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Whatever it takes to halt inflation: September 2022 Market Commentary

September 20, 2022

Global Macro:

The US Federal Reserve is leading most central banks to continuously raise interest rates in order to combat inflation, at any cost, it seems. The Fed is likely to hike its Fed funds rate by a third consecutive 75 basis points at its meeting on September 20th. The impact on financial markets and real estate is direct, reducing asset prices and deflating bubbles that formed in these asset classes over the past decade. On the positive side, CPI figures show that inflation may have peaked in the US (9.1% in June). Yet, a less accommodative monetary policy poses risks to growth in the US and globally. In Europe, the situation is more complex with the lasting war in Ukraine. The rising prices of energy, food, and raw materials have slowed the Eurozone economy into recession with a trade balance that became negative (-EUR 25bn/month vs a 5-year average of +EUR 20bn/month). Consequently, the global macro dynamic is still governed by the 3 Rs: Risks linked to the war in Ukraine and US-China tensions, Rising interest rates, and Recession fears.

Financial Markets:

Equity: Most equity markets posted losses in August (S&P 500 -3.5%; Euro Stoxx 50 -5.3%; HSI -1.0%) amid lasting inflation and expectations of further substantial interest rate hikes. Fixed Income: The 10-year US yield gained 45bps in August to 3.12%, which contributed to the decline of Emerging Market government bonds (-2.9% in USD; -0.1% in local currencies) and High-yield corporate bonds (-3.9% in USD; -3.7% in EUR). Currencies: The USD strengthened against other major currencies amid rising market uncertainty: EUR -1.5%, AUD -1.8%, CNY -2.1%, JPY -3.9%, CHF -2.5%. Commodities: Gold and oil prices further retreated in August (-2.9% and -10.7%, respectively).

What to expect for the last quarter of the year

Equities: Global equity markets are still under pressure as the 3 Rs are firmly ingrained in market sentiment. This negative global macro context is weighing on earnings and, as a result, equities will remain weak until a number of catalysts change the damaged economic backdrop. Those could be the beginning of ceasefire talks with Russia, the outcome of the 20th National Congress of the Chinese Communist Party, where President Xi is expected to be re-elected by his peers, or the confirmation over time that inflation has peaked. The market will need not one but a group of catalysts in order to see an inflection point for growth in Western economies, for the Chinese economy to consolidate its 4%-plus growth target, and hopefully for commodity prices to stabilize at a level allowing global growth to be sustainable.

Currencies: USD: The greenback has reached its strongest level in 20 years, fueled by 2 factors. First, the Fed has multiplied by 30 the remuneration of USD cash from the Fed funds rate of 0.07% at the beginning of the year up to 2.33% at this time. It is likely to reach 3% by the end of the month if the Fed raises the short-term rate by another 75bps on September 20th, as expected by Fed officials. Second, as the US is the one and only superpower for the time being, the US dollar is the ultimate “safe haven” in case of war and geopolitical tensions, which is precisely what has happened since Covid two years ago, one crisis after another: Covid pandemic, Ukraine war and US-China-Taiwan tensions. It seems that most of the bad news are already in the market and, at some point, we will see some type of “detente” across these crises, with the USD likely to resume its secular bearish trend, reflecting the US’ strong negative trade balance (around -US$100bn/month), increasing domestic deficit, and the global de-dollarization trend. EUR: In this context, the euro is the greater part of the other side of the USD currency coin. EUR will remain weak until ceasefire talks begin. The ECB ambitions to hike rates from zero currently to positive territory, which should help the euro stay above the previous lows of EURUSD = 0.98 (20-year low). RMB: The RMB has been under pressure for two main reasons: first, the geopolitical unrest with the Ukraine war and the Taiwan tensions resulting in a flight to quality to the safe-haven USD; and second, the continuation of the zero-Covid policy, seen as a damaging factor for China’s growth. When these two factors dissipate, we anticipate that, from the end of 2022, the USDRMB is likely to resume its bearish trend, reflecting the asymmetric trade balance and the money flow between the US and China. JPY: The yen is expected to remain depressed (at around USDJPY = 140, 20-year low for the JPY) as there is no immediate catalyst for the yen to rebound given the fact that Bank of Japan is sticking to its zero-rate policy and Japan’s trade balance is still under pressure, from +US$4bn/month before Covid down to -US$1bn/month now. CAD & AUD are well supported by the elevated price of commodities and energy, in addition to their respective central bank hiking interest rates in sync with the US Fed.
Fixed Income: The yield of 10-year US Treasuries rebounded up to 3.45%, close to its peak of 3.5%. The spread between the 1-year yield (3.80%) and the 10-year yield is still negative (-0.35%). The fact that the US yield curve is inverted may be considered by market participants as an indicator of future recession. Meanwhile, European yields increased by 1ppt (10-year German yield at 1.70%), as markets anticipate interest rate hikes from the ECB amid low-growth prospects and a conflictual environment with Russia.

Commodities: In parallel with inflation, energy and food prices may have peaked. Crude oil prices declined 10% in August after a 6.5% decline in July, erasing part of the price increase triggered by Russia’s invasion of Ukraine. However, as the energy sector is underinvested, 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 3% over 3 months, RMB 2.6% over 3 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 over 5% net income in USD from a 1-year to 2-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.