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Equity rally pauses amid investor concerns about inflation and SVB’s collapse: Market Commentary March 2023

March 16, 2023

Global Macro:

In the US: The Fed caught in a dilemma over its next interest rate decision: The US labor market exceeded expectations in February by adding 311k jobs, compared to the market consensus of 205k and a monthly average of 183k between 2010 and 2019. However, the unemployment rate rose from 3.4% to 3.6%, signaling that the recovery is not without challenges. Although the US inflation report for February, which was published on Tuesday, March 14th, showed a still-high annual inflation rate of 6% and a core consumer price inflation rate of 5.5% – both in line with market consensus – the recent collapse of Silicon Valley Bank (SVB) has led an increasing number of investors to believe that the US Federal Reserve would leave the Fed funds rate range unchanged at its next monetary policy meeting in March in a bid to stabilize the global financial system. This contrasts with former market expectations of a 25-to-50bp raise.

In Europe: The ECB expected to continue to raise interest rates: Although consumer price inflation in the Eurozone slowed to 8.5% in February, the reading was higher than the market consensus of 8.2%, while core inflation hit a new high of 5.6%. As a result, the European Central Bank (ECB) may raise its key deposit rate by another 50bps to 3.00% on Thursday, March 16th to combat high inflation. ECB President Christine Lagarde’s press conference will be closely watched for hints of the next rate hike’s size after several policymakers supported the idea of more aggressive tightening.

In Asia: China’s key economic data expected to reflect its full re-opening: China’s re-opening from Covid lockdowns earlier this year is expected to be reflected in key data releases for both January and February, including figures on industrial production, retail sales, the labor market, and fixed investment, which are likely to demonstrate a rise in activity. Meanwhile, investors in Japan are looking forward to the Bank of Japan’s (BoJ) monetary policy decision minutes and February trade data.

Financial Markets:

Equity: US equities retreated in February (S&P 500 -2.1%) amid investor concerns about future interest rate hikes, while European equities recorded further gains (Euro Stoxx 50 +2.2%). Chinese equities suffered from increased geopolitical tensions (HSCEI -11.4%). Fixed Income: The 10-year US yield gained 39bps to 3.92% while the 10-year German yield rose 19bps to 2.46%, which contributed to the price contraction of Emerging Market bonds (-2.8% in USD; -3.4% in local currencies) and High-Yield bonds (-1.3% in USD; -0.1% in EUR). Currencies: The USD recovered against all major currencies in February, driven by rate hike expectations: EUR -2.3%, AUD -4.5%, CNY -2.7%, JPY -5.1%, CHF -2.4%. Commodities: Gold and oil prices went down 6.5% and 2.7%, respectively, against the backdrop of a stronger US dollar.

Equities: Persistent volatility

February has seen global markets experiencing a pause in optimism, as interest rates were expected to remain high for a longer period. This has resulted in continued volatility in equities, with investors closely monitoring companies’ fourth-quarter results. Albeit not exceptional, company results have been better than anticipated several months ago.

In the US, equities have had a positive start to the year, driven by stronger short-term US and global economic growth prospects.

In the Eurozone, fears of an energy crisis have eased, but geopolitical tensions continue to be a concern, and the region appears to be heading towards a period of slower growth. Despite these challenges, valuations of equities in the Eurozone appear fair, with downside risks to earnings partially priced in at current levels.

In China, despite the recent setback, we believe Chinese equities’ upside potential remains strong, underpinned by supportive economic policies and lower regulatory uncertainty.

Equities: Persistent volatility

In the US, equities have had a positive start to the year, driven by stronger short-term US and global economic growth prospects.

In China, despite the recent setback, we believe Chinese equities’ upside potential remains strong, underpinned by supportive economic policies and lower regulatory uncertainty.

Currencies: All eyes on the Fed’s balancing act

USD: After a strong recovery against all major currencies in February underpinned by market expectations of a 25-to-50bp interest rate raise at the next Fed meeting, the greenback retreated sharply following SVB’s bankruptcy and the subsequent shift in market anticipation of future interest rate hikes in the US with more and more investors expecting that Powell will announce a 25bp rate hike or even keep the Fed funds rate unchanged. As such, the Fed’s interest rate decision on Wednesday, March 22nd will have a strong impact on the upcoming price action of the USD as Fed Chair Jerome Powell weighs the need to provide support to the financial system post-SVB in the context of high inflation.

EUR: The market expects the ECB to raise its key deposit rate by 50bps to 3.00% on Thursday, March 16th, as core inflation in the Eurozone hit a new high of 5.6% in February. However, the risk of a lower-than-expected rate hike by the ECB is increasing as the Fed is considering a less hawkish stance following SVB’s collapse. Such a scenario would likely weaken the EUR with respect to the USD.

RMB: The recent strengthening of the renminbi reflects China’s re-opening and strong trade balance data. Activity figures for January and February will give a clear indication of China’s speed of recovery and could provide further support to the yuan.

JPY: The Japanese yen remains highly sensitive to changes in the Fed’s interest rates and US yield movements. Investors will look for hints of a potential policy change ahead of the next BoJ meeting on April 28th, chaired by incoming Governor Kazuo Ueda. A change in the central bank’s monetary policy could trigger a strong re-appreciation of the yen.

Bonds: Sticky inflation and banks’ widening credit spreads

The latest inflation data coming from both the US and Europe have intensified concerns of persistently high inflation. In the Eurozone, core inflation accelerated to reach 5.6% in February (vs consensus: 5.3%), while US core inflation remained high in February at 5.5%. As a result, central banks will have an incentive to continue to raise interest rates to tame inflation. However, the recent collapse of SVB has shifted down market anticipations of future interest rates in the US, thus pushing yields down and triggering a US treasury rally. Nonetheless, given the widening of banks’ credit spread, we see opportunities to buy investment-grade bank bonds at attractive levels.

Commodities: China’s economic recovery to drive prices

Commodity prices have been volatile this year. However, we see China’s economic recovery as the key driver of commodity prices, particularly with the increasing demand for oil and base metals.

Risks:

SVB’s bankruptcy: The consequences of SVB’s collapse are yet to be fully known and could have a lasting impact on the banking sector, especially for small- to medium-sized banks.
Russia-Ukraine war escalation: A worsening of the war would affect Europe the most, and if the Russian army crossed the Belarus border, which is 150km north of Kiev, EURUSD could drop fast towards 0.90. In addition, the US and Asia could suffer a stronger economic slowdown amid surging commodity prices.
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.
Covid variants: New waves of infections caused by Covid variants could further weigh on the economic growth outlook.
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:

Value sectors, including energy, should be more resilient if inflation proves sticky or rates go up more than expected. Earlier inflection points in China and Europe favor outperformance in these regions. China’s re-opening and an end to the winter gas crisis in Europe means that growth prospects in China and Europe look stronger at present. We therefore see opportunities in China and sectors exposed to China’s re-opening, as well as commodities.

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 2.75%, GBP 3.5%, RMB 2%.
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 4%, GBP 5%.
Japanese yen: The JPY is extremely undervalued, close to a 30-year low. A change in BoJ’s 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.