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Mounting geopolitical risks: Which assets are in high demand? May 2024 CIO Market Commentary

Market Context

    • Gold, Energy, AI, Bitcoin: In high demand as military and economic wars are ramping up
    • Tech Equity bullish market: Resilient on earnings growth and lower interest rates expectations
    • US Dollar interest rates: The US Federal Reserves says the next move is a rate cut
    • Euro interest rates: The European Central Bank (ECB) is expected to cut rates ahead of the Fed in June
    • USD FX risk: The dollar is at the all-time high versus Asian currencies (RMB, JPY), expected to drop with lower USD interest rates
    • EUR FX risk: The euro is expected to follow the downward path of EUR interest rates
    • The ramping up of AI adoption is fuelling Tech earnings and is underpinning the equity rally.

Global Macro: World growth is slowing down

Global economic growth is expected to decelerate due to the delayed effects of previous interest rate hikes. Despite this, strong consumer spending is likely to cushion against a significant economic contraction, with a preference for services over goods. Additionally, declining inflation across major economies indicates that existing monetary tightening has been effective. We anticipate reductions in interest rates and a relaxation of monetary policies by Western central banks as inflation continues to decrease.

In the US: Resilient consumption

Economic growth has remained at 3%, predominantly driven by consumer spending as pandemic-era savings diminish. Inflation stands at 3.2%, propelled by rising service sector prices due to increasing labor costs. The ISM Services Purchasing Managers’ Index (PMI) in the US fell to 49.4 in April 2024, signaling a potential impact of heightened borrowing costs on business conditions. US job creation in April slowed significantly, adding only 175,000 jobs, well below the anticipated 243,000 and a sharp decline from March’s 315,000, while the unemployment rate rose to 3.9%.

In Europe: The ECB to cut rates in June ahead of the US Fed

Economic growth in the Eurozone remains tepid at +0.1%, with sentiment surveys indicating only slight improvements and remaining at low levels overall. The economy is expected to continue its lateral trajectory in the near term but may experience modest growth later in the year as real income rises and the effects of restrictive monetary policy diminish. Inflation, currently at 2.4%, is anticipated to decrease to the 2% target in upcoming quarters, prompting the ECB to commence rate cuts in June, potentially before the US Fed.

In China: Strong momentum in manufacturing

First quarter GDP growth exceeded expectations, registering a 5.3% year-over-year increase, primarily fueled by strong manufacturing performance. Fixed-asset investment rose slightly to 4.5% year on year, with manufacturing and infrastructure investments leading the growth. Retail sales moderated to 4.7% year on year, though a rebound is anticipated in the second quarter. Meanwhile, export growth climbed to 1.5% year on year, benefiting from a technology upcycle and improved foreign demand.

Financial Markets: Investors are seeking assets that mitigate geopolitical risks

Equity: The April performance of global equities was uneven across sectors and regions, with profit taking in the US and Europe and new fund inflows in China (S&P 500 -4.2%, Nasdaq -4.5%, Euro Stoxx 50 -3.2%, HSCEI +8.0%, Nikkei -4.4%).

Fixed Income: The 10-year US yield increased 48bps to 4.69% and the 10-year German yield rose 28bps to 2.59%, while the 10-year China yield edged down 4bps to 2.37%. Meanwhile, High-Yield bond prices lost 1.2% in USD and gained 3.0% in EUR on upcoming ECB rate cuts.

Currencies: All major currencies declined on average 1% versus the USD in April as the US Fed announced that rate cuts would likely be postponed to the second part of the year.

Commodities & Crypto: Gold climbed 3.9% in April on expectations of central bank rate cuts in 2024. Oil prices declined 1.5% on softer global growth. Bitcoin retreated 14.3% while maintaining a year-to-date performance of +44.0%.

Equities: Wide performance dispersion across sectors and regions

Global equities have been boosted by strong macroeconomic data and improved earnings, leading to relatively high valuations. The MSCI Global Equity ACWI Index’s 12-month forward P/E ratio is currently 17.0x, which is 0.7 standard deviations above the 10-year average. Despite a recent dip, the equity index remains well above its 200-day moving average, indicating robust price momentum.

In the US: Equity prices underpinned by AI and buybacks

The S&P 500 has retreated from peak levels due to concerns over prolonged high Fed interest rates, increasing geopolitical tensions, and instability in the technology sector. However, expectations of solid economic and earnings growth, potential decreases in interest rates, and increased investments in artificial intelligence are anticipated to provide a favorable environment for equities in 2024. Apple shares surged nearly 6% following a USD 110bn share repurchase announcement and earnings that exceeded forecasts.

In Europe: Low growth weighs on earnings

The economic outlook for the Eurozone is improving, and with anticipated reductions in interest rates, the environment remains favorable for equities, especially the Euro Stoxx 50, which is mostly exposed to global markets and not only to domestic Europe. Despite the recent robust performance, future gains are expected to be more modest, with projected earnings growth of 3% this year and 8% in 2025.

