History does not repeat itself but it rhymes

It is too early to draw full conclusions over 2022, but the adage takes on its full meaning as a number of events experienced this year are presenting some similarities with historical ones. "History does not repeat itself but it rhymes" – Mark Twain.

Fund Commentary
28 Nov 2022

It is too early to draw full conclusions over 2022, but the adage takes on its full meaning as a number of events experienced this year are presenting some similarities with historical ones. “History does not repeat itself but it rhymes” – Mark Twain.

Cold War and Mao Zedong’s China making a comeback

On the political front, the Russian-Ukrainian conflict is not without reminding of the Cold War situation, as the United States and Russia are fighting each other and are doing it through a proxy war. The parallel ends there.

The ideological motivation appears more tenuous with Communism disappearing. The definition of opposing blocs is also quickly evolving: Central and Eastern European countries, former Moscow’s allies, changed sides as they joined the European Union for the most part; neutral countries such as Finland and Switzerland are now leaning more towards the Western bloc. China’s role is also of concern: Once a vassal of the USSR, it now dominates Russia politically and economically and is key to resolving the conflict.

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Never has a Chinese leader had so much control over China and so little counter-power since Mao Zedong.

The 20th Congress of the Chinese Communist Party (CCP) ended up with a clear victory for Xi Jinping. His power and control over the CCP were strengthened as evidenced by the reshuffle of the Standing Committee and the dominance of Xi-Jinping loyalists over reformists. On that note, the exclusion of Hu Jintao, the late president of China from the National Congress is enough to frighten the most daring investors… Never has a Chinese leader had so much control over China and so little counter-power since Mao Zedong.

The comparison can be frightening, especially since it is accompanied by a tough stance on Taiwan and the sidelining of market-friendly reformists in favour of ideologues. Without surprise, Chinese markets badly reacted and suddenly fell on October 24th post-Congress. It is worth noting that once again, the Chinese stocks listed on domestic markets (A shares) did better than the “offshore” ones mostly owned by foreigners, which could indicate some form of capitulation…

If the risk premium of Chinese assets clearly increased, the need for a thriving Chinese economy is also affirmed:

1. to make sure Chinese households continue to grow wealthy and to keep the social pact intact by keeping a lid on unemployment (youth unemployment rate at 18%).

2. to ensure Chinese technological development and independence – a sector in which the innovation and entrepreneurial spirit strongly depend on the private sector.

All good reasons not to completely despair.

Inflation, higher rates and a strong dollar

The current economic situation looks also similar to the one experienced in the late 70s, after two oil shocks when faced with double-digit inflation Paul Volcker, then Fed chairman had no other option but to raise the Fed fund rate to almost 20%, plunging in the process the US economy into a severe recession.

With Fed Funds at 3.0% – likely 3.75% in a few days – and core inflation at 6.6%, we are not there. With a higher public debt in 2022 compared to 1981 (125% Debt to GDP ratio vs. 31% in 1981), the pain threshold is assumedly lower and the embedded impact of the FED balance sheet reduction should not be underestimated.

Chart 1: US Dollar Index

Source: Bloomberg, Banque Eric Sturdza.

Paul Volcker’s actions also partly explained the subsequent strengthening of the US dollar that peaked by the mid-80s and led to the Plaza Agreement in 1985 by which the United States, Japan, France, Germany and the United Kingdom agreed to jointly intervene to weaken the US dollar. The intervention was so successful that the countries involved had to revert their interventions a few years later…

Once again, this situation is similar today, as the USD strongly appreciated against almost all currencies and has rarely been so overvalued. While such concerted interventions may have seemed very unlikely a few months ago, the likelihood has increased especially since a number of central banks (BoJ, BoE) appear to have already capitulated to prevent further weakening of their currency or to ensure financial stability.

In conclusion, we think it is important to stay true to our convictions without complacency and to refrain from succumbing to herd effects. YES, the USD had good reasons to be strong, but not all of them were obvious earlier in the year and the USD has rarely been so overvalued, making it prone to mean-reversion moves…

YES, investing in China has never seemed so difficult in light of increased political risk, but it’s equally important to note that Chinese authorities also need robust economic growth to ensure social stability and that Chinese assets seem to already discount a lot of bad news.

YES, the recession risk is high in Europe with potential energy rationing, but European stocks’ valuations are also partly reflecting this risk – and don’t forget that economic growth has been stronger this year on this side of the Atlantic. These are all elements that we develop in this communication.

Fixed Income: 3.50 + 6.60 = 0.75

Core inflation remains an issue

The US Consumer Price Index (CPI) slowed very little this month, from 8.3% to 8.2%, but the core CPI (excluding food and energy) came out at a worrying 6.6% YoY, the highest level witnessed since September 1982. This figure lends credence to the thesis that more and more people share: if inflation is to come down from 8% to 2%, it will be a much longer process than the one imagined only a few months ago, since out of the 6% to be shaved, about half is coming from structural components.

If we add to this the fact that the unemployment rate released at the beginning of the month stood at 3.5%, there is not much suspense left about the next FOMC meeting on November 2 and the upcoming rate decision: It will be 0.75% and the comments will shift to the probability of an additional 0.75% on December 14.

We could end up with a US policy rate of 4.75% in three months. If we add virtually 1% to this Fed funds rate to take into account the impact of Quantitative Tightening, which is too underestimated for our taste, we should enter the truly super-restrictive phase of the Fed’s monetary policy. With possibly a wrong timing?

By trying to bring down inflation while pursuing a monetary policy that goes “too hard, too fast” to quote the words of Charles Evans, the chair of the Chicago Federal Reserve, the central bank in Washington is taking a big risk with the US economy, as much as with the world economy. Inflation fears are about to be supplanted by recession ones.

