Market sentiment improved significantly last week, supported by softer-than-expected October US CPI data. Good newsflow from China has also provided support for the markets. In contrast, the FTX collapse has put further pressure on the very volatile crypto market and has added to the fears about centralised exchanges.
Following the October CPI data, US 3Y and 5Y treasury yields plunged 40bp, while 2Y/7Y/10Y yields were all more than 30bp lower in the week, and bond yields fell more than 20bp. Moreover, markets have started to price in almost a 100% probability of a 50bp hike in December, while a week ago the probability of a 75bp hike was 40%. Terminal rate pricing has also fallen to around 4.90% for next May, having been higher than 5.20% a week ago. In our view, underlying and core inflation are still too high and the economy (labour markets) and earnings remain quite resilient. All this still points at US terminal rates of above 5%. This said, we now think that the Fed will likely moderate the pace of rate hikes, with a 50bp hike in December.
The decline in rates also spurred a huge rally in equities, with the S&P 500 Index up more than 5% last week and the NASDAQ nearly 8% higher, confirming that the equity market has been more resilient in the face of aggressive Fed tightening. Our take on the underlying resilience of the economy strongly suggests short-term rates have much higher to go than is currently discounted, and the eventual reversal will be much further out than the three or so months being projected by consensus, suggesting that the recent equity rally may soon pause.
The decline in rates and pull-back in Fed rate hike expectations following the CPI release also caused the USD to plunge 4%, the largest weekly decline since March 2020, following the largest one-day decline on Thursday since December 2015. There are now some real signs that suggest the USD could have reached its peak.
New measures relaxing COVID-19 policy and addressing the collapse of the real-estate market in China could add to cyclical concerns, reducing the probability of a severe recession in the global economy. This said, given the uncertainty about the new top leaders' policy priorities – economy vs. social agenda/security – we believe Chinese equities are still a long-term play rather than a momentum investment theme, assuming the short-term rally continues.
Actionable idea: China remains extremely inexpensive, although uncertainty is likely to prevail in the coming months. We would, therefore, play China's revitalisation through global companies with high exposure to the region. Last month we noted increasing interest in Chinese upside via options on the FXI. At the time we wondered if the market was speculating on an upside surprise coming out of the CCP Congress on COVID-19 restrictions or fiscal policy. In the event, neither happened, but the trend continues. Moreover, the trades we recommended back then, expire this Friday. We suggest recycling profits into similar calls for March expiry.