June 2022 Market Commentary

Though the US equity markets fell yet again, June was a much tamer month despite our leading and lagging economic indicators not being particularly bullish. With that in mind, we thought we would take the opportunity to discuss recessions and Asia markets. As usual, we will just briefly cover how the rest of the world did.

On recessions One of the most misunderstood parts of finance is the definition of a recession. Many punters typically take it to be two consecutive quarters of negative GDP growth, although the Fed now chooses to define it as a “sustained period of negative growth.” Semantics aside, we now see it as inevitable, although we don’t think the market has priced it in yet. Looking at corporate credit default swaps (an insurance policy) we can see signs of stress, while global corporate earnings revisions look to be on the decline after two years of significant and unusual outperformance. Put another way, we think that over the last two years, the S&P 500 has over earned, and a strengthening dollar is likely to be the catalyst for a Q3 earnings season downtrend. The market now indicates a 33% chance of having a recession in the US. We believe this number will climb significantly, as it did with COVID. With continued inflation and WTI oil prices, largely, unaffected by releases from the strategic petroleum reserve (SPR) consumer sentiment has understandably degraded further- even beyond the depths of the global financial crisis. As such, we continue to be short term bearish although a broader bear market rally is now likely. Although JP Morgan seems to have been very wrong in calling a 7% rally this week, we also agree with their underlying justification. Pricing for credit default swaps (CDS)’s on corporate investment grade bonds. Higher prices indicate corporate credit stress and difficulties financing debt. With a stronger dollar and lower corporate earnings, we think companies highly reliant on overseas sales are likely to suffer. Although last month we stressed that the US consumer was strong, we think it’s a trend on the decline. Bear markets, however, don’t last forever. In fact, from 1920-2022, the average bear market lasted just 15 months while the typical bull market lasted six years. Although we think there is more pain ahead, time in the markets does indeed beat timing the markets. As long-term investors, bear markets present fantastic opportunities to acquire companies at favorable prices. Japan’s monetary policy The Bank of Japan (BoJ) is continuing its mantra of keeping bond yields close to zero, having recently stuck to its guns to buying as much government debt as possible to ensure that 10-year borrowing costs remain below 0.25%. A result of this policy is that the BoJ now owns >50% of Japanese Government Bonds. BOJ purchases hit a record to defend its yield policy. Decisions by the BoJ to conduct daily purchases of 10-year bonds at yields of 0.25% and an implicit capping of bonds of yields at 0.25% have led to dips in the Yen versus the dollar. The BoJ’s philosophy that demand in the economy still needs to be stimulated by lower interest rates have earned some ire as core consumer prices have reached 2.1%, rising at the fastest rate in seven years. USD/JPY exchange rate, the Yen is sinking as the BoJ continues its loose monetary policy. With no response from the BoJ to deal with rising prices, and elections coming in July, coupled with ire from the public, the BoJ may begin to rethink how it communicates its actions or its policy making decisions, especially to a public that has experienced deflation for decades and a lack of wage growth. Soaring fuel costs and rising raw material imports caused by commodities soaring and a weakening Yen have resulted in inflation, something Japan has been seeking for decades, however due to all the wrong reasons. As the BoJ continues its policy of low interest rates, whilst developed countries increase yields to tackle inflation, a disconnect between yields in Japan and other developed countries will thus be felt through the depreciation of the Yen. The BoJ now has a choice to sacrifice the Yen and suffer inflation and take the chance to end the lost decades and re-stimulate the economy, or abandon its loose monetary policy and follow in the footsteps of the Federal Reserve, through an adjustment of the yield cap from 0.25%. We expect market disturbances and an increase in volatility if the BoJ exits yield curve control. On the other hand, if yields continue to be suppressed, the BoJ will continue to purchase more bonds. They can choose to defend the Yen in doing so, through the selling of US treasuries and Yen repurchases. While the Fed’s recent policy of tapering and rate hikes have already impacted equity markets, we believe that this possibility is an added risk to US markets. If not, the Yen may weaken further providing a forex opportunity. BoJ seems to be under pressure from benchmark and super-long yield rises. Asia Emerging Markets Asian central banks are struggling to fight the continued strength of the dollar, with a dry up of foreign reserves in Asia. After the