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Looking at the performances over the first half of 2022, both equity and fixed income markets have faced negative returns. Investors have had to turn to commodities and forex markets to realise some gains. In hindsight, this should not have come as a surprise. Gavekal, one of the leading independent providers of financial research, developed the ‘4 Quadrants framework’ to analyse the current state of the economy. Using the direction of inflation and economic activity as driving forces, the provider came up with four states: inflationary boom, inflationary bust, disinflationary boom and disinflationary bust. In an inflationary environment, commodities tend to outperform during a boom while safe-haven currencies tend to outperform during a bust. In a disinflationary environment, investors should hold long duration stocks during a boom and government bonds during a bust. While we are clearly in an inflationary environment today, a capitalist system has the natural tendency to redirect the economy towards a disinflationary environment as companies are continuously striving to raise their level of output per unit of labour or capital. Therefore, central banks are trying to guide us towards this natural disinflationary state, but it should be clear by now that this transition will not happen overnight.
Let us take a step back and look at some of our investment decisions. In 2018, we started to gradually add some gold to our portfolios. It was low-priced and very attractive in an environment with low government yields. Since then, gold has indeed significantly outperformed EUR government bonds. However, this year, gold is facing some headwinds due to the strong dollar and the rise in real rates. Over the first half of this year, EUR-denominated gold returned 7%, but this return is fully explained by the EUR depreciation relative to the USD. Even so, we stay positive on gold as it could provide some relief in the event of a recession. Since October 2020, we have also been adding non-agricultural commodities where possible. Although prices more than doubled, we believe it is still too soon to fully close these positions, as we don’t think prices will come down immediately. Nevertheless, we did take some profit by reducing our positions in February this year. Carbon emission futures are a third commodity-like product that has caught our interest. The system that the EU put in place has changed a lot over the years. We believe we now have an interesting setup which creates a better balance between supply and demand. Since last year, we have been actively trading this product for a certain number of clients. Today, these futures are trading at more elevated prices, but we might increase our positions again when prices drop to EUR 60-70. This price level serves as an implicit threshold in the market because different actors have advocated for a price floor around EUR 50 (mentioned by Frans Timmermans) or EUR 60 (mentioned by the new German coalition), which would seriously limit the downside potential of the investment.
There have also been some interesting trades on the fixed income side. Since 2020, we have taken some positions in Chinese government bonds for two main reasons. Firstly, there has been a wide yield gap between Chinese treasuries and Euro treasuries. Secondly, China attaches great importance to a stable and strong currency. This has been proven by the fact that China was one of the only countries that did not monetize the COVID crisis, meaning that they did increase their fiscal or monetary spending to get the crisis under control. This year, we have reduced our position because the yield differential has become less pronounced, and the currency might come under pressure as China needs to stimulate their economy to come out of the recession. Inflation-linked government bonds have also been added to our portfolios over the past two years. During the 2020 recession, inflation was very limited and therefore, inflation-linked bonds traded at very low prices. As inflation has skyrocketed over the past year, the linkers greatly outperformed nominal bonds. A lot of inflation is priced into the market today, but we still hold a small position for diversification reasons.
Looking forward, we cannot exclude the probability of an economic recession. However, the severity of a possible recession will likely be tempered by several factors. First, the labour market is still strong, as shown by the underlying data (e.g., nonfarm payrolls, which are almost back at pre-COVID levels). Second, we are witnessing a loose fiscal policy, supported by government investments in projects like the energy transitioning. Third, China could move out of a recession by softening their lockdowns and by pushing their economy towards their official target of 5.5% economic growth. Fourth, the consumer has built up a savings buffer, which they can now readily spend. Of course, there are also forces in the opposite direction. Central banks are really determined to get inflation under control. We already observed some prices coming down (e.g., DRAM, fertiliser, lumber, shipping prices), but it is impossible to say whether we have reached peak inflation or not. Central banks have mentioned that they want to see financial conditions coming down, which means that rates need to go up, spreads need to go up, equity prices need to come down and the USD needs to go up. Even though this is a painful pill to swallow, it is best for markets if this happens quickly. Afterwards, we can get back to trading at the newly accepted market levels.
Despite the challenging macro environment, earnings revisions have shown some resistance over the past months. However, earnings revisions tend to come down in times of increasing interest rates, during periods of high commodity prices and when the USD is strong. As we are currently facing all three conditions simultaneously, it is highly likely that earnings expectations will ease over the next couple of months.
It is clear that investors are operating in a very challenging market environment, but one where patience will be rewarded. If central banks succeed to move to the previously-mentioned natural disinflationary state, we will —once again— see more opportunities. Unlike before, we have built up a substantial cash position in our portfolios, but when the time is right, we will make sure to put that cash at work.