Tom & Jerry, Oil, China and European Banks
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The Fed’s cat-and-mouse game with markets will get a reality check this week with the October CPI print.
- The game goes as follows: 1) the equity market rebound in early November was fuelled by lower yields at the long end of the curve; but, 2) the easing of financial conditions goes against the Fed’s intentions to keep fighting against inflation, at least in the short term; and then, 3) the Fed members’ remarks have been a tad more hawkish in recent speeches, as if the Fed was exercising implied yield curve control, in a range of 4.5-5% for the 10-year.
- Consensus expects the US CPI at 3.3%, from 3.7% in September. The near 3% fall in retail fuel prices in October will be helpful. The core CPI is expected to remain unchanged, at 4.1%. Yet, there is room for the shelter component, one of the biggest contributors to inflation, to edge lower and bring positive surprises.
Lower oil prices, a tailwind for disinflation. The steep fall in oil prices continued last week, despite worsening geopolitics in the Middle East, as weak demand prospects came sharply into play. Recent weakness in China’s growth (PMI, exports) contributed to drag oil prices lower, a positive for global disinflationary forces. We have no exposure to cyclical commodities in our asset allocation and are OW Energy in our MSCI Europe ratings framework.
- The next OPEC meeting on 26 November is a critical milestone. Oil supply cuts by major oil exporters will be reviewed and probably extended into early next year. We believe the cartel is fine with oil prices of around USD80/b, which is exactly Saudi Arabia’s fiscal breakeven oil price (the level needed to balance the budget) according to IMF estimates.
- Should oil prices fall below USD75/b, we might add Oil to our asset allocation on the back of expected hawkish comments regarding supply cuts.
Recent macro data from China suggests the mid-term outlook stays adverse: house prices keep falling in most cities, credit risks in the property sector stay elevated, and capital outflows are significant. We show in the report that global corporates appear to be fleeing China, as foreign direct investment into the country has turned negative for the first time in decades. Although fiscal policy has turned more supportive, the room for additional monetary stimulus is limited by the Fed’s tightening bias. We note, however, that the Chinese authorities are becoming increasingly frustrated with the levels of equity markets while valuations are low.
- We are exposed in our asset allocation to EM equities ex-China. We show that Latin America and Brazil are particularly attractive from a valuation standpoint. Note that Brazil is set to become a major oil producer by the end of the decade. According to Rystad, South America is poised to produce 9 mb/d by 2030, not far from Saudi Arabia’s current oil production.
In European equities, we keep banking on Banks. We are revisiting our stance on the back of expected interest rate cuts by the ECB next year and ahead of a growth deceleration in the euro area.
- On a positive note, valuation and shareholder-friendly policies (dividend and buybacks) remain highly supportive. Our macro scenario, which involves a mild contraction, should have no meaningful implications for banks’ asset quality. Capital ratios are strong, and provisions are high. Nevertheless, net interest income will be under pressure with falling rates, while exposure to commercial real estate remains an issue for some players. The sector could indeed be highly vulnerable in the event the recession turns out to be deeper than expected.
- In our view, a dividend and buyback yield of close to 10% in Europe (15% for some banks) remains highly appealing in our base macro scenario. The sector beta and volatility have decreased in recent quarters. We stay OW.
Week ahead: the US CPI and PPI releases for October will be key market movers next week. US retail sales will also be available and are expected to have eased compared to the previous print. In China, retail sales, fixed asset investments and industrial production will be available. Keep an eye on the Xi-Biden meeting on Wednesday.
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