Central banks’ hawkish messages, ignored by markets in recent weeks, are starting to sink in. Policy rates at the Fed, ECB, and RBA are likely to go higher than what markets were pricing and, crucially, likely to stay there for longer than markets were anticipating. The blowout US jobs and services business confidence (PMI) indicators, while accentuated by seasonality, were the triggers for the latest repricing of rates, which also led to a mild pullback in risk assets and a rebound in bond yields.
We believe the strong rally in risk assets in recent months has overpriced the improvement in global fundamentals (as Europe averted widespread energy shortages due to a mild winter and China’s economy reopened earlier-than-expected). Risk assets are likely to face headwinds from tightening real (inflation-adjusted) policy rates and weakening economic and corporate earnings fundamentals. Hence, we would continue to fade the rally in risk assets and gradually rebalance into higher-quality bonds and other income assets. Better opportunities in riskier assets are likely to arise when core inflation and wages decline sustainably (watch core services, ex-housing inflation in next week’s US data) or the job market deteriorates sharply, allowing central banks to cut rates and focus on supporting growth.
US government bond yields have jumped more than 30bps and the USD has bounced since the January US jobs report, which saw payroll gains nearly three times consensus estimates. While average weekly wage growth moderated to 4.4% y/y, aggregate weekly payrolls (payrolls x hours x earnings) jumped in January, reversing past year’s trend. Separately, US services PMI (ISM) rebounded strongly from contraction territory (55.2), driven by a surge in new orders (60.4), new export orders (59.0) and business activity (60.4). Taken together, the data points to a still-robust economy, driven by services consumption.
This incoming data explains why Fed Chair Powell and other policymakers highlighted the need for continuing with monetary tightening and holding rates restrictive for a long period of time (New York Fed President Williams this week said he expects to keep rates restrictive “for a few years” to bring inflation back to 2%). Similarly, ECB officials warned they are a long way off from pausing rate hikes, given a more challenging inflationary backdrop (especially core inflation) than the US.
While central banks remain hawkish due to inflation concerns, other US leading indicators, especially in the manufacturing and housing sectors, are deteriorating. These include declines in the job quits-to-layoffs ratio from very high levels, manufacturing sector inventories growing faster than new orders, orders backlog shrinking, building permits contracting, persistent inversion of the US government bond yield curve, rising auto loan defaults and a contraction in money supply. The latest Fed loan officers’ survey too pointed to flagging demand for loans and tightening lending conditions at banks.
Investment implications: Given the combination of strong services sector, a weakening manufacturing sector, elevated wage pressures and hawkish central banks, we expect headwinds for corporate earnings and valuations. As a result: a) We would trim any overweight allocations in US, Euro area equities (we retain a Neutral weight in both those markets within equities) – the S&P500 index has broken below the 4,100 technical support level, raising the risk of declines towards the next supports (4,015 and 3,886). The EuroStoxx 50 index is approaching key resistance levels around 4,288 and 4,396; b) Equity investors may consider rotating into Hong Kong and China equities, particularly if the Hang Seng index reaches key support levels at 20,300 and 19,300; c) More broadly, we would rebalance from equities to an income basket, which now offers better yields. For those looking for better entry levels – the next key resistance levels for US 10-year yield are 3.7% and 3.9%. Asia USD bonds remain our preferred area in bonds as spreads continue to tighten amid China’s improving growth outlook.
Rajat Bhattacharya- Standard Chartered
