Notes from the Trading Desk – U.S. 10-yr Yields Tighten in a Normal 'Risk-Off' Way

May 22, 2022

11 minute read

by Franklin Templeton Investments blog, Franklin Templeton Investments

The Digest

Last week global equity markets struggled for any clear direction as investors fretted about economic growth. Regionally, performance was very mixed. The S&P 500 Index closed the week down 3%, the STOXX Europe 600 Index closed down 0.6%, whilst the MSCI Asia Pacific Index outperformed, closing the week up 2.8%.¹ Investors focused on consumer sentiment last week as corporates made clear the true impact of inflation on the consumer. Household savings have been dented of late and that has started to feed through to retailers—last week served as a wake-up call for the retail space. The ongoing war in Ukraine as well as China’s zero-COVID-19 policy also continued to weigh on global growth estimates. We are now through most of the current earnings season with 95% of the companies in the S&P 500 and 86% of the STOXX Europe 600 done reporting. Overall, earnings have surprised to the upside, by 10.5% in Europe and 5% in the United States. Outperformance in Europe was mainly driven by the energy space. Yet, market sentiment remains very negative given the latest inflation data, more hawkish central banks and growth fears. The CNN Fear and Greed Index remained in Extreme Fear territory last week.² The latest Fund Managers Survey showed very high cash levels.

Inflation concerns bring on growth fears

Inflation has been a hot topic for markets for months now and there was no change last week. Eurozone Consumer Price Index (CPI) surged to 7.4% in April. Oil and gas prices reached new peaks after Russia’s invasion of Ukraine and, we believe that inflation will likely stay close to current levels until the fourth quarter. In the United Kingdom, April’s inflation accelerated to 9% year-over-year (Y/Y), a 40-year high. Rising energy costs drove last month’s jump also. April’s number was actually a touch lighter than market expectations and in line with Bank of England expectations. The latest reading will keep the cost-of-living crisis front and centre for UK politics. Germany’s April Producer Price Index (PPI) report, which measures price change from the perspective of the seller, rose 33.5% Y/Y, the biggest increase since it was first measured in 1949. Also, last week, the European Commission increased their inflation forecast for fiscal year 2022 to 6.1% from 3.5% previously.

The impact of inflation on the consumer became clearer last week following poor earnings for large US retailers. Merchandise retailer, Target said that they saw a trading down from brand to private label and that discretionary spending was suffering. With that, the stock closed down significantly last week as investors fretted about the continued squeeze on consumers and the impact on future growth. It was a similar story for Walmart, Kohls and Ross. In Europe, Richemont warned of margin weakness and closed the week down substantially. Richemont’s report pointed to revenue weakness in Asia Pacific.

All these news added to concerns around global growth. With that, we saw a number of US banks slash their growth forecasts. JPMorgan cut their US gross domestic product (GDP) forecasts for this year, with second half of 2022 growth now expected to be 2.4% vs 3.0% previously. Goldman Sachs also cut their growth forecasts. They now expect the economy to grow 2.4% in 2022 and 1.6% in 2023, down from 2.6% and 2.2% previously.³ Also, the latest Fund Managers Survey showed that global growth optimism was at record lows.

Despite last week’s renewed fears on growth, the Federal Reserve (Fed) commentary was notably hawkish once again. Fed Chair Jerome Powell said that the Fed would not hesitate to raise rates until there is “clear and convincing evidence that inflation pressures are abating and prices are coming down”. Powell also noted that the labour market is “extremely strong” and consumer spending is healthy, implying the Fed feels that the US consumer can tolerate higher prices for a while longer. Chicago’s Charles Evans noted that forthcoming hikes were needed for tightening financial conditions “as well as for demonstrating our commitment to restraining inflation”. Philadelphia’s Partick Harker said the US economy could withstand a “methodical tightening”. As it stands, Fed fund futures are pricing in rates of 2.75% by the end of the year.

There was plenty of rhetoric from the European Central Bank (ECB) policymakers last week. Firstly, Pablo Hernandez de Cos said that the ECB would likely decide at its next meeting to end its stimulus programme in July and raise interest rates “very soon” after that. Luis de Guindos said that that the ECB needs to move gradually and cautiously, whilst Georg Muller had noted that “gradual” meant rate hikes of 25 basis points (bps)⁴. The market expects a rate hike in July. Ignazio Visco said that a rate hike in June is “certainly” out of the question and that July is “perhaps” the right time to start hiking rates. Meanwhile, Joachim Nagel said that a July hike is possible and that more hikes could follow in quick succession. As it stands, the market expects three 25 bps rate hikes in 2022, with the first fully expected to come at the July meeting.

The Week in Review

Europe

Last week was another volatile one for European equity markets. Despite the continued push-and-pull in markets, the STOXX Europe 600 Index closed the week down just 55 bps following a late sell-off. Albeit, volumes were poor—last week’s moves lower were on the lowest volume week of the year in Euro STOXX 50 cash. European equities have seen extensive outflows year-to-date. Macroeconomic data was in focus again last week as investors debated what the latest reports mean for future inflation and subsequent rate shifts. With that, sentiment has been very cautious of late and we believe we are at the mercy of a bear squeeze on any positive news. Markets did rally on Tuesday on more supportive headlines out of Asia on Chinese technology stocks and as the COVID-19 situation appeared to be easing there too. However, this rally was short-lived as European equities gave up all their gains and more on Wednesday and Thursday as markets struggled for their next move in either direction.

