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June 16, 2022

Global asset markets in turmoil; Hong Kong shows signs of recovery

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Julius Probst
Arnaud Lieugaut
Patrick Malm
Karl-Philip Nilsson
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US equity fundamentals

The Shiller CAPE (cyclically adjusted price-earnings) ratio is one of the most common indicators used to assess whether equities are under or overpriced relative to long-term fundamentals. The following chart displays the correlation between core inflation and the CAPE.

The period from 1990 to 2009, and the decade after the financial crisis, were marked by rather low inflation rates combined with high equity valuations. 

With inflation surging to levels not seen since the 1970s, current equity valuations are thus far too high, based on the relationship mapped out below. We can therefore expect further declines in the US stock market over the next year.

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Fed fund futures

With annual inflation rising to 8.6% in May, it was hardly surprising the Federal Reserve raised its benchmark policy rate by 75bps – the first time in three decades – to 1.75% on 15 June. 

Our chart below looks at Fed fund futures to calculate where investors thought rates would be over the next 12 months. It shows they anticipated another 10 rate hikes, followed by two rate cuts. Bond traders evidently expect an economic slowdown or even a recession in 2023.

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US two-year yield

US two-year yields have risen by more than 200bps in the past year, from below 0.5% to almost 3.5%. In the last few days, they have jumped by some 20bps every day – an extremely unusual occurrence for the liquid US bond market – on expectations interest rates may rise faster and further than anticipated. 

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US yield curve inversion

The surge in the two-year yield was such that it rose above 10-year borrowing costs on 13 June, causing the yield curve to invert – often seen as a harbinger of recession. 

The next chart shows the extent to which yields on short-term debt have exceeded those on long-term securities. The higher the percentage, the higher the likelihood of recession – as indicated by the drop in the S&P 500 following historical spikes. As you can see, we are currently approaching dangerous territory. 

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Equity/bond correlation

Until the late 1990s, bond and equity market movements were negatively correlated. But as the following chart shows, that relationship inverted with the dot-com bubble and became even more positive after the financial crisis. The most likely explanation is that the US economy fell into a secular stagnation regime after the financial crisis, which fundamentally changed the relationship between stock prices and expected inflation (and thus also bond prices) due to the liquidity trap (interest rates stuck at zero).

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OECD growth forecast revisions

The Organization for Economic Co-operation and Development (OECD) is anticipating a significant global economic slowdown. As the chart below shows, it now expects almost every country to grow at a much slower pace than previously forecasted. This is particularly true for many European countries hit by rising commodity prices fueled by the war in Ukraine.

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UK GDP

After more than a year of relatively strong growth, the UK economy unexpectedly contracted in April, shrinking 0.3% after falling by 0.1% in March – the second consecutive monthly decline since the start of the pandemic. 

The following chart shows monthly GDP including contributions by sector. The service sector contributed most to post-pandemic growth, but its contribution has turned negative in recent months as consumers cut spending amid a cost-of-living crisis.

Despite the poor growth outlook, the Bank of England hiked rates by 25bps this week to tame inflation that is expected to reach 10% this year.

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Japanese yen and yield curve control

In an effort to achieve a 2% inflation target, the Bank of Japan adopted a yield curve control (YCC) strategy in 2016 that fixed the 10-year yield at +/- 25 bps from 0%. With global yields now surging higher and pulling the Japanese 10-year yield along with it – it recently rose 25bps above target – the BoJ is now desperately trying to defend the peg with massive asset purchases.  

Meanwhile, the yen has depreciated to a record against the US dollar as the spread between global and Japanese yields widen. Japanese policymakers are now trying to support it with verbal interventions, directly conflicting the BoJ’s other target – not a sustainable policy in the long run!

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Yen-dollar exchange rate

Taking a closer look at the yen, we have built a momentum indicator of the yen-dollar exchange rate using an exponential moving average, which places greater value on more recent data points.

The moving average convergence-divergence (MACD) displays the relationship between two moving averages. 

Our chart below shows the yen to be significantly below its fundamental value. According to this metric, it is therefore expected to appreciate.

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Hong Kong PMI

Finally, some good news from Hong Kong. Manufacturing and services have improved significantly in recent months, with the Purchasing Managers’ Index (PMI) climbing to the highest since March 2011. 

Residential real estate prices have also started rising again. 

While employment has dropped sharply, it may be just a matter of time before it picks up as the economy recovers. 

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