Markets development - opportunities and challenges

I think markets have been evolving especially rapidly in the past few years since the onset of Covid. The various major market movers include Covid, the Russia-Ukraine war and China's now-abandoned Zero Covid policy (2022 markets wrap up here). These 3 major market movers have resulted in inflation in the majority of the world, from the US at 9.1% in June 2022, to Eurozone at 9.2% and Japan at 4% in December 2022. This is because of the supply crunch from factory and port closures in the last few years, coupled with the reduced commodity supply from Russia and Ukraine. Reduced supply of such commodities resulted in a spike in prices, driving up inflation. 

Central banks around the world are struggling to balance the impossible trinity - tackling inflation or generating economic growth or keeping to a target exchange rate. Notably, the US started the fight against inflation by raising rates in March 2022, as opposed to the ECB which started only in July 2022 because of recession fears. Several indicators point toward a drop in inflation in the US, except for the strong nonfarm payrolls last week, which delayed expectations of rate cuts from 2023 to 2024. Besides employment, the US savings rate has dropped to only 3.4% in 2022, and 47% of them make more than 6 figures a year (Yahoo). Thus, while prices are increasing, I think that people are perhaps sticking to their usual lifestyle more so than reducing spending, which will prolong inflation for a bit longer. On the east side, eyes are on BOJ's new governor to steer their Yield Curve Control policy which will have implications on the Japanese yen and global Japanese-owned assets. 

While market expectations have soured slightly, I think it is currently a risk-on environment, and commodities like iron and oil present opportunities, especially with China's reopening. Bond yields are expected to fall, so it would be good to hold on to high-yield investment-grade ones like US T-bills and Singapore's SSB, while we should remain cautious toward junk bonds like distressed debt, given the current economic environment. For currencies, AUD is expected to rise with its anticipated upcoming rate hikes, while JPY might not rise as much as expected because of the uncertainties surrounding the new governor. 

2022 Global Markets Wrap Up

2022 was a tumultuous year for the global markets. We've seen equities crashing $14 trillion (Reuters), the US bond market was the worst year on record (CNBC), and global currencies fluctuating. Here, I outline some of the major market movers of 2022.

1) Russia-Ukraine War
Russia and Ukraine supply oil and other commodities to other countries. The war reduced the supply, causing a spike in commodity prices, most notably oil. This fueled the fire of rising inflation. Thankfully, it was reported that a warmer-than-average winter resulted in lower demand for fuel for heating, preventing an exacerbation of oil prices. I think this will fuel the transition to alternative sources of energy like coal and (hopefully) other greener sources. 

2) Global Inflation and Recession Fears
Factory closures in 2020 and the energy crisis in 2022 reduced supply while demand increased. Shipping costs also rose -  shipping and oil companies get windfall profits because of the higher prices (see CMA CGM and Shell). The Federal Reserve expected inflation to be transitory, but it hit a record high of 9.1% in June 2022, and the Fed is still fighting it today. Interest rates went up by 25bp to 4.75% yesterday. Other central banks started raising rates later (Fed started raising rates in March 2022) on fears of an economic recession. ECB only started raising rates in July 2022, while BoE raised rates aggressively from 0.50% to 3.50% within a year, the highest in about 14 years since the GFC.

3) China's Zero-Covid Policy
Although now abandoned, the policy that ended in December 2022 had some repercussions. People could not travel, and economic activity was sluggish due to port, factory and highway closures (Santander). With China being the second biggest economy globally, reduced economic activity in China rippled through to the global markets.

What that means for the asset classes

1) Equities
S&P reported its worst performance (-19.4%) since the GFC in 2008, and DJI returned -8.9% (Reuters). Among them, tech was down significantly, with Amazon, Tesla and Meta down 51%, 68% and 66% (CNBC). 

2) Bonds
Bonds usually do well in a risk-off situation when people switch from equities to bonds for more safety. However, with the recession and interest rate hikes in 2022, bond prices and yields were hit left and right. With the rate hikes, bond prices fell, causing the "biggest spike" in the US 10-year Treasury yield since 1788 (Barrons). BoJ and its Yield Curve Control policy is a big topic. We've seen the BoJ controlling their 10-year rates at a strict 0%, which caused investors to jump to other bonds with higher yields and BoJ buying back bonds to maintain the 0% level. This would affect the yen.

