Macro

Based on all upcoming macro data, the FED is highly unlikely to cut rates as much as the market expects. CPI and PCE reported this week that they are falling but above expectations. Most of the resilience in inflation comes from the services sector, which is mostly a post-COVID catch-up. The overall mosaic of the data emboldens the FED’s patient stance. It is unlikely that there will be a cut before May, and we need to look at how the total data will unfold until then.

Chinese economic growth is still very dependent on export and government investment, which leads to unsustainably high construction. Now, China is in a painful period of adjustment after the initial liquidity crisis, where major developers such as Evergrande, Kaisa Group Holdings, China Fortune Land Development, Sunac China Holdings, Fantasia Holdings Group, Guangzhou R&F Properties, Modern Land (China) Co. (and more) are struggling to service their debts and defaulted on some of their obligations.

Although this liquidity crisis has already been managed, there has been no significant adjustment to the overall construction intensity. Projects have shifted from the private sector to public housing, which keeps the economy dependent on government spending and keeps enlarging the debt burden. This largest component of economic growth is unsustainable in the mid-term, and the Chinese government is struggling to replace it with more organic sources of growth.

China is also remaining heavily dependent on foreign demand, which consumes over half of its industrial output. Although demand has increased thanks to the robust growth in US manufacturing, it remains vulnerable to an increase in protectionism and a potential economic downturn abroad. Rebalancing foreign demand from domestic consumption remains challenging.

There is also the question of sustainability, with capital flowing into government-favoured sectors and over-investment in areas with sizeable political oversight, not those most productive or profitable. The ambition to focus on higher-quality growth through high-tech manufacturing yields questionable results. The most noticeable example is the aggressive acquisition and development of semiconductor technology with strong state support and massive investment in R&D.

At the same time, the new regulatory framework has significantly constrained the private tech sector. They include antitrust measures and fines, righter control on IPOs and foreign listings, data protection laws, and restrictions on private education and online gaming. Major tech players have been fined for unfair competition practices, such as exclusive music copyright agreements and e-commerce deals. They also found more stringent data processing and consent requirements through the introduction of the Personal Information Protection Law.

Rates

After inflation data came out hotter than expected, 2Y has increased to 4.67%. Much of the re-calibration will happen at the end of February when the FED’s preferred measure of inflation, the PCE Deflator, will be published.

The current rate environment is more likely range-bound, and we are at the upper end of the range. With repricing, it is important to see what the market expects of the terminal rate. With the most recent increase in rates, the expected terminal rate is close to 4%, which should be a good buying opportunity if one assumes that, over time, yields will gravitate closer to the long-run rate approaching 2%.

Based on this backdrop, this should be a good time to look for longer-dated bonds and add to the duration. Also, buying further out on the curve is more attractive, especially when capturing the expected long-term rate. Investors, however, should consider the heightened risk. Duration has been a low-sharp ratio strategy due to the high volatility of rates.

Credit

It is a very strong start to the year for the credit. Issuance remains hot and is approaching a record level, with a $37b volume added last week (and $41b the previous week); February issuance is on track to come close to January’s $196b IG issuance – the busiest January on record. Borrowers are taking advantage of the tight spreads and lower financing costs than last year. Given those lower financing costs, they are also trying to pull forward some of the refinancing from the ‘maturity wall’ discussed in the previous 12 months.

The macro backdrop is very strong, with stable growth, disinflation, and the expected beginning of the easing cycle. Therefore, this high supply meets even higher demand as investors emboldened by a “soft landing” outlook try to lock in high total yields. Diversified high-grade credit portfolios can now generate 6 to 8%, and by adding high yields to the mix, can reach 8 to 10%.

Credit risk is different in different sectors and very different for different credit issuers requiring prudence in credit selection. As we might be in the late cycle (which might take years) and spreads are very tight, investors must analyse their exposure with greater caution.

Equities

—— Pending ——