Analyst Weekly – Bonds back in the toolkit

Bonds more attractive as recession looms

US treasury bonds are coming back in from the cold after a terrible six months of performance when they gave little protection from plunging markets. Bonds are seeing renewed interest again as recession growth risks rise and inflation forecasts fall, with bond yields rising sharply. Long-term bonds, like the IEF and TLT exchange-traded bond funds, are the most sensitive to this. Short-term bond funds, like BIL and SHY, are more defensive. The bond market is clearly signaling that recession is increasingly likely.

Inflation and earnings headwinds

Markets are hurt by a new US inflation high, the risk of a next 1% Fed rate hike, and US bank’s weak Q2 earnings start. China was hit by renewed covid and reg-tech concerns, and Europe by gas supply and Italian political uncertainty. This week to see historic ECB rate lift-off. We see only a gradual U-shaped recovery. See the latest presentation, video updates, and Twitter @laidler_ben.

The race between recession and inflation

High 9.1% the US and 8.6% EU inflation is driving hawkish central banks, and recession risks. A second-half 2022 inflation decline, and Christmas end to rate hikes, is the market catalyst.

‘Our currency, your problem’

US dollar soared 20% over the past year, a two-decade high vs major currencies, cutting US earnings growth and tightening global conditions. It’s 45% of all FX trading vs 25% of world GDP.

Europe’s energy nightmare deepens

Europe and UK nat gas prices surged again, the region’s worst energy fear, as the Nord stream closes. Stokes inflation and recession risks. See @OilWorldWide, @EuropeEconomy.

Euro is still not cheap

EUR/USD parity biggest line-in-the-sand level in global FX markets. EUR fundamentals are worsening and valuation is not cheap.

Crypto assets resilient to an inflation spike

Bitcoin (BTC) was resilient to the latest US inflation surprise, whilst Polygon (MATIC) was boosted by latest in string of adoption announcements, and Uniswap (UNI) by its Robinhood (HOOD) platform listing. DOGE held back by Elon Musk backing away from Twitter (TWTR) deal.

Recession worries hurt commodities

Commodity markets fell further as recession worries intensified as the US yield curve ‘inverted’ and the dollar surged to a 20-year high. This drove a 10% fall in ‘Dr. Copper, whilst wheat prices also slumped on the hope that Ukraine could resume stalled exports. US gasoline prices fell from $5/gallon highs, easing inflation fear.

The week ahead: earnings season accelerates

1) Q2 earnings accelerate after a weak start with banks BAML, GS, tech NFLX, TSLA, healthcare JNJ, and ABT. 2) ECB to raise interest rates for the first time since 2011 and to announce a bond plan. 3) Flash PMIs from the US, EU, UK, and Japan are a timely health check on growth and inflation risks.

Our key views: Inflation versus recession race

Recession and earnings risk driving markets, with valuations slumped and bond yields peaking. Recession not inevitable, on resilient corporates and consumers, and easing price pressure. But recovery is only U-shaped. Focus defensives, in the ‘new’ world and manage risks. Healthcare and high dividend yield, to UK and China.

Top Index Performance

	1 Week	1 Month	YTD
DJ30	-0.16%	4.68%	-13.90%
SPX500	-0.93%	5.12%	-18.95%
NASDAQ	-1.57%	6.06%	-26.80%
UK100	-0.52%	2.03%	-3.05%
GER30	-1.16%	-1.99%	-19.01%
JPN225	1.02%	3.18%	-6.96%
HKG50	-6.57%	-3.69%	-13.25%

*Data accurate as of 18/07/2022

Market Views

Inflation and earnings headwinds

• Markets are buffeted by stiff bad news headwinds. US inflation rose to a new high, driving potential for a coming 100bps Fed rate hike, and US banks led a weak Q2 earnings season start. Also, China was hit by renewed covid and reg-tech concerns, and Europe by gas supply and Italian political uncertainty. This week see the ECB rate lift-off. We see only a gradual U-shaped recovery. Page 6 for Resource reports, presentations, videos, Twitter.

The race between recession and inflation

•  High US and EU inflation driving hawkish central banks. They were late to the inflation threat and now hiking into a growth slowdown. The longer this goes, the more likely recession. Consumer and corporate buffers are not insurmountable.
• June’s 9.1% US inflation surprise makes a 100bps July 27th rate hike very possible. A second-half 2022 inflation decline, and Christmas end to rate hikes, is the market catalyst. Until then it’s a bear market rally and U-shaped recovery.

