Addressing the three peaks

In brief

• China’s COVID-19 outbreak is coming under control, allowing for a rebound in 3Q 2022 with strong stimulus support
• Inflation may be peaking in the U.S., but the path of decline could take longer than the Fed hopes
• There is scope for both equities and fixed income to catch up after a challenging 1H 2022. Volatility and the late U.S. economic cycle mean investors should focus on quality 

In the past few months, market performance has been very difficult and we have been waiting for some signposts that should allow investors to feel less pessimistic. These could simply be described as the three peaks, which include the peaking of inflation in the U.S., peaking of infection numbers in China, especially Shanghai, and the peaking of energy and food prices globally. 

The good news is that two of these three peaks have been reached. While this does not guarantee it will bring immediate joy, market sentiment did improve in the second half of May.

China: Need to reheat the economy

The number of COVID-19 daily infection numbers has declined sharply. This allowed the reopening of Shanghai on June 1. As lockdowns in various cities are relaxed, the government is turning up the macroeconomic stimulus. There is the need to protect small and medium enterprises, a key source of employment. Tax cuts, loan facilities and deferral of social security payments should provide some support. In addition, public spending on infrastructure, including on transportation and renewable energy, should offer an additional boost to the economy. We still believe the 2022 economic growth target of 5.5% will be hard to achieve. Nonetheless, May Purchasing Managers’ Index (PMI) data shows that the trough of the economic downturn is behind us. A robust recovery in 2H 2022 should still set an upbeat tone as we approach the 20^th Party Congress in November. 

On top of fiscal and monetary stimulus, the authorities would also need to boost consumer and business confidence. This could be achieved by adopting a more pragmatic approach on future lockdowns while maintaining the zero-COVID-19 strategy. Enhanced protection from higher vaccination rates and progress in treating COVID-19 could also allow the Chinese authorities to be less stringent in containing the pandemic. 

U.S.: Need to cool things down (but not too much)

The Federal Reserve (Fed) is rightfully concerned about inflation, and reducing price pressure is its top priority. There is good news and bad news. 

A piece of good news is that year-over-year (y/y) inflation has most likely peaked. It fell to 8.3% in April from 8.5% in March. This was largely expected considering the high base set in 2021. However, the bad news is that month-over-month (m/m) momentum in price increases is still strong, at 0.6% in April, and significantly above the 10-year average of 0.2%. 

In terms of the drivers of inflation, the good news is that the impact from higher oil and food prices should fade in the coming months. However, the bad news is that there are other areas where inflation could be more stubborn to come down. Housing costs, especially rent, are usually sticky. The job market in the U.S. is also hot, with strong labor in the services sector. Employers need to raise wages to attract new hires or to retain existing workers. These businesses may need to pass these higher costs to customers, which could fuel inflation. 

While the Fed can’t do much about food and energy prices, higher interest rates can help to cool the housing market and overall demand in the economy. Global investors are widely expecting the Fed to raise interest rates by half a percentage in its June and July meetings, then move to a more modest 25 basis points for the rest of the year and early 2023. Even as the Fed is now laser-focused on controlling inflation, we still think it will avoid pushing the economy into a recession. Provided the central bank does not turn much more aggressive relative to this expectation, we should see calmer markets in 2H 2022. 

Food and energy prices: A challenge for low-income households

One area where we have yet to see a clear peak is food and energy prices. Having hit above USD 125 per barrel in the early days of the Russia-Ukraine conflict and returned to USD 100, Brent crude has been rising steadily again through May in response to tightening European sanctions against Russian oil exports. OPEC’s pledge to increase output has yet to show a clear impact on calming the market. The economic recovery from Asia could push demand up further and keep the price pressure high. 

Food prices have also seen a strong rise in recent months. Food prices are usually closely linked to energy prices because of transportation and fertilizer costs that go into food production and distribution. The Russia-Ukraine conflict also had an impact on the supply of grains and vegetable oils, which have seen the steepest rise in prices compared with a year ago. The price index compiled by the United Nations Food and Agricultural Organization has seen a modest drop in May versus March and April, but it is still 23% higher than a year ago. Meanwhile, some countries, such as Indonesia and India, have limited selected agricultural exports to protect domestic supply, and this could disrupt global supply and exacerbate price volatility.

This is hurting consumers around the world, especially for the lower income group where a higher proportion of household income is spent on food and fuel. Governments are expected to deploy fiscal policy to offset some of this impact. Yet this could still be a threat to discretionary consumption as well as corporate profitability for companies that are dependent on food and fuel as input. 

