Surge in rates hits every assets
With the Federal Reserve (Fed) and other central banks embarking on their most-aggressive tightening campaign in decades to rein in red- hot inflation, with the risk to send the economy into a recession, it is a particularly difficult environment for investors, with bonds and stocks sinking in tandem this year (-17% in euro).
As bonds hate inflation and equities hate recession, the MSCI World All-Countries index of global equities has lost7% in euro (versus -18% in USD) so far this year on a total return basis and the Bloomberg bond gauge has lost 10% in euro (versus -17% in USD). The global shift away from easy money – 85% of central banks are in tightening mode - and rising borrowing costs, but also the energy crisis in Europe, Covid lockdowns in China, the war in Ukraine and the geopolitics instability have prompted investors to reassess all financial assets, leading to the fastest valuation contractions for stocks and bonds since 2008.
The key driver of investor angst remains the Fed’s determination to make monetary policy restrictive until price pressures are conquered. The thinking among investors is that a hawkish-at-all-costs Fed is increasingly determined to engineer tighter financial conditions via lower stock prices and higher bond yields. The 10-year US Treasury yield (3.4%) is around the highest since 2011 amid a bond selloff exacerbated by bets on other Fed interest-rate hikes, after a monetary tightening of 3% since mid-March. Fed Chair Powell continues to use Paul Volcker as his guidepost for Fed policy in 2022. In a question, Powell said that Volcker acted after “several failed attempts” to get inflation under control in the 1970s. And he said the Fed is working to prevent that outcome straight away so that it doesn’t have to act as aggressively as Volcker did. These remarks strongly suggest that the Fed will hold the Fed funds rate at a restrictive level for a considerable period of time until inflation falls much closer to its 2% target, something the Fed of the 1970s did not do. The market’s expected peak in the Fed’s policy rate remains around 4.4%.
As US financial conditions are looser than when tightening started, the Fed will accelerate its efforts to trim its balance sheet. And that risk to add even more weight to equity and bond prices. Stabilize inflation around 2% without boosting unemployment and causing a recession is indeed a great challenge for the Fed!
In another sign that the free-money era is no more, US real rates (or the yield on inflation-protected securities), which are seen as the true cost of money for borrowers -, are again breaking out. After being trapped in negative territory during the lockdown days, 2-, 5- and 10-year measures are back in positive territory (between 0.7% and 1%).
The prospect of aggressive Fed monetary tightening lifted a dollar gauge to another record, and that is also hurting risk assets. In a world where central banks are aggressively hiking rates (bad for fixed income) in order to tighten financial conditions (bad for equities), then one of the only place to hide is in USD cash.
A lot of economic data are looking really uncertain so that usual offset to higher real rates - the economic optimism - just isn’t there. Among fundamentals that are keeping risk assets on edge, August’s global composite PMI’s print in recession territory (49.3), inflation expectations are rising again and a threat to dividends and buybacks (especially in Europe) are looming as corporate margins come under pressure.
Strong (but less strong than in June) commodity prices, driven by both the impact of Russia’s invasion of Ukraine and the strains imposed by extreme climate events, are indeed acting to keep cost pressures elevated around the world, even as they also weigh on growth. A year into Russia manipulating European gas supplies, the market is finally convinced that Moscow will continue to do so, and perhaps with greater intensity as Russia’s Gazprom decided to keep the Nord Stream gas pipeline indefinitely offline.
Concerns are thus growing about the outlook for companies earnings given the various global economic headwinds. The number of negative earnings revisions are higher than the number of positive earnings revisions since the end of February. The ratio is now at a 2-year low and a net 92% of fund managers in the monthly Bank of America survey now expect profits to decline in the next year!
That suggests investors in just about every asset class risk higher volatility, as yields on 10-year inflation-protected securities are moving closer to levels that would materially restrict economic activity. The next few months for equities will be bumpy and there is a risk of further drawdowns if this dynamic of rising real yields with decelerating growth continues. The latest yield surge with echoes of the June tumult began when Jerome Powell surprised investors at the Jackson Hole symposium with a somber message that borrowing costs will need to go higher and stay in potentially growth-restricting territory to get inflation down. Since then, 10- and 5-year real rates in the US have advanced some 30 and 38 basis points while the MSCI World All Countries index has plunged 8%. It is likely that any push to new multiyear highs in real yields would likely correspond with a new leg down in stocks.
All this is bad news for fund managers across the board, with rate-sensitive allocations harder to justify from growth stocks (especially tech stocks) to long-maturity corporate bonds (especially among high yield bonds).
- Looking ahead, downside risk probability remains high while the inflationary environment is confirmed. Taking into account factors that may bring volatility in the short term (Central Banks communication, news flow related to the energy crisis, some global macro weakness etc.), we have shifted to a more cautious stance (with a “neutral” exposure) on equities. If inflation continues to outpace GDP growth, it will raise the specter of a bear market for equities in which valuations remain suppressed and limit stock-price upside. US equity bull markets are typically marked by periods when the real economy grows faster than inflation. Consensus suggests the latter is likely to run hotter than GDP through at least 1H23, with uncertainty rising about both projections. Major bear markets of the past half-century were accompanied by inflation outpacing growth, such as the rapid jump in prices in the 1970s.
- The steady ascent in global stock duration over the past two decades indicates greater sensitivity to interest-rate increases than in the past, and as a result global equity markets are suffering severely as rates rise. Ten years ago, the average global stock had a duration of 13 years (median 15.3). Now, the amount of time it takes, in theory, to get paid back for an initial investment (given cash-flow forecasts) is 15.7 (18.8).
- This acute sensitivity puts the most pressure on the world's highest-duration stocks. That is why long-duration stocks (mainly growth stocks such as IT and Communication Services) have been some of the market's weakest links this year and are likely to keep underperforming short-duration peers (mainly value stocks such as Energy or Financials) if rates keep rising. Risks to the macro environment are thus skewed in favor of value stocks, which have historically outpaced growth when inflation peaks and the Fed is engaged in a hiking cycle. In addition to the benefit to Financials from rising rates, weakness in the euro and sterling provides a boost for dollar earners, many of them being found among oil majors that also gain from strong commodity prices.
- At the same time, we keep also a defensive bias by overweighting defensive versus cyclical stocks and by overweighting the US versus Europe. Although we continue to see deceleration in the US, it remains far more resilient compared to Europe. With contracting margins, squeezed consumers, and decelerating economic activity, there is a limit to how much pricing power and top-line growth companies can deliver. In the past, the relative performance of cyclicals bottomed on average one month after a PMI trough, and we are not there yet. In other words, defensive companies, such as Healthcare which, thanks to their lower sensitivity to economic conditions, pricing power, high dividend income or low volatility, have outperformed cyclical stocks by almost 13% (in euro) since the beginning of the year, should keep the lead.
After a strong correction, bonds are back, but an active approach is paramount given the still high uncertainty. After the great repricing in the first half of the year, yields are now more appealing. Investors looking to protect themselves against more market turmoil could start to be less negative about “blue chip” bonds as yields on investment-grade bonds (sovereign and credit) average now 3.3%, compared with an average dividend yield of about 2.3% for stocks in the MSCI World All Countries index. The current gap between the two yields, of about 1%, is the widest since 2008! In the US, where the rate hike is the strongest, the gap (2.6%) is even wider! This should be welcomed by investors reeling from the worst drawdown for global bonds since at least 1973 as the worst of the historic rout is likely over. The “TINA” (“There Is No Alternative”) mindset that has been dominating asset allocation over the past few years, favoring equities over bonds, is clearly gone now as bond yields look more attractive, as risks of recession are weighting on dividend expectations.