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Central banks’ “terminal” interest rate numbers will be key market drivers: Market Commentary December 2022

December 13, 2022

Market Context

The US Federal Reserve, European Central Bank (ECB), Bank of England (BoE), and Bank of Canada (BoC) are all hiking their benchmark rates to combat inflation. These hikes are mechanically compressing the valuation of capital asset classes: Equity, Bonds, and Real Estate. These assets are subject to depreciation and volatility while interest rates keep rising. Market participants, investors, financial institutions, corporations, and governments all need to estimate and understand what the “terminal” interest rates from the major central banks will be to decide how they will invest and deploy capital in 2023. The terminal interest rate is the one following the final rate hike, i.e. the peak of the central bank benchmark rate. The market is pricing (via the Futures market) that by the end of the first semester in 2023, the terminal US Fed funds rate will be 5% and the ECB benchmark rate 3%. Although global inflation may have reached a plateau (energy and overall food prices are declining), its path remains uncertain. Consequently, these terminal rate estimations are likely to be adjusted and subsequently we anticipate further volatility in the market for the first half of 2023. Moreover, we note the hiking of interest rates by central banks has overshadowed the other market drivers: the geopolitical events (war in Ukraine, US-China tensions, the Covid pandemic), the slowing growth in the US, and the potential recession in Europe.

Global Macro:

In the US: The economic growth seems to have slowed down and inflation may have reached a plateau. The manufacturing PMI (Purchasing Managers’ Index) fell into contraction territory at 49 (50 is neutral) in November and job openings declined to 10.3 million in October, which is close to twice the number of unemployed Americans. Nonfarm payrolls expanded by 263,000 in November, the slowest pace since April 2021.
In Europe: The old continent accumulates negative drivers for its financial markets and the euro currency: the war in Ukraine is generating uncertainty and capital flight to USD assets. In addition, rising euro interest rates from the ECB are contributing to sending the European economy into recession.
In China: It appears that China is taking steps to re-open its economy while controlling Covid. The government needs growth and financial results that can only be achieved if China remains the leading manufacturer of the world. We anticipate this reopening may start to be really operational following Chinese New Year. Consequently, we may see an increase of mercantile activity in Asia, which may be the only region to show substantial growth in 2023: 4.5% growth is expected in China while it may be close to zero or negative on the other continents outside of Asia. That means that commodity prices may rise on stronger Chinese demand, supply chains must improve further to deliver the desired business amount, and we may see a further rise in the RMB as China (the number one oil consumer) and Saudi Arabia (the number one oil producer) agreed to do business in RMB. Furthermore, the Chinese authorities and the People’s Bank of China (PBoC) are implementing supportive measures to help the property sector, which should underpin the Chinese economy.

Financial Markets:

Equity: Global equity markets recorded further gains in November (S&P 500 +2.0%; Euro Stoxx 50 +9.5%; Nikkei 225 +1.4%), with Chinese equities rebounding strongly (HSCEI +26.6%) amid improved investor sentiment. Fixed Income: The 10-year US yield contracted 26bps in November to 3.75%, which contributed to the rebound of Emerging Market government bonds (+7.4% in USD; +7.6% in local currencies). Currencies: After recording strong gains over the past months, the greenback started to weaken against other major currencies: EUR +4.3%, AUD +5.4%, CNY +2.9%, JPY +6.6%, CHF +5.0%. Commodities: Gold recovered 8.0% in November while oil prices declined 7.6%.

