Exposure rates of the Dorval Asset Management Range – July 1st, 2022

Dear Clients and Partners,   Signs of an economic slowdown – bar China – have fueled an abrupt downgrade to inflation and interest rate projections for the quarters ahead. Should equity investors take fright at this news or rejoice?

An increasing number of economists are expecting the quickening pace of interest rate hikes to trigger a recession in the US in 2023, yet the implicit scenario on the financial markets seems to be moving in a different direction. The recent slowdown in US consumer spending, dipping 0.4% in volume terms in May, the deterioration in certain cyclical indicators (PMI, ISM) and the drop in industrial commodities prices are fueling investor expectations of a sharp slowdown as early as 2022. These fears are quite naturally amplified by the Russian gas supply crisis in Europe, yet they should in theory be at least partly offset by the prospect of a recovery in China…in practice they are not. On Wall Street, the cyclical/defensive stock ratio recently took a speedier downturn, hitting levels on a par with an ISM manufacturing index at around 45 and characteristic of an industrial recession (cf. chart 1).

 

Cyclicals to defensives ratio slides more quickly in the US

Goldman Sachs baskets of US cyclical and defensive stocks

 

·       ISM Manufacturing index (LHS) / Cyclicals to defensives ratio (RHS)

Is Wall Street therefore expecting a fresh imaginary recession, like in 2011/12 during the euro crisis, in 2015/16 during the Renminbi crisis, or even in late 2018? Forthcoming statistics, such as job figures, will provide a bit more insight. But in the meantime, the bond markets have rallied considerably (cf. chart 2), as investors downgrade both expected inflation (which is already low) and the trajectory for short-term interest rates in the US and Europe. The short end of the yield curve now prices in a peak at around 3-3.25% for Fed funds at the end of the year, and points to ECB rates under 1.25% until the middle of next year.

 

Sharp drop in bond yields

·       US 10-year / US 2-year

·       German 10-year / German 2-year

 

These swift and surprising moves reflect both investors’ extreme positioning on the bond markets – which accounts for massive repurchases of short positions – and the uncertainty of economic lines of reasoning during this exceptional period in world economic history. Economists, central banks and investors are merely feeling their way now more than ever. For now, we are seeing a moderation in growth in developed countries, which is not a result of central banks’ policies – it is still too early – but is most likely due to the economy’s automatic adjustment to the damaging effects of rising prices on the cost of living. Alongside this moderation, we are seeing a gradual normalization in inventories/sales ratios and delivery times, and hence a decrease in cyclical inflationary pressure.

 

This moderation scenario looks seemingly positive for the equity markets, yet three threats still loom large. The first is of course the risk of a more severe recession phase than expected as early as this summer – an express adjustment scenario – which is perhaps not yet entirely priced in. The second is in Europe with the very major risk of a halt to Russian gas deliveries. The third risk lies on Wall Street, where relative valuations are still high and the animal spirits remain curbed by the crisis in digitalization-related sectors.

 

Against this backdrop, we maintain our cautious asset allocation, with lower equity exposure rates than our reference indicators, on liquid assets and with broad diversification.

 

Download the weekly letter in PDF version: Exposure rates of the Dorval Asset Management Range – 1st July 2022

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