Markets Weekly podcast - 28 November 2022
28 November 2022
Where next for global interest rates? Join host and Market Strategist Henk Potts as he reflects on the US Federal Reserve and the Bank of England’s most recent efforts to tackle inflation. He’s in conversation with Julien Lafargue, our Chief Market Strategist, who looks ahead to 2023 and discusses the potential risks and opportunities for investors.
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Henk Potts (HP): Hello. It’s Monday, 28th November and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.
My name is Henk Potts, Market Strategist with Barclays Private Bank. Each week, I’ll be joined by guests to discuss both risks and opportunities for investors.
Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then discuss how investors should be positioned for next year. And, finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.
The positive trajectory for equity markets continued last week, on growing expectations the Federal Reserve will ease the pace of rate hikes and marginally better-than-expected Europe economic data.
The rally in risk assets continued despite a ramping up of COVID restrictions in China. In terms of equity market performance, the S&P 500 was up 1.5% over the course of a shortened trading week, with the index hitting its highest level since early September. The STOXX 600 rose 1.7% during the course of last week. In fact, European stocks have now registered six straight weeks of gains. That’s for the first time since November 2021. The benchmark index is now up 15% from the September low.
The softer tone around US rates weakened the dollar and pushed Treasury yields lower, all of which has been positive for gold. Gold finished the week around $1,750 an ounce and has rallied more than 8% during the course of this month.
The Federal Reserve’s November minutes and post-meeting press conference, delivered to markets the slower, but slightly higher, rates message. The statement highlighted a substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate, while the press conference chair, Jerome Powell, said that rates will probably ultimately go higher than officials’ September forecast indicated.
The staff’s economic outlook revised down their output projections and warned officials their assessment of the risk of a recession had now grown to almost 50:50.
So, what do we take away from the minutes in the meeting? Well, the FOMC are, indeed, determined to raise rates to counter the uncomfortable high levels of inflation and tight labour market. The scale of the rate hike in December will likely be stepped down to 50-basis points versus the bumper 75-basis points that we’ve seen at the previous four meetings. The peak rate still looks set to be 5% to 5.25% at the end of the first quarter next year.
In the UK, we now believe that persistent inflation, a very tight labour market, strong wage growth, and limited near-term fiscal timing will encourage the MPC to implement a longer and tighter heightening cycle, despite the significant deterioration in activity and inevitable recession. Inflation looks set to remain elevated, in fact, averaging 7.9% during the course of 2023 in the UK, and not falling below that 2% target level till the end of 2024.
In terms of the policy outlook, we continue to expect a 50-basis points increase in the bank rate in December and about a 50-basis point hike in February, and a further 25-basis points in March, taking the terminal rate to 4.25% in the first quarter of next year.
China’s strategy of unwavering commitment to zero COVID, combined with mild policy support, was in evidence once again last week. On COVID commitment, major cities were once again subjected to increased controls, resulting in, as we’ve seen over the course of the weekend, significant social unrest. Large parts of Beijing, for example, which, remember, is a city of 22 million people, were placed into targeted lockdowns.
As the number of new infections surged, schools were closed, apartment blocks were sealed off, cinemas and shopping malls were locked. Some public parks’ capacity was reduced to 50%. The restrictions were enforced despite officials rolling out new COVID protocols, which seek to reduce the intensity of testing regimes, periods of quarantine, and travel rules.
Meanwhile, China’s also trying to improve its ability to cope with COVID by increasing its health resources, including increasing hospital beds, promoting vaccine usage, and through the stockpiling of medicines and equipment to try and treat the disease.
Increasingly conscious of the depth and the breadth of the economic weakness, officials continue to gradually ease policy. On Friday, the People’s Bank of China reduced the reserve requirement ratio by a further 25 basis points. The move increases long-term liquidity and encourages banks to lend.
