Quarterly Investment Review

July 13, 2022 - 14 min read



Central banks are fighting inflation
Central bankers tell us that failing to restore price stability is currently a bigger risk than generating recession. Following the surprising higher than expected inflation data in the US in June at 8.6%, the Fed has raised Fed Funds rates by 75bps, a rare move.

More surprisingly, the Swiss National Bank has acted and taken the lead in Europe. It raised rates, for the first time in 15 years, by 50bps to counter inflationary pressures which reached their highest level since 2008 at 2.9%. After years of fighting deflation, inflation is now too high and the SNB has decided to act quickly. This rapid shift is also explained by a mindset change. After being seen as overvalued for years, the CHF is no longer seen as highly valued. By raising rates before the ECB, the SNB indicates that a stronger CHF is no longer a problem. It is possible because the strong CHF has allowed inflation to be more moderate than in Europe.

On the opposite, despite the ECB held an emergency meeting only 6 days after its June regular one in response to higher Italian bond yields, it did not act. However, the ECB has already pre-announced a rate hike for July by 25 or 50bps.


Bond shock has continued
The larger than expected Fed move in June has triggered a new wave of volatility on the bond markets. The US 10 -year government bond yields has continued its move higher and spiked to its highest level since May 2011. Even more surprisingly, the US 2-year yield reached its highest point since 2007. The Swiss Confederation 10-year yield have visited the 1.0% mark for the first time since 2013.

Credit markets have been shaken too. The spreads have sharply widened across the board. The US and EU investment grade credit have widened by 60bps and 100bps respectively in 2022, of which 30bps and 50bps in June. In the High yield space, US and EU spreads have both skyrocketed by 300bps in 2022, included 180bps in June.


Largest equity market de-rating since 1970
The first half of 2022 has gone down in history as a period when we saw the fastest rise in US yields, inversion of the yield curve with the first rate hike and one of the fastest de-rating of US equities on record. World equities have lost 12% over the 2nd quarter according to MSCI. Most of developed markets have delivered very close performance. However there were some exceptions. The most negatively impacted index has been the Nasdaq which has lost 18% in Q2. The main reason is the highest sensitivity for Big Techs to higher yields. The most resilient market has been once again the UK due to its high exposure to the energy and healthcare sectors.


Gold disappoints
In a context of risk aversion, gold price has gradually slipped to $1’800 from $1’900. However, it has remained resilient to rising expectations of aggressive rate hikes and a stronger USD, which historically was painful for gold prices. However, equity market weakness and ongoing geopolitical uncertainty would have support investor demand. It has been a relevant diversifier once again in a balanced portfolio to mitigate equity market losses.


Currencies – Q2 2022 performance

Currencies - Q2 2022 performance

A hawkish Fed, hiking rates aggressively to curb inflation, has pushed the USD to its highest level since early 2000s. In the developed world, the JPY has been the big looser due to a reluctant central bank to tilt to a more restrictive stance to fight inflation.

Emerging currencies have remained under pression, except the RUB., in a context of economic slowdown risks and lower commodity prices.


Bonds – Q2 2022 performance

Bonds - Q2 2022 performance

Another awful quarter for bonds. Higher inflation, hawkish central banks and fears of economic slowdown have pushed yields and spreads up. Bonds have delivered their worst semester in history.

The only exception, once again, is the Chinese market which has confirmed its lower correlation with international bond markets.


Equities – Q2 2022 performance

Equities - Q2 2022 performance

Another quarter of loss on equity markets. A prolonged war in Ukraine, elevated energy prices, higher yields and risks on corporate margins have pushed global equity markets down.

Emerging stocks were once again the biggest losers. China has been an exception thanks to easing Covid restrictions.


Commodities – Q2 2022 performance

Commodities - Q2 2022 performance

A big reversal happened in Q2. Excluding energy prices, most of commodities are down. Energy prices remained supported by the lack of supply to compensate the Russian offer. Other commodities have been penalized by the growing recessions fears.



Growth concerns

Manufacturing output

Global macroeconomic leading indicators nudged lower in June to their lowest levels since mid-2020. The deterioration took place despite an easing of COVID-19 restrictions in China – which allowed mainland manufacturing activity to rise at the fastest rate for over a year – and reflected weakened factory trends in the US, Europe and across much of Asia.

More encouragingly, the alleviation of China’s pandemic restrictions contributed to a further easing of supply chain delays, which – alongside a stalling of global demand growth for manufactured goods – helped cool price pressures, albeit with energy providing further upward pressure on costs.


Improvement limited to China

Manufacturing trends excluding China

Production trends varied markedly around the world. Of the major economies, only mainland China reported an improving production trend, with output rebounding sharply from three months of lockdown-induced contraction, to register the strongest expansion since November 2020. It was also one of the strongest expansions seen for over a decade.