In terms of sectors in Europe, renewables were notably strong last week, following some mergers and acquisitions headlines in the space. Basic resources also outperformed in Europe, making up for recent losses. Utilities also performed better last week. Increasing concerns of consumers getting squeezed is evident when we look at the week’s laggards: Food and beverage, personal and household goods, and retail stocks. Sentiment was hit further as UK Consumer Confidence reported its lowest level since 1974.

United States

It was another tough week for US equities with the S&P 500 down 3.0% and the NASDAQ Composite Index down 4.5% as fears over central bank policy error, stagflation and global economic slowdown stalked markets. For the S&P 500, the decline makes it a seventh week of declines for the index, something that has not happened since 2001, and only happened four times prior to this run. On Friday, the S&P 500 briefly fell into bear market territory, down 20% from its January peak, but the index recovered ground later that same day.

Looking at weekly sector performance, energy names rose significantly, while consumer staples and consumer discretionary names fell, following high-profile profit warnings in the space.

In terms of macroeconomic data, two sentiment surveys came in weaker than expected with the May Empire State Manufacturing Survey falling 36 bps to -11.6 and the May Philadelphia Manufacturing Business Outlook Survey falling 15 bps to 2.6. However, the April US Retail Sales data was better than expected—albeit this reading did lose its significance given the corporate warnings in the space.

Looking at other asset classes, US bonds saw yields tighten in a ”risk-off” environment with the 10-year Treasury yield at 2.78%, down 14 bps. The US dollar (USD) actually saw some respite after weeks of strengthening, with the USD spot down 1.3% with some putting this down to the suggestion we are at peak Fed hawkishness. Interestingly, US credit markets appeared calmer than European credit, with no signs of panic yet in high-yield or investment-grade spreads.

Asia Pacific

Asian equities outperformed global peers with the MSCI Asia Pacific Index seeing a 2.8% rise last week. Hopes that China would step up its support for the economy and ease the crackdown on tech stocks helped improve sentiment.

Hong Kong stocks rose 4.1% after Vice Premier Liu He said the government will support the development of digital economy companies and their public listings. On the back of this, the Hang Seng TECH index gained 6.0% on hopes that China may be ready to ease up on a year-long clampdown on tech giants.

In China, the Shanghai Composite Index rose 2% with talk of a phased reopening of shops in Shanghai. On Friday, the People’s Bank of China (PBOC) lowered the five-year loan prime rate to 4.45% from 4.60%, exceeding expectations for a move of between 5 bps and 10 bps, which should help disposable income for the middle class and counter weak loan demand.

Over the weekend, US President Joe Biden was in the region and helped sentiment further by stating he will review US tariffs on Chinese imports. He noted: “We did not impose any of those tariffs—they were imposed by the last administration”. However, he also stated that the US will defend Taiwan in any attack from China.

The economic picture remains challenging in China. April macroeconomic data released last week were weak, with Industrial Production down 2.9% and Retails Sales down 11.1%.

In Australia we saw a change of government following the election victory of Australian Labor Party leader Anthony Albanese, replacing the current Liberal-National government. There are eight seats left to be counted, with Labor requiring two more seats to hold a majority by itself in the House of Representatives. There was a muted reaction from Australian equities, with the Australian Stock Market Index rising a mere 0.1%.

The Week Ahead

Holidays:

Wednesday 25 May: Sweden (half day)
Thursday 26 May: Denmark, Finland, Norway, Sweden, Switzerland
Friday 27 May: Denmark

Key Events:

Monday 23 May: Germany IFO Survey
Tuesday 24 May: Euro area and UK flash composite Purchasing Managers’ Index (PMI)
Wednesday 25 May: US Federal Open Market Committee (FOMC) minutes
Thursday 26 May: US GDP and Jobless Claims
Friday 27 May: Month-end US pension rebalance

Monday 23 May

Germany IFO Survey
Sweden Public Employment Service (PES) weekly Unemployment

Tuesday 24 May

Euro area flash composite PMI Survey
UK flash composite PMI Survey
US S&P/Markit Manufacturing PMI

Wednesday 25 May

Sweden Unemployment Rate and PPI
Germany GDP and Government Spending
Norway Unemployment Rate
France Consumer Confidence
US Durable Goods
US FOMC minutes

Thursday 26 May

Italy Consumer Confidence Index
Italy Industrial Sales
US GDP and Jobless Claims

Friday 27 May

Sweden Retail Sales
Spain Retail Sales
US Personal Income

Views You Can Use

Drilling Down: Oil Production Scenarios Across Countries

With economies scrambling for alternatives to Russian fossil fuels, Dina Ting, our Head of Global Index Portfolio Management, offers perspective on single-country portfolio exposure to other world oil producers. Read more.

Credit: This Time Is Different?

The Great Wave of Yen Weakness

China: Separating Myth from Reality

What Are the Risks?

All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.

Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.

Past performance is not an indicator or guarantee of future performance. There is no assurance that any estimate, forecast or projection will be realised.

Links to External Sites

Franklin Templeton is not responsible for the content of external websites.

The inclusion of a link to an external website should not be understood to be an endorsement of that website or the site’s owners (or their products/services).

Links can take you to third-party sites/media with information and services not reviewed or endorsed by us. We urge you to review the privacy, security, terms of use, and other policies of each site you visit as we have no control over, and assume no responsibility or liability for them.

Important Legal Information

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.

Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.

Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.

Issued in the U.S. by Franklin Distributors, LLC, One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com – Franklin Distributors, LLC, member FINRA/SIPC, is the principal distributor of Franklin Templeton U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.

_______________

1. Indices are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.

2. CNN’s Fear & Greed Index tracks seven indicators of investor sentiment. Indices are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.

3. Bloomberg.

4. One basis point is equal to 0.01%.

This post was first published at the official blog of Franklin Templeton Investments.