What to expect for year end and the start of 2023

Equities: In the month of November, non-US markets rallied substantially: +27% in China, +10% in Europe, while the US equity market increased only 2%. The equity market will remain under pressure until there is more clarity on the terminal rates from central banks. Slowing global economic growth should cause earnings growth to contract in 2023. The Chinese government is easing its Covid control policy and has announced plans to boost elderly vaccination: it seems a gradual reopening of the Chinese economy has started. Consequently, Chinese equity market optimism has continued to build up, with the Hang Seng Index and the CSI 300 up 27% and 13%, respectively, in November. In Europe, most companies beat consensus revenue expectations in Q3, with corporate revenues up about 25%, helped by the weak euro, which dropped 20% compared to 2021. The situation may change going forward as the war in Ukraine could last and euro interest rates are rising.
Currencies: USD: The dollar has entered – for now – a bearish trend as US interest rate hikes from the Fed are slowing down with inflation showing signs of stabilization. EUR: The EURUSD broke above 1.05 in anticipation of some type of resolution in Ukraine in the months ahead. The euro will likely remain fragile until there is a ceasefire in Ukraine. The euro has been underpinned by the ECB, which committed to keep on raising interest rates moderately to combat inflation. GBP: The pound is negatively affected by the war in Europe as well. The change of government in the UK has helped stabilize the GPBUSD above 1.20. RMB: The USDRMB broke below 7 and continues to drop as US inflation is stabilizing and China will gradually reopen for business in 2023. An important point to note is that the PPP (Purchasing Power Parity) of USDRMB is 4.8 compared to a spot rate close to 7. The PPP is a fundamental economic pull-back force that, just like gravity, cannot be escaped. PPP is the USDRMB exchange rate equilibrium that is based on the price of goods in the two largest world economies. This imbalance is well reflected in the trade balance that is close to an excess of US$80bn per month in favor of China versus the US. JPY: The USDJPY declined from 150 to stabilize under 140 as markets prepare for an end to the Japan negative interest rates era.
Bonds & interest rates: Bonds have been under pressure amid elevated inflation and aggressive central bank tightening. In Western economies, 10-year bonds have fallen on average 20% since their peak in 2021. But after the sell-off, government bond yields are now closer to their fair value. In the US and Europe, the inverted yield curve (the 10-year US yield minus 2-year US yield is about -0.80%) is signaling that a recession could be coming.
Commodities: In November, oil sold off 7.5% down to US$80/barrel, reflecting a growth slowdown, particularly in China. After surging in early 2022, commodity prices have eased back 15% year-to-date amid concerns over slowing global economic growth. Energy prices are expected to remain elevated on the back of tightening crude supply dynamics in 2023, Russia’s potential retaliation in holding back oil exports, and China’s reopening.

Risks:

Russia-Ukraine war escalation: A worsening of the war would affect Europe the most, while the US and Asia could suffer a stronger economic slowdown amid surging commodity prices.
President Biden’s loss of power: The US president’s mental and physical health is a cause for concern. A disruption of the US presidency could generate impactful instability domestically and globally.
Omicron variant: New waves of infections caused by the Omicron variant could further weigh on the economic growth outlook.
US-China tensions: US-China friction remains strong, with increasing tension around Taiwan and the South China Sea. In addition, the US is maintaining pressure on Chinese companies listed on US stock exchanges by implementing stricter rules targeting Chinese firms, effectively leading to the delisting of Chinese stocks from US exchanges in favor of Hong Kong and Shanghai.
Increasing defaults for High-yield corporate bonds: The realized default rate of High-yield bonds in Western economies has been low (<2%); however, slowing economic growth combined with higher financing rates may result in higher corporate defaults.

Opportunities:

Income from safe cash deposits: Cash can be safely placed in cash deposits and earn several percentage points of annualized net interest, e.g. over a period of 6 months: USD 5%, EUR 2.25%, GBP 3.5%, RMB 1.8%.
Income from Investment Grade bank bond issuers: Banks are implicitly protected by central banks and their bonds have already mostly integrated the ambitious interest rate hiking cycle. Investors can enjoy a substantial yield from a diversified bank bond portfolio of 2-year duration: USD 6%, EUR 3%.
Japanese yen: The JPY is extremely undervalued, close to a 30-year low. A change in Bank of Japan’s (BoJ) monetary policy could trigger a re-appreciation of 10% to 15%.
Nuclear energy: We believe the nuclear sector will be instrumental in the world’s decarbonization efforts. To achieve fossil fuel reduction targets, the nuclear power industry’s safety standards need to be brought to the next level, for instance by using new technology to recycle uranium. New “green” nuclear energy is the number one priority of President Macron in France, while being high on the agenda in the US and China, which will build 150 nuclear power plants in the next 15 years.
Defense and security: The war in Ukraine has triggered massive investment in military defense and the overall security sector – including cyber, food, energy and semiconductor supply security – in Europe and around the world.