My name is Bond, Corporate Bond

The short end of the US Treasury curve was even more interesting this month. The 2-year rate at 4.5% and the 5-year at 4.25% really encourage you to start investing in Treasuries again. The first one is as a “buy and hold” investor to park excess cash at higher yields and the second one is as an active investor with a duration higher than 4.5, synonymous with capital gains when rates will fall once the recession arrives.

Investing in US long rates above 4.5% was already a possibility if you dared invest in the too-often neglected 20-year whose yield even exceeded 4.60% during the month.

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Inflation fears are about to be supplanted by recession ones.

Above all, the current yield of US 2 to 5-year bonds allows us to consider investments in Investment Grade credits at gross yields close to 5% or even higher. This environment is also very favourable for dated products, which intend to “lock” a targeted yield and repay investors at maturity. We took advantage of this opportunity to launch a similar strategy with a 2025 maturity in dollars offering a very attractive yield.

Active management also has a bright future ahead of it and we must not make the mistake of pitting the two strategies against each other. There is no one style that is better than the other and the complementarity of the two will be for sure the winning solution.

Equities: Atlantic Spread

In 1492 Christopher Columbus discovered what would later become the land of Freedom. As in most modern countries where democracy has taken hold, the United States has also gone through its darker hours… The word “freedom” takes on its full meaning politically and in a country where everything is deemed possible, the famous “American Dream” becomes a way of life.

On the other side of the Atlantic, Europe also experienced tough moments – autocratic regimes, revolutions, wars – the borders are no longer the same… In 1950, Robert Schuman, then French Minister of Foreign Affairs, proposed to pool coal and steel productions both in France and Germany, the beginnings of what would become the European Union.

A few decades later, while the Western world is facing a major geopolitical crisis, the North Atlantic Treaty Organization (NATO) gathers countries on both sides of the Atlantic and reminds us how good the decision was, at the end of World War II, to unite the great democracies around the idea of a common defence. Sometimes contested, NATO got a new boost and the political differences on both sides of the Atlantic are erased allowing for the balance and union that are needed to maintain peace and world order.

While political differences are fading, a gap is growing between the New World and the Old Continent in terms of valuation. The price-earnings ratio gap between US and European equities remains well above its long-term average (see chart 2 below). Indeed, European equities seem to have discounted a worse scenario, especially when taking a closer look at some companies that are more closely linked to the economic cycle, such as automobile manufacturers.

Among European indices, there are a good number of so-called “value” stocks that are now trading at a deep discount compared to their intrinsic value. Surprisingly enough, this situation occurs as the broad European value indices (-13% YTD) are outperforming while more growth and technology-biased indices dropped 30% YTD.

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While political differences are fading, there is a widening gap between the New World and the Old Continent in terms of valuation.

This greater resilience, the uncertainties related to business models of growth companies and the much more affordable valuation of the European market make it a rational choice. While the United States already entered into a “technical recession”, real estate is already showing signs of weakness and as the Federal Reserve is struggling to contain inflation, Europe may not look more appealing, but yet it stays more affordable.

Admittedly inflation is also an issue there, but so far it remains primarily driven by commodities and looks more temporary on that angle. Surely, the Ukrainian-Russian conflict is affecting more Europe than the US and could deteriorate into a major energy crisis, but the ability of Europe to cope with it through a mix of reduced consumption, supply diversification, and increased storage should not be underestimated.

Finally, even if the European markets rarely outperformed the US ones in recent history, the hurdles facing US companies are clearly higher – tighter financial conditions, wage inflation, and a strong USD to name a few – adding to that the possibility of a valuation normalisation, it leads us to rethink this debate.

Chart 2: Estimated P/E STOXX 600 and S&P 500 (LHS) and PE spread S&P 500-STOXX 600 (RHS)

Source: Bloomberg, Banque Eric Sturdza.

The question of the Fed Pivot is still very much alive and the long-awaited critical point seems to be approaching, while in Europe Christine Lagarde announced a new, widely expected, 75 basis point increase in the ECB’s key rate.

At the time of writing, the monthly performance of global equities (MSCI ACWI) is 5.2%, with the European market outperforming the US in local currency. The earnings season is well underway and continues to surprise positively.

Broadly speaking, sales growth remains robust, and margins seem less impacted as companies raised their prices to adjust to a new inflation paradigm. However, the results of the major tech and internet companies came in a bit disappointing, particularly in light of slowing digital advertising revenues and more muted guidance.

In Europe, quality growth is making a comeback as evidenced by the leading luxury companies reporting outstanding quarterly results, once again demonstrating their ability to adapt and diversify their end markets, even if Chinese lockdowns are taking a toll on their activity in China, which often remains their biggest market. These publications also demonstrate the positive side-effects of a weak EUR for exporters.

We remain very selective and cautious in our investment choices decisions. We continue to focus on quality, especially in Europe and Switzerland, and to look for diversification through sectors, styles and geographies.

Without modifying our underlying geographical allocation, we decided to change the geographical focus of our hedging overlay by placing more emphasis on our US exposure and less so on European equities. We also continue to favour less directional and more asymmetric approaches (long short, structured products) to invest in equities.

Contributors: Marc Craquelin, Eric Vanraes, Pascal Perrone, Jeremy Dutiot and Edouard Bouhyer. The original PDF document: “History does not repeat itself but it rhymes” by Banque Eric Sturdza can be downloaded here.

As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolios.

Adam TurbervilleAdam Turberville
Director
+44 1481 742380
a.turberville@ericsturdza.com

The views and statements contained herein are those of Banque Eric Sturdza SA as of 04/11/2022 and are based on internal research and modelling. Please click on BES Disclaimer to view Banque Eric Sturdza’s disclaimers. Please click on Disclaimer Page to view full disclaimers.