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Global equity rebound despite recession fears and geopolitical headwinds: August 2022 Market Commentary

Market Context:  Global equity rebound despite recession fears and geopolitical headwinds

Global Macro:

The drivers of global markets remain the same: the “3 Rs”.

1. Risks of escalation of the Russia-Ukraine war and increasing tension between China and the US over Taiwan following the visit of Nancy Pelosi, speaker of the US House of Representatives.

2. Rising interest rates from central banks to combat inflation.
The US Fed announced it may hike its Fed funds rate from 2.33% currently to 4% by year end (vs 0.07% at the beginning of the year). In July, the European Central Bank (ECB) hiked its deposit rate by 50bps from -0.50% to 0% in a bid to underpin the euro and avoid imported inflation from energy imports. On August 4th, the Bank of England (BoE) raised its key interest rate by 50bps to 1.75%, the biggest rate hike since 2000.

3. Recession fears.
Recession fears are receding in the US. Nonfarm payrolls increased 528k in July, beating market expectations of 250k. The unemployment rate went down to 3.5%, thus returning to February 2020 levels, prior to the Covid-19 pandemic. However, Europe and UK are expected to enter recession this year as inflation is lasting longer than expected and growth is slowing down. Inflation is weighing on global growth; nonetheless, the two drivers of the current supply shock – energy and food – are showing signs of price stabilization. Crude oil prices declined 6.5% in July, erasing part of the price increase triggered by Russia’s invasion of Ukraine.

Financial Markets:

Equity: Most equity markets rebounded in July (S&P 500 +9.3%; Euro Stoxx 50 +8.6%; Nikkei 225 +5.3%), while Chinese equities posted significant losses (HSCEI -10.2%), amid investor concerns over China’s property crisis and a resurgence in Covid cases. Fixed Income: The 10-year US yield decreased 43bps in July to 2.67%, which contributed to the rebound of USD-denominated Emerging Market government bonds (+4.1%; vs -2.9% in local currencies) and High-yield corporate bonds (+7.3% in USD; +7.0% in EUR). Currencies: With respect to USD: EUR -1.9%, AUD +1.3%, CNY -0.7%, JPY +2.0%, CHF +0.7%. Commodities: Gold and oil prices further retreated in July (-1.5% and -6.5%, respectively).

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 potential Recession. Geopolitical risks remain elevated, amid the ongoing Russia-Ukraine war and increased tension between China and the US over Taiwan. Interest rate hikes from central banks as well as inflation dynamics are well incorporated in market prices. This is why we believe global market valuations will revert to a higher price equilibrium when some type of “détente” is witnessed in Ukraine or in US-China relations. Given the very large ongoing costs related to these geopolitical tensions for all protagonists, we anticipate an exhaustion of the Ukraine conflict within the next 6 to 12 months and a “soft landing” of the main economies over the next 12 months, in our base scenario. We believe 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 in Ukraine and commodity price surge are impacting the European economy much more than any other region.

  • Equities: Global equity markets are still in negative territory, below their 2021 highs. As energy and food prices seem to have stabilized at high levels, the peak of inflation may be near. Once 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 ahead of the 20th Party Congress where President Xi is expected to be re-elected by his peers. Meanwhile, 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 inflation continues to increase in the euro area (currently at 8.9%) and the balance of trade keeps worsening (from a pre-Covid average of +€20bn down to -€26bn per month), EURUSD is staying close to parity. The ECB started hiking interest rates for the first time in a decade in July in order to move away from negative interest rates territory (ECB short-term deposit rate is currently at 0%, up from -0.50%). Unless the war in Ukraine escalates, the ECB’s slow and moderate interest rate hiking cycle should support the euro and avoid the risk of further imported inflation due to a weak euro. If a ceasefire is declared in Ukraine, EURUSD may revert to pre-war levels, around 1.10. The expanding Chinese economy should support the RMB, which is expected to resume its secular bullish trend in line with the fast restoration of the Chinese trade balance (back to +US$100bn per month, close to pre-pandemic levels and the largest in the world). As the Bank of Japan (BoJ) is keeping its zero-interest rate policy, the JPY stays at a 20-year low.
  • Fixed Income: The yield on 10-year US Treasuries has fallen from a peak of 3.5% to 2.7%. The spread between the Fed funds rate (short-term rate) and the 10-year yield is now negative and the lowest since 2000. The fact that the US yield curve is inverted may be considered by market participants as an indicator of future recession. Meanwhile, European yields remain stable (10-year German yield at 1%), as markets anticipate a very slow interest rate hiking cycle from the ECB amid low-growth prospects and a conflictual environment with Russia.
  • Commodities: Energy and food are showing signs of price stabilization. Crude oil prices declined 6.5% in July, erasing part of the price increase triggered by Russia’s invasion of Ukraine. However, as the energy sector is under-invested, we expect oil prices to remain elevated around US$100/bbl. If there is no ceasefire in Ukraine, oil prices may rise closer 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 2.80% over 6 months, RMB 2% 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.
  • 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.