In terms of the impact, well, even if the new COVID playbook was fully adopted and piecemeal policy support continues, any improvement in its growth prospects will at best be marginal. To materially change its near-term growth profile, China needs to abandon its zero-COVID strategy, something that still looks very unlikely given the low vaccination rates, particularly amongst the elderly, the low efficacy rate of the domestically produced vaccine, and an inability of the health service to cope with the high numbers of cases.
In terms of market reaction, well, pretty muted it has to be said. The Hang Seng is down around about 1.5% today. Commodities have come off. If you look at Brent crude, for example, it’s down 2.7%, now trading at $81.34 a barrel.
In Europe, investors are bracing themselves for yet another set of miserable economic indicators. In the event, the eurozone purchasing managers’ index did show that business activity fell for a fifth-straight month, but the intensity of a downturn moderated to 47.8 in November, compared to 47.3 in October, helped by a reduced rate of loss of new business, fewer supply constraints, and a small increase in business sentiment, although the improvement, we should remember, is from a very low base and demand continues to decline at a rapid rate.
On the positive side, price pressures have started to ease. Firms’ costs rose at the slowest rate in 14 months, according to the report. We maintain a pessimistic view of eurozone growth through the course of next year, based on energy security concerns, weaker domestic demand, slow industrial output, and reduced levels of investment. We forecast the euro area will contract by eight-tenths of 1% during the course of 2023.
So, that was the global economy and financial markets last week. In order to discuss how investors should be positioned for 2023 and beyond, I’m pleased to be joined by Julien Lafargue, Chief Market Strategist at Barclays Private Bank.
Julien, great to have you with us today. As we know, it’s been a turbulent year for the global economy and certainly a rough ride for investors. Before we look into 2023, I wanted you to share some of your key takeaways from 2022 so far.
Julien Lafargue (JL): Well, if we look at 2022, I think the main message that we got, looking at the performance of various assets and asset classes, is that there was really nowhere to hide and, in fact, if you look at the major asset classes, the only two that posted positive absolute returns were cash, and you probably made around 1% in dollar terms over the year so far, and commodities, where returns were actually quite strong, close to 20% in dollar terms.
But, realistically, I don’t think anybody had a portfolio made solely of commodities, and other asset classes, which tend to be represented in most people’s portfolio, namely stocks and bonds, have suffered quite significantly in 2022.
So, I would suspect that most people have experienced a very difficult year, and the reason why the year was so difficult is because of the massive shift that we’ve seen in terms of central bank policies. If we had recorded this podcast a year ago, I would have said, well, looking into 2022 the Fed is expecting to increase interest rates maybe once or twice, and the reality is they’re on par to increase rates by 17 times at least, if you’re thinking about 25-basis point increments.
So, we’ve seen that sea-change and that’s not at the Fed level only. If you look at central banks globally, you’re really seeing this wave of cuts in 2019, 2020 with COVID-19, being followed in late 2021 and early 2022 by an equally impressive wave of hikes, and that has completely changed the backdrop for investors and has led both stocks and bonds to perform very poorly, so poorly, in fact, that it’s one of the worst years for a 60:40 portfolio that we’ve ever seen in the past, you know, 30 years or so.
Now, the good news is that inflation, which has been the main reason why those central banks have been trying to hike rates as fast as they have, inflation is starting to come down, especially in the US. We have the leading indicator pointing to the fact that this trend should continue in 2023. Unfortunately, in the US, in particular, the job market remains too hot, and so this hiking process is probably going to continue at least into the beginning of 2023.
HP: OK. So, let’s start thinking about the future. What are your main messages for investors going into next year?
JL: I think that the four main messages that we want to give to investors as they prepare for 2023 is that, well, first, from a macroeconomic standpoint, and you’ve covered that in many podcasts previously, clearly a recession in Europe and in the UK, and possibly in the US, is likely, more likely than not, in fact.
