A few months ago, we used the experience of 2018 as a roadmap for what might happen to the US stock market this year. Today's question isWhether this story script is still a meaningful reference. Our answer is yes.Of course, the overall macro environment is different from that in 2018, so the exact path of policy tightening and the cyclical performance of the economy will also be different, but the important lesson of 2018 is that it usually takes a few heavy punches to knock over the stock market and vent emotions.

Similarities are important.

Figure 1 compares the current S & P 500 with 2018. At that time, the stock market initially sold off on fears of rising interest rates and quantitative tightening, followed by a strong V-shaped recovery, with share prices hitting new highs as economic strength continued to strengthen. In the end, he succumbed to renewed fears of "excessive tightening" of the Fed's monetary policy.

There are some obvious similarities between today and 2018:

The stock market fluctuated in the first quarter of this year on fears that the Fed would tighten monetary policy, on a scale similar to that of early 2018, led by high-valued stocks. Like the V-shaped recovery in early 2018, the stock market has been struggling to rebound since March.

The characteristics of the current US economic cycle are similar to those in 2018, with ISM peaking from a high level and expected earnings per share remain strong, but it is turning around, the labor market is booming and the unemployment rate has fallen below 4 per cent (figure 2).

As early as 2018, the Fed believed that the economy had no problem with rising interest rates and shrinking tables. Today, the fed is even tougher and is expected not only to raise interest rates sharply, but also to shrink its balance sheet by about 1 per cent a month, or 13 per cent a year, as early as next month.

The expected 2-year real rate of return, that is, the 2-year real rate of return adjusted for the 5-year / 5-year forward break-even, rose to about 1% at the end of 2018, causing the stock market to fall. Today, the yield level is 0%. If today's "bottleneck" is lower than in 2018, the stock market could get into trouble sooner than many expected.

Yields on 10-year and 2-year bonds began to hang upside down in 2018. Similarly, the indicator has been hanging upside down in recent months.

It's hard to know exactly what these similarities will bring to the financial markets, but in our opinionTo be sure, shrinking liquidity, peaking economic growth and rising interest rates are unlikely to be a good story for the stock market.

Differences are more important.

Although the similarities are important,But the main differences may be more meaningful in judging the development of the stock market.The most important difference is inflation. In 2018, US and European policymakers were most worried about the risk of deflation, or insufficient inflation.

Today, the overall CPI index is about 8% in the United States and 7.5% in Europe, mainly due to supply disruptions caused by the epidemic. The war between Russia and Ukraine and subsequent sanctions exacerbated supply shortages and led to a sharp rise in commodity prices (figure 3).

Today, policymakers are seen as lagging far behind the inflation curve and are therefore under intense pressure to raise interest rates. Central banks are no longer interested in figuring out whether inflation is "cost-driven" or "demand-driven". Their only goal is to contain it at all costs. How can this inspire confidence that the Fed can achieve a "soft landing" for the US economy?

In addition, economic growth in Europe and China is significantly weaker than in 2018. In Europe, economic growth is being dragged down by the war between Russia and Ukraine, and the worsening energy crisis will weaken economic growth in Europe as a whole.

Judging from the rapid decline in the ZEW economic forecast index and the sharp decline in the stock / bond ratio, the possibility of a recession in the euro zone as a whole cannot be ruled out (figure 4). However, in 2018, eurozone economic growth was in a period of small prosperity, with GDP growth of more than 3 per cent.

Although China's GDP growth in 2018 was affected by Beijing's deleveraging movement and Sino-US relations. The trade war has eased somewhat today, but Chinese manufacturing and consumer spending have fallen sharply. Recently, both manufacturing and non-manufacturing PMI in China have plummeted (figure 5).

Under the epidemic, China continues to resort to closed management to curb the spread of the virus, and the Chinese government has not considered other alternative policies for the time being. Sun Chunlan, China's vice premier in charge of public health policy, declared that "protecting lives and curbing the spread of the virus is the biggest politics", indicating that the government is willing to sacrifice the economy for the sake of a dynamic zero policy. This has greatly increased the downside risks to the Chinese economy.

In short, inflation is much higher today than it was in 2018, but economic growth in the rest of the world is weak. The Fed is under pressure and policymakers are panicking. All of this is usually a bad combination for the economy and the stock market.

Bonds vs stocks: who is right?

The US bond market is clearly worried that the Fed may act too aggressively, plunging the economy into recession, but stocks do not seem to have similar concerns. The stock market is still trading at 20 times forward earnings, and the embedded stock risk premium is significantly lower than the average since 2010 (figure 6). Some clients ask us an interesting question: who is right, bonds or stocks?

The answer is that the bond market is a clearer and more reliable indicator of the underlying state of the economy.

The reasons are as follows:

Although there always seems to be a bear market before a recession, a bear market does not necessarily herald a recession. The stock market can experience a sharp fall, not necessarily followed by a recession. In other words, the stock market is an emotional and chaotic economic discount mechanism.

Will the stock market lead the economy? The answer is no.There is little lag between the stock market's plunge of more than 20 per cent and the unfolding recession. Figure 7 depicts the major bear markets and recessions since 1980. Obviously,Share price declines almost always coincide with economic contraction.

People think that the stock market leads the economy because economic data are lagging indicators. In other words, only with hindsight can these data confirm the economic contraction and confirm a bear market in the stock market. This is the key reason why few equity investment companies can avoid a bear market before the economy falls into recession.