3) Currencies
Yen depreciated against the dollar due to the difference in interest rates between US and Japan, which would have adverse implications, especially on inflation (happening now). On the European side, the euro fell to match the dollar for the first time in 20 years (see my blog post here).

4) Commodities
Oil prices increased due to the war, but decreased on fears of an economic recession leading to lowered demand. China's Zero-Covid policy was also an attributing factor. Supply of soft commodities was also reduced as Russia and Ukraine were major producers of crops, leading to higher commodity prices and inflation. This caused a spike in prices in 2022 (Trading Economics). Reduced gas led to higher take-up of coal. 

Just like the rooks, bishops and knights on the chessboard, major market movers like inflation, interest rates and war change the economic landscape. I believe that we can become better "big-picture thinkers" of investing by being cognizant of how these pieces intertwine and affect each other.

To look out for this week

 Mini update:

This week (week of 29th January 2023) we will see a lot of action in the markets mainly because of 2 main factors - central bank announcements and company earnings.

Central banks from the most powerful economies - Federal Reserve, ECB, and BOJ - are expected to announce rate hikes this week. Current rates are at 4.50%, 2.50% and 0.5%. 

ECB - expected to hike rates by 50bp in both February and March this year to curb inflation. With the 9.2% inflation in December and improving PMI report in the Eurozone, I think the ECB might have to further raise rates more than the anticipated 25bp in the second quarter of this year if this continues. 

BOJ - With Japan's yen falling over the last year, prices have increased substantially, causing a 41-year high inflation of 4%. BOJ has recently started to loosen its yield curve control policy from 0% to 0.5%, but analysts expect the rates to increase further.

Earnings season - Q4 earnings are coming. This week alone, there are 109 companies within S&P500 that will be releasing their reports, including megacap firms like Apple, Amazon and parent company of Google, Alphabet. 

I believe we will see a lot of movement in the markets this week, but with the earnings reports coming out, I think we will get some direction for the coming year in terms of whether inflation and rate hikes are set to continue, demand within the economy, and perhaps nonfarm payrolls further down the line. Nonfarm for January will be out on Friday.

Economic Development of Luxembourg

What about Luxembourg?

Luxembourg, one of the smallest countries in the world with a population of less than 650,000 as of 2021 (World Bank), is the richest country in the world. Its GDP per capita was the highest at US$110k in 2021 (Trading Economics) and its minimum wage is one of the highest in the world at €1,923 per month. Consequently, with such wealth, it is 13th in the world in terms of quality of life QOL, above Japan, Sweden and Canada (Numbeo), and one of the safest countries in the world.

Natural resources kick-started its growth

Its shining ray of hope was its iron ore deposits discovered in the 1840s, which allowed it to launch its industrial revolution, and its membership in the Zollverein. That was the period of the industrial revolution, so steel was used in almost everything and thus was in very high demand. This accelerated Luxembourg’s trade. Subsequently, it played an active role in the European Community (Britannica), including through the establishment of the Belgium-Luxembourg Economic Union in 1921 and participation in the North Atlantic Treaty Organisation. It also had a sound position within the European Coal and Steel Community. 

The 1929 Holding Law was instrumental in its continued success (discontinued)

Companies were allowed to hold multiple subsidiaries under one holding company, which provided many tax benefits to these corporations (Mondaq). This drew many MNCs into the country, pumping investment, jobs and skills into the country. The economy took off in the 1970s when big US holding conglomerates expanded to European markets and chose Luxembourg to hold their European headquarters (HQ) because of the tax benefits. There were also many big banks, law firms and accounting firms that were already operating there, which helped these big conglomerates to set up the HQ. 

The arrival of Big Tech grew its economy exponentially

The 2000s was an era of the dot com boom, in which their economy doubled within 5 years (World Bank), and has been growing exponentially. Luxembourg was the ideal location in Europe for tech companies and was also becoming a financial hub. To date, Luxembourg is the second-largest investment fund centre and a worldwide leader in cross-border fund distribution. There are more than 14,800 Luxembourg-domiciled funds with more than €4.7 trillion in assets as of December 2019. It has a stable business, political and social environment and a wide treaty network and a favourable tax regime (EY). 