In contrast, output fell into decline in the eurozone for the first time in two years and came close to stalling in both the United States and United Kingdom, where steep slowdowns led to the worst performances for over two years. Japan likewise reported near-stalled production growth, its worst performance since January’s Omicronrelated restrictions.

Growth of new orders likewise generally deteriorated, with declines registered in the eurozone, US and UK. Even China only saw a modest revival of demand, and near-stagnation was seen in Japan and across the rest of Asia as a whole. Notably, in all cases, new orders growth fell below that of output.

Excluding the rebound recorded in China, the global factory trend therefore looked less impressive. In fact, excluding China, factory output growth came to a near standstill in June, registering the weakest performance since June 2020, while new orders fell for the first time in two years..




Equity to Bond correaltion

The magnitude of the inflation surge in G10 and its stickiness has impacted major asset classes in depth. Global equity and bond markets fell in synch, in a crucial challenge to the two decades’ prevailing – negative – correlation.

A global recession seems inevitable, putting a definite end to the current unusual business cycle. The question of its magnitude and intensity will gradually take over the fears of an unbridled inflationary regime change.

We consider that equity to bonds correlation will remain highly volatile this year but should not remain durably in positive territory. From a cyclical perspective, the left tail risk of a deflationary shock, due to the confluence of the durable energy shock and inevitable consumers’ retreat, not to mention the huge debt burden, is rising. It is becoming at par with the right tail risk of a runaway
inflationary regime as in 70/80’s.

Markets have now rebuilt a risk premium consistent with the – dangerous – G-Zero landscape.

The ongoing brutal repricing of risky assets’ valuation is well underway. The necessary drying up of excess liquidity and the onset of the severe economic downturn will continue to weigh
on risky assets.


Investment landscape

Central banks balance sheet

Stagflation is entrenching in G10. Such a landscape hasn’t prevailed since about 5 decades. Markets have acknowledged for that in suffering: both equities and bonds have cratered, for two quarters, in sync. Not only are these framework conditions difficult for investors to cope with in themselves. Worse, they are completely new to almost two generations of investment professionals
and further overshadowed by the pandemic and geopolitics. Making forecasts in this environment becomes particularly uncertain! A future return to some form of calm / neutrality is illusory.

The range of possible outcomes for the economy and markets has become particularly wide and opaque.



Central banks tackled the pandemic head on but are now fighting inflation

Dollar trade weighted

With higher yields, elevated volatility and wider spreads, the bond market is sending warning signals that the FX market is listening. The global economy is hit by supplychain shocks, China zero-COVID policy, higher energy prices and the war in Ukraine. Recession fears are growing, and the USD has been the principal beneficiary of the longest period of high volatility we are living in
since early 2010s.

The USD is reaching its 3rd peak in 40 years. The first episode in 1985 was straightforward, the Fed tightened aggressively to cool down strong growth and accommodative fiscal policy, just before the Plaza Accord. The 2001 peak came after a lengthy period of heightened volatility. The USD was boosted by the Asian crisis, the Russian default, the LTCM collapse, the Dotcom burst, and the 9/11 attacks. The 2008 peak followed the global central banks easing to counter the Global Financial Crisis.

Dollar performance (weeks around recession)

Since then, the investment environment has been a secular stagnation (low growth and little inflation). Looking ahead, a more permanent stagflation (low growth and elevated inflation) seems a more likely scenario. The focus may move towards elevated energy prices winners, or predictable cash flows such as profitable tech, healthcare, and energy sectors. The US economy looks well positioned than any other (industry, banks).

According to history, there is no consistent USD pattern when the US enters recession. In contrast, there is a very consistent pattern when the market has fully priced in the recession: the USD has historically always weakened when the equity market has troughed, around the midpoint of the recession.

The next large move is likely to be down but not until tangible signs confirm that inflation is peaking, growth slowing, Fed tightening taking a break and markets calming down. Until then the USD will stay firm.


Global central bankers hawkish shift

Central banks and CPI rates changes in 2022
The Fed remains unconditionally committed to bring inflation down but recognized that without price relative calm, macroeconomic or financial stability are unlikely. If inflation remains high, the Fed will be reluctant to cut rates in respond to deteriorating macro context. The Fed target of reaching 2.0% inflation and a strong job market would be challenging. Achieving a soft landing is not
going to be easy. The Fed has no intention to cause a recession but acknowledged that is a possibility. This contrasts with the previous testimony when achieving a soft landing was more likely than not.

The Fed remains committed to reduce its $9.0trn balance sheet by 30%. More importantly, Powell pushed back on the possibility of the Fed raising its 2.0% inflation target. Several Fed officials are promoting another 75bps hike in July. Although 75bps hikes are rare, it was not the first time the Fed implemented such moves. Since 1971, the Fed has raised rates 5x by 100bps, 4x by 75bps and 9x by 50bps.

