EDURAN NAVIGATOR

Quarterly Market Review with an Outlook.

Zurich, 5th July 2022

“Summer peak.” Inflation has reached record levels, stock markets are pricing in the interest rate hike, yet also hiding potential drops in profits. In this precarious situation, if facts give way to emotions, a bear market rally could occur. However, a summer peak could form in terms of inflation as well, specifically if it is possible to overcome manufacturing bottlenecks. However, given the salary increases that have already been partially implemented by labor unions, inflation could remain an important topic, albeit somewhat less pronounced, for the foreseeable future. At the same time, we can expect the economy to cool down, which brings with it the potential for further market corrections. Although it was less popular during the bull market phase, one thing can make the difference in this type of environment: active stock selection.

Market Review

The second quarter was defined by an acute period of weakness on the markets. While American indices continued the correction from the previous quarter, European indices showed a certain strength at times; however, they experienced abrupt drops late in quarter, ending the second quarter back at the previous lows from the first quarter. For example, the DAX lost more than 10% in the last month alone.

After gold climbed to new heights in the first quarter, the precious metal, together with silver, also continued its correction, managing to hold itself just above its most recent lows.

Measured against the 10-year benchmark, returns from government bonds reached new heights over the quarter, drawing down slightly towards the end.

With a view to the yield curve, the predictions of the markets show that the most recent interest rate hikes – the Fed raised interest rates by 0.75% in the month of June alone, essentially doubling the previous interest rate – will weaken the economy such that the Fed will have to temper its policy again soon. In other words, the capital market is anticipating an economic downturn and inflation that will be tamer than what the media buzz would have you believe.

In terms of sectors, every sector that was forced to adjust its prognoses downwards against the backdrop of shrinking liquidity or due to the increasing costs and rising scarcity of energy suffered in particular. Correspondingly, the relative winners were defensive consumer goods or energy stocks themselves.

In Focus

Following the statements made by government agencies, the economy is in good shape, if not necessarily extremely good shape. The global growth rate is around 4.5%, which is higher than average. According to the latest reports, the US economy, which is still the world’s largest, shrank by 1.6% in Q1 2022. Governments also enjoy pointing to the strong job market with record low unemployment figures – in the US, they are as low as they were before the pandemic and, before that, in 1969/1970. However, at 62.5%, the labor force participation rate, which is rarely reported on, is still around one point under the pre-pandemic level, and therefore the lowest it has been since 2015 and, before that, at the end of the 1970s.

Even though the income situation for households still appears robust and demand remains high for goods and services, consumer confidence has dropped significantly according to surveys conducted in the second quarter of the year. Plus, industrial production in the US, the world’s largest economy, expressed in units, shows signs of decreasing. In short: The economy is looking weak, or at least not as strong as official sources would have you believe.

Inflation is currently in the political crosshairs, and it’s no wonder, because it is tangibly affecting many households and therefore many potential voters. Price caps are being discussed, energy reserves are being tapped into in some cases (Biden in the US), and the central banks – independent or not – have awoken from their slumber and are trying to slow price acceleration through measures and speeches. Whether interest rate increases can really halt inflation in this kind of environment is questionable. Unlike in the 1970s, we are not currently in the midst of an economic boom. Manufacturing bottlenecks will keep us occupied for some time to come. Firstly, this is a result of the pandemic, which caused factories to shut down and was the reason many ports laid off workers. Governments made up for lost wages and, while restaurants, cinemas, casinos and amusement parks were all closed, consumers chose to spend it on online shopping. When lockdowns were lifted, ports were flooded with ordered goods from Asia. As a result, the ships often had to return without the empty containers themselves because there was no time to reload them at the destinations. As a result, prices for containers jumped from USD 1,000 to more than USD 10,000. This, in turn, had an impact on the prices of goods apart from the increased demand. We can expect the situation to normalize, and in fact this normalization has already begun somewhat. Logistics is slowly getting back into the groove, freight costs are sinking, even if there’s still a bit of an unpleasant aftertaste and supply chains are still in the process of rearranging in parts.

Now, interest rate hikes are throwing factories a curveball, and production is being hampered instead of fostered.

What’s more, these are the years in which the post-war generation is reaching retirement age, resulting in a shortage of skilled workers around the globe. The bottom line is that all of this could result in higher prices; however this will be driven rather by structural factors rather than primarily by excess money alone.

Outlook

The coming months will show whether or not we slide into a recession, perhaps a steep one, or if it’s all far less dire than we feared. An easing in the conflict with Russia would help Europe; plus, the ability to flatten inflation could allow us to avoid a global recession.

Even in this environment, where there is liquidity available, there are relatively attractive entry opportunities that are to be approached with caution – relatively attractive because prices could continue to rise as a consequence of the aforementioned monetary situation. However, many stocks have already strongly corrected, and from a historical perspective, prices are no longer all that expensive – that is, if future yields do not slump dramatically. Don’t fear the gaps: A first tranche for purchase is a smart move, especially when a company has held back on acquisitions in recent years and put liquidity aside. Markets may have already priced in upcoming interest rate hikes and, if the economy cools off, we will see whether the central banks stay the course in the face of rising unemployment, or if they revert back to their old ways of relying on cheap money.

No one wants to see a steep recession with unemployment in combination with global debt at record highs on the state level. This would force us in the west to face difficult challenges as a society. In this case, pressure on politicians and governments would grow in other areas in addition to inflation. In turn, defensive portfolio with a focus on investments with a steady cash flow will pay off.

“Share prices fluctuate more than share values.”  Franklin Templeton

EDURAN AG

Thomas Dubach