Asian crisis of 1997, countries such as South Korea, Malaysia etc. realized the importance of large currency-reserve holdings, ensuring the region could stay afloat after 2008 and 2013. Developing Asian countries still possess a solid life jacket in case of a policy surprise by major central banks, however, developing countries still are majorly impacted by decisions of the Fed. Foreign reserves in Asia declined this year as currencies weakened amid a strong dollar. Couple this with global inflation, a Chinese economic slowdown, recession risks in Europe & America, deglobalizing efforts by major countries, food concerns, and a reduction in foreign investment, and you have an environment that is hostile to developing markets. We’re beginning to see the impacts of this in South Korea, the 7th largest exporter in the world, with a 12.7% YoY reduction in exports in the first ten days of June. What do we expect to see in the Asia Markets as a result of this? Chaotic trading in the FX markets and a continued drawdown in Asian indices excluding China & Japan. The UK market Alongside the state of the global economy, the UK scene has not been more favorable than others. With the drop in the value of the pound assumedly resulting from the news of the risk of a recession and higher interest rates, US imports may become more expensive causing strains on international businesses such as retail and could work adversely on the economy alongside its Brexit deals. Current deals have already contributed to about a 6% increase in food prices from 2020 to 2021, international trade has lagged, and business investment has become weak. The UK is in a position where it has become less internationally competitive and if unemployment rises, risks that the economy could move into stagflation are becoming more prevalent. With property prices increasing on average 11% per year, these have begun to take a different turn due to recent monetary decisions. The bank of England’s recent interest rate hike of 25 basis points, being the highest since 2009, has led to housing markets experiencing a slowdown as the cost of mortgages begin to increase. In June, prices rose by 0.3%, a notable slowdown from 0.9% in May. With consumer confidence reaching its lowest in half a century and a fall in real household incomes, the effect of inflation with soaring prices in energy bills and food is due to hit hard on consumers, reducing levels of affordability, and slowing down growth in the economy. However, inflation is not expected to slow down anytime soon, having risen to a 40-year highs of 9.1% with food prices expected by the Bank of England to rise year-on-year 11% by October. The Central Bank aims to combat inflation with independent monetary policy and responsible fiscal policy, however, ongoing issues with trying to recover from the short supply of consumer goods after Covid and a shortage of goods and services due to the war between Russia and Ukraine have made this goal more challenging. What the G7 summit means to Europe and Russia The 48th G7 summit ending on the 28th of June has shown us the dedication of the 7 leaders to squeeze Russia in spite of domestic woes. To begin with Britain, Canada, Japan, and the United States have prohibited newly mined and refined Russian gold imports into their economies to support Ukraine. As gold accounts for the second largest Russian export after energy, with roughly $18.7Bn sold every year the impacts on the Russian treasury could be rather significant. The G7 are also in the process of capping the price paid for Russian oil. While analysts have warned this move could push Putin to completely halt the gas supply to the West, they remain undeterred. If anything, G7 may be discounting that the sanctions on Russia seem to have not been effective anyhow. At the least, India and China have largely picked up Russia’s discounted prices, but not without diplomatic consequences. As for Europe, a continued fall in consumer sentiment coupled with inflation in the Eurozone at 8.1% is certainly not a sign of strength in European markets. If faced with Russian retaliation, expect further pessimism in European indices as consumers tackle the higher costs of living. Macroeconomics and global market Regarding the macroeconomic picture, the global market has been quite bearish. Stringent lockdowns in China have had a huge impact on growth and lack of consumption has damaged businesses. Recession fears also seem to carry weight on investor decisions, causing a global downturn in stocks and bonds. Despite the current state of the global market, opportunities in emerging markets look quite attractive regarding commodities. With unfinished business between Ukraine and Russia, trade may move towards countries such as India, Brazil, and the Middle East which specialize in key commodities like crude, wheat, oil, and gas. These could work as substitutions in the meantime whilst there’s still conflict to reduce shortages of supply and create more efficiencies in international trade. Ernest, Taiga, Crystal & Simon Belvedere Wealth Management

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