‘Our currency, your problem’

• US dollar soared 20% the past year, a two-decade high vs major currencies. It has negative impacts, from tightening financial conditions to exporting high inflation. As a US Treasury Secretary said ‘the dollar is our currency, but it’s your problem. 
• But this is not a one-way street. The stronger dollar is also holding back US corporate earnings growth, whilst giving a welcome competitiveness boost to many European and Asian exporters.
• The US dollar dominates the global financial system, making up around 65% of international debt, 60% of global currency reserves, and 45% of all currency trading. This is dramatically larger than the US’s one-quarter weight in the global economy. It is also around three times the usage of its nearest currency competitor, the Euro.

Europe’s energy nightmare deepens

• Europe and UK nat gas prices have surged again, the region’s worst energy fear. Is stoking inflation and recession risks. The immediate cause is the closure of the Nord Stream pipeline and fears it may not reopen.
• The focus remains on trying to fill gas storage before the winter demand spike. This price surge has left US gas and global oil prices in the dust, a stark reminder of the local nature of gas markets. @OilWorldWide, @EuropeEconomy.

The Euro is still not cheap

• EUR/USD parity is the biggest line-in-the-sand level in global FX markets. It has not been breached in twenty years. But the odds are increasingly stacked against the EUR, with its deteriorating relative fundamentals, as the energy crisis worsens, and still far from a ‘cheap’ valuation, especially vs the JPY.
• A fall below 1.00 stoke’ Europe’s imported inflation concern, but is not all bad news. It would be ‘growth insurance’ for many big exporters, from Airbus (AIR.PA) to ASML (ASML). Over 50% of European corporate sales come from abroad, versus only 30% for US companies.

Key events to watch in the third quarter of 2022

Crypto resilient to latest inflation high

• Bitcoin (BTC) held around $20,000, despite the latest high US inflation surprise, and increase in Fed rate hike expectations. Weakness led by Dogecoin (DOGE), dampened by Elon Musk backing away from his Twitter (TWTR) takeover. 
• Strength was led by Polygon (MATIC) after it was the only blockchain selected to be part of Disney’s 2022 Accelerator Program, the latest in a string of major adoption announcements. Also, the decentralized trading protocol Uniswap (UNI), as was listed on the Robinhood (HOOD) platform. 
• Bitcoin addresses rose to 1.0 billion for the first time, as adoption continues. Lender Celsius Network filed for bankruptcy, after halting withdrawals. 

From commodity feast to famine

• Commodities eased further on recession worries and a surging US dollar. Is now the worst performing asset class this month and back at pre-Ukraine invasion levels, a turnaround from leadership so far this year. This helped cut medium-term US inflation expectations by 0.2% in the past month. 
• ‘Dt. Copper fell 10% as the US yield curve ‘inverted’, with short-term yields above long-term, in one of the clearest market signs of a coming recession. Meanwhile, US gasoline prices fell from a record $5/g, as high prices cooled consumer demand. 
• Wheat prices also fell 10% on hopes for a deal to resume Ukraine’s stalled wheat exports. 

US Equity Sectors, Themes, Crypto assets

	1 Week	1 Month	YTD
IT	-1.50%	7.31%	-27.30%
Healthcare	-0.66%	9.98%	-10.09%
C Cyclicals	-0.60%	8.09%	-29.13%
Small Caps	-1.41%	5.73%	-22.31%
Value	-0.55%	3.33%	-12.99%
Bitcoin	-3.20%	0.80%	-55.55%
Ethereum	1.98%	-14.64%	-66.25%

Source: Refinitiv, MSCI, FTSE Russell

The week ahead: earnings season accelerates

• Q2 earnings accelerate with banks BAML to GS, tech titans NFLX, TSLA, ASML, and healthcare heavyweights JNJ, and ABT. Company profits have been key market support. Forecast is +5% S&P 500 growth, 20% in EU, and 30% UK. 
• The ECB (Thu) to raise interest rates from zero to 0.25%, or more, in the first rise since 2011. Face cross-currents of 8.6% inflation, 4x target, but soaring recession risk on energy crisis. Also, see the plan to contain diverging gov. bond yields. 
• Flash US, EU, UK, and Japan July PMIs (Fri) give a timely outlook for the pace of the global economic slowdown and inflation risks. Numbers have fallen towards the breakeven 50 levels below which signifies an economic contraction. 
• Hope EU gas imports restart on Nord stream pipeline (Thu) after the maintenance shutdown. 