Most central banks are still behind the curve, with very few still dithering. The world hawkish twist will last at least until a recession starts.


High Yield market passiveness

Economic activity indicator and HY spread

Since the GFC, investors have been conditioned to buy on the dips across risky assets, including HY. The pandemic reinforced this practice and thanks to fiscal stimulus, monetary intervention, and Fed facilities. That promoted complacency and raised questions as to how investors would react to a real recession. Logically, default rates increase, and issuers are less likely to cover interest payments and debts.

Spreads have always widened in a higher macro uncertainty and equity volatility environment. Their spikes occurred when volatility suddenly jumps. For now, US HY spreads at 500bps are pricing in a moderate economic slowdown. In a recession (ISM Manufacturing below 50), the US HY spread should be closer to 700bps and above 900bps in a deeper one (ISM below 45). The probability of a protracted slowdown and even a true recession is much higher now than before the war in Ukraine and the rapid unwinding of Fed stimulus.



A Bear market, from inflation to recession

S&P500 earnings and recession periods

The 1st phase was the compression of multiples, the second should be the correction of profits. Over the past 12 months, stock market valuations have contracted by around 40% with the sharp  upturn in inflation. Multiples contract when inflation rises. See graph below. In the two oil crises of the 70s and 80s, US inflation had risen above 12% and the PE ratio of the S&P 500 fell to 7x.

The Growth segment and disruptive stocks with high PER generally do not withstand these periods when inflation returns and interest rates rise; in relative terms, their stock market valuations have fallen much more than those of the Value segment, characterized by low PE ratios. This explains the outperformance of the Value segment vis-à-vis the Growth segment in recent months. Since 1975, we have witnessed the largest decline in stock valuations on an annual basis.

The downward readjustment of multiples due to rising inflation is coming to an end, as we believe that inflation peaked mid-year due to falling demand caused by the rising prices and consumer caution in the face of an uncertain future..

Macro models show a decline in profits

According to the correlation model between the PER of the S&P 500 and US inflation, the PER of the S&P 500 should be between 10x and 12x if inflation were to remain between 8% and 10% in the coming months. Today it stands at 16x, which is high and inappropriate based on the model below; unless, as we think, the market is anticipating a return of inflation towards 5% by the end
of the year. Otherwise, PERs will continue to contract.

Since its peak at the start of 2022, the MSCI World index has lost more than 20%, validating its entry into the bear market, through the drop in PERs. Indices could continue to decline with the contraction in profits. Equity indices never rise when profits fall. By a bottom-up approach, which is lagging, US profits are expected to rise by 10% both in 2022, 2023, and in 2024, which seems (very) optimistic given the probable recessionary orientation of the economy in the coming months. By a top-down approach, which is leading, profits should fall by 20%.

If the US economy were to go into recession, profits would fall, even in an economic downturn.


<span “>Commodities

Cyclical pause in the Supercycle

Bloomberg Commodities Index

The global recession is becoming more threatening and inflation of energy prices is pushing consumers to reduce their demand. With the sharp decline in Russian gas exports, Europe is on the verge of a major energy crisis; measured rationing could allow gas reserves to be filled to 100% for the coming winter and reduce pressure on prices. The sharp decline in industrial metal prices signals that the Chinese economy and its real estate sector are not doing very well, despite the authorities’ optimism and supporting measures.

We will therefore move from a historic supply shock, due to Covid, then to the war in Ukraine, to a gradual process of falling demand due to the economic slowdown/ recession and alternative measures taken by consumer countries. In this major energy disruption, coal is regaining “color”, with a reactivation of coal-fired plants to produce electricity in Europe, India and China.

We believe in high but stable energy prices. Demand is expected to weaken in the coming months and OPEC may add capacity to the market, but the market remains tight and a problem at a major producer could push prices higher. For some years now, experts have been warning of a lack of investment in production capacity. These crises show that the green transition will have to be done in a more coherent way and have very solid alternative solutions to fossil fuels before doing without oil and gas.


Industrial metals

Long term gold price dynamic

Industrial metal prices have fallen significantly since March 2022: -35% for Bloomberg Industrial Metals, dominated by copper, aluminum, nickel and zinc. Metals are suffering from Chinese Covid lockdowns and the restrictive monetary policy of the Fed which prefers to sacrifice economic growth to control inflation.

Nobody talks anymore about the great needs of metals which are arising for the energy transition. Yet they are very real and huge. Energy and Industrial Metals sectors could be less attractive in the coming months, as investors are focused on the risk of recession. But China and the green transition remain two major factors for a resumption of the Commodities Supercycle after this economic pause.



Allocations - Julliet 2022


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