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Ongoing flight to safe-haven USD as risky assets sell off: Market Commentary October 2022

Market Context: Ongoing flight to safe-haven USD as risky assets sell off

Global Macro:

In September, global equity markets lost about 10%, marking the longest series of losses since 2009, with most equity indices down 20% to 30% year to date. This long-term sell-off is fueled by central banks’ rate hiking cycle, the war in Ukraine, and the aftermath of the Covid pandemic. Central banks communicated clearly that they will continue to raise interest rates to bring down inflation, even if this causes some economic distress. Nonetheless, the impact of the Covid pandemic is progressively fading away.

In the US, air travel has returned to 95% of 2019 levels. In China, economic activity has broadly improved ahead of the 20th National Congress, which will start on October 16th. China’s manufacturing purchasing managers’ index surprised to the upside in September, rising to 50.1 from 49.4 in August. Covid restrictions in China are expected to ease progressively following the congress. We think China’s growth is likely to remain above 3% as the government and central bank (PBoC) continue to support the economy despite the real estate crisis. Meanwhile, Europe is heading for recession. We believe the difficult economic situation will persist so long as the Ukraine war is raging. Inflation in Europe has reached 10% annualized, which will prop the European Central Bank (ECB) to hike rates further, from 0.75% to an expected 2% by year end.

At some point, hopefully, discussions about a ceasefire in Ukraine will begin, which, against the backdrop of slower growth or recession as witnessed in most economies, will help stabilize prices, inflation, and interest rates. When these catalysts happen, the equity market will likely rally until its currently depressed valuation normalizes. In order for investors currently holding risky assets such as equity to benefit from the market normalization and rebound in the future, which is difficult to time, it is necessary to stay invested.

Financial Markets:

Equity: Global equity markets posted significant losses in September (S&P 500 -8.1%; Euro Stoxx 50 -6.2%; HSCEI -13.9%) against the backdrop of continued interest rate hikes. Fixed Income: The 10-year US yield gained 58bps in September to 3.70%, which contributed to the decline of Emerging Market government bonds (-6.1% in USD; -5.0% in local currencies) and High-yield corporate bonds (-3.2% in USD; -3.9% in EUR). Currencies: The USD continued its bullish trend against other major currencies: EUR -2.9%, AUD -5.4%, CNY -3.3%, JPY -4.2%, CHF -0.6%. Commodities: Gold and oil prices further retreated in September (-3.2% and -11.5%, respectively).

What to expect for the last quarter of the year

  • Equities: The global equity market sentiment is back to the low level of 2009. We thus expect to see regular rallies in equity markets as a number of investors still buy on dips and are attracted by low equity valuations. Yet, equity markets are likely to stay volatile for the rest of year, driven by inflation, rising policy rates from central banks, and destabilizing geopolitical events such as the Ukraine war. For the equity market to turn around, concrete catalysts are needed, like a decrease in the inflation level of developed markets and a detente of current geopolitical tensions.
  • Currencies: The USD continued to benefit from safe-haven flows. The DXY US dollar index has increased to its highest level in 20 years, up 4% in September and 20% over the past 12 months. We are likely to see a cap in the progression of the USD as central banks, such as the ECB in Europe, BoE in the UK, BoJ in Japan, and most likely the PBoC in China, are taking measures to stop the depreciation of their currency against the USD in order to reduce “imported inflation”. Moreover, the US trade balance versus the rest of the world remains strongly negative, between -US$70bn and -US$100bn per month, generating large selling flows of USD versus other currencies, particularly the RMB. In September, the GBP reached its lowest level ever against the USD at 1.035, while the EUR reached a 20-year low at 0.955. In the meantime, the USDRMB hit a 15-year high at 7.25 and the USDJPY traded at 146, a 30-year high.
  • Bonds: The risk of global recession and the higher-than-expected inflation caused a further increase of government bond yields and corporate bond credit spreads. Investment grade bond yields from 1-year duration are above 2% in EUR and above 4% in GBP and USD. For RMB, the yield goes from 2% (from 1 year) to 3% (above 10 years).
  • Commodities: We note commodities carried on with their global sell-off in September on the back of slower global growth and recession (Europe, UK). In September, oil prices contracted 11.5% while gold went down 3.2% as central banks raised interest rates to combat inflation. However, as the energy sector is underinvested, we expect oil prices to remain high around US$100/bbl or above depending on the duration of the war in Ukraine.

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%, GBP 4%, RMB 2.8%, or over a period of 12 months: EUR 2%.
  • Income from Investment Grade bank bond issuers: Banks are implicitly protected by central banks and their bonds have already integrated their ambitious interest rate hiking cycle. Investors can enjoy a substantial yield from a diversified bank bond portfolio of 1-to-2-year duration: USD 5.5%, EUR 3%.
  • Chinese equities: We believe the Chinese stock market is now at a low point with valuations currently 60% below their pre-Covid level.  We will be monitoring the outcome of the 20th National Congress, starting on October 16th next week. 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. A change in BoJ’s monetary policy, which may happen in the second half of 2022, 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.