Investment implication

The challenges from inflation and the Chinese economic slowdown have not completely disappeared, but there are some improvements that should help investors to be less pessimistic. Over the next several quarters, the U.S. economy is likely to transition from mid to late cycle. Historical analysis shows that risk assets, such as equities and corporate credits, can still deliver return to investors in the late cycle. Combining with more appealing valuations in equities and corporate bonds, we believe investors should not be too defensive as we approach the second half of 2022. It still makes sense for investors to maintain a balanced portfolio of stocks and bonds. There should also be a greater emphasis on quality in corporate fundamentals in preparing for volatility to stay elevated. 

For the U.S., ongoing monetary tightening means equity returns are likely to be derived from earnings growth, instead of valuation re-rating. Economic growth and 1Q earnings results imply this is still very much alive, but there are some pressures building on profit margins. Economic recovery and economic stimulus should provide more support to market sentiment in China. Additional growth engines in Asia in the form of domestic demand and the services sector should also be positive. 

For fixed income, a surge in risk-free rates and wider credit spreads have once again made fixed income appealing, both in generating return and providing diversification benefits. Investment grade corporate debt strikes a good balance in meeting these two objectives. Emerging market fixed income is also a good candidate when the U.S. dollar uptrend starts to stabilize. 

Global economy:

• In the U.S., inflation moderated slightly in April, rising 8.3% y/y, down from 8.5% y/y in March. On a sequential basis, CPI slowed to 0.3% m/m as surging energy and food prices abated. Despite a continued tight labor market, May saw solid jobs growth, with the U.S. economy adding 390,000 jobs. The unemployment rate held steady at 3.6%. Wage growth moderated slightly, rising 5.2% on an annualized basis in May, down from 5.5% in April. There continues to be roughly 1.9 jobs per unemployed worker.
  (GTMA P. 25, 26)
• Economic data was weak in China in April as COVID-19 weighed on consumption and manufacturing activity. Industrial production declined 7.0% m/m, while retail sales fell 9.9% m/m. That said, toward the latter end of May, the decline in COVID-19 cases and re-opening of Shanghai saw manufacturing and services PMI improve sequentially to 48.1 and 41.4, respectively. We also saw increased signaling for further policy easing to help prop up China’s economic growth over the coming quarter.
  (GTMA P. 6, 7)
• Global central banks tightened monetary policy in May. The May Federal Open Market Committee (FOMC) meeting saw the Fed hike rates by 50bps. The Bank of Australia hiked rates by 25bps. The Bank of England hiked its bank rate by 50bps. On the other hand, China cuts its 5-year loan prime rate by 15bps.
  (GTMA P. 18)

Equities:

• Equity returns were relatively flat in May. From a regional perspective, Asian equities outperformed. MSCI Japan returned 1.9%, while improving COVID-19 sentiment and policy easing signals saw China’s Shanghai Composite Index up 4.6%, after two consecutive months of declines. ASEAN equity performance skewed to the downside in May, Singapore’s FTSE Straits Times Index was down 3.7% while Malaysia’s FTSE Bursa KLCI Index lost 1.9%. DM equity performance was flat in May, with MSCI U.S. up 0.4% and MSCI Europe returning 0.05%. From a sector perspective, Energy continued its outperformance in May, with the Energy sector within MSCI World returning 10.8% in May. Defensive sectors such as Utilities also held up relatively well, rising 1.9%. Meanwhile, sectors such as Consumer Discretionary, Consumer Staples and Real Estate underperformed, falling more than 3.0%.

Fixed income:

• Following the FOMC meeting in May, the U.S. Treasury yield curve steepened slightly, with rate differentials between 10-year and 2-year Treasury bond yields widening from 19 bps to 30 bps. 10-year U.S. Treasury yields moved back below 3%, ending the month at 2.84%.
  (GTMA P. 29)
• Fixed income performed better relative to prior months as U.S. Treasury yields pulled back marginally in May. U.S. Treasury and high yields both returned 0.2%. U.S. investment grades fared well, returning 0.9%. EM high yield underperformed. Asia high yield returns declined 2.8% in May.
  (GTMA P. 51)

Other assets:

• Developed market currencies appreciated against the U.S. dollar across the board as rate differentials widened relative to U.S. Treasury yields. In particular, the euro and the Australian dollar gained 1.8% and 1.6%, respectively, against the green back in May. Several emerging market currencies continued to strengthen off the back of their central bank’s tightening. Most notably, the Mexican peso and Brazilian real rose 3.9% and 5.0%, respectively, against the U.S. dollar. Chinese yuan fell 1.0%, while the Japanese yen gained 0.7%.
  (GTMA P. 69)
• Commodity prices continued to gain modestly in May, with the Bloomberg Commodity price index rising 1.4%. The price of WTI crude rose 9.4% in May. Wheat prices moderated, rising 3.0%. Gold prices declined 3.6%.
  (GTMA P. 71–73)