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Global growth slowed by rising US interest rates and China lockdown: Market Commentary November 2022

Global Macro:

In the US: In October, the Manufacturing PMI (Purchasing Managers’ Index) and Services PMI both fell to their lowest level since 2021. Nonfarm payrolls (new jobs creation in the US) increased by 261,000, the slowest job growth since December 2020, while the unemployment rate rose to 3.7%. We note inflation slowed to 8.2% over the past 12 months, the lowest since February, which indicates inflation may have peaked. The US Federal Reserve raised rates by 75bps on November 3rd, setting the Fed funds rate target range at [3.75% – 4.00%]. The Fed also announced it will continue to hike rates for as long as inflation does not recede. As such, the US central bank’s action plan is slowing the US economy and may drive it into recession.

In Europe: The war in Ukraine as well as rising energy, food, and raw material prices are causing European economies to enter a recession. The activity slowdown is felt across most sectors in manufacturing as well as services. Governments continue to support the population and corporations to ease the inflation burden, which is now on average above 10% in Europe and the UK. As a result, the European Central Bank (ECB) announced it will keep on raising rates, with the ECB deposit rate – currently at 1.5% – most likely to reach 2% by year end.

In China: The Chinese export bulldozer is moving forward. The economy is recovering, growing 3.9% in Q3 (vs only +0.4% in Q2), thus beating market expectation of 3.4% and bringing year-to-date growth to 3% (still below the government target of 5.5%). The main causes of the economic slowdown are the strict zero-Covid policy and the real estate crisis. However, thanks to the massive positive trade balance of US$85bn per month, strong infrastructure and industrial investment, and government support, China’s economic growth is expected to reach 5% by year end.

Financial Markets:

Equity: Most equity markets rebounded in October (S&P 500 +6.5%; Euro Stoxx 50 +9.6%; Nikkei 225 +6.4%) with the notable exception of China (HSCEI -16.5%) as the 20th National Congress of the Chinese Communist Party did not reassure investors with the strict zero-Covid policy still in force. Fixed Income: The 10-year US yield gained 31bps in October to 4.01%, which contributed to the decline of Emerging Market government bonds (-0.5% in USD; -0.6% in local currencies), while High-yield corporate bonds recovered 3.9% in USD and 2.3% in EUR. Currencies: Against USD: EUR +1.8%, AUD -1.4%, CNY -2.6%, JPY -2.8%, CHF -1.9%. Commodities: Gold further retreated in October (-1.7%) while oil prices gained 8.1%.

What to expect for year end and the start of 2023.

  • Equities:

The global equity market rebounded in October despite slowing earnings and slowing economic growth. The Tech sector was particularly impacted by lower-than-expected earnings for Alphabet, Microsoft, Meta, and Amazon, all falling by almost 20%. The Tech sector in general, and Apple in particular, are affected by the rising US dollar.

  • Currencies:

USD:  The dollar is supported by the Fed, which announced it will keep hiking rates until inflation recedes.

EUR: The euro will likely remain weak until there is a ceasefire in Ukraine. The fall of the euro has been slowed down by the ECB, which commited to keep on raising rates moderately to combat inflation. The interest rate differential between the USD and the EUR will remain elevated at around 2%, making it unlikely for the EURUSD to rebound soon from the current 20-year low range of [0.95 – 1].

GBP: The pound is also negatively affected by the war in Europe as well as the new UK budget to be released on November 17th. The latter may be a catalyst for the GBPUSD to exit its all-time low range of [1 – 1.15].

RMB: The USDRMB has stabilized within the [7 – 7.40] range, a 15-year high. A higher USDRMB is boosting Chinese exports but also penalizing energy and commodity imports into China, the world’s largest commodity importer. Two catalysts may trigger a USDRMB sell-off (reversion): a decrease of inflation in the US and announcements laying the base for a path out of the zero-Covid policy.

JPY: The USDJPY is close to 150, a 30-year high. The JPY is unlikely to rebound as long as the Bank of Japan (BoJ) sticks to its zero-interest-rate policy.

  • Bonds & interest rates:  As inflation is expected to peak soon, most of the rate hikes may be behind us. The bond sell-off observed in the market since the beginning of year has attracted investors and consequently bond allocations are experiencing large inflows, which are then slowing down the bond fall. An increasing number of investors believe bond yields have reached a fair value reflecting credit and liquidity risks.
  • Commodities: Energy and food prices are likely to remain high due to the Ukraine war, supply disruptions, and a cut in OPEC+ oil production.

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 placed in cash deposits and earn several percentage points of annualized net interest, e.g. over a period of 6 months: USD 4.5%, GBP 3.5%, RMB 1.8%, or over a period of 12 months: EUR 2.25%.
  • Income from Investment Grade bank bond issuers: Banks are implicitly protected by central banks and their bonds have already 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%.
  • Chinese equities: We believe the Chinese stock market is now at a low point with valuations currently 65% below their pre-Covid level. We think the downside risk from here is moderate as the Chinese government and PBoC pledged to support the economy in order to underpin economic growth in 2022.
  • Japanese yen: The JPY is extremely undervalued at 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 and energy security – in Europe and around the world.