What's happening? ??

Financial markets sold off sharply during September?as the US Fed reiterated its commitment to fight rising inflation, and as Europe heads into recession amid a major escalation in the Ukraine-Russia war. All asset classes except the US dollar underperformed. The S&P 500, Nasdaq and the MSCI All Country Index dropped -10% while China erased -14%. Oil, Commodities and Gold dropped -9%, -7% and -3% respectively. The 10-year treasury yield rose 0.6% to 3.76%. The USD appreciated 3% versus major currencies.?

Why is the US Dollar so strong? In a flight to allocate money into “safe” assets over the past month and with the objective of safeguarding investments, investors switched allocations from risky assets including stocks, bonds and other currencies, into safer assets such as USD and US short term treasuries that pay 3% interest. The USD broke parity versus the EUR now trading at 0.98 EUR per one USD. The strengthening of the USD came mainly on the back of the US Fed acting faster than other central banks in increasing interest rates. USD short-term deposits are paying 3% vs 1.25% for short term EUR deposits. Moreover, the US economy is looking more resilient to navigate low growth and high inflation than that of Europe, China, and Japan. We expect the USD to remain strong for the short term. However, the USD strengthening might reverse as the US Fed reaches the end of a “high rate” cycle and as the rest of the Central Banks catch up with the Fed’s hiking cycle.?

Figure 1.?Investors sold off risk assets and safeguarded in the USD

Inflation remains elevated and is broadening beyond food and energy.?US core inflation, which excludes food and energy, accelerated to 6.3% year-over-year in August from 5.9% in July. Highly volatile food and energy inflation accelerated 11% and 24% year-over-year. What is concerning is that inflation is broadening beyond food and energy. Shelter rose 6.2%, accounting for about 40% of the total increase in all items excluding food and energy. Other categories with notable increases include household furnishings and operations (+9.9%), medical care (+5.4%), new vehicles (+10.1%), and used cars and trucks (+7.8%).?

Nevertheless, inflation expectations are falling sharply.?Consumers surveyed by the New York’s Fed believe inflation will fall to 2.8% in three years. And the price of Treasury Inflation Protected Securities (TIPS) has been plummeting as the Fed hikes rates. This suggests that consumers and markets believe that the US Fed will be successful in cooling off inflation.

Figure 2.?Inflation expectations are falling sharply suggesting that consumers and markets believe the US Fed will be successful in cooling off inflation

How far along is the Fed from shifting their monetary policy strategy??During the September meeting, the US Fed increased the federal fund rate to 3.1% from 2.3%. The US Fed reiterated a strong commitment to move its policy purposefully to a level sufficiently restrictive aiming to return inflation to 2% target, not only by increasing rates, but also by significantly reducing the size of its balance sheet. Over the following months the US Fed will be looking for compelling evidence that inflation is on the way to return to its 2% objective to shift their policy stance. In the next few months, the Fed might slow the pace of increases but won’t stop until the job of bringing inflation down to target is done. This would entail higher rates for a long period of time.. The market –reflected in the Fed Fund Futures– is now expecting the Fed to increase rates to 4.5% by April 2023 from 3.8% a month ago. The US Fed monetary policy meeting participants expect the federal funds rate to be at 4.25% by December 2022, 4.75% by December 2023 and 2.5% in the longer run.

Figure 3.?The US Fed interest rate is projected to stay high for a long period of time. When market expectations on monetary policy change markets selloff

Small corporates cost to borrow money is rising fast as banks are becoming more concerned corporates might go bust thus requiring higher interest rates. The high yield spread, measured as the cost to borrow funds on top of the risk-free rate, is now at 9.5% well above the 8% long term average and close to the COVID crisis peak of 11%. The high yield spread rising fast and breaching the long-term average suggests that banks and investors are turning increasingly negative on economic expectations for the future to come. It is serving as a leading indicator of an economic recession.

Figure 4.?The cost to borrow for small corporates is rising fast meaning investors are turning increasingly negative on economic expectations

Economic conditions in China are weakening.?Chinese property market sales are contracting 35% year-over-year, similar to the declines seen in July and August. Consumption has decelerated from COVID-related restrictions, and exports have slowed amid a weaker global economy. All these factors explain the underperformance of Chinese equities. The path to recovery seems a long way to go and we would need to see a stable property market, additional fiscal measures to support the economy and relaxation to COVID-related restrictions to turn more positive on Chinese equities.

Great investment opportunities emerge when markets reach extreme pessimism levels. Europe might have to endure a long winter with high gas prices during times of war, China will have to stabilise a property market crisis and the US might have to absorb an economic recession. Most risk asset classes have sold off heavily and have reached levels of two standard deviations away from the mean. In this incredibly difficult environment great opportunities arise. Resilient companies with strong cash flow generation, a durable competitive advantage and high growth prospects. Such companies will navigate through economic environments successfully and will sail stronger once the storm has passed.

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Best wishes,

Pedro Cabrero