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November 03, 2022

Services Inflation: Higher Hurdle for Further Upside

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November 03, 2022

Services Inflation: Higher Hurdle for Further Upside


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Services Inflation: Higher Hurdle for Further Upside

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November 03, 2022

 
 

In  October, equities across developed markets rallied. The U.S. was the best performer as the S&P 500 Index returned 8.1%1. In local currency terms, the MSCI Europe Index and MSCI Japan Index each returned 6.2% and 5.7% respectively1. In contrast, the MSCI EM Index (USD) fell 3.1%1. The energy sector rallied hard, with the MSCI ACWI Energy Index returning 18.0%1, far outperforming the other sectors. While monetary policy continues to tighten, inflation remains broad-based and far too elevated. The U.S. 10-Year yield was pressured higher, ending the month at 4.1%2  and the VIX peaked at 33.6 in mid-month, before easing somewhat to a level of 25.9 by month-end3.

 
 

U.S.: From goods to services inflation
Many expect U.S. inflation to plateau and subsequently fall, as supply chain constraints have eased meaningfully and goods inflation normalises. However, pressure remains elevated in another component of inflation: services. Historically stickier than the more volatile goods component, it may take longer to come down. The services sector is still exhibiting tight labour market conditions, creating wage pressure. In an economy heavily based on services, wage inflation may prove difficult to suppress. However, at the same time, some key categories within the Consumer Price Index (CPI), such as shelter and healthcare, are subject to significant lags. This can make it more challenging to isolate the ongoing impacts of a tight labour market and the lagged effects of the pandemic within the CPI.

Towards a more insular China
China’s 20th Party Congress held from 16 to 22 October, concluded with President Xi Jinping’s re-appointment for a third term. The reshuffle in his executive committee demonstrated that President Xi’s top priority is to concentrate power, as his committee predominantly now consists of people who should help further his stronghold. The present-day policy direction is likely to be maintained, with the zero-COVID policy dynamic expected to be in place longer than anticipated. There is an increased emphasis on national security, as opposed to growth and development, along with a further sharpening of focus on Taiwan’s re-unification with China.

Investment implications
We have maintained a stable allocation to equities throughout the month. We remain cautiously positioned given the headwinds that we continue to see for global markets as they could cause further volatility. We see residual downside to equities, especially with respect to earnings. It is in this context that we made the following tactical changes in October:

China A Equities
We moved from overweight to neutral in China A equities. We no longer expect China A to outperform global equities, due to a lack of positive catalysts.

UK Gilts
At the end of October, we reduced our underweight of UK gilts versus European government bonds, as the UK government’s policy U-turn and change in leadership reduces the risk of downside.

Short-Dated Mexican and Brazilian Bonds
For portfolios which permit, we added short-dated Mexican and Brazilian bond exposures. Both Mexico and Brazil are considerably ahead of the U.S. in terms of tightening monetary policy. Consequently, their short-dated bonds offer attractive carry, while we see the potential for FX upside in BRL and MXN in 2023.

Duration and U.S. 10-Year Treasuries
We moved from underweight to neutral duration on U.S. 10-Year Treasuries. U.S. 10-Year yields had risen significantly since we moved underweight in late August. Since then, the U.S. terminal rate has moved above 5.0%, rate cuts in 2023 have largely been priced out, real yields have moved above the top of our forecast range and financial conditions have re-tightened to YTD highs. The U.S. labour market remains resilient, but other segments of the economy, such as residential and non-residential investment, are showing growing signs of weakness. Moreover, valuations at current levels appear fair. Consequently, we see the risk to yields as more balanced.

Sterling (GBP)
We moved underweight sterling at the beginning of October, as we believed the fiscal deficit was likely to rise meaningfully following the tax cuts and support to households on energy bills. The twin deficit is at risk of being the highest on record over the next two years.

Euro (EUR)
We moved from overweight to neutral the euro versus the U.S. dollar. A higher risk premium may need to be applied to the euro, given the structural issues facing the eurozone. Also, we believe that the U.S. dollar’s strength is likely to continue, as long as flows to “safe haven” assets persist. Demand will likely remain high until the U.S. terminal rate peaks and global growth expectations bottom. In addition, we are looking out for catalysts, such as a capitulation in the S&P 500 and signs of the U.S. labour market starting to soften.

The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.  See Disclosure section for index definitions.

 
 
 
Tactical Positioning
We have provided our tactical views below:
 

Source: MSIM GBaR team, as of 31 October 2022. For informational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The tactical views expressed above are a broad reflection of our team’s views and implementations, expressed for client communication purposes. The information herein does not contend to address the financial objectives, situation or specific needs of any individual investor. The signals represent the GBaR team’s view on each asset class. A negative signal indicates a negative or underweight relative view, a positive signal indicates a positive or overweight relative view. Light blue indicates the tactical view before the change, with dark blue indicating the view as of 31 October 2022.

 
 

1 Bloomberg, 1-month returns, total return indices, as of 30 September 2022.
2 Bloomberg, as of 30 September 2022.
3 The VIX spiked to 32.6 on 27 September and ended the month at 31.6

 
andrew.harmstone
Managing Director
Global Balanced Risk Control Team
 
manfred.hui
Managing Director
Global Balanced Risk Control Team
 

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RISK CONSIDERATIONS

There is no assurance that the Strategy will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them.  Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events.  Accordingly, you can lose money investing in this portfolio. Please be aware that this strategy may be subject to certain additional risks. There is the risk that the Adviser’s asset allocation methodology and assumptions regarding the Underlying Portfolios may be incorrect in light of actual market conditions and the Portfolio may not achieve its investment objective. Share prices also tend to be volatile and there is a significant possibility of loss. The portfolio’s investments in commodity-linked notes involve substantial risks, including risk of loss of a significant portion of their principal value. In addition to commodity risk, they may be subject to additional special risks, such as risk of loss of interest and principal, lack of secondary market and risk of greater volatility, that do not affect traditional equity and debt securities. Currency fluctuations could erase investment gains or add to investment losses. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Equity and foreign securities are generally more volatile than fixed income securities and are subject to currency, political, economic and market risks. Equity values fluctuate in response to activities specific to a company. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Exchange traded funds (ETFs) shares have many of the same risks as direct investments in common stocks or bonds and their market value will fluctuate as the value of the underlying index does. By investing in exchange traded funds ETFs and other Investment Funds, the portfolio absorbs both its own expenses and those of the ETFs and Investment Funds it invests in. Supply and demand for ETFs and Investment Funds may not be correlated to that of the underlying securities. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolio’s performance. A currency forward is a hedging tool that does not involve any upfront payment. The use of leverage may increase volatility in the Portfolio.

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EPS Growth Rate: Total earnings divided by the number of shares outstanding. Companies often use a weighted average of shares outstanding over the reporting term. EPS can be calculated for the previous year ("trailing EPS"), for the current year ("current EPS"), or for the coming year ("forward EPS"). Note that last year's EPS would be actual, while current year and forward year EPS would be estimates.

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S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization U.S. stocks.

VIX©: This is a trademarked ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 Index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market’s expectation of stock market volatility over the next 30-day period.

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