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- Infrastructure bounces back as markets meander
Market index returns
Week to date since September 6, 2023 as of September 13, 2023
Index definitions: Global Real Estate = FTSE EPRA/NAREIT Developed Index; Global Infrastructure = Dow Jones Brookfield Global Infrastructure Index; Natural Resource Equities = S&P Global Natural Resources Index; Commodity Futures = Bloomberg Commodity Index; TIPS = Barclays US TIPS Index; Global Equities = MSCI World Index; Real Assets Index = 30% FTSE EPRA/NAREIT Developed Index, 30% Dow Jones Brookfield Global Infrastructure Index; 15% S&P Global Natural Resources Index; 15% Bloomberg Commodity Index, 10% Barclays TIPS Index. Source: Bloomberg, DWS. Past performance is not indicative of future results. It is not possible to invest directly in an index.
Market commentary:
Risk assets searched for direction this week ahead of new incoming inflation data and several important central bank meetings. Broader equity markets eked out a minor gain, with volatility largely absent from both equity and fixed income markets. Within Real Assets, Global Infrastructure securities were the standouts, with American utilities leading the charge. TIPS and Commodities also outperformed the broader markets, with the latter assisted by the continuing rise in energy prices. Global Real Estate securities and Natural Resource Equities experienced minor losses for the week from softness in the U.S. Office REITs, Hong Kong developers, and Metals & Mining names.
Why it matters: In the near-term, markets will likely take their cues from central bank policy measures, but self-inflicted economic injury is also a risk. For example, an extended strike by the United Auto Workers (UAW) union, which will have started in limited fashion by the time you read this, or a U.S. government shutdown, which seems increasingly likely at the end of the month, could easily shatter fragile hopes for a soft landing and tip the U.S. into a recession. Given these concerns and other geopolitical risks (i.e. Russia and North Korea becoming besties), we maintain that a professionally managed, holistic allocation to Liquid Real Assets can offer diversification benefits, inflation protection, and defensive posturing, given the necessity-based traits of many Real Assets. Furthermore, the liquid nature of these securities can allow professional investment managers and individual investors alike the opportunity to shift their allocations quickly and efficiently as needed when compared to similar assets in the private markets.
Digging deeper: Data in the U.S. this week shows that disinflation is on pause, yet the market expects the U.S. Federal Reserve (Fed) to hold steady next week and is only pricing in a 31% likelihood of a hike in November. Recent data has generally been positive, and with an election in 2024, the Fed will want to be out of the way; hence, we ponder whether the Fed may view a hike next week as an insurance policy. The European Central Bank (ECB) went ahead with another rate increase, though its future rate-setting path is not so clear. Across the channel, the UK remains in a bind: stubborn inflation suggests the Bank of England’s (BoE’s) work is not finished, but contracting economic growth portends caution lest it risk tipping the country into a recession. Finally, we note that crude oil prices have continued to climb and could head even higher in light of a production shortfall that could last through the year-end.
Why it matters: In the near-term, markets will likely take their cues from central bank policy measures, but self-inflicted economic injury is also a risk. For example, an extended strike by the United Auto Workers (UAW) union, which will have started in limited fashion by the time you read this, or a U.S. government shutdown, which seems increasingly likely at the end of the month, could easily shatter fragile hopes for a soft landing and tip the U.S. into a recession. Given these concerns and other geopolitical risks (i.e. Russia and North Korea becoming besties), we maintain that a professionally managed, holistic allocation to Liquid Real Assets can offer diversification benefits, inflation protection, and defensive posturing, given the necessity-based traits of many Real Assets. Furthermore, the liquid nature of these securities can allow professional investment managers and individual investors alike the opportunity to shift their allocations quickly and efficiently as needed when compared to similar assets in the private markets.
Digging deeper: Data in the U.S. this week shows that disinflation is on pause, yet the market expects the U.S. Federal Reserve (Fed) to hold steady next week and is only pricing in a 31% likelihood of a hike in November. Recent data has generally been positive, and with an election in 2024, the Fed will want to be out of the way; hence, we ponder whether the Fed may view a hike next week as an insurance policy. The European Central Bank (ECB) went ahead with another rate increase, though its future rate-setting path is not so clear. Across the channel, the UK remains in a bind: stubborn inflation suggests the Bank of England’s (BoE’s) work is not finished, but contracting economic growth portends caution lest it risk tipping the country into a recession. Finally, we note that crude oil prices have continued to climb and could head even higher in light of a production shortfall that could last through the year-end.
- Inflation gets gassed up: Consumer Price Index (CPI) data for August was released this week and, while mostly in line with expectations, showed acceleration from July on several fronts. The month-on-month headline print of 0.6% increased from 0.2%, largely driven by a 10.6% increase in the price of gasoline, while year-on-year increased to 3.7% from 3.2% overall. Core CPI (which excludes volatile food and energy) was tamer, growing 0.3% month-on-month from 0.2% in July while also sliding to 4.3% from 4.7% on a year-on-year basis. The Producer Price Index (PPI) print was also released for August and was hotter than expected at 0.7% month-on-month (vs. 0.4% expected) and 1.6% year-on-year (vs. 1.3% expected), with both metrics accelerating from July. Even with these higher inflation prints, investors see almost no chance (as measured by Fed Funds Futures) of a rate hike by the Fed next week, and the odds are against any additional hikes this cycle.
