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Strongest first-half market correction since 1970: July 2022 Market Commentary

Market Context: Strongest first-half market correction since 1970

Global Macro:

Three global concerns for market assets: the 3 Rs.

1. Risk of escalation of the Russia-Ukraine war

2. Rising interest Rates from central banks to combat rampant inflation

On June 30th, top central bankers met in Sintra, Portugal at the ECB Forum. The outcome was the acknowledgement of three facts: first, the low inflation era is over; second, bringing down inflation in Western economies from almost 10% to the target level of 2% will be costly in terms of growth; third, commodity and food prices are bound to stay elevated due to the “structural legacy” from Covid and the ongoing war in Ukraine.

3. Recession fears

Slowing global manufacturing growth, supply chain disruptions following Russia’s invasion of Ukraine, and the highest inflation in years have triggered recession fears among investors, which materialized in the worst first-half correction since 1970 for most equity markets.

However, despite these recession fears, China’s recovery continues with economic activities rebounding firmly in June. The Purchasing Managers’ Index (PMI) for manufacturing and services recorded its fastest expansion in 13 months at 53 (PMI > 50  = economic expansion), while Chinese cities are emerging from lockdowns.

On July 1st in Hong Kong, President Xi Jinping delivered his 25th anniversary speech celebrating the Hong Kong handover to China. He stated that the city will continue to enjoy its unique status and remain free and open, which underlies the objective for Hong Kong to remain the number one international hub in Asia and the conduit for the increasing RMB adoption for international commerce.

Financial Markets:

Equity: Most equity markets suffered significant losses in June (S&P 500 -8.9%; Nasdaq -9.3%; Euro Stoxx 50 -10.2%), while Chinese equities posted solid gains (HSCEI +3.4%), underpinned by the end of Shanghai and Beijing lockdowns and expectations of a tech crackdown easing. Fixed Income: The 10-year US yield rose 35bps in June to 3.09%, which contributed to the sell-off in Emerging Market government bonds (-7.7% in USD; -4.2% in local currencies) and High-yield corporate bonds (-7.2% in USD and -7.1% in EUR). Currencies: With respect to USD: EUR -3.0%, AUD -4.1%; CNY -0.6%; safe-haven JPY -6.3%, CHF +0.1%. Commodities: Gold further decreased 2.3% in June while oil prices fell 8.7% on recession fears.

What to expect for the second half of the year:

Global markets, stocks, bonds, currencies and commodity valuations will be driven by the 3Rs expectations: anticipation of the war Risk, central banks’ actions on interest Rates and realized GDP growth by year end, and either slower growth or Recession. As market participants and central banks have already taken into account many risk scenarios and bad news, we expect a “soft landing” of the economy over the next 12 months. Strong stimulus from governments shall mitigate the recession risk and reduce its duration if it happens. We expect the recession risk to be local to Europe rather than global as the war and commodity price surge are dramatically impacting the European economy more than any other region.

  • Equities: Global equity markets are in bear market territory, more than 20% below their 2021 highs. Central banks’ current actions to raise interest rates are slowing down growth, which is negatively impacting equity indices. As energy and food prices seem to have stabilized at high levels, the peak of inflation may be near. Once it is behind us, most of the anticipation for interest rate hikes will be integrated in equity valuations, meaning the bottom of the equity market would have been reached. It may already be the case for Chinese equities since the People’s Bank of China (PBoC) started to lower interest rates and provide an accommodative monetary policy to boost growth as China is progressively reopening within the second semester. The country’s objective is to be on track for 5.5% annualized growth for China’s 20th Party Congress where President Xi is expected to be re-elected by his peers. The persisting strong inflation in the US has triggered fears that the Fed’s interest rate hiking cycle may push the US into recession. Global equity markets remain vulnerable to interest rate hikes and slowing growth.
  • Currencies: As Euro Area inflation continues to increase (currently at 8.6%) and the balance of trade keeps on worsening (from a pre-Covid average of +€20bn down to -€32bn per month), EURUSD is staying close to its lowest support level in 15 years: 1.0375. The European Central Bank (ECB) announced it will start hiking interest rates for the first time in a decade in July in order to move away from a negative interest rates environment (ECB short-term deposit rate is currently at -0.50%), 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. President Xi’s speech in Hong Kong for the 25th anniversary of the handover to China confirmed the political will to reach China’s growth target of 5.5% for 2022 and the progressive re-opening of the Chinese economy following the pandemic. The Chinese economy is in expansion again with June PMI above 50. This backdrop should support the RMB that is expected to resume its secular bullish trend in line with the fast restoration of the Chinese trade balance back to +US$77bn per month, close to pre-pandemic levels and the largest in the world. As the Bank of Japan (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.
  • Fixed Income: The US Fed indicated a stronger policy to fight inflation and an additional 1.75 percentage point tightening by the end of the year to 3.5%. Consequently, US yields have increased to reach 3% from the 2-year bond maturity onwards. European yields rose to 1.5% from the 5-year bond maturity onwards.
  • Commodities: As the energy industry is under-invested, we expect oil prices to remain elevated around US$120/bbl. If there is no ceasefire in Ukraine, oil prices may drift higher to US$150/bbl.

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 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.
  • 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. USD 2.3% over 6 months, RMB 2.3% over 6 months, EUR 2% over 1 year.
  • 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 4% net income in USD from a 1-year bond portfolio.
  • 0.50% discount on the offshore renminbi in Hong Kong: Depending on market volatility, 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.
  • 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 triggered massive investment in military defense and the overall security sector – including cyber, food and energy security – in Europe and around the world.