“Every good officer prepares for panic” wrote Tom Clancy. But what panic to prepare for? Record inflation, the end of central bank support, war, the nuclear threat, fears of an imminent recession, the return of a great containment in China… Investors are now prey to “the sum of all fears”: each month since the beginning of the year brings a new black scenario to the roadmap that asset allocators are trying to draw: their sentiment is depressed and their pessimism exceeds March 2020 levels.
The prognosis of a year of historically high and synchronous growth across the globe is being followed by uncertainty, downward revisions and the first signs of a dislocation of the macroeconomic outlook across regions. The decoupling of the banking sector from rising interest rates shows that the fear of the end of the cycle (the cost of risk and the default rate of borrowers would then rise sharply in the event of a recession) outweighs the good performance of retail banking. Oil oscillates between the fear of a collapse in demand as China persists in its uncompromising zero-covid policy and the speculative euphoria that follows the Russian ransom.
The repercussions of the differences between the geographies (growth, rates) are particularly percussive on the increasingly volatile currencies (after a sea of oil year in 2021) with one observable constant: the most important of them (euro, yen, yuan) are losing ground to the dollar.
In the eyes of foreign investors, the euro, backed by a political and monetary union of variable geometry, difficult to visualise in the long term, is weakened by the threat of asphyxiation hanging over the continent’s industrial lung. Determined to gradually stop buying fossil fuels from Russia, Germany fears an economic recession of 5% of GDP if the embargo on Russian gas is extended.
The continent’s growth will finally be lower than that of the United States, when the forecasts at the beginning of the year had us excited about the opposite. The ECB, which a year ago was still anticipating inflation at 1.3% (compared to 7.4% last March), is not showing the same determination as the FED to combat price slippage.
As a result, the continent is suffering from a growth and interest rate differential against the dollar to the extent that the single currency, the market’s primary adjustment variable, is trading at a 20-year low of $1.054.
The European case is not isolated. As the world’s main importer of LNG, Japan, which shares Europe’s energy problem, has a rate differential with its partners such that its currency is falling not only against the dollar but also against the euro. For these two net commodity importing economies, the fall in domestic currencies increases the cost of energy and increases the volatility of inflation expectations, disrupting growth forecasts.
During the first quarter, the yuan and Chinese sovereign bonds had remained immune to the vicissitudes of the local equity market, playing their role of safe haven asset perfectly at the height of the geopolitical crisis. However, like the yen and the euro, the renminbi is now under attack. The end of a two-year long cycle of appreciation in the Chinese currency is looming. The withdrawal of foreign capital from the country is putting pressure on its currency. With 14% of its GDP affected by health restrictions, manufacturing activity is slowing. The contraction of the current account due to a drop in exports is stretching payments in yuan. Fears of a slowdown in Europe, China’s preferred customer, aggravate this risk. Above all, the country’s economic slowdown already seems to be leading the Chinese central bank to intervene, going against the grain of its international counterparts, notably the FED. For the first time since 2010, real rates on US sovereign bonds are higher than those on Chinese bonds. Resisting until now the turmoil of the Western bond markets, Chinese sovereign bonds have finally given in.
Buying dollars is therefore now the most consensual position. Taking advantage of this sum of all the market’s fears, the greenback is resisting the downturn in the winners at the start of the year, namely commodities or their derivatives (the Brazilian equity market, which had held up best in the first quarter of 2022, driven by Vale and its strong oil composition, is now down 7 sessions, the first time this has happened since the trial of Dilma Rousseff in 2016). After only 25 basis points of rate hikes by the FED, the market now incorporates at least 6 more increments by the end of 2022!
Is there even room for the FED to be more hawkish than expected? In which case, the current level of short-term dollar rates may offer a historic opportunity for investors to reconstitute a 60/40 allocation that has been particularly battered since the beginning of the year…
Thomas Planell, Portfolio manager – analyst at DNCA. This article was finalised in April 28th, 2022.
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