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Interest rates to stay higher for longer: May 2023 Market Commentary

Global Macro:

The degrading credit worthiness of US regional banks is largely due to the fact that they were allowed to opt out from international banking regulation standards under the Trump administration. This has triggered a depression of equity valuations within the broad financial sector around the world. Large banks that are fully regulated and protected by their central bank are largely unaffected and present interesting investment opportunities both on the equity and fixed-income side.

On the other hand, the labor market is still strong in the US with nonfarm payrolls up 253k in April, beating market consensus. On May 4th, both the US Fed and European Central Bank (ECB) hiked their key interest rate by 25bps.

On the Fed side, comforted by a strong job report, the upper bound of the Fed funds rate moved up from 5% to 5.25%. This was the 10th consecutive rate increase, bringing the Fed funds rate to its highest level in 15 years. Fed Chair Jerome Powell implied that interest rate hikes may be over if inflation, which went down from 9.1% to 5%, keeps on declining. He was also clear that rate cuts are not on the agenda for 2023. Yet, the market is “fighting the Fed” as it is anticipating five rate cuts by the end of the year, i.e. a 1.25 percentage point decrease, as priced in the Fed Funds futures market, which seems unrealistic with respect to the current stance of the US central bank.

On the ECB side, as Eurozone inflation slowed from 10.6% to 7%, the central bank has increased its deposit rate by just 25bps (as opposed to 50bps as initially planned) from 3% to 3.25%. ECB President Christine Lagarde hinted that more hikes would follow to combat a still-elevated inflation.

Financial Markets:

Equity: Most equity markets rose in April (S&P 500 +1.2%, Euro Stoxx 50 +1.0%, Nikkei 225 +2.9%), with the notable exception of Chinese equities (HSCEI -3.8%) amid ongoing geopolitical tensions. Fixed Income: The 10-year US yield decreased 4bps to 3.45%, which contributed to the modest rise in USD High-Yield bonds (+0.6%, vs flat in EUR), while the 10-year German yield decreased 14bps to 2.32%. Currencies: Both the EUR (+1.6%) and CHF (+2.3%) appreciated against the USD in April, while the AUD (-1.1%), CNY (-0.6%), and JPY (-2.6%) all weakened against the greenback. Commodities: Oil prices went up 1.2% as OPEC+ nations announced production cuts, while gold ended the month up 0.6%.

  • Equity: Strong start to the year, decelerating momentum

As the fear of severe recession eased, equity market returns have been positive so far in 2023. Yet, the momentum is losing steam as the inflation decline is not as quick as anticipated and the US regional bank crisis is adding a layer of market uncertainty.

In the US: the equity market has been quite resilient despite the Fed hiking rates 10 times in a row and increased volatility due to the banking sector turmoil. The inverted yield curve, which has often preceded a recession historically, and the persistent inflation in a newly elevated interest rate environment are both increasing the downside risk on the US equity market.

In Europe: the equity market has outperformed the rest of the world so far in 2023, mainly due to sectors benefiting from China’s re-opening, such as luxury and high-end manufacturing. However, the ongoing war in Ukraine, low business confidence, highest inflation of all developed markets (7%), and rising borrowing costs are likely to weigh on European equity valuations.

In Asia: led by China, it is the only region with substantial growth (over 5% expected in China), low inflation (2% in China), and relatively low interest rates (2% in China). The Chinese equity market is supported by strong economic re-opening momentum, a pick-up in domestic consumption, and continuous domestic policy support.

  • Currencies: Main currencies rallying versus the greenback

USD: The secular decline has resumed: With the Fed pausing its interest rate hike, a lower relative growth, and a very negative trade balance, the USD may correct on the downside and revert to previous levels seen in 2022 against other major currencies.

EUR: EURUSD at the top of the range, waiting for a catalyst to break out: So far in 2023, EURUSD has been stuck within the [1.05; 1.10] range. It is currently at the top of the range. To get out of the range from the upside, EURUSD would need a concrete catalyst, like for instance a ceasefire in Ukraine or an aggressive rate hike from the ECB. The latter could happen if inflation remains persistent in the Eurozone.

RMB: Underpinned by China’s re-opening and growth: The USDRMB downtrend continues, caused by China’s recovery and the Fed signaling that it is pausing its rate hike cycle. The next main downside target for USDRMB this year is 6.30, which is the support level at the beginning of last year.

JPY: Ready to rise on signs of a policy change: The Bank of Japan (BoJ) has kept its negative interest rate policy unchanged so far in 2023. We don’t know when, but the next move of the BoJ will be to get out of its negative rate policy as it is a headwind for the Japanese banking sector. Inflation in Japan, currently at 3.2% (vs 2% only in China) is already above BoJ’s target of 2%.

GBP: The GBPUSD is benefiting from the USD weakness: So far in 2023, GBPUSD has been stuck within the [1.18; 1.26] range. It is currently close to the top of the range. As with the EURUSD, it would need a catalyst to break out on the upside.

AUD: Supported by China’s re-opening and RBA hiking rates: The Reserve Bank of Australia (RBA) announced further rate hikes will be necessary to combat inflation, currently at 7% in Australia. The RBA is continuing with its hiking cycle while the Fed is pausing, thus underpinning the AUDUSD.

  • Bonds: Volatility remains elevated, opportunity with large banks 

Investors are witnessing a series of banks in crisis: US regional banks with Silicon Valley Bank (SVB), First Republic Bank, and the Credit Suisse absorption by UBS. Consequently, we are observing a contraction of financial sector bond valuations, providing investment opportunities within the “large banks” sector, i.e. the so-called “Global Systemically Important Banks (G-SIBs)” protected by central banks, which are largely unaffected by the current turmoil. We note European banks’ reporting season started well. HSBC reported a profit of US$9.4bn, validating its new strategy, while Deutsche Bank recorded higher-than-expected profit at €1.9bn.

  • Commodities: Golden Opportunity

Gold: Safe haven as US dollar weakens: Gold is close to its all-time high of US$2,070, reached in August 2020, and is playing its safe-haven role following a string of financial crises, the fear of recession, USD weakening, and central banks’ gold buying spree. The inflow from investors in physical gold, gold-linked funds, and gold futures and options is the highest in a year.

Energy / Oil: In April, OPEC+ announced surprise oil production cuts of more than 1m barrels a day. This decision will support higher oil prices, currently at US$71/bbl.

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 (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% 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 favour profit taking at these high historical levels.
  • 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 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.