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Market Insights – November 21, 2022

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

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L'essentiel

Commodities rallied sharply in early November on rumours that China’s economy might be reopening. But they have since dropped back to their pre-rumour levels. Oil prices lost considerable ground last week, nearing their September lows.

UK inflation continues to rise and is now at its highest since 1981, putting further pressure on the Bank of England to keep raising interest rates. However, we think that UK inflation should soon peak, given the six-month energy bill freeze and the decline in oil prices since the summer.

Economic sentiment in Germany rebounded strongly in November and far exceeded economists’ expectations. This improvement can be put down to the energy situation, which has not been as bad as expected – this year’s mild autumn meant that natural gas reserves could be quickly replenished.

 

European Central Bank – no longer under the Bundesbank’s thumb

The euro’s 20th anniversary almost went unnoticed. Although the first banknotes weren’t circulated until 1 January 2002, the single currency was officially created in January 1999 and initially used purely for accounting purposes. Despite the many doubts in the currency’s early days – and the string of existential crises it faced a decade ago – the euro has become one of the world’s major currencies. It now accounts for the largest share of central bank currency reserves after the US dollar.

The single currency owes much to the now undisputed credibility of the European Central Bank (ECB). Yet the ECB’s policy approach has changed considerably over time. In its early years, the ECB was heavily influenced by the rigour of northern European central bankers, and particularly the Bundesbank, with its anti-inflation policy. In the summer of 2008, in the midst of the global financial crisis and at a time when the US Federal Reserve (Fed) had been easing its monetary policy for more than a year, the ECB raised its rates one final time to curb inflation, which was being driven up mainly by soaring energy prices. However, since Mario Draghi became president in 2011, the ECB has taken a more pragmatic approach, seeking to strike the right balance between economic growth and inflation. And Christine Lagarde continued on that track when she became president.

At a time when Europe is grappling with its highest rate of inflation in 40 years, the ECB has been tightening its monetary policy surprisingly cautiously. In the past, a policy rate of 2% would have been deemed far too low when inflation is in double digits in many countries, including Germany. And yet these days nobody is surprised that Ms Lagarde is already talking about the possibility of slowing the pace of rate hikes.

What is surprising is that the Fed is refusing to acknowledge the sharp improvement in US inflation – as seen again in last week’s production price figures – and is still threatening to continue tightening lending conditions even though its policy rate is twice as high as the ECB’s. When it comes to monetary policy, the boot may now be firmly on the other foot.

Switzerland – a gradual return to small caps

The SPI index has not fared that much better than global equities in 2022 – it has outperformed them only slightly. However, the SPI’s 14% decline this year is nothing compared to the losses recorded by Swiss small cap indexes: the SPI Extra and the SMIM, for instance, declined 23% and 27%, respectively.

Rising interest rates and the prospect of a recession in Europe drove this underperformance, causing multiples to drop off sharply. What makes these declines particularly harsh is that Swiss small and mid caps were trading at a record premium of over 50% relative to blue chips in 2021.

But we think the time has come to re-enter this market segment. First, long-term interest rates have stabilised, and any excessive valuations have largely disappeared – the premium on small caps now stands at 10%. And second, recent market developments suggest that Europe’s economic slowdown might be shorter and weaker than expected.

This is good news for cyclical sectors, such as industrials, chemicals and financials, which make up a significant proportion of the domestic small cap market. To increase exposure, we still recommend taking a diversified approach to this market segment, notably through the Piguet Actions Suisses SMID fund.

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