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May inflation in Western countries the highest in 40 years: June 2022 Market Commentary

Global Macro:

  • Inflation: May inflation in the US hit 8.6% (above consensus), the highest since 1981, vs 8.1% in the euro area and 2.1% in China. The main driver is the price of energy that has increased by more than 50% year to date across the energy commodity sector.
  • War in Ukraine: There is no ceasefire in sight. Energy supply disruptions continue with prices increasing. The continuation of the war is derailing economic growth in Europe this year. As a result, Europe may be in recession by year end. We note the deterioration of the eurozone’s trade balance, from +US$21bn in July 2021 down to -US$32bn in April 2022.
  • China’s Covid lockdown easing: President Xi Jinping reaffirmed that China’s 5.5% growth target for 2022 must be met. The zero-Covid policy is being adapted to allow the economy to resume expansion. The container shipping activity at Shanghai’s port returned to 95% of its normal level in May. The government will support the development of tech companies in China, while the People’s Bank of China (PBoC) may lower interest rates to boost consumption and economic growth. Services and manufacturing activities in China are expanding with the highest trade balance since January (pre-Shanghai lockdown) at US$79bn.
  • Central banks’ actions: High inflation triggered a strong interest rate hiking cycle across Western economies. In the US, the short-term effective Fed funds rate went up from 0.08% in January to 0.83% in end-May. The Fed raised its funds rate range by 75bps to [1.5%; 1.75%] on June 15 and is anticipating that the effective funds rate may reach over 3% by year end. In Europe, European Central Bank (ECB) President Christine Lagarde announced the exit of the negative interest rates policy that lasted a decade. The ECB has planned to hike its short-term interest rate, currently at -0.50%, by 25bps both in July and September. On June 16, the Swiss National Bank (SNB) hiked its policy rate by 50bps to -0.25% in a bid to curb inflation. Meanwhile, the Bank of Japan (BoJ) decided to stick to a zero-interest rate policy in order to boost the Japanese economy, fueling the ongoing weakening of the yen.

Financial Markets:

  • Currencies: Following the euro area’s negative trade balance results, EURUSD dropped back to its lowest support level in 15 years: 1.0375. Last Friday, the ECB announced it will start hiking interest rates for the first time in a decade, which may underpin a progressive EURUSD rebound. Moreover, if a ceasefire is declared in Ukraine, EURUSD may revert to pre-war levels, around 1.10. Since the Ukraine war has started, the USD strengthened against most major currencies, playing its role as a safe haven, while the ambitious US Fed interest rate hiking program to fight inflation is providing further support to the greenback. We expect the appreciation of the USD to reverse strongly when a ceasefire takes place in Ukraine, as the US trade deficit in 2022 is averaging -US$90bn per month (versus an average monthly trade balance of +US$60bn in China). As the BoJ has planned to keep its zero-interest rate policy, the JPY fell 25% over the past 18 months to reach a 20-year low.
  • Equity: Global equity markets are in bear market territory, over 20% below their 2021 high. The persisting strong inflation triggers fears that the Fed’s interest rate hiking cycle may push the US into recession. Global equity markets remain vulnerable in the face of a rising interest rates environment and decreasing growth.
  • Fixed Income: US yields have kept increasing to reach 3% from 2-year maturity onwards, underpinned by the Fed’s rate hiking program and persistent inflation. European yields rose to 1.5% from 5 years onwards.
  • Commodities: Oil prices climbed 14% in May to reach US$120/bbl, on the back of supply chain disruptions caused by the Ukraine war.

Equity: S&P 500 and Euro Stoxx 50 ended May flattish while Asian equities benefited from a small rebound amid improved sentiment in China (HSCEI +1.6%). Fixed Income: The 10-year US yield contracted 14bps in May to 2.74%, which contributed to a rise in Emerging Market government bonds (+0.1% in USD; +1.8% in local currencies). Meanwhile, High-yield corporate bonds edged down 0.6% in USD and 0.4% in EUR. Currencies: With respect to USD in May: EUR +1.6%, AUD +1.6%; CNY -0.9%; safe-haven JPY +1.2%, CHF +1.4%. Commodities: Gold decreased 2.6% while oil prices further rose 14.1% amid tight supply.

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 trade frictions remain strong, with increasing tension around Taiwan and the South China Sea. In addition, the US is increasing 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. We expect this to result in increased volatility in the coming months.

Opportunities:

  • Floating-rate safe cash deposits: Cash can be placed in safe-haven cash deposits and earn US Fed funds rate +0.80% (close to 1.60% currently) net annualized in USD.
  • 0.50% discount on the offshore renminbi in Hong Kong: RMB can often be bought in Hong Kong with a 0.50% discount compared to the onshore RMB in mainland China.
  • Chinese equities: We believe the Chinese stock market has turned the corner, after having strongly underperformed Western equities in 2021 and 2022 amid US-China tensions and increased Chinese regulation on tech firms, with Chinese tech stocks plunging 60%. However, we think the downside risk from here is moderate as the Chinese government and PBoC pledged to support the economy in order to reach China’s 5.5% growth target in 2022.
  • 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.