Insights
Energy Crisis: The Power of Positioning
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October 06, 2022
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Energy Crisis: The Power of Positioning
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October 06, 2022
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Energy Crisis: The Power of Positioning
Energy Crisis: The Power of Positioning |
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In September, volatility escalated as both equities and fixed income sold off. Equities fell given the impact of higher inflation, lower projected earnings, and a further derating in PE multiples. Likewise, aggressive central bank tightening hit fixed income. With the exception of cash (U.S. dollar, euro and Japanese yen) and the U.S. 2-year bond, assets across the board were down. In local currency terms, the S&P 500 fell 9.2%, the MSCI Europe and MSCI Japan each returned -6.3% and the MSCI EM (USD) -11.7%1. The U.S. 10-Year yield jumped, ending the month at 3.8%2 and the VIX spiked to 32.6 shortly before month end3. Notably, the UK experienced a collapse in gilt prices, in the wake of a “mini-budget” which included a programme of unfunded tax cuts, with the Bank of England subsequently stepping in to try to stabilise the financial system.
The Energy Crisis and Implications for Currencies
Supply shortages are likely to keep energy prices elevated, especially with ongoing underinvestment in oil exploration due to the sustainable energy transition and the potentially long-lasting halt in Russia’s oil/gas supply to Europe. As prices settle at higher levels, energy’s inflation contribution may start to diminish. However, energy’s impact on trade balances is likely to have a longer-term effect. Generally, net energy importers have seen their Real Effective Exchange Rates (REER) fall this year, whereas net energy exporters such as the U.S., have seen an appreciating or stable REER. Therefore, the energy transition may prove to be a source of structural support for the USD while remaining a headwind for net energy importing currencies such as the euro, sterling and Japanese yen.
A New Regime for Bonds
These dynamics are likely to impact bonds. Not only is the U.S. a net energy exporter, but a stronger currency also reduces imported inflation. This puts it at an advantage relative to the likes of the eurozone, whose weaker currency gives the European Central Bank, further reason to tighten. We anticipate longer-term inflation expectations for both the U.S. and Europe are likely to be at least 2.5% - this is meaningfully above averages over the last decade and suggests equilibrium bond yields are also likely to be higher.
Investment implications
We reduced equities initially, given increasing pressure on central banks to prevent inflation expectations from de-anchoring, and we also lowered duration across sovereign bond holdings. We made the following tactical changes, many of which are reflective of dynamics outlined above:
U.S. Equities
We moved underweight U.S. equities, as we are concerned that there is further potential downside due to the hawkish Federal Reserve and the deteriorating earnings outlook. U.S. equities remain overvalued and vulnerable to repricing, if margins start to come down due to wage pressures and softening economic growth.
High Dividend Low Volatility Equities and Japanese Equities
We removed our overweight to the U.S. High Dividend Low Volatility Equities due to concerns that a larger than normal number of high dividend stocks in this exposure, may not be able to sustain dividends in the face of weaker earnings. We replaced this with a hedged overweight to Japanese equities, which remain relatively resilient amid the current market downturn. Supporting Japanese equities is the accelerating economic activity post-COVID reopening. Moreover, JPY depreciation should provide EPS support. Finally, a greater relative safety is provided by cheaper relative Japanese valuations (especially versus the U.S.).
European Banks
We moved overweight European banks, given attractive valuations and high dividend yields as we seek tactical opportunities to add risk, within our prudent positioning.
UK 10-Year Gilts
We moved underweight UK 10-Year gilts, at the beginning of the month. Post the fallout from the mini-budget, we reduced our position in gilts further. The questionable debt profile, coupled with the divergence between the terminal rate and UK rates is problematic, even after the sharp sell-off.
European 10-Year Government Bonds
We moved underweight European 10-Year government bonds to reduce the European bond duration. The energy crisis is an ongoing issue for sovereigns in the region, which is likely to force central banks to remain hawkish, to cool the economy, support FX and avoid an entrenchment of inflation expectations.
European Investment Grade Credit
We moved from overweight to neutral European investment grade credit. Our updated EUR rates forecasts reflect higher yields in the eurozone. While we do not see much upside to spreads, given that at current levels credit is already priced for a mild recession, the total return in very low duration government bonds looks better over the coming months, than the total return offered by European investment grade credit.
Emerging Market Corporate Bonds
We moved overweight emerging market corporate bonds, which could provide some carry amid global macro uncertainty. We expect this asset class to outperform developed market fixed income, given its better fundamentals and supportive sentiment, as it has a higher-quality tilt, limited default risk, lower volatility, and lower correlation to developed market risk assets.
Gold
We moved from overweight to neutral gold, given gold’s long-held negative correlation with real yields and the U.S. dollar, both of which are experiencing persistent upside pressure.
JPY
We moved from overweight to neutral the Japanese yen. Whilst the yen has already priced in considerable fundamental weakness, potential upside looks limited. The Bank of Japan remains the outlier among developed market central banks, given their ultra-loose monetary policy. The widening U.S.-Japan yield differential and worsening terms of trade do not support the currency.
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.
We have provided our tactical views below:
We have provided our tactical views below:
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Managing Director
Global Balanced Risk Control Team
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