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Persistent economic growth despite higher interest rates: August 2023 Market Commentary

Global Macro:

The US GDP annual growth rate reached 2.6%, an acceleration that reduces the probability of a recession in the US and favors a “soft economic landing”. Going forward, the key will be the confirmation of a decline in inflation, currently at 3% in the US, and a rebound of world trade.

The global world economic big picture has not changed, with growth led by China at 6.3%, with no inflation, and close to no growth in Europe (+0.6% with negative momentum) and 5.3% inflation.

As Western economies’ inflation remains above the central banks’ targets (2% for the Fed and the European Central Bank (ECB)), Western central banks will maintain elevated interest rates for now and will reassess the situation in 2024. In July, the US Fed hiked its funds rate by 25bps from 5.25% to 5.50%, while the ECB increased its deposit rate from 3.50% to 3.75%.

By contrast, the People’s Bank of China (PBoC) has maintained an easy monetary policy stance. This is due to the fact China’s post-Covid economic growth was below expectations in the first half of 2023, which triggered an easier monetary policy and fiscal measures to support growth.

Higher interest rates in Western economies amid a sustainable global economic outlook is a favorable environment to invest in bonds. This is an opportunity not seen in the past 20 years, where investors can have visibility on regular income from bonds, such as bank bonds (e.g. 6% per annum in USD), and capital preservation regardless of market volatility.

Financial Markets:

Equity: In July, the global equity rally carried on. US equity performance was again largely driven by large Tech stocks (Nasdaq 100 +4.0%, S&P 500 +3.1%). The rebound in Chinese equities continued (HSCEI +7.4%). Fixed Income: The 10-year US yield gained 14bps to 3.96% (vs 10-year German yield +10bps to 2.49%), while the positive market sentiment for risky assets fueled the performance of High-Yield bonds in USD (+1.3%) and EUR (+0.8%). Currencies: The USD declined again in July versus most currencies as the Fed is signaling the end of the interest rate hiking cycle: EUR +1.4%, GBP +1.9%, AUD +0.6%, CNY +2.1%, JPY +2.8%. Commodities: Gold gained 2.1% as the USD bearish trend resumed and inflation remained above Western central banks’ target. Oil prices surged 15.8% on OPEC cut expectations and production disruptions in Russia.

Equities: Robust earnings and the prospect of sustainable growth in China pushes stocks higher

Global equity markets rallied 3.5% in July, led by China (+7.4%) and the US (+3.1%).

In the US: The US equity market is driven by the strong momentum of the “magnificent 7 Tech stocks” (or “AI Megatrend”) as well as corporate earnings, which were above expectations across the board, notably in the financial and energy sectors. US stocks have also benefited from resilient economic data and the end of the Fed rate hiking cycle.

In Europe: Luxury and Tech sectors have peaked after having driven European equity market performance this year (+16.1%). The economic recession in Germany and the uncertain outcome of the Ukraine war may cap the upside of the European equity market.

In China: The meeting of the Politburo in July confirmed that the main difficulty to reach sustainable growth comes from the weakness of domestic demand. The government is committed to support the domestic economy and the PBoC is keeping its key interest rate low (1.9%), which will help domestic firms and the real estate sector. Chinese markets reacted well to these announcements: in July, the Hang Seng China Enterprise Index (HSCEI) gained 7.4% and the Hang Seng TECH Index soared 16.3%, while the RMB appreciated 2.1% against the USD. With attractive equity valuations and earnings upgrade expectations, we believe mainland Chinese and Hong Kong equity valuations are bound to substantially increase within the next 12 months.

Currencies: USD bearish trend resumed

As inflation is declining and USD interest rates are peaking, the US twin deficit (commercial and domestic) and the relatively low growth in the US are progressively taking their tolls on the US dollar.

EURUSD: Trendless and volatile on the upper side of the range [1.05; 1.10].

Europe has low and declining growth (0.6%), still high inflation (5.3%), and geopolitical uncertainty with the war in Ukraine. In this context, where many outcomes are possible, we expect further currency volatility and the EURUSD to trade sideways.

USDRMB: Large economic differentials between the US and China are weighing on the USDRMB

The growth, trade balance, and inflation differentials are in favor of the RMB, although the stance of Chinese authorities and the PBoC is about supporting the economy and therefore providing a relatively easy monetary policy with low RMB interest rates (with no inflation). We believe the USDRMB has reached its peak since the end of June, currently close to the resistance of 7.30. The bearish trend of the USDRMB may be about to resume and may bring the USDRMB back below 7.00 within the next 12 months.

Fixed Income: Deposit rate and bond yield opportunity

In this exceptional Fixed Income environment, investing cash in bonds from large investment grade banks can provide an income per annum of 6% net in USD or 4% net in EUR from a portfolio of 2-year duration and above. In line with central banks’ interest rate levels, short-term deposit rates (<1 year) reached 5.25% net in USD and 3.50% in EUR.

As central bank yields, along with inflation, are peaking, investors are steadily growing their bond exposure. The risk-on mood so far in 2023 favored Equity markets, which already integrate a lot of good news, and could mean that the equity performance is capped. Thus, bonds are becoming a necessary diversification and return driver in investment portfolios.

US Treasury bonds were downgraded from AAA to AA+: the ever-deteriorating US twin deficit (trade balance: -US$70bn and domestic budget: -US$1,375bn) triggered the US debt downgrade by the rating agency Fitch, following the same downgrade decision by Standard and Poor’s a decade ago. We note, however, that the market impact of Fitch’s decision remained limited.

The Bank of Japan (BoJ) is about to start normalizing its negative interest rate policy. BoJ governor Kazuo Ueda acknowledged that inflation has been rising in Japan (current 3.3%), prompting the necessity for a monetary policy adjustment.

Commodities

Oil prices rallied 15.8% in July, up to US$81.80 a barrel, as investors continued to weigh August output cuts by Saudi Arabia and Russia and tighter oil supplies.

Gold prices gained 2.1% in July as the USD bearish trend resumed due to geopolitical uncertainty and the continuation of the central bank’s gold buying program. For these reasons and given the end of central banks’ interest rate hiking cycle, we believe gold prices are likely to be supported within the next 12 months.

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 post-Covid recovery (5.5% 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:

  • 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: USD 5.25%, EUR 3.50%, GBP 5%, RMB 2%.
  • Income from Investment Grade bank bond issuers: Major banks are implicitly protected by central banks as demonstrated during 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 5.5%.
  • 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.