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Market Insights, July 12, 2021

Each week, our Investment team shares its market views with you.

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Essentials

The European Central Bank has now completed its strategic review. One of the main changes is the increase in the long-term inflation target. Investors took this to mean that monetary policy could stay loose for longer than expected in Europe – and in Switzerland too. This news pushed the Swiss franc up against the euro and other major currencies.

As part of the transition to a low-carbon economy, the European Commission will unveil its updated emissions trading system on 14 July. This reform should help the region to meet its targets for curbing emissions, pushing up the price of carbon permits over the long term.

On Friday, China’s central bank announced that it would be cutting its reserve requirement by 50 bps, the first such move since April 2020. This accommodative measure should encourage banks to lend more to companies and will inject around USD 150 billion into the banking system.

A bond market unfazed by inflationary risk

When it comes to inflation, some developments are starting to draw attention. The global economy’s sharp rebound is giving rise to several bottlenecks which, coupled with low inventory levels, are creating shortages of certain products and materials. Many manufacturers are struggling with late deliveries and skyrocketing input prices.

This inflationary pressure upstream in the supply chain is often being passed on all the way through to end consumers. The trick is knowing whether the recent uptrend in consumer prices is here to stay. In theory, only higher wages could trigger a lasting inflationary spiral. This looks fairly unlikely in Japan and Europe, which are struggling to come out of several decades of disinflation, but things are different in the USA – the only major economy that we feel is at risk of such a scenario.

For now, wage increases in the country are occurring mostly among lower-paid jobs where employers are having to offer higher wages to lure the unemployed back into the workforce. The Biden administration is still sending out cheques to help limit the economic consequences of the pandemic. Time will tell if the Fed and other major central banks are right to view the uptick in consumer prices as a temporary phenomenon.

As things currently stand, the bond market offers paltry returns that barely compensate investors for the risk that inflation will stay around for longer than expected. Even though growth appears to have reached its peak in the States, the economic outlook is still bright and does not justify the decline in bond yields over the past two weeks. Riskier segments of the bond market do not offer much protection against an upcoming rise in interest rates. Risk premiums are at their lowest for several years, on both investment-grade corporates and high yields. We continue to recommend maintaining a core of short-to-medium term notes and purchasing Treasury Inflation-Protected Securities (TIPS).

Commodities – a correction during a cyclical upswing

The recent correction in commodity prices was needed given the excessive optimism among investors. Their euphoria was tempered by the Fed’s more aggressive tone and by comments from Beijing about an overly sharp rise in prices. But despite the recent correction, we remain bullish on several segments of the commodities market.

We still prefer industrial metals, especially copper. The cyclical upswing in demand – driven by investments in renewable energy – is still in its early days. What’s more, demand is now global, whereas previously China was the main buyer and could influence the market with its statements alone. This time, prices should remain high until new mines ramp up production, unless they reach levels high enough to curb demand. Oil prices are also experiencing upward pressure. Now that most lockdowns have been lifted, demand should very soon return to its 2019 highs.

Meanwhile, supply is struggling and depends largely on Opec’s production capacity, as oil-industry investments have been dampened by the growing consideration being given to ESG criteria. We believe oil prices will remain strong, even if Opec’s shenanigans have reduced visibility in the short term. When it comes to gold prices, the downward pressure from the strong dollar seems to have eased, and the metal is now being buoyed by today’s highly negative real interest rates.  We have therefore opted for a less conservative stance and, should this trend be confirmed, will once again become bullish on gold.

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