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Q2 2023 An Inflection point for inflation and interest rates: Market Commentary April 2023

April 13, 2023

Global Macro:

Credit Suisse crisis: The Swiss National Bank (central bank) has responded fast to the attack on Credit Suisse (CS) in the wake of Silicon Valley Bank’s (SVB) demise. It has provided ample liquidity, verbal intervention, and secured the highly criticized absorption of Credit Suisse by UBS, creating one giant Swiss bank.
Central banks’ terminal rate: As inflation and growth are receding in major economies, central banks have provided more clarity about the end of the interest rates hiking cycle (i.e. the “terminal rates”). The US Fed is expected to raise the upper boundary of the Fed funds rate from 5% to 5.25% on May 4th and by an additional 25bps or 50bps later in 2023 to bring the Fed funds terminal rate up to 5.5% or 5.75% by the end of the year. The European Central Bank (ECB) is expected to match the Fed’s rate hike of 25bps to bring the euro deposit rate from 3% to 3.25%, with the terminal rate expected to reach 4% by the end of 2023. Meanwhile, the People’s Bank of China (PBoC) is keeping its short-term interest rate (“7-day reverse repo”) steady at 2% to underpin the economy and support the real estate sector.
Inflation: We note inflation has passed its peak, although it remains well above central banks’ targets. The lagged effect of interest rate rises is feeding through to Western economies and corporate earnings.

In the US: Recession fear is driving markets

US growth data is pointing to a slowing economy. The US ISM manufacturing PMI (Purchasing Managers’ Index) fell further into contractionary territory, reaching its lowest level in nearly three years, the ISM services PMI dropped to a three-month low, and the number of US job openings came in below expectations.

In Europe: Geopolitical uncertainty and weak growth

European markets may stay volatile in the short term, however, current market valuations are relatively appealing. Declining energy prices pushed Eurozone headline inflation lower this month; however, policymakers are focusing more on core inflation, which is proving stickier.

In Asia: Positive outlook driven by China’s re-opening

The manufacturing efficiency of China is overpowering the tension with the US as Tesla chose China to make its new and most sophisticated mega batteries, with plans to build the new battery factory in Shanghai. We note Airbus is also building a new jet factory in China. Overall, foreign capital is flooding again into China, underpinning the RMB and Chinese financial markets. Despite the recent turbulence within the US and European banking sectors, the impact on Asian banks has been relatively muted. The MSCI Asia ex-Japan Financials Index was down just 5% from peak to trough since the collapse of SVB, compared with double-digit declines in the US and Europe. Moreover, credit default swap (CDS) spreads in Asia did not widen to the same extent as they did in the US and Europe. We believe China’s counter-trend recovery should further support the region’s growth prospects.

Financial Markets:

Equity: Most equity markets recovered in March (S&P 500 +3.7%; EuroStoxx 50 +1.4%; HSCEI +5.9%) amid investor expectations that the rate hiking cycle could come to an end shortly. Fixed Income: The 10-year US yield lost 43bps to 3.49% with the 10-year German yield down 18bps to 2.28%, which contributed to the rebound of Emerging Market bonds (+1.1% in USD; +4.4% in local currencies) and High-Yield bonds in USD (+1.3%). Currencies: The USD lost ground to most major currencies in March: EUR +2.2%, CNY +1.0%, JPY +2.9%, CHF +2.5%. Commodities: Oil prices edged down 1.6%, while gold strongly rebounded (+9.4%), largely driven by US interest rate anticipations.

Equities: Benefitting from lower long-term interest rates

Global stocks returned 3.1% in March, for a quarterly gain of 7.3%. This reflects investors’ confidence that regulators have done enough to avert a banking crisis and that an end to central banks’ rate hikes is near. Following a strong start to the year, global equities lost traction in February amid a slower-than-expected moderation in inflation and, most recently, the increasing uncertainty around US regional banks and the potential impact of tightening credit and liquidity conditions on economic growth.

In the US, the outlook for US equities is challenged amid tighter financial conditions, declining corporate earnings, and relatively high valuations.

In the Eurozone, European bank shares declined 14% in March, their worst monthly loss since March 2020. At 12.5 price-to-forward-earnings (P/E), equities in Europe are historically inexpensive, and the 3.5% prospective dividend yield is attractive relative to the 2.3% yield on German 10-year bonds.

In China, the official manufacturing PMI beat consensus at 51.9 in March (vs 52.6 in February), well above the 50 threshold and confirming an ongoing recovery. The non-manufacturing PMI, which covers both services and construction, rose to 58.2, the highest in nearly 12 years. Services like retail, airline and transport, IT, and financials were in solid expansion, while the construction PMI accelerated to 65.6 (vs 60.2 previously).

Currencies: Driven by central bank interest rate anticipations

USD: Has resumed its secular decline

We believe the US dollar is set to weaken, as US growth and interest rate premiums relative to the rest of the world erode.

EUR: EURUSD knocking on 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 needs a concrete catalyst: for instance, a ceasefire in Ukraine or an aggressive rate hike from the ECB. The latter is possible as the inflation is somewhat persistent in Europe.

RMB: Underpinned by China’s re-opening and the return of foreign capital inflows

The USDRMB downtrend continues, caused by China’s recovery and the Fed signaling that it is close to pausing its rate hiking 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: Rising speculation about an imminent BoJ move to favor higher JPY interest rates

The market is speculating that the Bank of Japan (BoJ) is gearing up for an imminent policy shift, reflected in the increase of the Japanese 10-year yield from 0.30% to 0.40% in March. Market participants anticipate a more restrictive monetary policy going forward.

GBP: The GBPUSD is benefiting from the USD weakness

So far in 2023, GBPUSD has been stuck within the [1.18 – 1.25] range. It is currently close to the top of the range at 1.2410.

AUD: Supported by China’s re-opening and Australia’s economic growth

Technical indicators turned positive in recent days, with the moving average convergence/divergence (MACD) indicator showing a fading of the negative momentum. The key line of support is around 0.665.

Bonds: What did we learn from the Credit Suisse crisis and how does it impact bond investing?

Recent turbulence in the banking sector led to a bond credit spread widening of 30bps in March. Valuations of hybrid AT1 capital instruments (note: AT1 are not bonds but hybrid equity-debt instruments) plunged following the write-down of Credit Suisse’s AT1 shares, while UBS agreed to acquire Credit Suisse. The CS support package from the Swiss central bank resulted in a complete write-down of the nominal value of all AT1 capital from CS, while common equity shareholders have not been fully wiped out and are still receiving new dividends post CS absorption. This is a Swiss specific situation, which prompted investor concerns about AT1 instruments. In Europe and in the UK, as confirmed by statements released by their respective central banks, common equity capital would always be first to absorb losses and would be fully written down before AT1 instruments are written down. We reiterate our preference for large, well-capitalized banks that operate with strong balance sheets, stable well-diversified deposit bases, and healthy credit metrics in line with our credit risk investment model, where we invest in so-called “Global Systemically Important Banks (G-SIBs)” protected by central banks.

Commodities: Weakened by banking stress and tightening global financial conditions

The more cyclical commodities like energy were strongly impacted, but they have since then recovered following the surprise production cuts by key oil producers. Meanwhile, amid the recent market turbulence, gold, a safe haven, rallied above US$2,000. Commodity prices may rise in 2023 driven by China’s recovery and a weaker US dollar.

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 ben 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:

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 2.75%, GBP 3.5%, 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. Bond prices have already largely integrated the 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.