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Five insights in five minutes

Five in Five: inflation, China, US dollar, earnings, value
13 May 2022

    US inflation and bonds

    You’ve no-doubt had clients hitting the phones of late (maybe even literally) because you said to diversify and yet bonds and equities have fallen in tandem of late, as per the chart. But suddenly you’re a hero because April’s inflation number in the US has finally broken the correlation. Why though? Here’s a simple explanation. Global stock investors, who are about to nurse a sixth straight week of losses for the first time since the financial crisis, have been obsessing about economic growth downgrades for a while, even while forward activity indicators such as JPMorgan’s manufacturing output index remain elevated. Inflation was the bigger worry for bond owners, however, which is why ten-year yields in the US recently touched 3.12 per cent. No longer, it seems. Despite a rise of 0.7 per cent month on month in core services prices in America – the fastest pace in more than three decades – on this occasion fixed income traders read it as a warning that policy rates have to squeeze until the economy pops. Hence it’s time to get defensive, they concluded. Almost 90 per cent of a USD36 billion ten-year note sale was quickly snapped up at 2.94 per cent. They have made money as yields are ten basis points lower already, and will make more if our strategists are right and inflation has peaked.

    Conversation starter for… global fixed income, global equities, credit portfolios, multi-asset

    US inflation and bonds

    Patterns in China

    Whether it’s a hedge fund manager seeking candidates for a long-short strategy, or an analyst looking for additional tools to gauge the attractiveness of an equity, the statistical property of ‘cointegration’ is worth understanding. Simply put, the presence of cointegration in a pair of stocks suggests that their price series exhibit a stable long-term pattern. If a significant deviation is observed, it is likely because one is overvalued relative to the other. Cointegration tends to exist in assets that are similar to one another, such as an A- and H-share pair that represent the same Chinese company but listed separately on onshore and offshore exchanges. The chart below summarises the results of our analysis on fifteen A-H share pairs with large market caps. We found substantial evidence of cointegration existing among some pairs, especially within the financial sector. For more details on why active managers benefit from this, don’t miss the upcoming edition of China Insights.

    Conversation starter for… Chinese onshore; offshore equities, Asia equities, EM equities

    Patterns in China

    Strong dollar

    Meanwhile a pattern has emerged that can be viewed from the moon, a surging dollar versus almost everything. On a trade weighted basis it’s at its highest level in two decades – up 15 per cent in the last year and eight in the past three months. Against the yen the chart is vertiginous. What is going on? The greenback has clearly benefited from a combination of relatively higher US rates as well as flows to safety amid current geopolitical stresses. But a weaker outlook for the global economy is also playing its usual role, as seen in the chart below. If the dollar is haven currency once again, the difference perhaps this time is that the Federal Reserve might be happy with this. Exchange rates aren’t the first tool central banks usually reach for, but given the desire to bring down inflation, a strong currency that mechanically reduces the cost of imports is certainly appreciated. Conversely, the Bank of England and European Central Bank will be concerned by the prospect of what economists call a ‘reverse currency war’, whereby regions battle to offset the risk to inflation by supporting their currencies. In 1971, US Treasury Secretary John Connally said, “the dollar is our currency, but it’s your problem”. For many investors it certainly feels that way right now.

    Conversation starter for… global assets

    Strong Dollar

    Global earnings

    But it’s not like Five in Five to be pessimistic. This week’s column feels like a real downer so far – sorry about that. Here’s something a tad brighter! The one tenth drop in global equities in a month is somewhat disconnected from the reality of strong earnings and profitability that many companies continue to enjoy. Amidst the highest inflation readings in four decades, margins for American companies, for example, are the highest they’ve been for years, as illustrated in the chart below. And their earnings growth remains in double digits, right at its long-run average. Or think of things another way. Forecasts for profit increases for US stocks are a third higher than they were back in February, and yet since then the S&P 500 has lost almost a fifth of its value. In multiple terms, you could say you’re getting three more years of earnings for the same price! Similar stories can be found elsewhere. In the past two months, earnings growth forecasts have risen by half in Japan, they’ve tripled in the UK, and jumped 15-fold for Latin America. Today’s discount in stock prices may not endure.

    Conversation starter for… Global equities, developed market equities, emerging market equities

    Global Earnings

    Value stocks

    Want something else to smile about? Bargain shoppers have avoided much of the carnage in stock markets highlighted above. Value stocks may have lost eight per cent this year, but they are still up a tenth since the start of 2021. Growth stocks, by comparison, are down by more than a tenth in the same period. The trend might continue, with relative earnings yields still in favour of value. Per the chart below, the long-term average yield premium, or the higher share of earnings you receive when buying value stocks, is just over one and a half per cent. Today’s readings are nearly double that, approaching three per cent. Furthermore, value stocks are more concentrated in sectors such as energy, utilities and healthcare – businesses with inelastic demand and strong pricing power, as evidenced by an increase in their profit margins last quarter. This leaves them more resilient to inflation or slowing growth.

    Conversation starter for… Global equities, sustainable healthcare, value strategies

    Value stocks

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