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Status report
of the economy.July 18, 2022

Experts say the key data this week has been the US consumer price index (CPI), which rose 9.1% over 12 months, the biggest rise since 1981, with prices jumping 1.3 % in June. An important part comes from the rise in gasoline, +11%, although core inflation (excluding food and energy) also surprised on the rise (+0.6% vs. 0.5%). Technology stocks performed relatively well in the closing days of the week, supported by very favorable earnings expectations from Apple. Energy companies fared worse as oil prices tightened, falling to levels not seen since before the Russian invasion of Ukraine.


Russia closed the Nord Stream 1 gas pipeline that supplies Germany for maintenance work until next Friday. The German government is concerned that Russia will not fully reopen it in retaliation for European sanctions, which could force Germany to impose rationing on industries and families to preserve winter stocks. Russia has already cut flows to 40% of the pipeline's capacity, citing delays in the delivery of equipment that the German company Siemens repairs in Canada. Faced with this delicate situation, the European Commission will hold an extraordinary summit on July 26 to discuss a coordinated gas saving plan aimed at preserving European reserves in the event that Russia cuts off the supply.

 


The European Commission has lowered its economic forecast for Europe and raised its inflation forecast due to the negative impact of the Russian invasion of Ukraine. According to their summer forecasts, GDP in 2022 is unchanged at 2.7%, but now sees a sharp slowdown in 2023 to 1.5%, instead of the forecast 2.3%. Inflation is forecast to accelerate to 8.3% in 2022, against the forecast of 6.8%. And by 2023, it rises to 4.6% from 3.2%.


On the other hand, in China, industrial production grew by 3.9% in June compared to the previous year, compared to the figure of 0.7% in May, while investment in fixed assets increased by 6.1% in the six first months of the year compared to the previous period, exceeding expectations. Retail sales rose 3.1% year-on-year in June and marked the fastest growth in four months, which we linked to the reopening of cities like Shanghai.

 


With the inflation data skyrocketing, the situation suggests that the Fed has more work to do to achieve its price stability mandate, but it is curious how, despite such a high data, the SP500 rose on Wednesday, while the US Treasury bond The 10-year bond was down, indicating that markets may already be looking beyond peak inflation to the likelihood of slower economic growth in the future.


INFLATION.

If the American data is analyzed, the 9.1% for June is above the 8.6% for May and above the consensus expectations. Energy prices alone rose 42% from a year ago and 7.5% from May, contributing to almost half of the global rise in inflation. Adding to the pressure, food prices posted the biggest monthly increase since 1981.


But since June, commodity prices have fallen sharply: oil last week fell to its lowest level since the Ukraine invasion, trading at $91. Gasoline prices, one of the main contributors to inflation, also rose but are beginning to stabilize. Although commodity prices remain high, we have seen a general decline, supporting hopes that inflation is peaking. For example, oil has dropped 22% from its maximum, natural gas 28%, copper 34%, wood 62% or wheat 44%...


If we look at core inflation, it's the third month in a row that it's cooled down. Two-thirds of the CPI components are rising more than 5%, and rent - the largest services component - has posted its biggest monthly rise since 1986 in the US. With borrowing costs rising, the housing market is starting to cool down. But historically, it takes about a year for a slowdown in house prices to be reflected in rents.


Pressures are expected to moderate slowly.  Inflation will moderate in coming months, helped by falling commodity prices, more favorable base effects, improving supply tightness, lower demand for goods as consumption shifts to services and a general slowdown in economic growth. However, this moderation will probably be slow. For example, the decline in commodity prices will depend on the easing of geopolitical tensions.



CENTRAL BANKS, THE CONTROL OF INFLATION AND THE INVERSION OF THE RATE CURVE.

Central banks are caught between a rock and a hard place; With the June CPI data, the Fed is under pressure to continue with its exaggerated rate hikes - inflation is unlikely to return to the Fed's 2% target any time soon. Markets are beginning to price in a greater likelihood that the Fed will announce a large-scale rate hike at the July meeting. It is believed that, with the CPI data, it is enough to justify a rise of at least 0.75%.


On the positive side, strong and rapid gains early on could mean this tightening cycle ends sooner than expected. The bond market now indicates that the fed funds interest rate will peak in January 2023, between 3.5% and 3.75%, at which point the Fed would start cutting rates, probably in response to weakening growth and falling inflation.
 

Yield curve inversion is a warning sign about the cycle - last week, the 10-2 year yield curve - the difference between the 10-year and 2-year Treasury rates - moved into more negative territory (inverted ) since 2000. In short, what it says is that higher short rates reflect Fed rate hikes, while lower long rates signal weaker growth expectations. In the past, an investment has advanced the scenario of economic recessions, something that the financial market (stock markets) has already priced, as we have commented on occasion.


But most of the “troubles” could already be priced in… While this reversal signal is not thought to be dismissed, short-term head pressures are mounting as the Fed tries to orchestrate a soft landing for the economy while slowing down inflation. However, the yield curve has historically inverted an average of 15 months before a recession starts, ranging from a six-month low to a 23-month high. What is different this time is that stocks are already in a bear market. In the crisis scenarios of the last 50 years, the stock markets continued to rise between two months and more than a year, after the first investment. This could indicate that this year's decline could already reflect many of the problems that an inverted yield curve would normally predict going forward.



 


IMPLICATIONS ON THE INVESTMENT STRATEGY

Inflation is the key: Although the drop in commodity prices that experts are commenting on is a good first step towards lower inflation readings, we will have to wait at least two or three months to gauge whether the general CPI and the underlying follow a downward path. Meanwhile, volatility could remain high. It is believed that inflation needs to be past its peak and on the way to moderating before equity markets can find their footing and define a "durable" rebound. This also relaxes fears that the Fed is too strict with its policy. The strength of business results is put to the test during these weeks with the results of the second quarter.
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Since changes in monetary policy take time to affect the real economy, experts forecast a period of weak economic growth. However, a deep recession is not expected. The starting point of the situation of consumers has improved a lot in relation to previous recessions. For example, the ratio of household debt to disposable income remains historically low, and income is supported by good employment conditions and wages that could be on the rise.

 


If the economy remains on a slower pace, larger caps will be favored over small caps, defensive sectors (commodities and healthcare) and companies with strong balance sheets. Value-type investments will continue to be favored slightly, but less than at the beginning of the year. Slowing growth, rising bond rates, and slowing inflation could provide a better scenario for growth and technology companies going forward, but some of these trends will take time to manifest, and relative valuations of "growth" niches (technology for example), are still somewhat high.
 

From an investment point of view, and although the risks for the economy have increased, it is believed that stock market valuations (by PER multiples for example) and bond interest rates have improved, improving expected future returns (obviously, after suffering a historic adjustment this year). Unlike what happened at the beginning of the year, the bond investor finds a yield base that can cover the average expectation of future inflation, something that did not happen at the beginning of the year.


Adjusting equity allocation to target (if appropriate based on circumstances and risk tolerance) could help investors prepare for the next market bull cycle. Proactive rebalancing and systematic investment are the best ways to take advantage of market volatility, trying to value the investment horizon over which we had defined the initial strategy. The great difference between short-term trading and medium-term investment defines the client profile and the associated risk. The first is willing to play the opportunistic risk, without valuing the asset. The second invests with a vision of value in the selection and trend, which may take more or less time.