The UK is probably the economy that’s going to be most challenged. Europe is not going to be far behind. The US, we’ll see if we see a recession, but probably growth is going to be roughly flat, at least that’s our expectation at the moment. So, we should be prepared for a scenario of a much-deteriorated macroeconomic landscape.
The second message is that fixed income, this asset class that really nobody wanted to talk about for the past maybe five or 10 years, simply because there was not much to be gained in terms of yield, in particular, and well this asset class, in our opinion, is back and interesting again, simply because of the massive repricing in terms of interest rates that we discussed previously.
The third message, I think, is the fact that volatility, which has been a key feature of 2022 so far, this volatility we don’t think is going away any time soon, and so that brings me to the fourth point, which is it’s very important for investors that look into next year to think about selectivity, what they want to own, as well as composure, the fact that they will need to have a very strong mind and will, in order to go through these volatile times and keep in mind their long-term goals.
HP: Julien, if fixed income is interesting again, where do you see the opportunities in this space?
JL: Well, I think first and foremost, we believe investors should start, what we say, locking in yields. What do we mean by that? Well, we don’t think this environment of higher yields is necessarily going to last forever. It could last for a while, but it’s unlikely to be sustained over a very, very long period of time, and, therefore, from a bond perspective and from a yield perspective, we think that the entry point that we’re getting today is quite interesting.
When you have a US 10-year government bond that yields between 3.5% and 4% at the moment, if you can lock that in for the next 10 years, it’s not a bad trade, or at least it’s a much better trade than locking that yield at 1% a few months back. So, very happy to be locking in those deals at this point in time.
Now, in terms of allocation within the fixed income markets, we remain more comfortable with the investment grade space, the higher-quality credit. This is because when we compare the yield that you can achieve in this segment of the market, we find them very attractive already, and spreads have somewhat widened to levels that we feel reflect the uncertainty that we continue to have, thinking about the macroeconomic outlook for 2023. And, this is not, at least in our view, this is not really the case thinking about the high yield space.
Of course, at face value, high yield looks very interesting. You can get upward of 9% in terms of yield, but the reality is you get this yield simply because the government bond yield has gone up quite substantially as well, so your actual spread is closer to maybe 500-basis points, 5%.
And, this is really very average, and it doesn’t account for the fact that, as we discussed, we may see recessions in part of the world and, therefore, some deterioration in terms of company fundamentals, and so we would like to get paid a bit more to take that extra risk with credits that are, obviously because they are high yield, probably a bit more dangerous or at risk when it comes to repayment and the challenges that those companies may face.
So, we would stick on the higher-quality side of the spectrum when it comes to fixed income as we go into 2023. And, when it comes to emerging markets, I think this is also a part where at this point in time there might be too much uncertainty for us to feel really comfortable, but we do think that it could be an attractive place to look at as we move along into 2023 and maybe the Fed stops hiking rates.
HP: OK. So, there are some clear opportunities in fixed income. What about equities? Do you feel there is upside potential for stocks during the course of 2023?
JL: Well, again, I think it’s important to think about the short term versus the longer term. In the short term, it’s fair to say that we think equities could be challenged for a couple of reasons.
One, because although the valuation repricing is largely behind us, we feel that there is still this uncertainty about the earnings side of the equation and whether we’re going to see, we’re probably going to see them, but how significant are they going to be, the earnings revision, the negative earnings revision, that we expect. The consensus is still expecting companies to be delivering roughly flat-to-slightly-negative earnings growth in 2023, and, of course, if we do see recessions, we could see downside to those numbers and until we have more clarity around that, equities are likely to remain challenged.
The other reason why equities may have a slightly tougher time in the short term, is because, while we just discussed with the fixed income space and there is now an alternative, and investors may be asking themselves, why would I take, you know, a risk in investing in equities when I can take much less risk by investing in high-quality credit instruments that would yield 6%, 7% even in some cases? So, until we get more clarity around the shape and the length of the upcoming recession, we think equities could be a bit challenged.
