fed’s May meeting (May 4), Brainard’s latest speech undoubtedly released a subtext. It is a reminder that people should not only focus on raising interest rates, but also be prepared for the risks of shrinking balance sheets.
The recent sharp rise in US bond yields has led to a sharp correction in high-valued chip stocks such as Qualcomm Inc, Nvidia Corp and Intel Corp, while valuations of technology stock are still sensitive and responsive to interest rates. US stocks are likely to show pressure in the short term before the Fed raises interest rates and shrinks in May, but liquidity indicators show little chance of a sharp fall in US stocks.
The global economy is likely entering a “war-cession”, and markets are underestimating its duration. It seems that Putin will not trade withdrawal for any ratcheting down of sanctions, so the sanctions stay in place. The implications for Europe are that you will see a recession because the sanctions will increase and move towards a total energy blockade. This is an enormous supply-side shock that will continue in food, energy and metals. At the same time, we are dealing with inflation worldwide and rising interest rates. We should monitor closely supply disruptions in China on the recent lockdown in the major cities. China is obviously a big supply side to the global system.
Investors expect the Fed to push up interest rates so much in the short run to fight off inflation that it ends up squeezing credit. The high short-run interest rate is driven by expectations of Fed interest-rate increases and the long-run rate is driven by expectations of recession, a subsequent drop in inflation and Fed rate cuts later on. Beyond these signals, inverted yield curves can cause practical problems. Banks typically borrow money in the short term and lend it in the long term. When short-term rates are higher than long-term rates, banks face profit pressures and disincentives to lend, which also curtail economic activity. Taken all together, the yield-curve signals seem to be saying that the Fed has room and time to raise short-term interest rates from their rock-bottom levels in the months ahead. The central bank hopes that inflation will come down along the way as supply bottlenecks in the economy ease. If inflation doesn’t recede as hoped and the central bank presses forward with rate increases further into 2023 or beyond, then recession might become more of a threat than it is now.
Inflation is likely to remain elevated for longer. Therefore, as households and businesses see high inflation as the new normal and change their behavior accordingly, we believe the risk of inflation expectations deviating from the Fed’s 2% target is rising. The Food and Agriculture Organization of the United Nations (FAO) warned that global food prices could rise further in the future. FAO’s global food price index has risen by about 75% since mid-2020, surpassing previous levels during the global food crisis in 2008 and 2011. Energy stocks have risen 38% so far this year, but it seems that these stocks will continue to rise. As the COVID-19 epidemic subsided, tourism demand increased, while the conflict between Russia and Ukraine led to a reduction in supply, and oil and gas prices rose sharply in 2022. Energy stocks are still attractive given high inflation and rising cash earnings.
Inflation is not only caused by geopolitical conflicts, but also because of the tight supply chain after the pandemic. The central bank’s interest rate hike cannot fundamentally solve the inflation problem. Overall, it is impractical. Central banks will coexist with inflation.
Equity market: Higher interest rates will still affect equities volatility. However, with inflation-adjusted real yields expected to remain historically low and the economy entering a recovery, the fundamentals are relatively solid, and the current relatively attractive valuation can support stock price gains; preferring developed markets over emerging markets.
Government bonds: Higher yields on government bonds in developed countries, medium-term inflation may be higher than market expectations, the long-term prospects of this asset class are challenged by rising term premiums, and fail to play a good role in risk diversification.
Credit: Although the coupons of high-yield bonds are attractive, there is little room for further compression of interest rate spreads, and there is still a certain interest rate risk in the context of interest rate hikes; considering the risk-return, stocks are more attractive among major asset classes.
The macro outlook for the rest of this year can only be described as complex and uncertain. Financial results showed investment banking revenues for Citigroup Inc, Morgan Stanley and Goldman Sachs Group fell by 36-43% respectively. The market is expected to be more volatile in the coming months as the Fed took steps to curb inflation. In the context of the expected decline in future earnings, which sectors can still make gains? We believe energy stocks, as well as the broader resource and materials sectors, still have room to rise. Looking back at US economic history, the energy and resources sectors used to account for 20% to 40% of the total market value. Today, they account for less than 7% of the total.
The latest earnings season for US stocks has begun. Pricing power will become increasingly important in the face of continuing inflationary and cost pressures, to assess the sustainability of profit margins, we will monitor the ability of companies to pass on increased costs to consumers.
Last week, Amazon announced that it will be employing a fuel and inflation surcharge for the first time, a mechanism broadly used across supply chain providers and apply to all products. Nearly 90% of Amazon’s 2m+ sellers used Fulfillment by Amazon in 2021, which provides services like storing, packing and shipping products. Last year, sellers even shelled out a total of USD103 billion in fees, making up around 22% of Amazon’s revenue. Several companies such as UPS, FedEx and Uber have implemented a fee and fuel surcharge in recent weeks.