- Can the ECB take a break?: Just after our review period, the ECB raised rates for the 10th consecutive time by increasing their main depository facility by 25 bps to 4.0%. In their press release, the Governing Council reiterated that they are “determined to ensure that inflation returns to its 2% medium-term target in a timely manner.” Alas, that goal may not be easily achieved as they forecast eurozone inflation of 5.6% in 2023, falling to 3.2% in 2024, and with 2025 still above target at 2.1%. These higher rates are also weighing on economic growth, with ECB President Christine Lagarde acknowledging that growth will be “very, very sluggish” near-term, with only 0.1% growth expected in the final quarter of 2023. While Lagarde gave no firm answer on additional hikes, investors are placing close to even odds (as measured by overnight index swaps) on one additional hike this year before cutting in the early-middle part of 2024.
- Bailey hanging on: GDP for the UK was released for July, showing negative growth of -0.5% (vs expectations of -0.2%) from the prior month, bringing the trailing three-month total to just 0.2%. There was plenty of blame to go around, with strikes at hospitals and schools, higher interest rates, and even adverse weather cited as reasons for the slump. While unemployment increased by 10bps to 4.3% in July, wage growth has not shown signs of easing, rising by 8.5% for the trailing three months over the same year ago period. We’ll get another look at the UK CPI next week, but with expectations of reacceleration to 7.0% year-on-year, stagflation remains a possible outcome, burdening the Bank of England (BOE) Governor Andrew Bailey with the difficult and unpopular choice of sacrificing growth to rein in inflation. A rate hike is largely expected next week, with possibly one more this year.
- Refining our thoughts on Crude: Crude oil prices have continued to climb, with WTI crude oil topping $90/bbl as we write and Brent crude closing in on $94. There are even reports of some barrels of oil leaving Saudi Arabia at over $100/bbl given demand from European and American buyers seeking alternatives to Russian supply. Yet, recent reports suggest that oil prices could climb even higher from here: OPEC is forecasting a 3 million barrel per day supply shortfall in the 4th quarter of 2023, and inventories in the U.S. are sitting near multi-decade lows. China remains a wildcard in the equation – they have been aggressively stockpiling crude oil, though actual refinement and consumption levels appear low given their sluggish economy.
What we are watching: While fixed income volatility has been dropping and rates have generally held steady for the past few weeks, we take a moment to revisit lessons from the yield curve. We’re also closely watching signals from the Bank of Japan (BOJ) and what those could mean for policy normalization and the future path of the yen. At a sector level, we review the upcoming wheat harvest (and where we might see surprises) and a recent M&A transaction in Natural Resource Equities.
- Yield curve inversion persists: Yield curve inversion can often be a harbinger of an impending recession; yet, it can first occur several months or up to two years before a recession actually starts. The U.S. 2s-to-10s is an often-cited curve for this measure, and while it currently sits around -72 bps, it first inverted this cycle in July 2022 and has remained so for 313 straight trading days. Other indicators, such as the 1s-to-10s and the 3mo-to-10s, currently sit at -114 bps and -119 bps respectively. The 1s-to-10s also became inverted in July 2022 and have remained so for 308 sessions, while the 3mo-to-10s have been choppier but have remained inverted since November 2022 (or 223 sessions, the longest on record since at least the 1960s). Finally, we’ll remind our readers that it’s not necessarily the inversion that’s dangerous, but rather the subsequent re-steepening, which we are monitoring carefully.
- How many years on a stone are too many?: This week, BOJ Governor Kazuo Ueda indicated the central bank could see conditions met by the end of the year to curtail their era of negative interest rates. These unexpected comments lifted Japanese bond yields and sent the yen up sharply against the U.S. dollar. According to overnight index swaps, market participants expect the Japanese policy rate to be in positive territory during the first quarter of 2024, and some economists are forecasting an earlier end to the BOJ’s yield curve control, possibly even next month, following the widening of its tolerance band in July. However, not all are convinced that Japan is ready to leave negative rates behind, with one influential lawmaker, Hiroshige Seko, pushing back and emphatically stating his preference for ultra-loose monetary policy. Perhaps he is abiding by the famous Japanese proverb about perseverance – that even a stone can become warm if you sit on it for three years. We would argue, however, that after seven (the BOJ yield curve control policy was introduced in September 2016), that it might be time to get up!
- More wheat here, but not there: Despite the ongoing war with Russia, this year’s Ukrainian grain harvest doesn’t look too bad. A recent statement from the Ukrainian Agriculture Ministry shows the wheat harvest is up 15.4% year-on-year (though still short of pre-war levels), while corn is up 12.4%, sunflower seeds are up 12.0%, and barley is up 5.4%. Additionally, while typically supplying around one third of the world’s soybean oil, Ukraine’s soybean harvest has (so far) harvested over three times the amount of soybeans as this same time last year. Furthermore, the U.S. Department of Agriculture (USDA) has upped its forecast of the Ukrainian harvest and export of wheat and corn for next year. However, the USDA also cut their global forecast for wheat stockpiles this year, citing extremely dry conditions in Canada and Australia, with a recent WASDE report expecting 10M fewer metric tons delivered than previously expected.
- Thinking inside the box: Smurfit Kappa Group, an Ireland-based paper packaging manufacturer, has announced intentions to acquire U.S. rival WestRock for $11B to create the world’s largest paper packaging company, which would have annual revenue of ~$34B. The deal struck involves a mixture of cash and stock and represented a 36% premium to WestRock’s closing price on September 6th, though it still faces some hurdles (as observed in the difference between WestRock’s current price and the inferred merger value), with at least 75% of Smurfit Kappa shareholders and 50% of WestRock’s needing to approve the deal. From a credit perspective, both S&P and Moody’s placed Smurfit Kappa on review for a potential upgrade should the deal consummate, given the increased size and better balance sheet of the combined entities.
