Monthly House View - May 2023 - Download here

Dear Reader,

On a recent flight to Madrid to visit our teams, the captain’s words “starting our descent” resonated with me just as the US inflation print had a few days before, confirming its descent from 9% year-on-year (YoY) to 5% in nine months. Captain Powell must take some comfort from the latest figures: for the first time since January 2021, energy was a negative contributor to headline inflation. The bears tend to look more at the sticky part of inflation – services – but a closer look at the shelter subcomponent is also showing signs of rolling over. Captain Powell is indeed trying to land several airplanes at once: inflation, the economy and financial stability. Inflation is unlikely to return to the target of 2% in the near future, but the current decline is encouraging. The economy is slowing, we see this slowdown happening in H2 2023, but not a hard landing outright. The big question mark remains how tight lending conditions will become: small companies in the US represent 35% of the workforce, they get 70% of their loans from regional banks. The Federal Reserve (Fed) is therefore close to completing its tightening path (for now): one more hike in May and it’s done for the year. To echo the Chicago Fed’s Austan Goolsbee this calls for “prudence and patience”. 

Back on financial markets, investors still expect 50 basis points (bps) of rate cuts this year, we disagree and think the Fed will pause for the year. Volatility of interest rates, which surpassed the level recorded in the Great Financial Crisis of 2008, is a very unwelcome visitor to portfolio construction and banks’ balance sheets. This is why we also favour in our fixed income portfolios lower duration assets and high quality credit as we are able to take advantage of attractive yields while suppressing duration risk. Liquidity in the market remains ample: money market funds in the US stand at USD 5.2 trillion, an increase of USD 500 billion this year as investors take advantage of strong yields and shy away from bank deposits. 

Equities in the meantime have shown remarkable resilience. If you had been lucky enough to lock yourself away on an island without WiFi for a month and upon your return heard that three US banks had failed, that Credit Suisse was swallowed by UBS in one weekend while both the European Central Bank (ECB) and the Fed were able to continue to raise interest rates… asides from the horrific shock of this news, you would have expected equities to be down sharply this year. Wrong. The descent that we were expecting on earnings is indeed not coming as brutally as expected, but why? Put simply, nominal matters more than real in the equity world. Companies have been able to grow their revenues thanks to the positive economic momentum. This has been offset by some margin contraction, but we are very far away from the collapse of expected earnings. This in turn explains the equity market’s performance. But not only. Investor sentiment remains cautious, and positioning on equities - particularly in institutional portfolios - at defensive levels. 

The pain trade is clearly on the upside, particularly as European equities power on: US investors have been buyers of European equity Exchange Traded Fund’s (ETF) listed in the US every week this year except one. The China reopening trade has greatly benefited European companies, as reflected by the strong results of luxury names. This is the frustrating part for us this year: Chinese equities are not taking off despite a strong domestic reopening. We continue to believe however that going east makes sense. This month we focus on the state of the Chinese economy, where we have revised our growth forecasts up, and continue to believe that risks are on the upside. While we acknowledge that many investors have decided to buy Europe as a proxy for the Chinese reopening, as they shy away from Chinese names, particularly for US investors, China is too large to ignore. If China’s A-shares inclusion factor in the MSCI Emerging Markets was revised from the current 20% to 100%, its weight in the MSCI Emerging Markets would ramp up from 5 to 22%. Global investors are poised to allocate more to China as the A-share market dynamics will benefit from increased institutional (foreign and domestic) participation. 

Finally, on a last personal note, as this is my first editorial as CIO for Indosuez Wealth Management, I would like to share with you that I am delighted to join the firm and feel fortunate to work in an organisation with such a high level of professionalism, client focus and integrity. 

 

Alexandre Drabowicz, Indosuez Wealth Management CIO

 

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