Exposure rates of the Dorval Asset Management Range – July 29th, 2022

Moves to unwind short positions have been gathering pace on the markets as a result of investors’ overly pessimistic positioning. The latest world economic indicators may be somewhat muddled, but they point more to a scenario of moderation, while corporate earnings reports are reassuring.

US GDP contracted for the second quarter in a row in 2Q – down 0.9% after shedding 1.6% in the previous quarter on an annualized basis – particularly as a result of a sharp decline in agricultural product inventories (-$45 billion). However, it makes little sense to talk of recession after a boom on the labor market and a surge in domestic demand in the first half of the year (cf. chart 1), not to mention very upbeat corporate earnings reports.

 

US economy posts contrasting showings in first half
% change (non-annualized) since the end of 2021

Jobs / Private domestic demand, excluding inventories / GDP

 

However, it is clear that the US is well and truly undergoing a slowdown – albeit of debatable magnitude – set alongside a decrease in some inflationary pressure, i.e. gasoline prices, delivery costs and times, etc. This was the signal that investors were waiting for and they can now feel reassured: continued overheating for the US economy would have been the worst-case scenario for the financial markets. However, with the economy slowing, the Fed will not need to tighten quite so much, although it is worth noting that short-term rates still sit well short of inflation, a situation that does not point to a change in monetary policy direction. Additionally, the latest inflation figures – for example June’s PCE deflator of +0.6%, its highest point YTD – show that there is still some way to go before inflation gets back to normal.

 

Unlike the US, the euro area put in surprisingly positive growth for the second quarter, jumping 0.7% after a 0.5% increase in 1Q, and jarring with investors’ extremely negative view on the continent. Most of this showing can be attributed to post-Covid impetus in the services sector, although this trend is set to even out, as the latest surveys with European companies already suggest. Additionally, Germany may already have entered a recession, with an economy more reliant on manufacturing than tourism. The country’s GDP stagnated in the second quarter, and unemployment in particular has been trending upwards over the past two months, up from 5% in May to 5.4% in July (cf. chart 2).

 

Has Germany already entered a recession?

Job vacancies (LHS) / Unemployment rate (RHS)

 

However, the bond markets have broadly priced in this slump on the German market along with the damaging effects of the Russian gas crisis for Europe’s outlook. The differential between very short-term rates and German 2-year bond yields has narrowed considerably, with this 2-year yield even slipping below the ECB’s main refinancing operations rate (cf. chart 3). On an even more worrying note, the 0.25% nominal rate on German 2-year bonds points to a real rate of -5.4% if we factor in projected inflation!

 

German bond market already prices in substantial pessimism

German 2-year yield / ECB Main Refinancing Operations rate / ECB Deposit Facility

 

In both the US and Europe, a continued drop in bond yields is looking increasingly unlikely: we steer clear of this market and home in on equities. We have completed moves to normalize our market exposure over the past few days with a view to drawing on the upturn. Our international funds retain their investment in the energy transition theme – buoyed by recent good news in this arena out of the US – and the rebound for low-priced US tech companies. We also pursue our significant investments in Japanese stocks and the yen.

 

 

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