Inflation & bonds
You’ve no-doubt had clients hitting the phones of late (maybe even literally) because you told them to diversify and yet bonds and equities have been falling in tandem.
But now you’re a hero because April’s inflation number finally broke the correlation. Why though?
Here’s a simple explanation. Global stock investors, who are about to nurse a sixth straight week of losses for the first time since the financial crisis, have been obsessing about economic growth downgrades for a while, even while forward activity indicators such as JPMorgan’s manufacturing output index remain elevated.
Inflation was the bigger worry for bond owners, however, which is why 10-year yields recently touched 3.12%
No longer, it seems. Despite a rise of 0.7% month on month in core services prices in the US – the fastest pace in more than three decades – on this occasion fixed income traders read it as a warning that policy rates have to squeeze until the economy pops.
Hence, it’s time to get defensive, they must have concluded. Almost 90% of a $36 billion 10-year treasury note sale was quickly snapped up at 2.94%.
Yields are five basis points lower already, and more money will be made if our strategists are right, and inflation has more or less peaked.
Patterns in China
Whether it’s a hedge fund manager seeking candidates for a long-short strategy, or an analyst looking for additional tools to gauge the attractiveness of an equity, the statistical property of ‘cointegration’ is worth understanding.
Simply put, the presence of cointegration in a pair of stocks suggests that their price series exhibit a stable long-term pattern. If a significant deviation is observed, it is likely because one is overvalued relative to the other.
Cointegration tends to exist in assets that are similar to one another, such as an A- and H-share pair that represent the same Chinese company but listed separately on onshore and offshore exchanges.
The chart below summarizes the results of our analysis on fifteen A-H share pairs with large market caps. We found substantial evidence of cointegration existing among some pairs, especially within the financial sector.
Strong dollar
Meanwhile a pattern has emerged that can be viewed from the moon, a surging dollar versus almost everything.
On a trade weighted basis it’s at its highest level in two decades – up 15% in the last year and eight in the past three months.
Against the yen the chart is vertiginous. What is going on? The greenback has clearly benefited from a combination of relatively higher US rates as well as flows to safety amid current geopolitical stresses.
But a weaker outlook for the global economy is also playing its usual role. If the dollar is haven currency once again, the difference perhaps this time is that the Federal Reserve might be happy with this.
Exchange rates aren’t the first tool central banks usually reach for, but given the desire to bring down inflation, a strong currency that mechanically reduces the cost of imports is certainly appreciated.
Conversely, the Bank of England and European Central Bank will be concerned by the prospect of what economists call a ‘reverse currency war’, whereby regions battle to offset the risk to inflation by supporting their currencies.
In 1971, US Treasury Secretary John Connally said, “the dollar is our currency, but it’s your problem”.
For investors it certainly feels that way right now.
Value stocks
Value stocks may have lost 8% this year, but they are still up a tenth since the start of 2021.
Growth stocks, by comparison, are down by more than a tenth in the same period. The trend might continue, with relative earnings yields still in favor of value.
Per the chart below, the long-term average yield premium, or the higher share of earnings you receive when buying value stocks, is just over one and a half per cent.
Today’s readings are nearly double that, approaching 3%.
Furthermore, value stocks are more concentrated in sectors such as energy, utilities and healthcare – businesses with inelastic demand and strong pricing power, as evidenced by an increase in their profit margins last quarter.
This leaves them more resilient to inflation or slowing growth.
