Exposure rates of the Dorval Asset Management Range – July 15th, 2022

The financial markets abound with reasons for anxiety. The post-Covid world economy is in chaos and macroeconomic stats are sending mixed messages. In the US, inflation is picking up the pace and spreading, fueling doubts on the bearing of the moderation scenario. Meanwhile on this side of the pond, the energy crisis is the focus of attention, making the ECB’s job extremely difficult. Further afield, China is struggling with its zero-Covid strategy and challenges in the real estate sector. Yet we can single out two pieces of good news: (1) in the face of these risks, there are now significant risk premia and investors must strike a balance between the two and (2) not all areas of the world are encountering the same situations, therefore increasing the appeal of international diversification.

In the US, rising prices are spreading broadly across the economy (cf. chart 1), and we can agree that this trend is now both widespread and persistent, but can we say that it is already self-perpetuating? Household surveys point to an increase in short-term inflation projections, but reveal a more moderate level in the longer term, which has recently dwindled (cf. chart 2). The latest job figures show a trend towards an easing in wage inflation (cf. our weekly note dated July 8th, 2022) while the pace of job creation marches on at a fast clip and the market is brimming with job vacancies. Lastly, the drop in commodities prices over the past several weeks and the robust dollar (falling prices on imported products) can also mitigate inflation over the months ahead.

 

Price rises pick up and spread in the US

Average of four measures of core inflation (annualized 3-month moving average)
Core sticky CPI
Median CPI
16% trimmed-mean CPI
CPI excluding energy and food

 

Anchored long-term US household inflation projections

Inflation expected next year (U of Michigan) / 5-year inflation expectations (U of Michigan)
Inflation expectation in 1 year (FRB NY) / Inflation expectation in 3 years (FRB NY)

 

Signs of a slowdown in the US economy are growing, although they are countered by resilience on the labor market. The effects of economies reopening after Covid are perhaps more persistent on the labor market than on other economic variables, thereby exacerbating the lag on jobs. In light of this situation, a 75bps hike at least in interest rates by the Federal Reserve on July 27 would be warranted, while a 100bps hike is possible but is not the baseline scenario.

 

However, the matter of the slowdown in Europe is a whole other kettle of fish. The slowdown in the US is pursued intentionally with a view to warding off overheating, while in Europe it is the inadvertent result of the energy shock. We will have a better view on July 21 with the end to annual maintenance operations on the Nord Stream 1 gas pipeline, which supplies Russian gas to Germany. The current baseline scenario is the definitive end to deliveries via this source. Yet, the decision is entirely in Putin’s hands and what he will do is anyone’s guess. In light of investor positioning on this event, the euro and German yields may well stage a dramatic about-turn in the event of a surprise resumption in deliveries. As if the situation were not challenging enough already, political instability has reared its head again in Italy, with cracks showing in the coalition government led by Mario Draghi after members of the Five Star Movement (M5S) abstained on a recent vote. The prime minister tendered his resignation, which was refused by president Mattarella: is this just posturing or a real political crisis? No political party really seems to want to trigger a general election (in the fall at the earliest) in the current environment, given that this is slated for spring 2023 anyway.

 

Meanwhile in China, growth in the second quarter of the year has been hit by the full effects of the economy shutting down to tackle Covid, with GDP shedding 2.6% (+0.4% YoY). However, June’s figures are much more upbeat and point to a clear recovery in the third quarter of the year (cf. chart 3).

 

“Stop & go” approach in zero-Covid strategy

GDP, YoY % / Consensus projections (Bloomberg) /
Median of activity indices: GS CAI / Bloomberg monthly GDP / Li Keqiang index

 

In macroeconomic terms, the situation for Asia looks very different to Europe or the US, making international diversification more compelling. The Japanese market looks like the right answer in this respect. Inflation in the country is much less problematic, although it does raise a challenge for Japanese households as they are not at all used to it. The country is much less dependent on Russian gas (10% of Japanese gas requirements). With the LDP’s landslide victory in the parliamentary elections (in tragic circumstances after the murder of former prime minister Shinzo Abe), prime minister Kishida is in a strong position, affording some visibility on monetary and fiscal policy. Lastly, valuations on the Japanese market remain attractive and are closer to figures in Europe than in the US (cf. chart 4).

 

Forward P/E for main MSCI indices

MSCI USA / MSCI EMU / MSCI Japan

 

We have made no changes to our flexible portfolios, and maintain high cash levels. However, we uphold our agile approach and are poised ready to take any investment opportunities that may arise on the markets.

 

 

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