In the past three months, markets have stabilized somewhat, but 2022 remains an annus horribilis for investors. Both equities and government bonds have posted negative returns so far this year. High inflation, slowing growth and the possibility of a recession continue to worry investors.
Gold fell in the mid-term bear market
Gold has been dropping since April this year, after retreating from $2069. For the second quarter in a row, gold has lost value as rising global interest rates and a lack of funds have led the metal to fall. In light of all these factors, investors have been turned off from buying gold. The value of gold holdings in exchange-traded funds (ETFs) has dropped nearly 9 per cent since April, demonstrating that. Having broken below $1676, gold will finish Q3 at its lowest level since April 2020, which confirms the beginning of a mid-term bear market, aiming for the 100-week EMA.
Currencies move to extremes
Large currency extremes have been triggered by the recovery following COVID-19, the inflation surge, and the energy price shock. As a result of Fed hawkishness and its safe-haven appeal during periods of market volatility, the dollar has been able to hold its value. As measured by real trade-weighted exchange rates, the US dollar is the strongest since the Plaza Accord era in the mid-1980s.
On a longer-term basis, the euro, Japanese yen, and British pound are significantly undervalued. In terms of purchasing power parity, the euro is 30% undervalued, while the sterling is 20% undervalued. The yen is the outlier, undervalued by 35%. With the euro at 0.95500 against the dollar, it reached a two-decade low. The British pound also saw its lowest record since the 1980s.
Also read: Financial Market Review Q2 2022
US markets revert to the beginning of the pandemic
Inflation dynamics have been mixed over the quarter for US markets. Retail gasoline prices have dropped more than 20% from mid-June, as have natural gas prices. Inflation is tentatively on the rise, and durable goods prices, which are among the most volatile drivers of US inflation, are calming.
Despite this, the labour market remains hot, with two job openings for every unemployed worker. Wages are a sticky driver of inflation and put pressure on the Fed to move decisively toward restrictive monetary policy. Increasing interest rates and/or lowering asset prices are necessary for the Fed to reduce inflation. This is an unfavourable macro backdrop for investors. It's good to see that the markets are already responding to these concerns. Earnings estimates are expected for 2022 and 2023 to continue to decline, even though we think they have more to fall. To date, the S&P 500 has lost 20% on the year. Treasury yields on the 10-year note have risen almost 200 basis points this year, and at 3.8% they offer a decent yield (over and above inflation expectations and our estimate of fair value).
Euro heads to a cold winter
During the winter ahead, consumers are likely to face high energy costs, which will depress industrial production and consumer spending. Persistently high inflation should lead the European Central Bank (ECB) to tighten monetary policy. Italian bond yields remain under pressure due to political uncertainty and the Russia-Ukraine war is nowhere near resolution.
As a result of the energy crisis, the government has announced nearly €400 billion in support measures, and more packages appear to be coming. A windfall tax on energy producers will be used to partly fund a plan by the European Union (EU) to save 10% in energy and set an EU-wide price cap.
It is difficult to see the region avoiding a mild recession in light of declining industrial production in response to rising energy prices. As a colder than usual winter will lead to a deeper recession, the severity of this year's winter will be important.
Markets' outlook for the remainder of the year
Despite the positive sentiment for Treasury bonds, positioning indicators indicate that investors are holding short-term positions. The cycle will, however, not support a rally until there is a convincing case that market expectations have peaked for Fed tightening.
The Fed is expected to pause once its target rate reaches between 4.0%-4.5% over the coming months as inflation trends lower and growth slows. In general, Fed tightening phases are anxious times for markets. Investors are likely to be concerned about excessive monetary tightening and a more severe recession risk during these phases. There is a possibility that the mid-2020 lows of equity markets will be retested, and markets are likely to remain volatile until inflation is clearly declining.