After a very challenging week dragged by very weak IT performance, the markets ended with a decent rebound as the market decided that the US data would not add any further risk of a hawkish Fed for now. The US dollar was pummelled, particularly vs. commodity currencies, which rebounded on chatter of China moving to ease COVID restrictions, only to see these hopes dashed over the weekend. The focus this week will be on the US October CPI release this Thursday and US-midterm elections.
After the November Fed meeting last Wednesday, it is important to start thinking about the outlook for 2023. The reason for this is that the November meeting could prove to be the last with an aggressive 75bp interest rate hike. The pace may slow to 50bp in December, perhaps 50bp or 25bp in February and then 25bp in March. The Fed policy rate may end within a range of between 4.75%-5.25% and the market is pricing in that these policy rate hikes will end at 5% sometime in 1Q-2Q2023. However, interest rate volatility still suggests that the risks are still biassed to the upside, as much of the incoming economic and inflation data continue to surprise to the upside. All in all a Fed pivot is not our central scenario for the coming quarter, and even if it happens, it is not enough by itself to drive a sustained risk-on move in the market.
US earnings are on average beating revised consensus estimates, but the pressure on margins is increasing with earnings in the cyclical sector underperforming. In addition, cyclical sectors are showing more guidance revisions, both for the top line and margins. Against a backdrop of growing uncertainty about the pace of downward earnings revisions, we still believe that valuation alone is not enough to see a sustained bottom in US equities, even more so in the sectors more exposed to the economic cycle. In our central scenario, we remain Neutral on US equities, although risks are still biassed to the downside.
European earnings are still growing faster than in the US due to sector composition – the lower relative weight of Communication Services, the higher weight of the Energy-related sectors and a much weaker euro. In terms of margins, European companies have benefited from lower wage growth. Going into 2023, European corporates’ pricing power should moderate as demand slows. This is in contrast with the consensus for 2023, which is still anticipating a modest margin expansion.
Bear market conditions remain intact but more attractive valuations in risk assets are changing the risk/reward, as the derating of major equity markets is taking place in an orderly manner and fears of a massive meltdown, such as in the GFC, are receding. In our view, this means that financial markets have become increasingly sensitive to any positive news, such as the unconfirmed reports last week about the end of the “Zero-COVID” policy in China, which prompted a significant rally in Chinese and HK equities and commodities. In our view, China is still a source of concern rather than a catalyst for a rotation to cyclical assets, but it is a signal that if a severe recession is avoided, the risk/reward for risk assets is more balanced and relative value plays in favour of fixed income will continue to work.
The strength of the USD continues despite the long squeeze seen on Friday. The softening move was driven by news on China unwinding its policy restrictions, Japan interventions in the FX market, and extreme long USD positioning. Indeed, according to last week's report, the BOJ announced that Japan's FX interventions amounted to JPY6,350bn for the period from 29 September to the end of October. This represents more than double the amount spent over the previous four weeks (JPY2,838bn) and shows that the forces weighing on the yen have intensified and are creating downward pressure. In our view, as the USD is likely to remain strong, Japanese investors will continue to adjust their leverage carry portfolios to the new international environment of higher rates.
Actionable idea: the Energy sector has been one of the hands-down winners in 2022. We expect oil to remain higher-for-longer, which means Energy companies should continue to shine. Despite the strong performance to date they remain fundamentally very inexpensive (e.g., forward 12 month P/E at c. 5x, and the highest undervaluation against MSCI World in a decade), and thus Energy stocks remain a conviction Overweight for us.