A standard risk off pattern this week for capital markets; government bonds rallied, the US Dollar appreciated, commodities and equities sold off, credit spreads pushed wider with investment grade outperforming high yield, and rating buckets decompressed. From the investment flow data, all asset classes received outflows.1 As it is May and we are writing this on Friday the 13th, it’s worth asking the question, are we witnessing the final leg of the selloff, the capitulation phase?
From a fundamental standpoint, investors have repriced both interest rate and growth expectations. Year to date the 10yr US Treasury and Bund are 140 basis points (bps) and 110bps higher in yield, respectively. Repricing seems to indicate that investors expect the Federal Open Market Committee to hike policy rates at every meeting this year—the next two meetings by 50bps each—with the terminal Bloomberg median forecast to be 2.75% and the 1-year interest rate, 1 year from now (“1y1y”) is pricing 3.17%. The anticipation of quantitative tightening has pushed real yields into positive territory with the 10yr and 30yr Treasury real yields now at 24bps and 58bps. In Europe, the European Central Bank is expected to hike rates in July; “the first hike in a decade,” with the September three-month Euribor future contract pricing in a positive yield of 18bps and the 1y1y Eonia now at 1.13%. The peak in optimism for economists was September last year. Since then, growth forecasts have been significantly revised lower, most aggressively in the Eurozone, peaking at 4.4% before falling to the current median expected growth forecast of 2.80%. See chart of the week.
Chart of the Week
Investors are focusing like laser beams on tracking Inflation, as terminal rates will ultimately depend on the central banks’ effectiveness in bringing inflation expectations back to long term trend levels. This week economic data released from the US included CPI and PPI (consumer and producer price inflation). The good news is that both indices fell from last month’s year-over-year (“YoY”) peaks in prices, although this was mostly due to base effects (the starting point was already higher) and investor expectations for a great fall in prices were left disappointed. Within the CPI, the strength in both home rental and airfare was notable. March CPI YoY was 8.5%, while April CPI YoY was recorded at 8.3% vs. the 8.1% anticipated by Bloomberg’s survey. March’s PPI YoY of 11.5 % fell in April only to 11.0% vs. the 10.7% predicted by Bloomberg’s survey.
From a technical standpoint it is estimated that global equity funds have lost $6.1T of assets under management year to date, through outflows and asset depreciation, or 60% of 2021 inflows.2 Bond funds have lost an estimated $2.1T of assets under management year to date, equivalent to 80% of 2021 inflows.2 Using cryptocurrency as our gauge for “hot money” the asset class peaked in November 2021, with a market cap of $2.95T. This has now fallen to $1.24T, a market cap fall of 57%. And for signs of market capitulation, we should search for investors selling their most treasured assets. Interestingly gold prices—a go-to safe heaven asset—fell 3% this week.3
On valuation, Muzinich’s 1 year Z Score analysis in which we compare and score the pricing of various markets relative to their historic values shows that credit spreads are 1.86 Z Score cheap with EU credit holding the best relative spread value. From a yield perspective, both investment grade and high yield credit markets are above their five-year average yields, with the high yield market now yielding 8.75%, 7.62%4 and 7.51% for emerging markets, European markets, and the US, respectively.
Picking tops or bottoms is foolish, but there certainly is a great deal now priced into markets and significant adjustments to investor positioning has taken place, meaning credit markets now offer investors compensation for the uncertainty ahead.
1.Standard Chartered “EM Flow dynamics – Flows turn even more bearish,” 13 May 2022
2.J.P. Morgan, Global Markets Strategy, Flows & Liquidity, “How much retrenchment by retail investors?,” 11 May 2022
3.https://coinmarketcap.com, 13 May, 2022
4.European HY reflects hedging to USD via a 3 month hedge which benefits returns by 1.98%