For reference, here are a list of few companies with the best pricing power in different industries. Google: the average 5-year gross profit margin is 57%. Coco-Cola: the average 5-year gross profit margin is 61%. Nike: the average 5-year gross profit margin is 44%. Johnson & Johnson: the average 5-year gross profit margin is 67%. Adobe: the average 5-year gross profit margin is 85%.
Investors in US stocks, worried about geopolitical uncertainty and the Fed’s measures to fight inflation will undermine economic growth They are turning to defensive industries that are better able to weather volatile times and tend to offer strong dividends. The health care, utilities, consumer commodities and real estate sectors have all risen so far in April, and although the broader market has fallen, it continues to outperform the S&P 500 this year. Defensive stocks could also be “some kind of inflation hedge”.
US natural gas prices hit a 13-year high. Last Friday, the Biden administration said it would resume leases to drill for oil and gas on US federal land from next week. The announcement marks the formal abandonment of Biden’s campaign promises. As a candidate, Biden called for an end to oil and gas drilling on federal land as a way to reduce greenhouse gas emissions that contribute to global warming, and ordered a suspension of new leases on the day he took office. Libya closed its largest oil field on Monday and warned of further disruptions. Demonstrations against Libyan Prime Minister Dbeibah are likely to affect the OPEC member’s energy industry, and Libya’s oil production could fall by more than 500,000 barrels a day.
Energy supplies have remained tight since the conflict between Russia and Ukraine, with oil prices surging above USD130 for the first time since 2008, and US natural gas prices recently hit USD7.5 per million British thermal units, the highest level since 2008. In order to reduce their dependence on Russian energy supplies, major European countries such as Germany are plan to import liquefied natural gas (LNG) from the United States and other places. US natural gas export revenue will be close to USD30 billion in the first quarter, more than half of Russia’s natural gas export revenue for the whole of 2021. Goldman Sachs Group predicts that US LNG exports will account for 22% of global demand this year, surpassing Australia and Qatar, the two largest exporters, and ranking first in the world. The obvious beneficiaries are the two US oil and gas giants Exxon Mobil and Chevron and the stock price of the two companies are up near 50% year to date. Occidental Petroleum, which was heavily increased by Warren Buffett is up 112% so far this year.
The spread of COVID-19 and soaring energy prices triggered by the Ukraine crisis are causing headwinds, casting uncertainty on China’s official growth target of “around 5.5%” for 2022. The Caixin PMIs was disappointing in March. If oil prices stay high, the trend will put upward pressure on prices around the world and raise producer prices in China which is expected to transmit into China’s economy, weighing on already-weak consumption sentiment and manufacturers. Economic sanctions on Russia will clearly show their effects in the form of economic deterioration in Europe. Exports to the European Union, which account for nearly 20% of China’s total exports, tend to face downward pressure.
Many investors struggling to discern the outlook for China. The bulls point to the better-than-expected 4.8% GDP growth in Q1 2022, marking an acceleration from the 4% pace of the previous quarter. The bears point to notable downshifts in retail sales and industrial output as evidence global headwinds are taking a rising toll. In March, China retail sales dropped 3.5% from a year ago. Factory output increased 5%, slower than in January and February. Imports also fell slightly in March, another data point suggests that Beijing’s “zero Covid” lockdowns are hitting GDP. The data reflected a Covid-19 resurgence followed by tightened social distancing measures. More cities are in lockdown or semi-lockdown in April and this will likely impact the May holiday’s performance. The authorities doubling down on pandemic controls (under zero-Covid policy) on Shanghai means that further outbreaks in other cities will produce unpredictable economic ripples.
In addition to maintaining sufficient liquidity in the market and promoting the downward financing costs of the real economy, the RRR cut will also have a certain impact on the financial market. The RRR cut will often have a catalytic effect on the market of the financial sector and the real estate sector in the short term.
For the stock market, the previous special meeting held by the Financial Stability Board of the State Council releases the signal of stabilizing expectations and stabilizing the market has achieved remarkable results, and the capital market has stabilized. This cut will further enhance market confidence and help the capital market run smoothly.
For the bond market, the RRR reduction will promote banks to do a good job in asset and liability management, increase the allocation of interest rate debt, and expect a steady decline in treasury bond yields and will lower corporate debt financing costs. Lowering the reserve ratio can also play a positive role in the real estate market.
In the context of property market, regulation and control causes China property sector contracted third straight quarter, the financing needs of real estate enterprises, and the demand for mortgage loans will be improved, which plays a positive role in resolving the liquidity pressure of some real estate enterprises, improving residents’ willingness to buy houses, and maintaining the steady and healthy development of the real estate market.
Sino-US interest rates are inverted which was unthinkable for nearly a decade. This is mainly due to the non-synchronization of the economic and monetary policy cycles of China and the United States in 2022. China’s epidemic prevention pressure intensified in the first half of 2022, and the economic downturn is expected to be obvious. The current economic downturn in China is expected to reach that of the epidemic in March 2020 and expectations of future monetary policy easing are also high. In the last 10 years, the world has faced a period of low growth and low inflation. The Sino-US trade, the global epidemic outbreak in 2018 to 2022, and then the conflicts between Russia and Ukraine gradually changed the global supply chain. Supply-side imbalances led to a sharp rise in global inflation. The current scenario may be high inflation that this generation of traders have never seen before. Even when the March FOMC meeting stressed that it might start shrinking by up to USD95 billion in May, US bond yields soared. It should be difficult for RMB to maintain the strong appreciation trend of 2020 to 2021 in 2022.
