Feb 28, 2023
• Further evidence of a resurgence in US inflation
• Fed has a headache – we expect them to raise rates by 75bps over the next two meetings
• US 10-year bond yield likely to push through 4% but still not a ‘real’ yield
• Equities still have downside risk particularly in the US
• Emerging markets to hold in unless the Fed has to really gear up its tightening
The strong set of US economic data last week provided further evidence of a resurgence in inflation. The Fed’s preferred measure of inflation, the personal consumption expenditures (PCE) index, rose much more strongly than expected in January. Up 0.6% month-on-month, the index rose sharply versus the 0.2% increase in December and was well ahead of economists’ expectations. The report again confounded market expectations that inflation was on a downward trajectory. The Fed prefers the PCE deflator because this gauge of inflation seeks to account for changes in how people shop when inflation jumps. Further, a surge in wholesale price inflation, which showed prices rose 0.7% from December to January, compared with a 0.2% drop from November to December, only showed how pesky the inflation saga has been.
A 1.8% month-on-month jump in retail sales in January added to the market’s fears that inflation will be higher for longer and that the Fed will have to keep raising the rates. Retail sales had fallen in December. The recent strong employment report only reinforces the fear that the economy is still running hot despite the earlier increases in interest rates.
The Fed must be worried about the developments since the last board meeting, and a 50bps increase in the Fed funds rate at the next meeting now looks quite possible. The market is currently pricing an approximately 75bps increase in the rates by July this year (Chart 1).
Chart 1: Markets expectations for the Fed funds rate by July 2023 Fed meeting
The poor inflation data presents a significant headwind to the markets. The US 10-year government bond yield has surged past the high levels seen at the end of 2022, with the US 10-year yield up 13bps on the week, pulling yields higher globally. As expected, New Zealand’s central bank raised policy rates by 50bps; however, the bond market still reacted badly, with the 10-year government bond yield rising 27bps on the week.
We suspect the US 10-year will eventually breach 3.94% and push on through 4.0% with an initial target of 4.10% to 4.20%. Institutional buying gained momentum the last time we saw the 10-year yield breach the 4.0% level (in late October/early November). But we must remind ourselves here that the US 10-year government bond yield is still negative in real terms. History tells us that bondholders must be compensated for inflation and more. Hence, the US 10-year bond yield may push even higher if the market loses confidence that the Fed will be able bring inflation under control in a timely manner. Nevertheless, today’s market trusts the Fed to bring inflation down to the 3% level, implying a prospective, near 1% real yield.
Chart 2: Real US 10-year government bond yield
Note: real yield is the US 10-year government bond yield less the rate of US consumer price inflation
Global equities are neither enjoying the recent spike in government bond yields, nor the ongoing increase in central bank policy rates. The US equity market, with its stretched valuation, remains vulnerable to further downside. We see the S&P500 index falling to 3800 in the near term, before descending to, maybe, as low as 3600, near the mid October level when bond yields were on their way through 4%.
It is not just the US that is seeing the persistence of better-than-expected growth. In Europe, growth is surprising to the upside—and inflation is persistently on the higher side of consensus. The flash industrial confidence surveys continued their recent strength reflecting broad-based improvement. However input prices have softened helped by weaker-than-expected energy prices, but continuing labour shortages are putting some upward pressure on inflation.
For equity investors there is quite a distinction in perspectives building between the US and the eurozone. In the US inflation forecasts continue to rise and growth remains robust. In the eurozone inflation has behaved rather well, aided by the significant fall back in energy prices in recent months. ‘Cheaper’ eurozone markets, therefore, should continue to outperform given the reduced risks to the upside to eurozone inflation and hence the diminished need for any aggressive central bank action.
The Fed and the ECB both now look likely to raise policy rates by 50bps at their next meetings, with a further increase in their subsequent meetings not ruled out. No one had expected the situation to evolve like this. The market has in the past priced a view that rates would have already peaked.
Emerging markets holding up in spite of dollar strength
The prospect of higher than expected US interest rates will likely weigh on emerging markets. The dollar has continued to recover ground after its Q4-through-January slump. However, to be fair, key emerging currencies to date have held their ground against the dollar quite well. Chart 3 shows the performance of the dollar (trade-weighted) versus the Indian rupee and the Indonesian rupiah. The chart is encouragingly unremarkable with the emerging market currencies performing largely in line with other major crosses.
The Indian central bank will be somewhat concerned that last week’s inflation report for January was above the upper-tolerance level for inflation of 6%. However, the market expects the Q4 2022 GDP report due this week to show a marked slowdown to 5.0% from Q3’s 6.3%. We don’t expect the Reserve Bank of India to announce any panic monetary tightening measures to support the currency. There is little sense of crisis.
Chart 3: Emerging market currencies not obviously struggling
Adnoc Gas; UAE IPO bellwether, 2023
The recent announcement from Abu Dhabi National Oil Company (ADNOC) offering an IPO of 4% of its subsidiary Adnoc Gas has put a massive spot highlight on the Abu Dhabi bourse, and the UAE equity markets in general. With an expected price range between 2.25 and 2.43 dirhams, this IPO will be the largest yet in the UAE capital, expected to raise USD2bn and valuing the company at more than USD50bn at the top end of the range.
For us, the response towards the numbers coming out of the IPO offering will have significant implications to the UAE and GCC markets, and this will reflect in three main areas – 1. Confirming that the appetite from investors to participate in such IPOs is still there. 2. The liquidity provided to investors, both at the retail and institutional level, for these IPOs is still available. 3. The appetite towards riskier local assets is still supportive relative to international markets. Initial signs from all three areas bode well for the UAE markets for the rest of 2023 but other companies looking to IPO should draw lessons.
In our opinion the strategy around how the Adnoc Gas is placed and executed is also critical for the IPO’s success, and a case study for future entrants. A couple of points worth highlighting ; First – they ensured that the pricing was appropriate, bearing in mind initial market whispers was between 2.45 – 2.76 dirhams, which would have taking much more value off the table from investors. And secondly – they consequently provided insight on potential dividends, where at mid rage pricing dividend payout would be between 6.5% – 7%. With the company also committing to an annual five percent increase in payouts for the following three years after the first year of trading.
With institutional investors already committed to taking 40% of available allocation and clear retail support also evident, we would not be surprised to see even more shares made available before the initial offering is closed.