Macro
Outside of the US, investors focus remains on changes taking place in the second largest economy. China has heavy debt burden while it’s population is shrinking and its productivity gains are slowing. Chinese cash reserves are expected to decline, as aging population will start spending their savings. Urbanization rate has slowed significantly, and the real estate market is in decline since last year (and for the first time since 1999).
Since country’s capital stock as percentage of GDP (which was increasing at a very rapid pace since 90’s) reach the level of western countries, the marginal return will significantly decline. Decline in investment efficiency can lead to decline in the investment rate, which should be gradual due to significant involvement of the government and heavy support from the state investments. As fiscal deficit grew, the government will have to pull back on a wider infrastructure spending.
Country already feels significant impact of the geopolitical tensions with the west and decoupling from China, and domestic demand is insufficient to offset declining export.
Rates
Short to intermediary rate seams to be closer to reaching equilibrium, while 10Y yields may continue to decline. However there is a risk that the long-term rates could still go higher after the recent sell-off, especially now with an increased supply of treasuries, and weakened international demand. Every week Treasury is adding additional USD 400-500b of Treasuries to the market, compare to around 100b per week before the pandemic. This large increase in supply comes at the time when the FED shifts to QT and stop buying treasuries, while private market is becoming saturated and is worried about the inflation.
As market calibrates rates, it’s important to take a closer at the dirvers of premiums. Large portion of the increase in the 10Y Treasury premium can be attributed to increase in the inflation uncertainty. This is caused by increase in inflation volatility since covid pandemic, supply chain disruptions, on-shorting/near-shorting trends, and loose fiscal policy. From the historical perspective, over the years decline of the total term premium was mostly driven by decline in the real term premium. This over time made inflation risk premium a much bigger portion of the total risk premium, therefore total risk premium are now more sensitive to the inflation risks than historically.
Being in cash on the shortest end of the curve has been undeniably the biggest winner in rates market. But adding to the long-term exposure and averaging into duration exposure is very attractive at the current rates. With real yields around 2% it is very tempting to lock-in those rates. Especially if one is aligned with the growing consensus that we have reached the end of the hiking cycle.
Credit
HY spreads still remains resilient, mostly due to changes to the credit market structure described in the last week’s snippet. HY market increase in quality in recent years as the lowest quality issues moved to the Private Credit and the Leverage Loan Market. Credit investors observe tight spreads but also tight liquidity.
There is significant amount of lending in the shadow banking system – the private side of the credit markets. As private markets are difficult to monitor there is no natural way to analysing where the potential cracks are.
Given all of that it may not be the best time to add to the credit exposure, with so much added pressure coming from increased financing costs for the companies. If rates will stay high, this pressure is expected to only increase, as the amount of debt due will increase significantly over the next few years.
Amount of debt due each year for Junk-rated companies
Source: FT
Other side of this argument is that the interest pressure adds to the total returns of a credit investors, while the same pressure increases the risk of capital much more for the equity investors. Therefore from a relative risk perspective, the credit investors are the net beneficiaries.
Equities
Stock has rallied for the whole week, and rapidly recovered from last Friday’s (27th of October) lowest point since May. Rally was a response to a renewed rate cut optimism, strong oversold conditions and risk-reversal from VIX reached over 20 points. This was also November, historically good month for equities as they tend to rally towards the year end, especially in recovery years.
There are also a good fundamental reasons for the rally. As analysts expect double digit earnings growth next year, stocks do not look expensive. Last week large caps where trading at roughly 16.5x next year earnings, and excluding ‘Magnificent 7’ below 14x next year earnings, and at 12x and 11x earnings for the mid and small caps respectively. Multiples will grow as investors will get more comfortable with the idea of soft landing or once the FED will confirm that they are starting to consider rate custs for next year.
Relative positioning is also supportive for equities. JP Morgan client survey shows that 67% of their clients are planning to increase equity exposure in the short run – highest reading since October last year.