De Gaetano Andrea Analista indipendente BondWorld

BondWorld : Hawks on the attack, Powell accommodative

BondWorld : Hawks on the attack, Powell accommodating. A correction is in the air, but the environment remains favourable for equities

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Andrea De Gaetano – Independent Analyst

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An exceptional corporate earnings season and government bond yields at their lowest have supported the market.

On the other hand, the inflationary flare-up has reduced consumer purchasing power and is putting pressure on central banks, which are discussing a reduction in monetary stimulus.

Inflation in the US, at 5.4%, reached levels not seen since 2008. At that time, ten-year US Treasuries were yielding over 4%, today 1.30%.

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The inflationary flare-up did not spare Europe, where the consumer price index jumped to 3%, above expectations of 2.7% and above the ECB’s 2% target. In Germany, inflation, at 3.9% (3.4% harmonised), returned to levels not seen since 1994. At that time the 10-year Bund yielded 6%, today -0.38%.

Absolute power of the central banks. This explains why the Germans are buying gold and why Bitcoin is rising.

In Italy, inflation is up 2.6%, a level not seen since December 2012, and the yield on the 10-year BTP is at 0.70%. In December 2012, with the same level of inflation, the 10-year BTP yielded 4.2%. Thank you, Draghi!

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European GDP expanded at a 17.3% pace in the second quarter compared to last year.

In the face of the recovery and the jump in inflation, 60% (25/42) of economists surveyed by Refinitiv expect the ECB to announce a reduction in PEPP purchases, from 80 to 70 billion per month starting next quarter. The ECB will meet on 9 September. 70% of respondents expect cautious gradualness of the ECB in completing tapering.

On 22 September, it will be the Fed’s turn, with zero interest rates and 120 billion of securities purchases per month.

Jerome Powell, in the Jackson Hole symposium on 27 August, reassured the markets by anticipating tapering, but without haste. „It may be appropriate to start tapering purchases this year,“ Powell said, stressing that the start of tapering will not signal a rise in interest rates.“ Other Fed members are decidedly less accommodative. Among them, Bullard, St. Louis Fed, would like to start tapering now and end it in the first quarter of 2022. Bostic, Atlanta Fed, said it is „reasonable to begin tapering in October if the jobs recovery remains strong“, assuming the first interest rate hikes in 2022. Harker, Philadelphia Fed, „tapering more sooner than later“. Rosengren, Boston Fed, „another strong jobs report would support a tapering announcement as early as September“. Loretta Mester, Cleveland Fed, assumes a start of tapering this year, to be completed by mid-2022. „The economy has made great progress and it is time to scale back the extraordinary measures introduced with the pandemic“. We shall see.   

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On the macroeconomic front, signs of a slowdown since mid-August, with retail sales below expectations in the US, Europe and China.

The resumption of Delta variant infections and inflation have impacted consumer sentiment. The 27 August University of Michigan survey, at 70.3, confirmed the weakness in consumer sentiment seen in mid-August, one of the biggest declines in 50 years.

US employment slowed to only 235,000 new non-farm payroll jobs in August, compared to 750,000 expected, down from July, 1,100,000, and June, 962,000.

Unemployment rate at 5.2 %, from 5.4 % in the previous month. 

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On the other hand, the manufacturing and services sectors on both sides of the Atlantic were above pre-pandemic levels. The Eurozone’s Markit Composite PMI, at 59.5, still close to 15-year highs, was followed by the US Manufacturing PMI, 59.9, and Services PMI, 61.7, which marked the 15th consecutive month of expansion, following the contraction in April 2020. 

Along with liquidity, corporate earnings are the mainstay of US and European equity market gains. Earnings exceeded expectations in 87.7% of the 497 companies in the S&P 500 and 63.9% of the 289 companies in the European Stoxx600 that have reported so far.

In this strong recovery, the most striking discord is the government bond yield, which is unsustainable should inflation remain at current levels, at 3% in the Eurozone, with the German 10-year Bund yield at -0.38% and 5.4% in the US, with the US 10-year yield at 1.3%.

The other discordant aspect was the slump in China’s stock market, accompanied by slowing economic data and government regulatory and fiscal tightening, which sent stock markets reeling. PMI data for the services sector fell to 47.5 in August, down sharply from 53.3 in July and below expectations (50.2).

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Equities would still have room to climb. It would, because the market could encounter three obstacles: new lockdowns due to the Delta variant, faster than expected interest rate hikes, tax hikes, all of which would impact corporate profits.

Central banks are discussing how to manage higher inflation and pandemic risks, but they do not want to scare the market. This was seen in Jackson Hole. All the more so with the geopolitical storm in Afghanistan, the upcoming general election in Germany on 26 September and the much weaker than expected US employment figure for August.

The prospect of reduced liquidity from central banks is a wind in the face for the markets, justifying profit-taking on US and European indices, which have risen around 20% since the start of the year, close to technical selling levels and entering September, one of the least favourable months for equities.

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Hence the opportunity to:

– Do not chase the rally, so do not make new purchases before a correction.

– Gradually hedge positions on individual stocks by selling on indices (put options and/or ETFs on the downside).

– Lighten positions in the event of new upward stretches.  

Analysts‘ estimates of future earnings are so optimistic that it takes little to disappoint them, and a sharp correction would not be surprising. Zoom, for example, reported above-expected revenues and profits on 30 August, but revised its growth estimates downwards. The effect was a price drop of over 15% the following day. Cases like this lead us to take a more conservative stance, entering September to defend the performance achieved. 

Emerging market bond sector recovers

Powell’s accommodation at Jackson Hole has weakened the dollar, with the EUR/USD rising from a low of 1.1662 on 20 August to the 1.19 mark.

We await the ECB on Thursday 9th. If Lagarde is as accommodative as Powell, we could see a new market pullback. Or, the market will have an excuse to take a breather.

We will adjust our focus accordingly.

Have a good recovery everyone,