In Greater China: Equity market rebound and normalization on the way

The technology sector in China, particularly in artificial intelligence, has shown significant potential with first quarter 2024 earnings surpassing expectations, bolstered by strong revenue and profitability forecasts. Despite some cautious sentiment in non-AI tech areas, the current market, especially H-shares, presents a favorable investment entry point into prominent tech firms across China, Taiwan, and Korea. Additionally, the property sector is poised for recovery, with current valuations near those of the global financial crisis.

Currency outlook: Investors are selling dollar for gold and virtual assets

The primary risk to the USD is a sharp decline in US GDP growth, which would shift investor attention to the fundamental weaknesses of the USD, including escalating US debt, the Fed’s rate cut program commencing this year, and the currency’s high valuation.

EURUSD: At 1.0775, trading within the [1.05; 1.10] range with downside risk

The EURUSD pair fell 0.7% in April, with expectations that the ECB will cut interest rates before the US Fed. This anticipated policy move could lead to a significant depreciation of the EURUSD, possibly returning it to parity. The ECB is leaning towards early rate cuts as inflation pressures diminish, adding to the increased risk premium on the euro amidst escalating geopolitical tensions from Europe’s involvement in the Russia-Ukraine conflict.

USDRMB: At 7.24, stuck in the [7.00; 7.30] range  

The yuan remained stable in April, supported by Chinese monetary authorities actively monitoring the currency market as part of broader measures to strengthen economic recovery. This stability is underpinned by expectations of more assertive policy actions to support Chinese financial assets. Consequently, it is recommended for companies with exposure to the RMB to employ hedging strategies to manage the risks associated with currency volatility.

USDJPY: At 156.00, all-time high downside risk

The USDJPY pair increased 3.2% in April. It faces upward pressure as long as US economic data remains strong, which reduces expectations for US rate cuts. However, it is becoming increasingly challenging to drive the pair higher as the exchange rate approaches levels that are concerning for Japanese officials. Additionally, the extent of net short JPY positions is approaching record highs last seen in 2007, a period that also marked a peak for the USDJPY exchange rate.

 

Fixed Income: Opportunity to lock high interest on cash deposits or high bond yields before the central banks’ rate cuts

We believe there is a window of opportunity that we have not seen in the past 20 years where it is still possible to receive substantial income from cash deposits, with duration of 3 to 6 months (5.25% in USD and 4.25% in EUR). High interest rates can be locked for longer periods by investing cash in bonds from large Investment Grade banks, which can provide an income per annum of close to 6.00% net in USD or 4.50% net in EUR, with a duration of 2 to 10 years.

Commodities

In light of increasing geopolitical risks, an increasing number of investors are including a moderate amount of both gold and energy (e.g. oil) in investment portfolios to mitigate these risks.

Gold: Reached a new all-time high at USD 2,430 in April

Gold rose 3.9% in April and is establishing new highs as both a hedge and a safe asset with growth potential. This appreciation is driven by technical factors leading investors towards gold futures and ETFs. Additionally, robust central bank purchases of approximately 1,000 metric tons per year, along with expected US Fed rate cuts by midyear, are likely to sustain gold demand. This could catalyze further price increases. Gold remains a strong portfolio diversifier, and we anticipate that investor demand will continue to support its price in 2024.

Oil: Prices well supported

The oil market remains undersupplied due to strong demand and disciplined supply management by OPEC+. Oil inventories are expected to decrease further in the coming weeks. Despite increased tensions in the Middle East, oil prices have shown only modest reactions. Crude oil peaked at USD 92.2 per barrel in April, it is currently trading at around USD 82 per barrel.

Risks:

  • War escalation in Ukraine or the Middle East: These conflicts hold significant implications for Europe. Specifically, if Russian forces were to advance across the Belarusian border, 150 kilometers north of Kyiv, this could precipitate a rapid devaluation of EURUSD, potentially driving it towards the 0.90 threshold. Furthermore, statements made by former US President Donald Trump concerning the US’ potential withdrawal from NATO commitments have notably undermined the confidence of US allies.
  • US-China tensions: US-China friction remains strong, with increasing tension around Taiwan and the South China Sea.

Opportunities:

  • Geopolitical risk mitigation basket: Gold, Energy (e.g. Oil), AI and Bitcoin. As military and economic wars are mounting, these four assets are in increasing demand. With the new US sanctions on Chinese electrical cars, the most sophisticated chips recently developed in China, and maintained US sanctions for EU products, the dedollarization is here to stay. We believe moderate exposure to these assets calibrated with respect to investors’ risk tolerance and preferences may help preserve both performance and capital in the long run.
  • 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: 5.25% in USD, 4.25% in EUR, 5.00% in GBP, 4.00% in AUD.
  • 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. Investors can benefit from the substantial yield of a diversified bank bond portfolio of 3 to 10-year duration: close to 6.00% in USD, 4.50% in EUR, 5.50% in GBP.
  • High coupon (10%+) on structured deposits: Opportunity from market volatility.
  • All-time high, compelling “risk premium” for Chinese stocks: We believe that historically low prices for China stocks are an opportunity for long-term investors looking for asset growth, substantial income and de-correlation with Western markets. Given attractive equity valuations and earnings upgrade expectations, we believe mainland Chinese and Hong Kong equity valuations are likely to increase significantly within the next 12 months.
  • 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 wars in Ukraine and Palestine have 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.