Our key views: Recession fears in driving seat

• Saw the biggest sell-off since the 2020 covid crash. Recession and earnings risk drive markets, with valuations, slumped and bond yields peaking. See the fundamentals stressed but secure, with recession not inevitable, on resilient corporates and consumers. But recovery U, not V, shaped. 
• Focus on cheap and defensive assets. To be invested in this ‘new’ world, but to manage still very high risks. See Value sectors, like healthcare, defensive styles like high dividend yield, and related markets from the UK to China.

Fixed Income, Commodities, Currencies

	1 Week	1 Month	YTD
Commod*	-2.11%	-10.51%	14.42%
Brent Oil	-5.62%	-10.98%	29.75%
Gold Spot	-1.98%	-7.34%	-6.77%
DXY USD	0.91%	3.14%	12.52%
EUR/USD	-1.04%	-3.95%	-11.35%
US 10Yr Yld	-16.51%	-31.71%	150.53%
VIX Vol.	-1.66%	-22.17%	40.71%

Source: Refinitiv. * Broad-based Bloomberg commodity index

The focus of Week: Bonds back in the investor toolkit

Bonds are coming back in from the cold after a terrible six months of performance

Fixed income, and especially US government bonds, had one of its worst six months in memory. It endured a perfect storm of rising interest rates, inflation, and high initial valuations. This was a shock to usually some of the world’s safest investments, backed by the full faith and credit of the world’s largest economy, and dominant currency. They are the key building blocks of global finance and among the widest held instruments. But with yields now higher, and inflation expectations falling, they are more attractive again. 

Fixed income has provided no protection from plunging markets

With its income fixed, the sensitivity to inflation is high. The longer the bond’s term, or duration, the more sensitive it is to being eroded by inflation. It has been a tough year. With low bond yields at the start of the year (yields move inversely to bond prices). Further sharp rises in inflation concerns. And the US Fed turning more aggressive in raising rates. This bond slump has been most dramatic for longer data bonds (see chart). It has also seen volatility surge. The MOVE index (the bond equivalent of the VIX equity vol index) has doubled. 

But bonds are now starting to become ‘investable’ again as inflation expectations fall

Bond yields have now risen significantly to above inflation expectations, giving a positive ‘real’ yield. Additionally, with the Fed aggressively raising interest rates and recession fears mounting, inflation expectations are now showing signs of peaking. Five years forward US inflation expectations have fallen from a peak of 2.7% to a current 2.1%. Whilst 10-year bond yields have eased back from 3.5% to 3.0%. This is beginning to attract some investor inflows back into bonds, after the dramatic price rout this year. 

Long-term bonds are the most sensitive to inflation; short term the most defensive

The longest-term bonds, most sensitive to inflation, are 20+ year US Treasuries (in TLT ETF). They are down over 33% from 2020 highs. The next most sensitive are 7–10-year US Treasury bonds in IEF ETF. More defensive are the shorter-term 1-3 year bonds in SHY ETF. Most defensive is the shortest duration 1-3 month BIL ETF.

The bond market is also telling worrying messages about a coming recession

The bond market is also telling us worrying signs on potential recession. The yield curve has near ‘inverted’, with short-term yields above long-term. This is historically a strong indicator of a coming recession.

US Treasury Bond ETF Performance vs Inflation (Last 5 Years)

Key Views

The BlockFi Market Strategy View
Global Overview	Geopolitical risks alongside the Fed hiking cycle are boosting uncertainty and weakening markets. We see this as slowly fading, the global growth outlook secure, and valuations more compelling. Focus on cheap cyclical and defensive assets within equities, like Value, plus commodities, crypto. Relative caution on a fixed income and the USD.

 

Traffic lights*	Equity Market Outlook
United States	The world’s largest equity market (60% of total) seeing strong c4% GDP growth and a resilient earnings growth outlook. Valuations have now fallen back to average levels, and are supported by peaked bond yields and high company profitability. Fed interest rate risks are now well-priced. See cyclical and value catch-up, after lagging for a decade, whilst big-tech is supported by structural growth outlook. See overseas markets leading in global ‘U-shaped’ rebound.
Europe & UK	Favor defensive and cheap UK equities (‘Economies are not stock-markets) over high risk/high return continental Europe. Recession risks rising with Russia and the energy crisis, threatening to overwhelm ‘buffers’ of rising fiscal spending (defense and refugees), low-interest rates (slow to raise ECB), and weak Euro (50%+ sales from overseas). Equities are cushioned by the greater weight of cheap cyclical sectors, lack of tech, and 25% cheaper valuations versus the US.
Emerging Markets (EM)	China, Korea, and Taiwan dominate EM (60% wt), and are more tech-centric than the US. Positive on China as economy reopens, cut interest rates, and eases tech regulation crackdown. Valuations are 40% cheaper than in the US and the market is out of favor. Recovery helps global sectors from luxury to materials. More cautious rest of EM on rising rates and strong USD.
Other International (JP, AUS, CN)	Canada and Australia benefit from strong equity market weight in commodities and financials, as global growth rebounds and bond yields set to rise. Japanese equities are among the cheapest of any major market and vaccination rates accelerating but have structural headwinds of low GDP growth, an aging population, and the world’s highest debt.

