Inflation, the loitering villain

In brief

• February saw releases of stubborn inflation and tight job market data, reinforcing the expectation of higher interest rates for longer, leading to a hawkish repricing of rates in the futures market.
• The appointment of Ueda as the next BoJ governor could lead to a review and potential revision to the YCC policy.
• Economic and mobility activity have recovered in China after the reopening, while the National People’s Congress meeting will be key to watch on any government policy to provide further support.
• With expectations for a few more rate hikes in the coming quarter and heightened macro uncertainties, our preference for high-quality fixed income over equities remains.

In our February 2023 edition of the Monthly Market Review, we were looking forward to the end of the Federal Reserve’s (Fed’s) hiking cycle and China’s economic reopening. The latter has proceeded better than expected, with consumption recovering at a brisk pace. However, the hope for the Fed wrapping up its hiking cycle by 1Q 2023 is dashed by the exceptionally strong January job data and the rebound in month-over-month core inflation in the same month. Like a movie villain, inflation just won’t go away. The positive expectations for the Fed to complete its hiking cycle that buoyed market sentiment in January has turned to be more cautious once again.

A soft landing? More like no landing for now

January inflation and job data were disappointing to those hoping for the Fed to end its rate hiking soon. Non-farm payroll grew by 517,000, when we usually get significant job losses in most Januarys due to seasonality. Both the consumer price index (CPI) and personal consumption expenditure price deflator accelerated in the month as well, reflecting that the underlying inflation pressure is slow to subside. Consumption data was also robust. The overall message is that the economy is not cooling down enough, and the Fed may need to keep raising rates in 2Q 2023 in order to ensure inflationary pressure is contained.

The futures market is now pricing in for the policy rate to reach around 5.5% by June, implying three 25bps rate hikes in March, May and June. This has also led the 2-year U.S. government bond yield to rise by 65bps in the month and the 10-year yield to rise 44bps, with the latter returning close to 4% handle. This also implies a further inversion of the yield curve. 

One question is whether the Fed’s determination to raise rates further would increase the risk of an economic recession. We have argued for some time that the more real interest rates move into positive territory, the risk of recession would be higher and eventually the Fed would have to cut rates sooner and more aggressively. The futures market is still indicating that the Fed would need to cut rates before the end of 2023.

We believe we are still some time away from the Fed conceding and pivoting to a more dovish stance. A weakening of inflation and job data would be an important signal to increase duration in fixed income investing and perhaps start to dial up allocation in risk assets such as U.S. equities and U.S. high yield corporate credits.

In the euro area, a warm winter allowed the economy to avoid fuel shortages and the subsequent damage to the economy. The economic bloc managed to avoid a recession in 4Q 2022, which gives the European Central Bank more confidence to deploy its monetary policy to cool prices. The Bank of Japan (BoJ) is scheduled to have a new governor in March, and the government has nominated Kazuo Ueda, an academic. It seems that continuity is still the focus for the new BoJ leadership. However, with inflation climbing and the central bank’s Yield Curve Control (YCC) policy leading to considerable distortions in the government bond market, coming months could be a good opportunity to review and revise YCC. The key would be adequate communication with investors to avoid surprises.

The low hanging fruits are plucked in China’s recovery story

China’s COVID policy was quickly relaxed in late 2022, with a sharp increase in infections around the country. Now the domestic economy is starting its recovery process. High-frequency traffic data, such as subway passengers and domestic flights, are showing a solid rebound, returning to pre-pandemic levels. Anecdotal evidence also shows that food and beverage, tourism and luxury items are enjoying a robust recovery.

This should help economic growth in 1Q 2023 as we approach the National People’s Congress. Chinese President Xi Jinping will unveil his new core team, including a new premier, widely expected to be Li Qiang, Shanghai’s Party Secretary. The government is also expected to maintain loose monetary policy to facilitate economic recovery. While it is relatively straightforward to boost day-to-day consumption, reviving private corporate investment and residential real estate will take more effort.

Geopolitical uncertainties between the U.S. and China and the pace of economic recovery may persuade companies to be more cautious in making new investments. There are sectors and industries that could receive more policy support, such as renewable energy and advanced manufacturing, as well as those making an effort to reduce dependence on imported technology products. For the real estate sector, policy support has been gradually stepped up in recent quarters. Yet, a determinant of buyers’ sentiment would be the expectation of return from real estate. If the government remains firm on its objective to limit price increases to improve overall affordability, investors may choose other financial assets that could provide better potential returns. This would allow for only a gradual recovery in the real estate market.

Investment implications

Some of the expectations on inflation and policies are being pushed back. Instead of the Fed’s hiking cycle ends in 1Q, it seems we could have a couple more 25bps rate hikes in 2Q. This also means our preference for fixed income over equities would be extended by a few months as well. With the Fed still looking to cool growth to curb price pressure, the risk of recession remains. This continues to point toward high-quality U.S. fixed income (short-duration government bonds, mortgage-backed securities and investment-grade corporate debt) instead of high yield bonds. On equities, quality companies with stable earnings and greater resilience toward an economic downturn are preferred. 

