Investment Strategy Insights: Looking for a Pivot? Look at China

Stance: While headline and core CPI numbers showed progress in November, the prices of many services, particularly rents, remained sticky. The movement to lower inflation due to supply chain normalization and falling commodity prices is positive, but it will need to continue and be replicated in services for the Federal Reserve to take notice. Current trends fit well with the widely forecast scenario of a shallow and extended recession in the US due to a divided federal government that would not provide accommodative fiscal policy and a central bank focused on inflation that would not loosen monetary policy. Thus, the macro scenario focuses on a Fed that pauses but does not pivot. Globally, we believe Europe is at greater risk of enduring a more severe recession given European Central Bank (ECB) tightening and energy problems due to the fragility of Russian supply. While warmer weather has helped prevent shortages thus far, the gas situation is likely to require several years to fully resolve and, as a result, continues to drag on sentiment and growth. China is the bright spot, as expectations of a second-quarter reopening and the recently announced property support measures provide tailwinds through 2023.

Outlook: The focus in the US remains inflation. Should current rapid price declines extend into services, the question will become how quickly the Fed will pivot and whether a soft landing becomes possible.

Risks: 1) Inflation falling faster than expected or the Fed looking through services inflation and pivoting earlier; and 2) systematic issues in either Europe or the US.

As we head into the holidays, two competing themes have emerged: Peak inflation versus liquidity. On the inflation front, when the CPI headline number for November dropped by two basis points, the Treasury market had its best day in years, possibly even its best day in history, if only considering the days without the Fed’s help. On the first good news in months, the market rallied 25 basis points across the board. If peak inflation has been reached, then a Fed “pause” or “stepdown,” or even “the pivot,” can’t be far off. In contrast to the rosy inflation scenario, there is the thorny issue of liquidity — or lack thereof, as technicals continue to deteriorate. During the three-day week of Thanksgiving, the Treasury was scheduled to issue $375 billion of government paper, of which $120 billion was to be in four-year notes and the remaining $255 billion in T-bills and floating-rate notes. The Treasury has scheduled an almost identical issuance for the week between Christmas and New Year’s — the least liquid week of the year. That’s a lot to absorb.

While we are probably near the tail end of Fed rate hikes, the negative economic impact of higher rates is just beginning and will not be in full force until 2023 as the US and Europe head into recession or stagflation to varying degrees. On the positive fundamental front, China’s policy pivot to provide support for the property segment and some relaxation of Covid restrictions indicates an improving economic trajectory relative to major developed market (DM) economies. Rather than reflecting recession worries, spreads have tightened further into soft-landing territory. While the market may be looking beyond 2023 into 2024, history indicates that as earnings deteriorate in the quarters ahead, spreads will widen and more likely overshoot to the wides. Therefore, we maintain our defensive bias with no change to our conviction score. We continue to favor more defensive investment grade (IG) issues over high yield (HY) and the US over Europe and emerging markets (EM). However, we are looking to narrow some of our geographic underweights to get closer to neutral in the months ahead.

In November, a combination of reduced tail risks and bearish positioning triggered a bounce in broader risk appetite, causing a sharp reversal in the US dollar, which sent the U.S. Dollar Index (DXY) back to its 200-day moving average for the first time since May 2021. Still, the global backdrop has not changed significantly and the factors supporting the US dollar — US exceptionalism and the yield differential — remain intact. As a result, the recent decline in value and the switch to a short US dollar in the marketplace provide an opportunity to reallocate to the US dollar. Into 2023, we will be looking at three key criteria that would trigger a reversal of the strong US dollar: a Fed peak, growth bottoming outside the US, and coordinated currency intervention to weaken the US dollar. None of the three criteria yet have been met. However, financial markets misread a recent US inflation print as a Fed pivot rather than a market pivot. We remain of the view that the Fed will tighten further than the ECB, which will support the US dollar.

Reduced downside risks within Europe and China were clear factors in the relief rally, but looking at the details, we contend that China’s reopening will be measured and gradual into the second quarter of 2023, while Europe’s “winter of discontent” may have been postponed rather than cancelled. Eurozone growth may hit a trough sooner than US growth, but currency markets are reluctant to give up on US exceptionalism as a core driver for US dollar strength. In all, we have moved our 12-month euro/US dollar forecast from 0.93 to 0.97, providing attractive upside from current levels.

