Mutual Daily Mutterings
Quote of the day…
“Would I rather be feared or loved? Easy. Both. I want people to be afraid of how much they love me” – Michael Scott, ‘The Office’…and yes, I have used this one before, but its Valentines Day, so it seemed appropriate
Chart du jour …market cash pricing
Overview…”from Russia with love…”
- Offshore stocks were pasted again on Friday, while bonds caught a bid after days of whipsawing from heavy gains to heavy losses and vice versa. A couple of culprits. Firstly, US inflation hit forty-year highs, which reinforced the growing belief the Fed will have to go harder and fast on its rate hiking agenda. But, then on Friday evening our time, the threat level around Russia getting frisky with their neighbour, Ukraine, went to DefCon 2. Not literally, but figuratively. Either way, a risk off tone ensued.
- The move in bonds (yields lower) came despite the Fed announcing on their website a closed board meeting for the 14 February. While there is no formal clarity around the purpose of this meeting, it is safe to say it won’t be to hand out secret Valentine’s Day cards to each other. The obvious speculation is an early hike / inter-meeting hike, although there has not been a lot of coverage in the offshore narrative over the weekend. Nonetheless, there was some public pushback from the Fed (and ECB) officials against increasing rate-hike speculation. On the ECB, one council member stated that talk of rate hikes in June was “unrealistic”, while another stressed that policy normalisation will be gradual.
- Some changes to street consensus expectations… Goldman Sachs cut its forecast for US stock returns this year, seeing the S&P 500 ending 2022 at 4,900 points, down from 5,100 points previously. That compares with Friday’s close of 4,418.64. “The macro backdrop this year is considerably more challenging than in 2021…and…uncertainty abounds regarding the path of inflation and Fed policy.“
- With US CPI data in the market’s rear-view mirror for now, it seems the Russia vs Ukraine potential bruhaha will be the main focal point. I’m no geopolitical expert, but I wouldn’t trust Putin as far as I could punt him. Nevertheless, if things kick-off into a formal donnybrook, this will likely trigger further risk off sentiment, with treasuries attracting some love, while stocks would likely weaken. I recall the last time Russia was flexing with Ukraine, markets were whippy for a while, but then attention shifted elsewhere and the conflict became second tier.
The Long Story….
- Offshore Stocks – a broad risk off tone took its toll with US markets smoked. The DOW fell -1.4%, the S&P 500 -1.9% and the NASDAQ was worst still, down -2.8%. European stocks were a little better, but still in the red on the day. Over the week US markets closed -1.8% to -3.0% lower, so much of the damage done on Friday, for the reasons touched on above – a mix of further inflation data digestion and growing risks around Russia and Ukraine conflict.
- Some commentary from Bloomberg for what it’s worth…”stocks remain overbought relative to bonds. If historical trends are respected, overbought extremes in the stock-bond ratio are followed by oversold extremes. Currently, the stock-bond ratio remains one standard-deviation rich on a long-term basis, reaching its most extreme overbought level in at least 30 years in 2021. That ‘over-boughtness’ still needs to be worked out, leaving stocks with a lot more room to fall relative to bonds before they reach oversold levels. When inflation starts to bite, producer prices rise first, and firms can pass this rising cost on to customers. But as consumer prices begin to catch up and close the gap with producer prices, profit margins start to fall. We are on the cusp of this happening today. Add in the fact wages are set to keep on climbing, and you have a perfect storm for weaker profit margins. Profit margins took over the baton from P/E ratios in supporting S&P returns last year, but they are unlikely to be able to retake it while inflation is a problem. The “E” in P/E ratios is a nominal measure, not a real one; as earnings rise with inflation, the ratio is depressed lower. We can see this in the data, with the Prices Paid component of the ISM manufacturing report generally showing a good inverse relationship with the P/E ratio.”
- Local Stocks – a dour day for local stocks on Friday, down almost a percent in response to the larger than expected US CPI print. Almost nine out of ten stocks retreated and only one sector, Materials (+0.3%), was able to advance – having said that, 87% of stocks in the sector down. The heavy lifting was left to a few, the usual suspects BHP, RIO & FMG… but still just a few. The worst of the worst were Tech (-3.8%), REITS (-2.6%), and Utilities (-2.1%). Despite the sell-off, forward PE’s are sitting around 16.7x. Well below pandemic peaks of over 20.0x, but also still above pre-pandemic averages (16.1x). Arguably elevated given known and unknown headwinds to earnings – specifically margins given above Bloomberg comments, which are similarly relevant for AU stocks. Futures are down -0.5% this morning.
