The shift to a tighter global liquidity backdrop continues and geopolitical risks in Eastern Europe have not faded, this is a volatile backdrop for EM assets and argues for a focus on relative value and tactical opportunities
The broad theme of a high vol, tactical macro environment continued last week, with global rates continuing to have high levels of intra range volatility (with a bearish bias) and continued divergence across macro assets.
Notably, Brazilian equities had a 1.6 weekly stdev move higher while S&P fell, the USD had a 1.3 stdev move lower despite another 10bp move higher in US front end yields, and oil and the energy sector meaningfully outperformed industrial base metals. Finally, a negative outcome from the Russia - US talks resulted in a sharp move higher in Russian rates, where 1y1y rates had a 127bp rise over the week, a 4.1 weekly stdev move higher.
We have held the view for several quarters now that we are in an inflationary environment, and inflationary environments are more volatile in aggregate, as the market needs to price the risk of either policy tightening or a policy mistake.
In that vein, this week had several key macro data that supports the view that we are at an inflection point where policy support driven expansion is shifting to a policy driven normalization (or contraction). A quick snapshot of this week’s US data tells this story:
· Headline CPI data came in at 7% on a yoy basis, despite a 0.4% mom fall in energy prices, while core CPI rose to 5.45% yoy the highest since 1991 with broad based gains for vehicles, rent, transportation, lodging, apparel, and household furnishings and operations.
· Uni Michigan median five-year-ahead measure rose to 3.1% the highest since 2011.
· Gov. Brainard, previously the standard bearer for the doves, said she supports rate hikes "as soon as asset purchases are terminated" and Harker among others clearly signaled to a base case of 3-4 hikes this year.
Taken together, this week's data must be concerning for the Fed. The rising and broadening inflation in core components is being reflected in both survey measures of inflation expectations and quantitative measures, such as the “sticky price" measure from the Atlanta Fed reaching the highest level since 1991. Inflation may indeed have peaked at 7% yoy, but if inflation remains high, the Fed will still be meaningfully behind the curve.
This, in our view, is why the Fed has been so quick to embrace QT as a way to tighten policy without steeper rate hikes. They have been successful so far, real yields are higher by 35bps this January, and mortgage rates reached the highest point since June 2020.
However, the most important factor does remain the Fed hiking path. Since the middle of last year, the market has been responding to the rise in inflation by bringing forward hikes (sooner), but not by pricing a faster or steeper hiking path. As a result, the Fed hiking path is extremely shallow, and the terminal rate has remained capped. However, with the market is now fully pricing a 25bp hike in March, 4 hikes to December and 6 hikes through to November 2023, something will have to give if the market (and the Fed) wishes to tighten financial conditions via the rate hiking path.
The fact is, given where inflation and inflation swaps are, the currently priced hiking path would keep rates at an extremely accommodative level. Therefore, assuming the Fed's desire to tighten policy, the risks are clearly skewed to the upside if inflation does not ease materially, and soon. The three options, steeper (greater than 25bp), faster (hikes not just on quarterly SEP meetings), longer (moving rates beyond neutral or higher terminal rate) are not mutually exclusive, but there is a path dependency in that a slower and shallower start leads to a higher probability of a longer cycle.
The key is inflation, its level and breadth. If there are no signs of easing in the key inflation data the Fed looks at, it seems reasonable that the Fed would consider the risks of waiting for each SEP meeting too high and the faster route would be taken. If inflation re-accelerates, then steeper hikes are on the table, and if inflation is persistent, we are likely to get a much longer cycle. QT buys some time by tightening financial conditions, but even if 5y inflation swaps were to normalize back to 2.60% , in order to get 5y real yields to -50bps (still very accommodative) it would require 5y nominal yields to be 50bps higher than here.
This shows the level of yield moves that may be necessary to get real yields and financial conditions back to a more normal level. Put simply, if inflation does not fall, the risks to the upside in yields are clear, and on balance they are likely to come first via a faster (hikes not just on SEP meetings) or steeper (50bp per SEP meeting) hiking cycle.
This type of risk premium is at least observable and hedgeable for market participants. The same cannot be said for the risk of war between Russia and Ukraine and there are a few observations we would share, which are informed by our long-standing focus on geopolitical risks at Calvion.