While our fundamental country analysis implies the market is pricing in too much pain due to default expectations, we nevertheless see the increased probability of a US recession in 2023 and prefer higher-quality names in IG and select ones in HY. Our forecasts show inflation in EM will be more subdued than in DM next year, which would be a remarkable outcome for the asset class and explains the relative stability in EM currencies in 2022 and bodes well for a disinflation-led rally in local rates next year. Our analysis shows food prices falling in 2023, helping to ease inflationary pressures. Yet the levels by which food prices decline may keep balance-of-payment pressures in place. In contrast, EM current accounts remain in surplus, and we believe inflation has already peaked in Latin America, which is the world’s largest exporter of agricultural commodities and where agriculture and fish production accounts for around 10% of regional GDP. We expect that a reduction in food prices will be positive for agricultural and food-related credits in the region, neutral for transporters, and slightly negative for fertilizer producers. Security selection remains key. The European gas picture is much improved from the universally pessimistic view held in March. This has been helped by the mild weather experienced thus far and forecasted, but 2023 remains an uncertainty as storage facilities will require restoring. We made no changes to our scenario weights, but moved duration from underweight to market weight based on increasing optimism that a Fed peak could be brought forward.

As expected, third-quarter earnings were like those in the second, with most companies showing remarkable resiliency in the face of high inflation and demand uncertainty. The market understandably is discounting this bottom-up outlook and focused on the unknown cumulative impact of tightening conditions heading into 2023. The labor market will be a key variable here, and we are seeing signs that the demand/supply environment for labor is normalizing on top of broad-based reductions in other cost pressures. Market volatility related to perceived potential changes in Fed policy continues to provide opportunities to upgrade our portfolio and invest in advantaged companies at valuations below typically high levels. As always, portfolio style balance remains a key component of our risk management.

In China, consumer companies saw operating deleveraging in the third quarter on weakening demand and lockdown measures, but some expanded margins through a mix upgrade and new product launches. Order backlogs among automation companies continued to decline in October, but some companies are cautiously guiding to an improvement in the fourth quarter. The government appears to be gearing up to reopen the economy and support the property market; does this mean national service risks for banks? In India, IT companies see a better recruiting market due to lower spending by start-ups. Segments such as consumer staples, building materials, and automobiles are indicating that gross margins have bottomed. In Brazil, Lula’s flip-flopping on fiscal restraint has unnerved markets. Central and Eastern European companies still contend with the war’s impact, while companies in the Middle East and Africa generally are neutral or beneficiaries. Against a backdrop of low expectations and wide country/sector variance, third-quarter global EM (GEM) earnings thus far have been slightly better than expected. Company guidance, too, has been restrained, with cost-cutting a growing component of the profit outlook. Although top-down issues remain prominent, GEM equities have been driven largely by underlying fundamentals in recent months and did not exhibit the same style-dominated behavior seen earlier in the year. This has been working well for our investment approach. We adjusted the portfolio by pivoting out of some of the top-performing consumer-driven names and adding to cyclicals in IT and financials in Asia.

Our US conviction score is 4.22, almost the same as last month, with both the BBB spread and yield slope very close to previous month-end levels. Our global corporate model remains positive on EM and negative on DM. In DM, our model favors energy, insurance, banking, and industrials, and dislikes financials, REITs, communications, and technology. In EM, the model likes Argentina, Israel, India, Brazil, Mexico, the Philippines, Indonesia, and Turkey, and dislikes Poland, Hungary, Colombia, China, Hong Kong, Taiwan, and Korea. Among EM industries, the model likes transportation, oil and gas, and financials and dislikes real estate, diversified industries, and infrastructure. Our global rates model continues to forecast lower yield and a flatter curve. The rates view expressed in our G10 model portfolio is overweight global duration. It is slightly overweight North America and underweight Europe, where it is neutral on peripheral countries and underweight core countries. In Asia, it is slightly overweight Australia/New Zealand and overweight Japan. Along the curve, it still positions for flattening and is overweight 20-year key rate duration, but only slightly overweight the two-year.