Now, longer term, though, the picture I think is much more attractive for equities, simply because the underperformance that we’ve seen year to date, which, again, has been mostly driven by valuations, made the entry point very interesting for longer-term investors.
One way to look at that is to look at the historical relationship between valuations at entry point, and for that we use what we call the cyclically-adjusted-price-to-earnings ratio and compare that with the next 10-year return that you would have achieved historically. And, at the beginning of the year, this measure was telling us basically that over the next 10 years, we could expect global equities to return, dividend included, around 6%, maybe 6.5%, per annum, which is very average.
Now, today, that number has gone up to 9% or more. So, if you invest today in equities and you have a long enough time horizon, you could expect that investment to generate a return of around 9%, which is very attractive. So, if you are a long-term investor, equities are actually quite attractive at this point in time.
Now, the last point I wanted to make is around where do we see the opportunities in stocks specifically, and we really see three main dislocations. One is in the banking sector, simply because this sector has lag. Quite significantly, the improvement we’ve seen, in terms of rates, is typically banking stocks and rates move hand in hand and that hasn’t been the case in 2022.
And, one reason for that, we feel, is simply because the market is worried about potential credit events and deterioration in the lending book of those banks. Those concerns are valid, but if, as we expect, recessions, whether it’s in Europe, UK, or US, are relatively mild, by a straightforward standard, and short-lived, then we shouldn’t see that much credit deterioration and, therefore, the gap that has opened between the performance of banks and rates should close.
The second sector is the energy sector, which has done fantastically well this year, but if you zoom out and you look at the performance of that sector over a long-term lens, you can see that basically, in terms of relative performance, the energy sector is back where it was in 1998.
In other words, if you had invested back then, you would have done exactly the same performance that the market has done and that is at odds with the massive improvement that we’ve seen in the fundamentals of those companies most recently. Obviously, the surge in oil prices has been very helpful, but earnings have gone up and they are almost back to where they were in the previous oil peak, and stocks, as I’ve said, haven’t really followed that. So, we think this is a dislocation that will be, or should be, resolved in 2023.
And, broadly speaking, energy stocks are good things to have in a portfolio in case you want some protection or hedge against inflationary pressure.
And, lastly, maybe more from a geographical standpoint, one market that we think investors should be taking a look at is the UK market, and I’ve talked about the fact, and you’ve talked about the fact, that the UK economy is, you know, facing many, many different challenges.
But, the reality is nobody is really buying GDP when they invest, they’re buying stocks or bonds, and we can ignore, to some degree, what’s happening at the domestic level when we look at especially large-cap UK equities which tend to be exporter driven. They have a lot of the characteristics that we’re looking for. They also have over-representation in terms of banks, energy stocks as well. So, all that makes it a good fit to our broad view, and they are extremely cheap compared to their own history and compared to the rest of the world.
HP: Well, thank you Julien for your insights today. As you’ve highlighted, it may be a difficult economic backdrop during the course of next year, but there’s still plenty of opportunities for investors to take advantage of.
Let’s move on to the week ahead, where the focus will be on November’s eurozone inflation report on Wednesday, where we look for CPI to print at plus two-tenths of 1% month on month, or 10.4% year on year, which would actually represent a slight deceleration from October’s 10.6%, driven by energy disinflation, weaker oil and gas prices, and adverse base effects, though we expect food inflation to maintain its strong momentum.
In the US, investors will await Friday’s nonfarm payroll and employment report, where we expect the US economy to have created 175,000 jobs in November, following October’s 261,000 gain. We expect the unemployment rate to cut to 3.8%, look for average earnings to hold steady at plus three-tenths of 1% month on month, and 4.6% year on year.
With that, we’d like to thank you once again for joining us. I hope that you found this update interesting. We will, of course, be back next week with our latest instalment, but for now may I wish you every success in the trading week ahead.
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