Russia and Putin have been remarkably consistent about the security demands from NATO, which would effectively end NATO as it is currently constituted and re-establish the Russian sphere of influence in ex-Soviet bloc states. Unsurprisingly, they have been rejected outright by the US and NATO. The concern is that talks in December and January have escalated the conflict, and there has been little to no sign (so far) that these demands are points of negotiation.
To be sure, the sanctions response to a Russian invasion of Ukraine would be extremely punitive, but the Russian economy is a better place than it has been to face this type of response, and furthermore the energy crisis in Europe gives Russia a key defensive lever in a sanctions response to military engagement. Put simply, if Ukraine is the prize Putin wants, the cost right now might be one he is willing to bear, and he has several strategic and tactical advantages that may not be there in the future. Our analysis therefore is that the risk of military conflict is higher than many market participants think, and we own RUB put options as a hedge against this risk.
Overall, our book remains relatively beta neutral, and we made moderate portfolio adjustments last week, adding Poland steepeners to reflect the new inflation shield 2.0 that we perceive will add to pressure on the belly of the curve. Our perception is that we are entering a new regime, but in this period of transition, a tactical orientation is prudent.
COVID Update
World COVID cases continued to rise over the last week to new record highs, with cases rising globally in every region. Despite the surge in global COVID cases, global COVID deaths remain near the lows seen in the last year. In Asia last week, Omicron waves increased to record highs in Australia and the Philippines and are rapidly approaching previous records in India. In China, where cases increased just +6.2% for the week to 1,285, COVID policymakers' zero-tolerance COVID policy approach has led to over 20 million people in multiple cities being put into lockdown. In CEEMEA, cases continued to fall in South Africa, while rising in much of CEE and rising to all-time highs in Turkey. In South America, COVID cases have rapidly increased to all-time highs - an increase that has come at a much lower cost to mobility than in prior waves, as the chart below shows.
In the US and Europe, COVID cases hit new highs last week, with hospitalizations and deaths as a share of reported cases in both regions well below the levels seen in prior waves. The last week also brought some initial signs that the Omicron waves in the US and Europe may soon peak. In the United Kingdom, one of the first countries in Europe to see a significant Omicron wave, cases are down nearly 32% from their early January peak. In the US, the leading data we track on Google searches for COVID testing and symptoms is now falling. Similarly, the charts below show that the leading wastewater data we track has peaked in Massachusetts and San Jose. In New York City, one of the first US cities to see a major Omicron wave last month, cases have begun falling sharply.
Several studies released in recent weeks have found that Omicron has a much higher rate of asymptomatic cases than prior variants. Beyond the association with lower severity, the higher share of asymptomatic cases helps explain part of Omicron’s high transmissibility levels. Omicron’s higher levels of asymptomatic carriage are another reason to believe that reported case levels are undercounting infections in this wave. An implication of these findings is that severity levels relative to confirmed cases underestimate the extent to which severity has fallen in the Omicron wave.
Potentially due to the lower severity data, there have been several signs of a shift in the policy reaction to COVID over the last week. On Thursday, UK Health Secretary Sajid Javid announced an end to COVID passes and cut in the COVID isolation period to five days. Some leading voices in global public health, such as Bill Gates, have also commented that COVID may be treated more like the seasonal flu after the current Omicron wave passes. If confidence in lower severity continues to build, it seems likely that policymakers will continue to pivot and moderate their responses to COVID risks. Markets are also starting to increasingly come around to the idea that Omicron is improving the medium-term COVID destination despite higher near-term cases which the chart below comparing Global cases with equity market lockdown outperformers/underperformers illustrates well.
Calvion's View: In the near term, we continue to see potential risks to demand and labor supply related to the elevated levels of Omicron cases. We also see policy risks associated with the rise of large Omicron waves, an economic risk that is particularly significant in China both due to the relative lack of flexibility regarding zero-tolerance and China’s importance to global supply chains. In the medium-term, we see the lower severity with the Omicron variant (along with vaccines and antiviral pills) as a key positive, which can potentially turn the COVID pandemic into a milder endemic phase, where the virus is no longer a significant macroeconomic factor.