Outside of the U.S., Asian and Chinese equities should still benefit from a rebound in domestic growth momentum, even though the export outlook will remain challenging for the coming months. Export-oriented markets, such as Taiwan and South Korea, have already seen substantial earnings downgrades and valuation de-ratings. This should help to contain the downside risks of these markets. However, their rebound is also dependent on the global consumption and capex cycle rebounding. Following a sharp rebound in Chinese equities, we could see a near-term consolidation. Catalysts for another rally could come from solid economic data, as well as additional economic stimulus to support the recovery and further clarification on Beijing’s industrial policy nurturing sectors on the rise.

Another medium catalyst supporting Asian equities and fixed income would be a weaker U.S. dollar (USD). A hawkish Fed should support the USD in the coming 2-3 months. Yet, expensive USD valuation and Asian outperformance relative to the U.S. economy should pressure the USD weaker and prompt more capital inflows into the region.

Global economy:

• U.S. economic data releases during February came in strong while inflation data continued to ease. The U.S. labor market continued to be tight, with the unemployment rate declining from 3.6% to 3.4%. Non-farm payrolls beat estimates by a significant margin, increasing by more than 300,000 compared to the previous month. U.S. Markit Manufacturing and Services February PMI gained, with manufacturing PMI remaining below 50 but services moving beyond. U.S. CPI declined from 6.5% (year-over-year) y/y in December to 6.4% y/y in January.
  (GTMA P. 22, 27)
• In Europe, recession concerns continued to subside. The Markit Manufacturing Purchasing Managers’ Index (PMI) declined from 48.8 to 48.5, while Services PMI increased from 50.8 to 53.0. Eurozone headline inflation eased from 9.2% y/y to 8.5% y/y in January, while the unemployment rate increased from 6.5% to 6.6%. In China, mobility and economic activity continued to pick up. The Caixin Manufacturing PMI rose from 49.2 to 51.6.
  (GTMA P. 13)
• Central banks continued to tighten in February. The Fed raised the federal funds rate by 25bps. The European Central Bank raised its refinance rate by 50bps, while the Bank of England also increased its bank rate by 50bps. The BoJ nominated Kazuo Ueda as its next governor.
  (GTMA P. 19, 21)

Equities:

• Equity markets sold off in February, driven by a significant re-pricing in policy rates. MSCI World declined 3%, with MSCI U.S. falling 2.6% and MSCI Europe falling 0.8%. Asian equities underperformed on a relative basis, with MSCI Asia Pacific declining 3%, led by a 9.4% decline in Hong Kong’s Hang Seng Index and 10.4% decline in MSCI China. Onshore Chinese equities fared better, staying flat in February at 0.7%. Taiwan equities outperformed, returning 1.6%.
  (GTMA P. 32-34, 37)
• From a sector perspective, growth stocks pulled back but continued their outperformance over value in February despite rising yields. The MSCI World information technology sector outperformed, returning 0.1%, while energy, communication services and utilities underperformed, declining more than 4%.
  (GTMA P. 36)

Fixed income:

• Driven by stubborn inflation and expectations of higher-for-longer interest rates, bond markets had a difficult month, reversing much of the global bond rally seen in January. Yields for U.S. 10-year Treasuries and UK 10-year Gilts surged 39bps and 38bps, respectively. Notably, at end-February, the U.S. 10-year Treasury yield briefly hit 4% for the first time since November 2022. The 2-year yield rose even more to reach nearly 4.9%, causing the yield curve to invert the most since October 1981.
  (GTMA P. 54)
• In Japan, after the appointment of Ueda as the next BoJ governor, investors sold bonds in expectation of an end to the ultra-loose monetary policy, with the 10-year Japanese government bond yields testing the upper limit multiple times and ending the month right at 0.5%.
• Fixed income fell across the board in February, with the Bloomberg Global Aggregate index falling 4.02%. Emerging market local currency debt underperformed by falling 8.27%. U.S. investment-grade and high yield bond option-adjusted spreads both fell in early February, before respectively ending February 10bps and 28bps, respectively, higher than the monthly bottom.
  (GTMA P. 49, 51, 53)

Other assets:

• The USD strengthened 3% in February after the hawkish repricing in U.S. rates, reversing much of the losses recorded since 4Q22. However, the effect was partially offset by rates outside the U.S. also being repriced higher. The euro and sterling fell modestly by 2.2% and 2.0%, respectively, while Asian currencies depreciated more. For example, the Thai baht fell 7.0%, Korean won fell 6.9% and Australian dollar fell 4.9%. The Chinese yuan slipped to a 2-month low against the USD, approaching the psychologically key 7 per USD mark. The Japanese yen jumped initially on Ueda’s nomination, but after news of softer Tokyo inflation and expectations that Ueda will not reverse policy soon, it remained weak and fell 4.6% against the USD in February.
  (GTMA P. 65, 66)
• February was a tough month for commodities, pressured by a strong USD, with the Dow Jones Commodity Index falling 4.9%. Warmer-than-expected weather in the U.S. while supply remained stable caused West Texas Intermediate crude oil to drop 3.4%. Despite China’s re-opening, the recovery in industrial metal demand remained muted, causing the S&P GSCI Industrial Metals index to fall 7.82%. Gold reversed much of its gains in January, falling 5.1% in February.
  (GTMA P. 68, 69)

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