It is early days, but the Fed seems to be gaining an upper hand in its battle against inflation. The US central bank, through its aggressive talk and action, has been able to cap long-term inflation expectations for now.
US 10-year expected inflation rate has fallen from April’s 3.1% peak to 2.6%. This has helped drag down US government bond yields and the USD.
A Fed victory over inflation and a USD peak are critical for a sustainable recovery in global risk assets. This explains this week’s first weekly rebound in global stocks in eight weeks.
Besides undervalued Emerging Market stocks and bonds, we see opportunities in our preferred income generating assets which are yielding more than 5%.
INVESTMENT STRATEGY
Is the Fed winning?
It is early days, but the Fed seems to be gaining an upper hand in its battle against inflation. The US central bank, through its aggressive talk and action, has been able to cap long-term inflation expectations for now: 10-year expected inflation rate based on inflation-protected bonds has fallen from April’s 3.1% peak to 2.6%. This has helped drag down US government bond yields and the USD and turn inflation-adjusted long-term yields positive. A Fed victory over inflation and a USD peak are critical for a sustainable recovery in global risk assets. This explains this week’s first weekly rebound in global stocks in eight weeks.
Although Fed Chair Powell and others have warned in recent weeks that they may have to take the benchmark interest rate to restrictive territory (ie. above the Fed’s estimated ‘neutral rate’ of 2.4%) to tamp down inflation pressures, the latest Fed minutes from its last policy meeting confirmed that most policymakers are no more aggressive than what is already priced into markets. The minutes suggested that policymakers are likely to remain data-dependent after pushing through 50bps rate hikes each in June and July meetings.
Also, data suggests the Fed is in a good place in its bid to cool the US economy without causing a recession in the next 6-12 months. This week’s business confidence data (PMI) for May indicated economic activity in the US and the Euro area remained at healthy levels, although it confirmed a further slowdown from last year’s peak. US core durable goods orders, which reflect business spending plans, rose a less-than-expected 0.3% m/m, but core goods shipment used in calculating GDP rose a more-than-expected 0.8% m/m. US job openings and non-farm payrolls data for May due next week are the next focus. Powell’s goal would be to slow job creation, without causing a surge in unemployment. The record number of job openings points to a tight labour market, which we expect will ease as more low-income workers return to the labour force in the coming months. This should help curb wage pressures.
The USD’s nascent pullback from 19-year highs is also good news for risk assets. Besides a peak in US Treasury yields, other global central banks need to turn more hawkish for the USD to ease and global risk assets to recover sustainably. This week saw the New Zealand central bank take the lead here – it raised rates by 50bps to a five-year high of 2% and projected that the rate could double to 4% in a year. Meanwhile, ECB President Lagarde hinted at a rate lift-off in July and positive rates by Q3. Persistently high inflation in May (data due next week) could force the ECB to turn more hawkish. The Bank of Canada is next, with the consensus expecting a 50bps hike to 1.5%, followed by Australia’s RBA meeting on 7 June.
Meanwhile, China appears to be picking up the pace of policy easing after extremely weak April data (PMI for May are due next week). This week, Premier Li Keqiang told local government officials to focus on reviving the economy, while authorities unveiled more tax cuts. The PBoC, after cutting a key rate linked to mortgages and infrastructure lending last week, met with big banks to discuss boosting lending. However, stringent COVID-19 policies remain a dampener for consumer and risk sentiment. While infections in Shanghai have sharply declined, enabling authorities to allow the restart of factories and gradually relax restrictions there, Beijing recorded a new high in COVID-19 infections. An infection peak across major cities will likely be needed for zero-COVID-19 policies to ease.
China’s COVID-19 challenges notwithstanding, the chart above shows that Asia ex-Japan equities (including China stocks) stand out in terms of the degree and duration of pullback, compared with the 2007-09 bear market. Asia ex-Japan and China stocks are also extremely undervalued, trading at a 20-30% discount to global equities. This shows the extent to which downside risks have been priced in. President Biden’s plans to lift tariffs on imports from China could revive sentiment.
US financial sector equities also look attractive. Higher interest rates are likely to boost net interest margins, further boosting profitability, while loans continue to grow and credit concerns remain muted. Meanwhile, income-generating assets are going on sale, with several of our preferred bond markets and hybrid asset classes offering more than 5% yields. This is a far cry from the start of the year when investors had to take on more risk to generate 4% income. We believe these beaten down markets offer opportunities for long-term investors as global inflation expectations likely peak and China jumpstarts growth.