However, the bond market's forecast for the economy is a much calmer indicatorThe upside-down spread between ten-year and two-year Treasury yields always accurately predicts a recession with an average advance of 14 months.The only exception was in 1998, when the yield curve was upside down, but the US economy was not in recession, but the upside down during the Asian crisis in 1998 was very short and lasted less than a month.

Anyway,Although the US stock market has been trying to return to its highs, the overall macroeconomic background has not improved at all. Investors need to pay attention to the message from the bond market: as the Fed tries to catch up with inflation and prepares to drain liquidity, the environment for economic growth and rising share prices is likely to get worse.

Stock strategies: commodities, wars and style switching

The world economy and financial markets have been and are likely to continue to be dominated by rising commodity prices, supply disruptions and the war between Russia and Ukraine.

Before the war between Russia and Ukraine, the oil crisis caused by the ESG movement had already occurred, which not only aggravated the energy crisis, but also pushed up the prices of agricultural products and industrial metals. This clearly benefits commodity producers while hurting net importers.

Chart 8 shows that commodity producers have far outperformed commodity consumers since the start of the year, with Brazil's Sao Paulo stock exchange index surging 34 per cent in dollar terms, while Germany's DAX index is down 16 per cent over the same period.

Note that the key issue is that industrial commodities and oil are usually consistent indicators of world economic activity (figure 9), and overall commodity prices are likely to remain strong until the recession hits the US sometime next year. In the meantime, commodity-weighted markets are likely to continue to outperform the market.

As for strategy, we are still reducing our holdings of stocks and increasing our cash holdings.In the stock sector, we prefer defensive stocks, such as must-have consumer goods and utilities, aerospace and military industries, materials stocks and economic reopening stocks.For global portfolio managers, they should be better suited to commodity-based markets such as Latin America, Australia and Canada.

Is it time to buy US bonds?

Although the volatility of the bond market is still very high, we thinkBond yields are close to highs and a sharp rise in bond prices is brewing.The assessment is based on the following reasons:

With the yield on the two-year note at 2.47%, it is hard to imagine that the Fed would be tougher than it has been discounted.

The price trend is extremely oversold, and historically, bond prices have always rebounded sharply when the total annual return on 10-year bonds has fallen by about 10% (figure 10).

We are rapidly approaching the point where CPI began to soar last year. A higher base effect will begin to slow inflation.

Yields on five-year / five-year forward Treasuries are now higher than the Fed's estimated nominal R-Star (figure 11). When this happens, bond yields usually do not rise further.

Yields on 10-year and 2-year Treasuries have been upside down, suggesting that the Fed's expected path to raising interest rates is likely to be too aggressive for the underlying economy.

Finally, Treasuries are by far the most disliked asset class for investors, and few investors are willing to hold them.

Historically, the leveling of bear markets has been the key reason for the reversal of the curve, and this time is no exception. However, as the economy begins to weaken, the reversal of the curve always paves the way for the decline of the long end of the curve. The challenge now is timing.

There are few signs of an economic slowdown, and the Fed is as aggressive as ever. As a result, the likelihood of a rebound in bonds is low, and the risk of further selling cannot be ruled out. However, in the second half of this year, we believe that the bond market may rebound sharply in the following circumstances:

First, inflation slows down

Second, the US economy is cooling down.

Third, the stock market was sold off again.

Finally, there is quantifying the impact of austerity. The experience of recent decades is that reducing quantitative easing or quantitative tightening (2018) tends to lead to a rebound in bonds.

In short:Although the tough Fed prevented an immediate rebound in bonds, the shape of the yield curve warns that a decline in the long-end curve is inevitable, which could happen in the second half of the year when inflation falls rapidly or the US economy slows sharply. The strategy is that bond investors can consider gradually increasing the duration when prices are low.

A world of two dollars

The dollar has recently shown two very different trends.Although DXY is very strong, the overall trade-weighted dollar trend is much weaker.（图12）。This difference is rare in modern history and mainly reflects the deviation of policies, economic performance and terms of trade between countries.

The strong DXY reflects the Fed's tough stance that the economies of Europe and Japan are much weaker than those of the United States. It also has a lot to do with Europe and Japan as net energy importers and is therefore affected by rising commodity prices. On the other hand, the United States has become self-sufficient in energy.

Commodity currencies have benefited from rising prices and the war between Russia and Ukraine. The Brazilian real and the South African rand have risen 14 per cent and 7 per cent respectively this year, while most other commodity currencies have also appreciated. Even the Russian rouble has recovered most of the territory lost after the outbreak of the war between Russia and Ukraine.

Looking ahead, we are not sure whether investors will be able to make a lot of money from these existing trends. Many currencies are already reflected in trading prices and are currently in the position of key technical indicators. The yen, for example, has fallen by more than 20% since 2021 and is at a level ready to rise. The euro also fell to a key level where there could be a sharp rebound.

The central catalyst for the rise of these major currencies against the dollar is a change in the Fed's hawkish stance or a weakening of the US economy.

Long Mexican peso

A better strategy is to tap into some potential pricing errors. Although commodity prices have been strong since February, the Mexican peso has barely responded, while the Brazilian real has risen explosively. The premise, of course, is that the real falls even more during the Covid-19 shutdown in 2020 and is much cheaper than the Mexican peso. However, in our view, after a long and sustained rise in the real, the Mexican peso looks cheaper, especially on the basis of the real effective exchange rate (figure 13).

Therefore, the logic of long Mexican pesos is unobstructed. It is worth noting that Mexico's short-term interest rate is 6.5% and CPI inflation is 7.4%, while the US policy rate is expected to reach only 2.5% within two years.

Be long Mexican peso and set closing position at 22.