Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Equity rally, Microsoft shows strength of mega caps, Vestas guidance cut
Peter Garnry
Chief Investment Strategist
Summary: Equities are up 2% going into the FOMC rate decision tonight as investors are taking comfort from the bond market, retail investors have become net buyers again, and speculation about a 'Fed put' meaning that the Fed will tilt a bit dovish tonight. We believe the probability is skewed in favour of the Fed remaining hawkish aiming to tame inflationary pressures and tighten financial conditions. We also discuss the strong earnings and outlook from Microsoft and how it bolsters the view that mega caps are suited to protect capital relatively well during inflation. Finally, we talk about the rising input costs hitting Vestas which cut its guidance for 2022.
Equities are rallying into the FOMC
Equity markets around the world are staging a comeback today up around 2% with Nasdaq 100 futures pushing above 14,400 ahead of the FOMC rate decision tonight. Four things are potentially driving the more positive sentiment today: 1) retail investors have slowed their selling which in itself is a self-reinforcing loop, 2) the US 10-year yield has stopped moving higher for now and global high yield credit spreads are still benign suggesting the bond market is still calm about inflation, 3) good earnings releases the past 24 hours with Microsoft posting a strong guidance, and 4) some market participants betting on the ‘Fed put’ that the Fed will lean a little bit dovish tonight given the selloff in equities.
In our view the Fed has been told to tame inflation and this is the number one priority for the central bank and the Fed has been surprised about inflation as their econometric models have not been able to capture the regime shift during the pandemic. Given the equity returns since early 2020, we believe the Fed sees it as investors have plenty of cushion and they will allow financial conditions to tighten all the way to a 20% correction in global equities. The only caveat is that fiscal situation in the US has moved from accommodative to tightening and it seems the Democrats have difficulties getting things through the US Congress given the current inflationary pressure.
Microsoft shows why investors like mega caps
Microsoft reported FY22 Q2 (ending 31 Dec) earnings last night with Q2 revenue hitting $51.7bn vs est. $50.9bn and EPS of $2.48 vs est. $2.32. Revenue grew 20% y/y and operating margin expanded to 50.7% from 49.1% a year ago highlighting why investors like mega caps. They are growing above average right now and can maintain operating margins amid inflation. So far this year our mega caps basket has outperformed the MSCI World by 0.6%-points which quite acceptable when you compare it to S&P 500 (-8.6%) and Nasdaq 100 (-13.3%).
The mega caps are also not as excessively overvalued as the more speculative growth stocks that have been hit hard by rising interest rates and investor selling. In the case of Microsoft, the free cash flow yield is around 3% which many investors will probably look at say that is good given US 10-year yield below 2% and Microsoft’s ability to grow faster than inflation.
Vestas is hit by steel prices and logistics
Vestas, the world’s largest wind turbine maker, is quite the opposite story of Microsoft on inflation. It announced today 2022 guidance with revenue guidance et €15-16.5bn vs est. €16.6bn and EBIT margin as low as 0-4%. The company is under pressure from global supply constraints and logistics which are delaying projects and thus revenue recognition, but rising steel prices which it does not hedge are also affecting margins as Vestas has been hesitant on passing on costs as it could slow down orders, but according to the CEO that stance is changing now.
The Q4 earnings season is accelerating this week and we are getting more and more data to make firmer conclusions on the previous quarter. It looks like companies for the most part have been able to pass on costs to their customers as Q4 profit margin so far is on par with Q3 suggesting little margin compression.
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