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Global Growth More Resilient than Inflation: June 2023 Market Commentary

Global Macro: Momentum of Declining Inflation

Inflation is moderating in Western economies. In the US, inflation declined to 4% in May, the lowest since March 2021 and less than half of June’s 9.1% peak. As a result, the US Federal Reserve decided to pause its interest rate hiking cycle on Wednesday, following ten consecutive increases. We note moderating inflation in the US is largely driven by a decline in energy prices and a slowdown in food inflation.

Over the past 12 months, oil prices went down 40% while the world food index lost 20% (see graphs). We believe the commodity price decline will translate into lower inflation in the months to come.

In developed markets, corporations took advantage of the inflation to re-build their profit margins, lost or compressed during the Covid crisis. Consequently, corporate earnings have surprised on the upside and have underpinned economic growth as well as the equity market rally, with the recent artificial intelligence (AI) hype boosting the valuation of large Tech companies in the US, Europe, and Asia.

This economic backdrop – less negative than expected – increases chances that recession be avoided in the US and last only a few months in Europe.

China is the only major economy with almost no inflation (0.1%) and the only major economy with significant economic growth (over 5%). Chinese equities have underperformed due to a slower-than-expected post-Covid recovery and geopolitical uncertainty. However, growth differentials with other developed markets are in favor of China and should support the Chinese equity market going forward.

We believe the main risks to future global growth and economic recovery are the threatening pockets of Covid variants, geopolitical uncertainties (e.g. the war in Ukraine and US-China tensions), and a possible interest rate hike overshoot from central banks.

Financial Markets:

Equity: In May, US equity performance was largely driven by large Tech stocks (Nasdaq 100 +5.8%, vs S&P 500 +0.2% only). Meanwhile, Chinese equities suffered from disappointing economic data following China’s post-Covid re-opening (HSCEI -8.0%). Fixed Income: The 10-year US yield gained 19bps to 3.64% (vs 10-year German yield -3bps to 2.28%), which contributed to the negative performance of High-Yield bonds in USD (-4.3%, vs flat in EUR). Currencies: The USD gained ground against all major currencies in May amid investor concerns about the global economic outlook: EUR -2.7%, AUD -1.7%, CNY -2.3%, JPY -4.5%, CHF -1.3%. Commodities: Gold and oil prices went down 1.8% and 11.3%, respectively, against the backdrop of a stronger US dollar.

  • Equities: AI, the New Tech Wave

In the US: The year-to-date (YTD) performance of the S&P 500 index (+9%) has been solely driven by 7 stocks: Apple, Amazon, Alphabet, Microsoft, Meta, Nvidia, and Tesla. These large and cash-rich corporations are massively investing in AI research and development. Given the triple-digit YTD stock performance of these stocks, we highlight the risk of an AI bubble in the stock market. High US equity valuations suggest that investors are overly confident in an economic soft landing.

In Europe: Both the Luxury and Tech sectors are driving the YTD performance of European equities (+10%). However, the close-to-zero European growth and the uncertain outcome of the Ukraine war may cap the upside of the equity market in Europe.

In China: The performance of the Hang Seng China Enterprises Index (HSCEI) was negative in May (-8%) as growth numbers following China’s re-opening have disappointed. As China is the only major economy with significant growth (over 5%), no inflation, low equity valuations, low and stable interest rates, and strong government support, we expect the Chinese equity market to outperform the US and Europe over the next 12 months.

  • Currency outlook: USD bearish trend to resume

With the US interest rate hiking cycle almost over, and given low growth, a large trade balance deficit and inflation, we think the US dollar is likely to weaken going forward.

EURUSD: Trendless but volatile within the [1.05; 1.10] range

Europe has low growth, still high inflation (6.10%), and geopolitical uncertainty with the war in Ukraine. Given this context, where many outcomes are possible, we expect further currency volatility and the EURUSD to trade sideways.

USDRMB: Large economic differentials between the US and China to weigh on the USDRMB

The growth, trade balance, and inflation differentials are in favor of the RMB. Although the stance of Chinese authorities and the People’s Bank of China (PBoC) is about supporting the economy and therefore providing a relatively easy monetary policy with low RMB interest rates (with no inflation), we believe we are near the peak of the USDRMB, currently close to 7.20 and below the resistance of 7.30, and that the bearish trend of the USDRMB will resume, bringing the USDRMB back below 7.00.

  • Fixed Income: Deposit rate and bond yield opportunity

In the US, interest rate hikes may be over soon as the Fed is pausing its hiking cycle amid moderating inflation.

In Europe, the interest rate hiking cycle is not over as inflation is the highest among major economies (6.1%).

In line with central banks’ interest rate levels, cash deposit rates and bond yields have increased in USD and EUR.

Short-term deposit rates (<1 year) have reached 5.25% in USD and 3.25% in EUR, and short-duration bond yields (~2 years) have reached 6% in USD and 4.25% in EUR.

Risks:

  • 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.
  • Recession:  So far, the US has escaped recession although growth has been tepid, while in Europe anticipated growth lies within the [-0.5%; +0.5%] range. By contrast, Asia is experiencing stronger, sustainable growth, fueled by China’s rapid recovery (over 5% expected growth for 2023). Depending on how corporates and governments navigate the new inflationary period with higher interest rates, recession remains a key risk to monitor.

Opportunities:

  • Gold downside protection: hedge and protect the gain on your physical gold and receive 3.5% net annualized interest. Following the multiple recent crises (Covid, US-China tensions, war in Ukraine) and buying spree of central banks, gold has moved up to US$2,050/ounce and is now close to its all-time high of US$2,070, reached in August 2020. As gold pays no interest and is competing with cash, which generates high interest (5.25% in USD, 3.25% in EUR), holders of physical gold have started to protect (hedge) their gold holdings as some anticipate that the lack of income may favor profit taking at these high historical levels.
  • Income from safe cash deposits: Cash can be safely placed in cash deposits and earn annualized net interest, e.g. over a period of 6 months: USD 5.25%, EUR 3.25%, GBP 3.5%, RMB 2%.
  • Income from Investment Grade bank bond issuers: Major banks are implicitly protected by central banks as demonstrated in the Credit Suisse crisis where actual bonds (not AT1) remained secured. Bonds have already mostly integrated the central banks’ 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. The anticipated 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.