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DOMESTIC VS. FOREIGN DETERMINANTS?

EMR September 2024

Dear Reader,

CURRENT SETTING

We have no doubt that the economic discourse in recent years/quarters/months has undeniably focused on managing interest rates to fight inflation and, in particular, to counter inflationary fears and pressures.

Indeed, fears of an imminent economic slowdown due to a short-term reduction in consumption and investment, coupled with fears of rising interest rates as a result of central bank action, did indeed argue in favor of a rate cut. However, it is the strength of economic activity that we believe will limit interest rate rises.

SHORT-TERM ASSESSMENT

We believe that the economic shocks of recent years have left the global economic system in a state of unexpected vulnerability. Recall that climate change and the pandemic have not spared anyone. Russia’s war against Ukraine underlines the free world’s “unexpected” dependence on energy imports, with unexpected implications for inflation, monetary policy and so on.

So, what now? Recently, the media have pointed out that China’s economy is slowing down. The difficulty at this stage is the speed and strength of the Chinese slowdown. What seems certain is that the Chinese economy is slowing, while the impact on overall economic growth, inflation and interest rates remains difficult to quantify with sufficient precision.

MEDIUM-TERM ASSESSMENT

Among the recent domestic and global economic shocks, the upcoming US election is a “new” factor that is difficult to quantify in the short and medium term. What policies might be implemented by whoever wins the election, and what might be the impact on the domestic and global economy?

Both the US presidential election (in November) and the feared slowdown in the Chinese economy are therefore likely to play a key role in the short and medium term.

ECONOMIC GROWTH

In this context, we consider two factors that are highly deterministic and difficult to assess with sufficient precision. The first is the contribution of the domestic economy, i.e. consumer spending, fixed investment and government spending. The focus is mainly on factors that can be determined at the national level. The second concerns the impact of decisions and actions taken by foreign entities. Let us now look at some details.

CONSUMER SPENDING

Consumers are increasingly expected to focus on goods and services from domestic producers for as long as possible. This is an early promise of sustained economic activity. In terms of asset allocation, there may be a discrepancy from country to country, depending on their degree of autonomy.

Going forward, we believe the degree of energy independence will play a key role in inflation and monetary fine-tuning.

BUSINESS FIXED INVESTMENT

Somehow, investors have learned that the availability of certain inputs is far more important than short-term “price advantages”. The economic environment has become more complex and, above all, influenced by unfair political practices rather than free market competition.

Investors should view recent developments as a possible dramatic reversal in investment activity: abandoning a strategy of short-term profit, investing and producing abroad to take advantage of lower production costs, possibly losing financially attractive customers in the long term.

GOVERNMENT SPENDING

In recent times, governments in the ‘free world’ have played a complex role in managing domestic and foreign investment. Perhaps we have all taken it for granted that politicians in other countries think like we do in the free world, that is, with an outlook based on market economics and free trade. Unfortunately, both Russia and China have taught us and continue to teach us that this is not the case for the whole world. Today, it is important to recall that the “free market” has taken on very different political connotations from those that have dominated the world market for years.

FOREIGN TRADE

We have no doubt that a significant shift is taking place. On the producer side, the battle is over the supply of raw materials from dirigiste countries (e.g. crude oil from Russia and Middle Eastern suppliers). The main objective of the producing countries is to maximize profits. Importing countries, on the other hand, are more concerned with sustainability than cost minimization. Developed countries, led by the United States, are forcing the “repatriation” of technological tools in order to reduce their dependence on foreign countries such as China or Russia.

The difficult question to answer at this stage is: who will be the winners and who will be the losers? From a contextual point of view, we have no doubt that there will be a significant impact, primarily on domestic economic growth and new product development, which will in due course determine the position of inflation, interest rates and currencies.

ON MONETARY POLICY

Monetary policy should be increasingly geared towards promoting investment that fosters technological innovation. In this context, the differences between nations are significant and represent an immanent and highly deterministic contextual key to international trade and even currency diversification.

ON INFLATION

Reading the press, watching television or listening to the radio, we are and will continue to be confronted with the whereabouts of inflation. It is not only central bankers and/or economists who face a number of daunting challenges, which will not end primarily with interest rate adjustments. They also require greater coordination in the context of productivity and new economic developments. The availability of crude oil remains crucial to containing rising inflation in conjunction with monetary and innovation adjustments.

BOND MARKETS

On the back of expectations of a further reduction in interest rates, investors are becoming more and more interested in bond investments, particularly in the United States. Total bond capitalization is approaching $70 trillion, according to the “Bloomberg global aggregate index”. As reported in the media, capitalization has increased by $6 trillion since the beginning of 2023 and by a further $12 trillion since the beginning of 2024. However, futures market discounts are confidently predicting that interest rates will continue to fall. These developments should (and will) be examined in the context of macroeconomic developments. If expectations prove to be relevant, they will help us to quantify the future disinflation process.

ON CURRENCIES

The scenario described above requires an accurate and diversified currency allocation. We do not doubt that extrapolating long-term historical developments is no longer sufficient. Productivity and innovation must be stimulated along with technological developments. Investors will increasingly have to consider the availability of the necessary venture capital to support innovation, which is not available everywhere, in comparable quantities and at acceptable prices. Red equals new.

EQUITY MARKETS

Forecasting has always been a tricky business. The chart showing the reaction of stock indices and the price of gold after the Russian invasion of Ukraine on 24 February 2022 speaks volumes. It is quite surprising that the Nikkei is the best performer. Do you think other factors were and are at play?

A difficult issue to assess is the availability and cost of energy, which is clearly visible in the rise in crude oil prices. If we look at the performance of the indices shown since the end of 2022, we see that the impact of inflationary fears varies considerably from index to index. In this context, the performance of the NIKKEI index relative to all other indices, except the NDX (NASDAQ), is puzzling. There is no doubt that the trend shown is indicative of a greater “repatriation” of technologically advanced products.

What is not obvious is the impact on currencies, or even country allocation, as evidenced by the rather low growth of the SMI (Swiss Market Index) compared to all other indices expressed in their respective currencies. As a result, we have adopted a rather restrictive country allocation based on technological innovation. The US elections are likely to have an impact on investment policy in the coming months and quarters. Economic activity and interest rates are likely to fuel volatility.

Suggestions are welcome.

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