Interest rates reached their all time high in 15 years: July 2023 Market Commentary

Global Macro: 

Market Context: The US 10-year Treasury bond yield reached 4% and European government yield reached 3%.

In this exceptional fixed income environment, investing a US$ nest egg in bonds from large investment grade banks can provide an income of 6% net that allows with certainty, to double the initial investment in less than 12 years, under the assumption that the central bank financial system will remain the safe harbor it is today.

Western central banks are not done hiking interest rates to fight receding yet persistent inflation.  On Thursday July 27th, the US Fed is expected to hike its funds rate by 0.25% from 5.25% to 5.50% and the ECB is expected to move up its deposit rate from 3.50% to 3.75%.

In the US fewer jobs than expected were created: The “nonfarm payroll employment” increased by 209K in June, the least since December 2020. The unemployment rate went down to 3.6%.

The US Inflation downtrend is confirmed as US PCE (personal consumption expenditure) slowed in June.

In Europe, the producer prices fell for the 4th Month, the Services activity was weaker than expected and the manufacturing downturn deepened.

In China, the government is targeting structural, sustainable growth. The manufacturing and property sectors are remaining soft. Looking ahead, the government may focus on structural growth drivers such as manufacturing upgrades and green tech. The recovery is ongoing and is supported by  services, however, the sentiment from households and businesses has yet to return to normal levels. The focus by policymakers on longer-term structural reform will help to achieve stable growth in 2024.

Financial Markets:

Equity: In June, Global equity rallied. US equity performance was again largely driven by large Tech stocks (Nasdaq 100 +6.6%, S&P 500 +6.5%). Chinese equities rebounded (HSCEI +4.2%). Fixed Income: The 10-year US yield gained 18bps to 3.82%, 10-year German yield +14bps to 2.42%), the positive market sentiment for risky assets fueled the performance of High-Yield bonds in USD +1.7% and EUR +1%). Currencies: The USD declined again in June versus most currencies as the Fed is signaling the end of the interest rate hiking cycle: EUR +1.3%, GBP +1.3%, AUD +1.6% however the USD gained ground versus “low interest rates Asian currencies”: CNY -2.3%, JPY -3.6%. Commodities: Gold sold off -1.8% within this new higher interest rate environment and oil prices (+3.7%) were supported by an OPEC production cut.

• Equities: Still driven by a handful of “magnificent” stocks

In the US: Following the year-to-date performance of the S&P500 of +15%, the equity market is losing steam following the strong momentum in the first semester driven by the “magnificent 7 Tech stocks”. There are growing concerns about further Fed rate hikes that could bring the financing cost higher for longer. The outperformance of tech stocks led to overvaluation fueled by the prospects of AI development.

In Europe: The Luxury and Tech sectors are still driving European equity market performance of +14% this year. The economic recession in Germany and the uncertain outcome of the Ukraine war may cap the upside of the European equity market.

In China: The Hang Seng China Enterprise was positive +4.2% in June as investors awaited US Treasury Secretary Janet Yellen’s visit to China. Given strong growth momentum and pro-growth policy, we expect China to deliver a GDP growth above 5% this year. It seems the US will keep pressure on China. However, Janet Yellen communicated during her visit in China that a decoupling of the two biggest economies is out of the questions. With attractive equity valuations and earnings upgrade expectations, we believe mainland Chinese and Hong Kong equity valuations are bound to substantially increase within the net 12 months.

• Currency outlook: USD bearish trend is resuming

As inflation is declining and USD interest rates are peaking, the US twin deficit (commercial and domestic) and the low growth in the US, are progressively taking their tolls on the US Dollar.

EURUSD: Trendless and volatile on the upper side of the range [1.05 ; 1.10].

Europe has low and declining growth (1%), still high inflation (5.5%) and geopolitical uncertainty with the war in Ukraine. In this context where many outcomes are possible, we expect further currency volatility and the EURUSD to trade sideways.

USDRMB: Large economic differentials between the US and China are weighing on the USDRMB

The growth, trade balance, and inflation differentials are in favor of the RMB. Although the stance of Chinese authorities and the People’s Bank of China (PBoC) is about supporting the economy and therefore providing a relatively easy monetary policy with low RMB interest rates (with no inflation). We believe we are near the peak of the USDRMB, currently close to 7.20 and below the resistance of 7.30, and that the bearish trend of the USDRMB will resume, bringing the USDRMB back below 7.00 withing the next 12 months.

• Fixed Income: Deposit rate and bond yield opportunity

In the long end of the yield curve, the US 10-year Treasury bond yield reached 4% and European government yield reached 3%.

In this exceptional fixed income environment, investing a US$ nest eggs in bonds from large investment grade banks can provide an income of 6% net that allows to double the initial investment in less than 12 years with certainty under the assumption that the central bank financial system will remain the safe harbor it is today.

In the short end of the yield curve, in line with central bank interest rate levels, short term deposit rates (<1 year) reached 5.25% in USD and 3.25% in EUR and short-term duration bond yields (e.g. ~ 2 years) reached 6% in USD and 4% in EUR.

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 been 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:

• Gold downside protection. Hedge and protect the gain on your physical gold and receive 4% net annualized interest: Following the multiple recent crises (Covid, US-China tensions, war in Ukraine) and buying spree of central banks, gold has moved up to US$2,050/ounce close to its all-time high of US$2,070, reached in August 2020. As gold pays no interest and is competing with cash, which generates high interest (5% in USD, 3.25% in EUR), holders of physical gold have started to protect (hedge) their gold holdings as some anticipate that the lack of income may favor profit taking at these high historical levels.
• Income from safe cash deposits: Cash can be safely placed in cash deposits and earn annualized net interest, e.g. over a period of 6 months: USD 5.25%, EUR 3.25%, GBP 5%, RMB 2%.
• Income from Investment Grade bank bond issuers: Major banks are implicitly protected by central banks as demonstrated in the Credit Suisse crisis where actual bonds (not AT1) remained secured. Bonds have already mostly integrated the central banks’ 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 5.5%.
• 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.