EDURAN NAVIGATOR

Quarterly Market Review with an Outlook.

Zurich, 3rd October 2022

“Pivot or not”. Interest rate policies aimed at combating inflation are fueling the potential for recession. With a removal of lockdowns, China could cause inflation to rise further.

Interest rate policies were intended to tame inflation, but now they are triggering the next recession. Meanwhile, the Chinese economy is increasingly suffering from the lockdowns imposed there. If the lockdowns were lifted, this would boost the supply side, but would also likely trigger a surge in inflation as a result of pent-up demand and higher energy costs due to oil consumption. The question is when the pivot point will come, and what it will look like when central banks readjust their interest rate policies. The stock market will presumably put a stop to the correction initially, before realigning itself.

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Market Review

The markets came under further pressure after a temporary rally (shorter than expected) over the summer. The US dollar in particular continued to strengthen and gained additional momentum, putting many regions – as well as asset classes – under pressure. One hypothesis, which we find credible, holds that a severe liquidity shortage is the primary cause of the current correction.

Hardly any stock markets have escaped the pressure. The prevailing trend has continued on the whole, although at a somewhat slower pace than in the previous quarter.

In terms of sectors, the real estate sector in particular came under interest-rate pressure, while the energy and consumer goods sectors posted slight gains after the latter had suffered severe losses in the previous quarter.

Gold also lost further ground, and in mid-September broke below the crucial support level at USD 1,680 per ounce. Bitcoin and similar companies also suffered from the liquidity squeeze and were well-represented on the supply side.

Both interest rates and the strength of the US dollar aligned with the relentless trend away from traditional levels: bonds plummeted while the dollar surged and currencies such as the yen and the British pound collapsed. All in all, this resulted from the monetary policy of the national banks, which have withdrawn large amounts of liquidity from the market.

In Focus

The dollar has continued its sharp upward trend. This has caused mounting stress in the financial system, forcing the sale of reserves in order to provide the economy with desired liquidity; US government bonds and even gold have come under pressure. So much for the monetary aspect, where the paradigm shift implemented by central banks, late in the cycle and driven by headline-grabbing inflation warnings, is draining the economy of its usual liquidity.

In addition, commodities have weakened, which again reflects the struggling economy. This is also the situation in China, where the economy is suffering due to lockdowns. Another relevant aspect is the governmental decision to curb the real estate boom: houses are for living in, as the thinking now goes. In general, it can be concluded that the leading indicators, in contrast to the lagging indicators, already point to a weakening economy – with varying degrees of severity depending on the region. However, the head of the US Federal Reserve made it clear in recent statements that the current course will be maintained, and that interest rates will continue to be raised. The interest rate curve already exhibits a structure, an inverse curve, that is typically followed by a recession.

In this context, again with respect to the US dollar, we see a US trade deficit at record levels, with much of the deficit going to China. Normally, these dollars flow back into the US (are “recycled”), whether through investments in businesses, infrastructure, real estate, or simply via US government bond purchases. Because of the lockdowns, the situation now looks different – almost none of this is happening, and most of the money is staying in China. If the zero-Covid strategy is lifted, this could trigger a new surge in inflation, as a large amount of capital flows again, or simply because Chinese tourists start booking hotel rooms again, where, nota bene, there is a shortage of skilled workers, especially in the tourism industry. Another factor is the energy sector, which is already suffering short supply due to a mixture of climate protection measures (new investment in fossil fuels is difficult) and sanctions against Russia, with a possible revival of production in China additionally stimulating prices.

Outlook

Barring other developments, the central banks are likely to stick to their current course as announced, and – in our assessment – will continue to raise interest rates “for the time being”. They are doing so because they still can, in light of the labor market statistics. Signs of a recession are likely to appear soon in backward-looking metrics such as unemployment statistics, prompting central banks to put the brakes on interest rates or otherwise deviate from their current course. That is, unless China reverses its Covid policy and lifts the lockdowns, and inflation temporarily gets a new boost. Noticeable uncertainties remain, and regardless of the outcome, it can be concluded that the central banks remain primarily in a reactive mode, lagging behind developments. For portfolios, this means continuing to focus on quality and on preserving capital rather than maximizing profits. In the current environment, interest rates are offering the first opportunities to make investments again, even if they are tainted with uncertainty and are therefore made cautiously. This is because there remains a possibility of lower interest rates, at least in the medium term. In such an environment, it is advisable not to be carried away by the immediate circumstances, but to remain calm and focus on quality.

EDURAN AG

Thomas Dubach