Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Volatility markets remain calm; China invokes “whole nation system”
Peter Garnry
Chief Investment Strategist
Summary: Equities traded lower yesterday responding to higher US bond yields setting the back on edge ahead of the ECB rate decision tomorrow. The US services sector is still red hot and thus the market is adjusting its expectations for the US policy rate suggesting financial conditions will be tightened further. We remain defensive on equities and the calmness in the VIX forward curve suggest plenty of room for downside moves. In China, the country is invoking the "whole nation system" policy in a response to the US CHIPS Act and the US restrictions on Nvidia to sell its most advanced AI chips to China bolstering our view that the world is accelerating into a bipolar world.
Equity sentiment remains negative but orderly
S&P 500 futures fell to the lowest low since mid-July in yesterday’s trading session as a better than expected ISM Services Index print for August showed that the US services sector remains very strong despite tighter financial conditions. The market immediately pushed US yields higher and the forward curve on the Fed’s policy rate shifted lower indicating the market expects higher policy rates and fewer cuts next year. Equities are naturally responding to higher bond yields and stronger USD is causing havoc in emerging markets which are looking weak. The next test is tomorrow’s ECB rate decision with economists expecting ECB to hike the main refinancing operation rate from 0.5% to 1.25% making it one of the ECB’s most aggressive moves in its history.
The VIX forward curve has gone from being in steep contango, very bullish with the spot trading significantly below the 2nd VIX futures contract, to being flat suggesting increased stress but nothing extraordinarily yet. Since the drawdown in global equities started we have not yet seen the full capitulation. Our best guess is that we will not hit the definitive bottom in global equities until the economy is in a recession, the Fed pivots on policy rates, and we have had a capitulation.
China confirms the direction is a bipolar world
In a speech today China’s President invoked the “whole nation system” used previously in the country’s space programme and Covid vaccine drive during the pandemic. The comments are likely a response to the recently enacted US CHIPS Act which aims to quickly establish broad-based production of semiconductors in the US, but the recent US restrictions on Nvidia to sell its most advanced AI chips to China. More and more pieces are pointing towards that the world is accelerating into a bipolar world in which global supply chains will be drastically reshaped. Globalisation only works if there is peace and mutual understanding of trade relationships, but when the two leading powers of the world are no longer in agreement globalisation no longer works. It is simply to risky for global supply chains to be to spread out and dependent on each other. Just like Europe learned that its dependence on Russian gas was a mistake geopolitical, the US has come to the conclusion that semiconductors should not be produced in Taiwan because it is a key risk to the US military and technology sector.
Germany’s Foreign Minister Baerbock said yesterday in a speech with business leaders that Germany has learned the lesson from Russia and that these learnings will guide its relationship with China. In other words, exports should not be too dependent on China. Again a confirmation that the world is changing fast these years. Germany is potentially one of the biggest casualties in the reshaping of globalisation being hugely depended on exports in its economy.
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