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Market Insights – August 2, 2022

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

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Essentials

The eurozone economy grew 0.7% quarter on quarter in Q2. This figure was much higher than forecast, with growth driven mainly by tourism-related spending. Retail sales in Germany, however, were down 9.8% year on year as a result of the surge in inflation. This unexpected decline suggests that the months ahead will be tougher for the region’s economy and that a slowdown may be looming.

Even though the US economy is close to full employment, it may already have entered a recession. That is the unexpected conclusion that can be drawn after US GDP declined for the second quarter in a row.

Speaker of the House of Representatives Nancy Pelosi will make a “provocative” visit to Taiwan on Wednesday. In addition to showing her support for Taiwan, which faces enormous pressure from China, she will no doubt be looking to impress US voters in the run-up to the mid-term elections in November by standing up to China. The risk of triggering a broader and more serious conflict may be low but it is also hard to quantify.

Have bond yields passed their peak?

Inflationary pressures quickly engulfed the entire supply chain in the first half of the year. This surge was fuelled mainly by soaring energy prices, which, in addition to driving household heating and travel costs higher, are affecting the transport costs for all types of goods, ultimately pushing up consumer prices. Because of the war in Ukraine, energy prices look set to remain high. The war has also resulted in increased food prices, as Ukraine and Russia are both major grain and fertiliser producers. After initially holding off, the main central banks took decisive action by quickening the pace of monetary tightening. Their goal is to slow their economies in order to rein in inflation and, above all, to prevent a self-reinforcing wage-price spiral. Recent data suggest that, in the developed world, the rise in the cost of living has already peaked. Prices of most raw materials have begun to decline since the start of the summer, and core inflation, which excludes food and energy, has also eased in several countries. Bond markets had been rattled by the surge in inflation. But recently, yields have stopped rising, as inflationary fears gradually give way to concerns that the economic slowdown will be bigger than initially forecast. And at the US Federal Reserve’s latest meeting, Jerome Powell hinted that much of the tightening has already taken place. After two consecutive 0.75 percentage point hikes, the Fed could well slow the pace of its rate increases, provided inflation eases in the coming months. The bond market welcomed the slight change in tone from the Fed. Long-term yields have dropped sharply from their mid-June highs. We still think that US bonds are attractively priced. Unlike euro-denominated bonds, yields on long-term US government bonds appear to comfortably offset long-term inflationary risks. This is also the case for US corporates, whose risk premiums have risen considerably in recent months.

 

 

Bank of Japan – the limits of determination

Japanese stocks proved their resilience during the recent bout of volatility, as they easily outperformed most other developed-world markets when measured in local currency. But some of those gains were offset by a decline in the yen. The Japanese currency has lost over 12% against the US dollar since the start of the year, falling to a 24-year low.

This depreciation mainly reflects movements in the JPY/USD interest-rate differential. While the Fed, like central banks in other G10 countries, is raising interest rates to combat inflation, the Bank of Japan (BoJ) is holding on to its accommodative monetary policy.

In keeping yields on Japanese bonds artificially low, the BoJ must resist pressure to abandon the 0.25% cap on long-term interest rates. And it’s deploying formidable resources to that effect – a sign of its determination. The central bank’s purchases amounted to the equivalent of over USD 100 billion during the month of June alone. It now holds over 50% of the country’s public debt – a first in the history of central banks – compared with just 10% when Abenomics was introduced in 2013.

It’s unlikely that the BoJ will conduct an about-face given the systemic risks associated with such a move, but it could widen the range in which bond yields trade by raising the cap to 0.50%. That could in turn strengthen the yen. It might also give financial stocks a boost and further fuel the outperformance of value stocks that began in 2021. We therefore believe that Japan’s economic recovery should continue despite the global slowdown and the effect of higher prices on Japanese consumers, who until now had been accustomed to a deflationary environment.

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