Sacrifices of economic progress
Income inequality has been rising. The Gini Index of the country has been increasing over the last few decades (World Bank). 21.5% of its residents live on the brink of poverty and social exclusion, and 18.7% of its working population is considered “the working poor”, who have low-income jobs that fall below the poverty line (SDG Watch Europe). This proportion is one of the highest in the EU. 

Prosperity in the country may not have been the same for everyone. Foreigners make up more than 60 per cent of the workforce (Harrington), holding high-paying jobs, pushing up the cost of buying a house. Furthermore, its public services such as education are lagging behind. Only 74 per cent of adults aged 25-64 finished their upper secondary education, compared to the average of 79 per cent in the OECD (OECD).

My thoughts on the future
I opine that there are two approaches to ensure sustained prosperity and happiness in Luxembourg, namely through continued upside development and reduced downside development. The country is doing good in thinking ahead, as seen by its “City of the Future” blueprint which aims to improve infrastructures, such as through digital transformation and transition to a green economy, such as through improved waste management and reduced energy consumption (Digital Luxembourg). I believe that more can be done, or perhaps done more visibly, in terms of improving its education system and addressing social mobility issues. These mean investing in the people who are the future of the country and modifying or introducing policies to improve their lives.  

The current tension between global powers and the teetering of a global recession paints a grim picture for the financial hub in Europe. The financial sector which makes up more than a third of its GDP will likely shrink or stagnate, possibly causing its GDP to follow behind. Expats might move back to their countries, causing a brain drain and potentially impairing the sector. The country will be less affected by the lack of gas due to the Russia-Ukraine war in the future if it is successful in its transition to alternative sustainable energy systems. Overall, once market activity picks up, its economy will probably pick up as well.

Analysis of Brexit

Edit: this research was done prior to the recent volatility in the UK markets.

Background

It is the withdrawal of the UK from the EU after having voted to leave in 2016. It officially left the trading bloc on 31 January 2020. After leaving the bloc, the UK and EU agreed to keep the status quo on several issues until the end of the year. This gave them time to agree to the terms of a new trade deal. They came to an agreement on 24 December 2020. 

It seems that leaving the EU was due to several factors, including how Brits felt that being in the EU wasn't all that beneficial, unhappiness following the 2008 recession, and the Arab Spring refugee crisis (Essex). 

What are some implications of Brexit?
There is now a restriction to work and living across the border, as well as restrictions on trade and travelling. UK nationals now need a visa if they want to stay in the EU for more than 90 days in a 180-day period. The UK has also become less open with its exit from the EU, which is detrimental to its economy and its growth. It is now less open and competitive (Bloomberg), which ultimately affects its growth. As a whole, the UK’s total trade as a percentage of GDP fell by 8% since 2019, and the country has lost market share in 3 of its largest non-EU import market in 2021 (US, Canada, Japan). The UK will be expected to grow by 3.6% in 2022, and zero growth in 2023, which renders it the slowest growing among the G7 (Guardian). This could trickle down to the individual as an analysis by LSE mentioned that the reduced productivity and lower salaries may result in employees earning 500 pounds less per year by 2030 (Reuters).

With the close integration of the UK and the EU, the impact of Brexit has certainly been reflected in the EU as it has on the UK. For example, with the decreased movement of goods and labour across the border, the EU will likely experience a decrease in labour supply in the financial sector because of the UK’s status as a financial hub in Europe. The market size of the UK is much smaller compared to the EU, so I expect that the decreased labour supply and trade across both regions is likely to affect the EU to a lesser extent. 

The effect of Brexit is not the same for every sector
Sectors that are heavily reliant on cross-border supply chains are among the worst-hit, like electrical equipment manufacturing. The fishing industry was also expected to shrink by 30% with the increased regulations for their catch to their customers in the EU (Reuters). On the other hand, some sectors might actually benefit from Brexit, or at least remain unaffected (Bloomberg). Sectors that focus on service will “remain largely unaffected”, and those that focus on supplying the UK market will benefit from the decreased import of goods and services. One example is food manufacturing, a key industry in the east of England that is set to thrive because it supplies the UK market. 

A silver lining for the UK
There is a glimpse of a rebounding system of economic governance in the UK (Bloomberg). It has started to improve regulation for businesses and consumers by enhancing competition and technology. Trade-wise, exports and imports to and from the EU have increased to above pre-pandemic levels, signalling a reignition of their collaborations.