It is also the first time that the interest rate spread between China and the United States has been reversed in 10 years since 2010. China’s monetary policy may be subject to the influence of US debt interest rates and capital outflows, but the complexity of the domestic economic environment will also make China more likely to focus on its own economic growth. One factor that may be considered by monetary policy is Sino-US interest rates and capital outflows, but it should be the Chinese economy that is more important. The monetary policy of China and the United States should be reversed in 2022.
China’s trade surplus from 2020 to 2021 was 533.8 billion US dollars and 676.4 billion US dollars respectively, maintaining a very high growth rate, which also benefited from the effective implementation of China’s epidemic prevention policy in the previous two years. However, the service-oriented expenditure on overseas tourism and education should be reduced in the past two years. The RMB should still be supported by fundamentals in the short term, and the factor is the outflow of foreign exchange capital under the capital account, including the outflow of stocks or bonds. It will be difficult for the RMB to maintain the strong appreciation trend of the previous two years in 2022.
Venture Smart Asia Limited (“VSAL”) is a company incorporated in Hong Kong and whose registered office is at 23/F, Lee Garden Five, 18 Hysan Avenue, Causeway Bay, Hong Kong, and is a licensed corporation regulated by the Securities and Futures Commission of Hong Kong for types 1 (dealing in securities), 4 (advising on securities) and 9 (asset management) regulated activities pursuant to the Securities and Futures Ordinance. VSAL is a member of Venture Smart Financial Holdings Limited (“VSFG”).
This document is for information only and is not intended to be construed as an invitation or offer of any securities or other investment products or as an invitation or offer to conclude a contract or to buy and sell any securities or other investments products. Any such invitation or offer will only be made by means of a confidential offering memorandum.
All information contained in this document is confidential and intended solely for the information of the person to whom it has been delivered and may not be distributed to any person in any jurisdiction where distribution to such a person would constitute a violation of any applicable law or regulation. Recipients may not reproduce or transmit it, in whole or in part, to third parties.
This document is only intended for professional investors (as defined in the Securities and Futures Ordinance (Cap. 571)) and is not to be distributed to, or relied on, in any circumstances by any person who is not a professional investor. This document and any securities or other investment products referred to in it have not been registered with, authorized, approved or disapproved, by the Securities and Futures Commission or any other authority, whether in Hong Kong or in any other jurisdiction. No authority has passed upon or endorsed upon the merits of any such securities or other investment products or the accuracy or adequacy of this document.
The information contained in this document does not constitute investment advice and has not taken into consideration any person’s investment objectives, legal, financial and tax situation or particular needs in any respect. Investors should seek professional advice as to the suitability of any securities or other investment products mentioned in this document.
Information contained in this document, unless otherwise specified, is obtained from sources which are believed to be reliable but no representation or guarantee is made by us as to the accuracy or completeness of any such information. If this document contains any information relating to the past performance of any securities or other investment products, you should note that past performance is not indicative of future results. If the base currency of any securities or other investment products mentioned in this document does not match your reference currency, the return may be affected by currency fluctuations. Potential for profit is accompanied by possibility of loss. This document may contain certain statements that may be deemed forward-looking statements. While forward-looking statements represent judgments and future expectations concerning any securities or other investment products mentioned in this document, a number of risks, uncertainties and other important factors may cause actual results to substantially differ from such judgments and expectations in a material way. Any market or investment view mentioned in this document is not intended to be investment research. Information contained in this document is subject to change without any obligation on our part to notify you of any change.
If this document forms part of a presentation or is presented to you together with other documents and materials, this document should not be read in isolation and may not provide a full explanation of all of the topics presented and discussed.
Investors should note that investment involves risk. The price of any securities or other investment product may go down as well as up. Investors should read the confidential offering memorandum for details and risk factors affecting the investment. If conflicts exist between this document and the confidential offering memorandum, the confidential offering memorandum shall prevail.
VSFG does not accept any liability whatsoever for any decisions taken based upon the material. No representation or warranty, express or implied, is made with respect to this document or views herein as to its fairness, accuracy or completeness. Neither VSFG nor any of its subsidiaries, affiliates, controlling persons, directors, officers or employees, or advisers shall be in any way liable or responsible, directly or indirectly, whether expressly or by implication, in contract, tort, by statue or otherwise for the contents hereof or any loss howsoever arising. Risks are involved in any investment. It is the investor’s responsibility to independently verify any data relied upon for an investment using qualified legal, financial, and operations advisors. Prior to investing, investors should also carefully consider possible tax consequences and legal requirements.