- Offshore credit – Wall Street expects $15bn – $20bn of primary high-grade bond supply this week, according to an informal survey of debt underwriters quoted on Bloomberg. While consensus forecasts in the last four weeks have settled around that same amount, actual supply has been less as the Fed’s plan to raise rates cooled the primary market. Volatility is not good for supply. Issuers get nervous and buyers tend to want a premium, so more often than not issuers will leave the cue in the rack…unless there is desperate need to issue, then you’re a price taker. Offshore CDS reached almost 18-month highs on Friday with both the CDX (US) and MAIN (EU) rising over +2 bps to 68 bps and 67 bps respectively, verses respective 12-month averages of 55 bps and 54 bps, with the Russia vs Ukraine headlines and developments the primary influences. On the week CDS spreads were +2 – 4 bps higher. Cash spreads were +3 – 4 bps wider in US IG markets on the week, while EU IG markets were mixed, with financials tighter (-4.5 bps) and corporates wider (+6 bps) according to Bloomberg indices.
|EU Cash vs CDS…
Source: Bloomberg, Mutual Limited
|US Cash vs CDS…
Source: Bloomberg, Mutual Limited
- Local Credit – traders…”it was a quiet day in the secondary credit market with the response to Thursday night’s US CPI drawing investor attention elsewhere. We traded two-way across most asset classes and saw no material weakness in risk, with accounts displaying modest appetite across the complex.” In major bank senior spreads, a very modest one basis point drift wider in the 3Y – 5Y part of the curve. Generic 3Y major bank senior now at +44 bps, with 4Y at +58 bps and 5Y at +66 bps. Further down the capital stack and we saw some driftage also in tier 2, a basis point wider across the 2026 callables (+139 – 145 bps). Despite the drift, traders have indicated it was a lighter day volume wise, with “direction of flow more balanced.” Still expecting spreads to drift wider.
AU Cash vs CDS…
Source: Bloomberg, Mutual Limited
- Bonds & Rates – some commentary from NAB on what happened in US markets on Friday evening…”the main action for Friday night was the few hours ahead of the NY close. At that time treasury yields were trading a couple of basis points higher in yield when headlines hit the screens that the White House had been advised that a Russian invasion of the Ukraine could happen within days. Within three hours of this news hitting the screens the US 10-year note had rallied 12 bps to 1.91% – back to its pre-CPI level (it closed at 1.94%) while the 2-year note rallied 9bps to 1.48% – still well above its pre-CPI level of 1.35%.” On the timing of conflict, if such eventuates…this also from NAB…”it is fair to say the next two weeks will be important as far as tensions go – the end of the Winter Olympics on Sunday removes one apparent constraint of respecting peace during the games, and ice will start to thaw in early spring with the terrain becoming less conducive to a land-based operation, meaning there is a relatively narrow window.” Locally on Friday, obviously before these headlines, we saw a meaningful sell-off as local markets digested US inflation data. There appears to be no development over the weekend on the Russia-Ukraine front other than a call between Biden and Putin, which didn’t seem to achieve anything.
- Macro – nothing meaningful out locally on Friday, while in the US we had the Consumer Sentiment Report. Confidence and expectations were lower with headline sentiment down to its lowest level in well over ten years. Outside of that, the main focus was on US CPI, which surprised to the upside on Thursday. Looking forward, for local markets we have January labour data out on Thursday. Bloomberg is indicating consensus employment change of donut vs +64.8K in December. No change in the participation rate (66.1%) or unemployment rates (4.2%) is forecast by the street at this stage. RBA Debelle will appear before the Senate Economics Committee while we also get the RBA Board meeting meetings. A flurry of data due out of the US this week including PPI, Retail Sales, Building Permits, and Housing Starts among others.
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Scott Rundell, Chief Investment Officer
T: +61 3 8681 1907