My thoughts on the future
In order for the UK to retain its position as a hub in Europe and globally over the long run, it will have to make adjustments and establish new trade relations with other countries and trading blocks. Brexit was majorly supported by the older generations while younger generations supported staying. This could mean that in the future, the UK might choose to return to the bloc once the younger generation takes over unless Brexit proves to be the better decision for them (Bloomberg). Ultimately, the direction of the EU economy will not be as affected by Brexit as it has been by the Russia-Ukraine war. If the EU and UK can come to a consensus on a fair-trade deal, I believe this will be the most beneficial to both parties. 

The Euro-Dollar parity

The overarching theme of the 2-decade low Euro-Dollar: investors buying more USD, causing it to appreciate relative to the Euro. There seem to be 2 main reasons for this – inflation in US and a recession risk in EU.

Russia and Ukraine supply a significant amount of wheat and corn, and Russia itself is also a “major supplier of oil, gas, and metals”. With the war, the supplies of these commodities have sharply decreased, causing a spike in prices (Ellyatt, 2022). Europe was hit particularly hard because of their closer trading relations with Russia. In 2021, EU imported US$168.75 billion worth of goods from Russia, while US only imported US$30.76 billion in that same period (Trading Economics, 2022).

Although inflation hit both regions, peaking in US at 9.1% in June and 8.9% in Eurozone in July (Trading Economics, 2022), only the US was quick to tackle this problem. They increased their Fed Funds Rate from 0.25% in March to 2.5% in July this year. In contrast, the Euro Area only increased its interest rate from 0% in June to 0.5% in July (Trading Economics, 2022). With the higher increase in interest rates in US, investors move towards USD, causing it to appreciate relative to Euro.

The Eurozone is also facing a recession risk (Faller & Landon, 2022). The reduction of oil and gas imported is alarming as these are needed for heating in the coming winter, representing an energy crisis. There is uncertainty in the region, with Italy’s and UK’s prime ministers Mario Draghi and Boris Johnson resigning recently (Faller & Landon, 2022). Due to this recession risk, it will be difficult for the ECB to increase rates which stunt growth.

With the increased interest rate in US and the uncertainty in the EU, investors flock to the safe haven that is the US Dollar (WEForum, 2022).

According to a Cambridge professor, roughly 50% of the Eurozone’s imports are invoiced in USD (O Falk, 2022). With a weakened Euro, their Dollar imports will get more expensive, exacerbating inflation. Households and businesses will feel the pinch, especially if they import their goods and services. The upside is that Euro exports will be cheaper and likely to benefit major Euro exporters like Germany and France, improving their competitiveness (O Falk, 2022). This also includes tourism, which is now “on sale”, prompting increased travel to Europe (O’Brien, 2022).

Food price increase, 2022

40% increase in wheat prices in 2022? (World Bank). You may have noticed, food prices have been increasing over the past few months. CNBC reported that food-at-home prices are expected to increase by 3-4% before 2023, and grocery prices have increased 7.9% in February 2022. The price increase is a general figure, and actual increase varies depending on the type of food. For example, meat and fish are up 13%, whereas vegetables are up at a much lower 4.3%. 

(note that these numbers are specific to the US, and different countries experience different levels of price variations)

Reasons for the price increase:

1) Covid-19. Business shutdowns and country lockdowns strained supply chains, shortage of labour, concerns of food security which caused some countries to limit supply to the global market.

2) Ukraine crisis. Russia and Ukraine account for almost 1/3 of the global wheat and barley market, and majority of the world's export of sunflower oil (cooking oil). Some knock-on effects include other exporting countries to ban their own exports to maintain food security in their countries.

Countries have begun to be more protectionist and reduced reliance on foreign countries during the pandemic. This issue of food shortage will likely spur further protectionism (as already seen in the case of Indonesia banning palm oil exports), and countries already facing a food crisis will likely bear the brunt of the food shortage. Such countries include Somalia, which obtained most of its wheat from Russia and Ukraine in 2021. 

As individuals, we can reduce food waste, help one another out, or even plant some foods of our own. Let's hope things get better ASAP.

Edit: why did the price of meat and fish increase more than vegetables? This is dependent on how the supply chains have been affected. Meat and fish are said to have more labour involved along the value chain as compared to vegetables, which could be a reason for this. Aside from labour shortages, food for livestock are also more expensive now, further driving up the cost.