Are Markets Getting Too Complacent About Inflation?
The US CPI print of 7.7% for October was well below market expectations, and drove some sharp repricing – risk assets rallied as perceived safe havens sold off (Figure 1). In equities, sectors with longer dated cashflows such as tech rose, with healthcare, staples and energy lagging (Figure 2). Expected inflation remains down from its peak, although we are currently seeing a small spike in consumer inflation expectations (Figure 3).
However, what do lower inflation and lower expected inflation mean for the future?
Despite the lower print, the market still expects four further rate hikes from the Federal Reserve (‘Fed’) by Q2 2023. While this has supported short-term yields, long-term yields have not kept pace, with the US yield curve inverted across a range of maturities. The 30-year minus 2-year, 10-year minus 2-year and 10-year minus 3-month yield spreads are negative, with the latter two seen as reliable recession indicators (Figure 4).
When we also consider the base effect after a year of high inflation prints, recessionary momentum is building to the point where we will almost certainly see lower inflation. The question is then whether lower inflation is low enough: supply constraints remain, which mean that we are unlikely to see inflation of around the Fed’s target of 2%. When combined with the weaker data we should see as the US slides into recession, October may be one strand of an argument which allows the Fed to finally pivot – to the likely benefit of risk assets. The only note of caution is whether this will be enough. After a decade when exceptionally loose monetary policy failed to spark meaningful growth, is it reasonable to expect another rally in the midst of recession?
Figure 1. Risks Assets Versus Safe Havens
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Source: Bloomberg; as of 18 November 2022.
Figure 2. US Equity Sectors
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Source: Bloomberg; as of 18 November 2022.
Figure 3. Median Consumer Inflation Expectations
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Source: Federal Reserve Bank of New York; as of 18 November 2022.
Figure 4. US Inverted Yield Curves
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Source: Bloomberg; as of 18 November 2022.
Emerging Equities and a Suddenly Submerging Dollar
A strengthening US dollar was one of the clearest market themes of the first three quarters of 2022, driven by tighter policy from the Fed and demand for US-denominated assets amid rising geopolitical risk in Europe and heightened volatility. Yet the dollar’s trajectory changed sharply in November after a US CPI reading of 7.7% year-on-year undershot investor expectations, fuelling hopes of a Fed pivot.
While this brought some relief to emerging markets (‘EM’), we expect already-high currency volatility to persist while investors continue to guess the Fed’s next step (Figure 5). For large-cap EM equities, Man Numeric’s proprietary Statistical Factor Risk Model captures such elevated volatility (Figure 5) as we believe it is prudent to control for unwanted currency risk in portfolios.
The bigger stocks in the region have more direct earnings exposure to developed economies and global capital flows (Figure 6), thus tend to be more sensitive to macro shocks. The cross-sectional return dispersion explainable by risk factors related to the macro environment – such as country, sector and style factors – is indeed much higher for larger companies (Figure 7).
In a scenario of continued global tightening and US dollar strength, we believe exposure to EM small-caps can provide exposure to EM economic fundamentals with reduced macro sensitivity and therefore a greater potential diversification benefit.
Figure 5. 252-Day Rolling Volatility of the US Dollar Index and % of Dollar Volatility Captured by Man Numeric Statistical Factor Risk Model (“SFRM”)
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Source: Man Numeric; as of 30 September 2022.
Figure 6. Foreign Sales as % of Revenue
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Source: MSCI, WorldScope, Man Numeric; as of 30 September 2022.
Figure 7. Share of Cross-sectional Return Dispersion Attributable to Risk Factors
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Source: Man Numeric; as of 30 September 2022.
With contribution from: Gilles Gharios (Man GLG – Head of Investment Risk) and Ziang Fang (Man Numeric – Portfolio Manager)
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