The U.S. July’s CPI inflation print surprised positively and raised the odds that headline inflation may have peaked this cycle though core inflation is likely to prove persistent. CPI moderation was driven by lower gasoline and airfares and a softer Energy PPI, though Food PPI surges.
GLOBAL MACRO: BUSINESS CYCLE STAGE – CONTRACTION
The U.S. July’s CPI inflation print surprised positively and raised the odds that headline inflation may have peaked this cycle though core inflation is likely to prove persistent. CPI moderation was driven by lower gasoline and airfares and a softer Energy PPI, though Food PPI surges. Absolute CPI index (in points) for the U.S. has shown first signs of wilting as Jul-22 print was actually for the first time this year, lower than prior month’s print. The key message, nevertheless, from the Fed Chairman at Jackson Hole was that the Fed will likely hike and hold and there may be a period of pain for households and businesses.
Composite PMI surveys indicate a contraction sustained contraction (2nd consecutive month) for the U.S. though EMs have maintained m-o-m economic activity. Yield curves have inverted for the U.S. The U.S. business cycle barring the low unemployment technically as well as economically points to a recession. But as long as the labour market remains tight things should not be text-book-style recessionary.
U.S. PPI Energy drove PPI down but PPI food surges
Source: Bloomberg, LGT
GLOBAL EQUITIES: REACTING TO INTEREST RATES IN 2022
The Fed Chairman’s speech at Jackson Hole suggests that the tight labour market has become the main factor for future decisions. U.S. unemployment should rise over the next few quarters, easing wage pressures, but not reach levels that correspond to past recessions. If a recession starts today, it will be from the lowest level of unemployment in 50 years.
The U.S. CBOE VIX has also risen post Jackson Hole and equity markets are respecting interest rate moves in CY22. Specifically, there appears a clear negative correlation between real yield on the U.S. 10Y and the S&P500. Currently, with the recent spike in the U.S. 10Y, U.S. equities have predictably seen some correction in Aug-22. We retain our tactical OW stance on Equities vs Bonds. We remain Neutral on Asia ex-Japan while retaining our tactical OW stance on the US, Japan and UW on Europe and EMs ex-Asia. We also remain UW on interest rate-sensitive sectors Consumer Discretionary, Real Estate, Financials, Utilities and Industrials.
Sub-50 Composite PMIs for most DMs makes India shine
Source: Bloomberg
GLOBAL FIXED INCOME: HAWKISHNESS SPURS YIELDS; STAY OW ON IG VS HY
The ultra short term curve has inverted for the U.S. Statistically, S&P500 forward 12-month returns have been weak, but it looks like the flagship equity index has weakened earlier this time in response to the real U.S. 10Y yield once again resuming its uptrend. Region-wise, Europe is seeing one its hottest inflation periods. Almost touching double digits (9.1%), CPI here is higher m-o-m, 1-year and 3-year averages. WPI – typically a leading indicator of CPI – here is at a mindboggling 36.1% (Jul-22). Similar is the situation in Japan, though inflation has not reared its head as much coming in at a much more manageable 2.9%.
The Housing sector contributes 42% to the U.S. CPI (rentals at as high as 32% of overall CPI) and any sign of softening here could mean an easing of U.S. inflation over the coming months. The supply-side has an equal if not more hand to play in the inflation spike and signs are emerging on that front too though the Fed likely has no control over supply-side factors. Consequently, we continue to favour short-duration IG bonds over HY bonds and stay UW on Sovereigns.
Supply chain related cost inflation falling
Source: UBS, LGT, July 2022
GLOBAL COMMODITIES: GAS WAR ESCALATING; UW GOLD
European natural gas prices surged by as much as 36% after Russia indefinitely suspending the flow of the vital fossil fuel through the Nord Stream 1 pipeline into Germany. European natural gas prices have surged more than 300% this year, putting pressure on the continent’s economy. As the power prices are closed liked to availability of gas, the surge in gas prices has driven up electricity prices.
Meanwhile, OPEC+ has agreed to cut oil output for first time in a year. The block has agreed to cut their supplies to the global economy by 1,00,000 barrels per day. With the DXY continuing its upward march, hitting its highest levels over 2 decades, and the Fed seen sticking to its sharp hikes in interest rates in coming months to cool off inflation, there could be more pressure on Gold prices. Downgrade two notch underweight on Gold vs Cash vs. only 1 notch last month.
VIX indices throw up significant volatility around Jackson Hole
Source: Bloomberg
INDIA MACRO: MORE TOWARDS INITIAL RECOVERY THAN MOST DMs
India’s yoy CPI growth has taken a breather like most DMs (esp. U.S.). The absolute level of CPI (173.4 in Jul-22 vs. 172.6 in Jun-22) still continues upwards unabated though. However, credit markets point towards some softening of monetary stance particularly in the short term: 3M OIS spreads (vs. repo) are now pricing in only 35bps hike vs. 50bps in Jul-22. The 10Y has actually softened in the last 2 months. Credit offtake has been very encouraging nearly across the board with all sectors showing appetite. Repo rate hikes have been transmitted effectively towards cost of credit as most loans are now linked to this benchmark. But despite these hikes, loans sanctioned and disbursed has not seen any negative effect. This does offer some hint of the resilience in the economy.