 

Traffic lights*	Equity Sector & Themes Outlook
Tech	‘Tech’ sectors of IT, communications, and parts of consumer discretionary (Amazon, Tesla), dominate US and China. Expect more subdued performance as bond yields rise. But are structural stories with good growth, high margins, and fortress balance sheets that justify high valuations. ‘Big-tech’ is the new defense. ‘Disruptive’ tech is more vulnerable.
Defensives	Core positions as macro risks rise and bond yields are better priced. Consumer staples, utilities, real estate attractive defensive cash flows, less exposure to rising economic growth risks, and robust dividends. Offset impact of higher bond yields. Healthcare is most attractive, with cheaper valuations, more growth, and some rising cost protection.
Cyclicals	Cyclical sectors, like consumer discretionary (autos, apparel, restaurants), industrials, energy, and materials, are cheap and attractive in a ‘slowdown not recession’ scenario. Are sensitive to re-opening economies, resilient GDP growth, and higher bond yields, with depressed earnings, and cheaper valuations, and have been out of favor for many years.
Financials	Benefits from higher bond yields, charging more for loans than pay for deposits. It also has one of the cheapest P/E valuations and has room for large dividend and buyback yields. But is being outweighed by rising recession risks, with lower loan demand and higher defaults. Banks are most exposed. Insurance and Diversified (like Berkshire Hathaway) least.
Themes	We favor Value over Growth on GDP resilience, lower valuations, rising bond yields, and under-ownership after a decade of under-performance. Dividends and buybacks recover with cash flows. Power of dividends under-estimated, at up to 1/2 of total long-term return. Secular growth of Renewables and Disruptive Tech themes.

 

Traffic lights*	Other Assets
Currencies	USD well-supported for now by rising Fed interest rate outlook and ‘safer-haven’ bid on virus fourth wave virus. This is likely more modest than prior USD rallies as the rest of the world’s growth recovers and the virus fears ease. A strong USD traditionally hurts EM, commodities, and US foreign earners, such as tech, but helps EU and Japan exporters.
Fixed Income	US 10-year bond yields to rise modestly as inflation above 2% average Fed target, ‘real’ inflation-adjusted yields negative, Fed to gradually tighten policy. Will be modest as inflation expectations are already high, wide spread to other market bond yields, and structural headwinds of all-time high debt, poor demographics, and low productivity.
Commodities	In the ‘sweet spot’ of robust GDP growth, ‘green’ industry demand, years of supply under-investment, and recovering China, and Russia supply crisis. Industrial metals and battery materials are well positioned. Oil was helped by the slow return of OPEC+ supply and Russia’s 10% world supply problems. Gold was helped by risk-aversion but held back by rising bond yields.
Crypto	Institutionalization of the bitcoin market has barely begun, as the asset class benefits from very strong risk-adjusted returns and low correlations with other assets. Altcoins have outperformed as see broader interest and use cases. Clear supply rules a benefit as inflation rises. Volatility remains very high, with the 16th -50% pullback of the last decade.

 

*Methodology:	Our guide to where we see a better risk-adjusted outlook. Not investment advice.
Positive	Overall positive view, and expected to outperform the asset class on a 12-month view.
Neutral	Overall neutral view, with elements of strength and weakness on a 12-month view
Cautious	Overall cautious view, and expected to underperform the asset class on a 12-month view

Source: eToro

Analyst Team

Global Analyst Team
CIO	Gil Shapira
Global Markets Strategist	Ben Laidler
United States	Callie Cox
United Kingdom	Adam Vettese Mark Crouch Simon Peters
France	Antoine Fraysse Soulier David Derhy
Holland	Jean-Paul van Oudheusden
Italy	Gabriel Dambach
Iberia/LatAm	Javier Molina
Poland	Pawel Majtkowski
Romania	Bogdan Maioreanu
Asia	Nemo Qin Marco Ma
Australia	Josh Gilbert

 

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This communication is for information and education purposes only and should not be taken as investment advice, a  personal recommendation, or an offer of, or solicitation to buy or sell, any financial instruments. This material has been prepared without taking into account any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or a packaged investment product are not, and should not be taken as, a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this publication.