High speed indicators, especially Manufacturing, Services and Composite PMIs for India are markedly better (all showing expansion) than DMs (contraction), FII flows have been buoyant and auto volumes stellar. One more niggle apart from the upwards march of absolute CPI could be the BOP (or the CAD). But this arguably, is a short term pain for long term gain: weaken the CAD to deflate the INR, and then let this depreciation recursively aid exports which closes the virtuous cycle.
Credit offtake on the mend
Source: RBI, Indus Equity
AMCs are sitting on a large pile of cash waiting to be deployed
Source: Capitaline, Mint, Anand Rathi Wealth Ltd.
INDIA EQUITIES: “INROGANIC” COLOUR OF GROWTH – STAY OW EQUITY; UP OW MID VS LARGE
The capital account has likely seen some relief after the FII rout of last few months. AMCs are now sitting on large cash piles of Rs. 57k Cr. in Jul-22 vs. 5-yr. avg. of Rs. 32k Cr. This should act as a cushioning buffer for any untoward fall in equities. With that safety net, capacity utilizations are now at a robust 75%. The NIFTY’s trailing P/B appears significantly overpriced in contrast to its trailing P/E. The P/S appears hovering near statistical averages. So asset turns are being sweated just about appropriately (courtesy the high utilization rates) and, earnings have also increased disproportionately but pointing to much less flow-through from India Inc.’s P&L to its balance sheet. Net worth should likely swell in the coming years as capex plans gather steam to normalize currently high utilizations and capture growth. This should inflate book values as the “inorganic” asset increase leads to an opening of the earnings growth flood gates.
Minor hiccups from global macro do take a toll on asset class outlook: Volatility in equities (and most asset classes) increased towards Aug-22 end as the Fed Chair reinvoked inflation jitters at the Jackson Hole Symposium. But volatility indices in general, are mean reversionary in nature. Net-net, we remain OW on Equity vs Bonds and within equities, increase our OW stance by one more notch towards midcaps primarily driven by their relatively higher earnings projections.
Deposit growth would need to pick up for sustainable credit growth
Source: Bloomberg
INDIA FIXED INCOME: DURATION CHOICE – A ROCK OR A HARD PLACE; RETAIN OW CORP
The rate hardening cycle is not yet in the rear view mirror as monetary policy makers world-over have demonstrated consistent lags in responding to real-world economic conditions since the first of the multiple COVID-19 waves. Naturally, this would reflect in long term yields as inflation expectations of hardening still linger.
Despite the phased policy response, one must acknowledge that globally, liquidity (one of the quickest monetary tools) has thankfully been on the wane. An immediate impact is a hardening of ST yields (in addition to LT yields) which has already happened clearly in India over the last 2 months. Credit growth is on the mend, though deposit growth is yet to keep pace. For the short term, banks could fuel this credit growth via liquidation of excess investments (part of their currently, overly robust SLR book). But capitalization / leverage ratios will soon be scrutinized and
sustainable credit growth would pan out only when deposits are shored up, which might happen only via increase in rates.
Consequently, we maintain our neutral position in terms of duration despite the recent hardening seen on the short end of the curve in last 2 months. Sectoral preference within Fixed Income remains unchanged (i.e. OW Corporate Bonds / Funds).
TTM PE should re-rate as capacity utilization drops on capex pickup
Source: Bloomberg
CURRENCY: INR IN FOCUS, REMAIN OW
The INR has been fairly resilient against the backdrop of global currencies. Not only against most EM currencies, but against most DM currencies as well the INR was able to hold its ground. India’s “virtuous cycle” strategy of weakening its CAD in a bid to weaken the INR in a bid to increase exports in a bid to stabilize the CAD in a bid to stabilize the INR might already be seeing some traction in the last leg of this strategic roadmap against most currency baskets. Capital flows, hot money, sticky money should start seeing some pick-up again as domestic macro currently, does not seem in a dire spot with high-frequency indicators in fine fettle. Remain OW on the INR vs. the greenback.
India REER is almost near all-time highs indicating significant
strength in INR stripping off inflationary/carry effects
Source: Bloomberg
TACTICAL ASSET ALLOCATION (TAA) VIEWS & PERFORMANCE
Source: Bloomberg. Assuming a 6% annualized yield for cash.
GLOBAL ASSET PERFORMANCE SNAPSHOT
Source: Bloomberg Equity/Fixed Income Returns/Yields in local currencies. Commodities in USD. Numbers for Fixed Income are Yields. As of August 31, 2022.
ROUTES TO MARKETS: MODEL ALLOCATIONS
