Gilles Seurat, Fixed Income and Cross Asset Manager, La Française AM. (photo credit: La Française AM)
By Gilles Seurat, Fixed Income and Cross Asset Manager, La Française AM
For investors, 2022 has started sour with almost all asset classes in negative territory. Stocks are struggling, with European indices at -10%. The only equity sectors that are doing so far are basic resources and energy, both of which are benefiting from the very strong rally in commodities.
The big loser, however, is the bond market, which is doubly penalized by the rise in core sovereign yields (10-year German +76bps, 10-year US +96bps) and the widening of spreads (Investment Grade Euro +42bps , High Yield Euro +92bps). As a result, the Euro Aggregate index has stood at -5.42% since the beginning of the year. For equity investors accustomed to double-digit declines, these losses appear limited. But 2022 may be the worst year on record for bond markets. (Source: Bloomberg per 25-03-2022)
The two culprits of this bond underperformance are Vladimir Putin, whose war in Ukraine has worsened investors’ risk appetite, and the central banks — notably the Federal Reserve (Fed) and the European Central Bank (ECB) — which have taken a very tough stance. about inflation. The war in Ukraine is raising fears of downward revisions to growth prospects and likely postponement of investment projects. We are already seeing this in the declining demand for consumer credit and the visits to real estate in France.
The primary objective of central banks has been and has always been price stability. However, the Fed is an exception to some extent because it has a second secondary goal, which is to keep unemployment low. While the ECB and the Fed do not have the same tolerance for inflation, both react when they see fit, and even with decisiveness like Paul Volcker of the Fed in the early 1980s or Jean-Claude Trichet of the ECB in the 2000s. .
Over the past decade, however, inflation has been very low and central banks have had no reason to tighten their monetary policy. It was the exact opposite! The political pressure to stimulate the economy through monetary easing has been strong: think of Donald Trump’s orders on the Fed rate cuts in 2019.
But today inflation is at its 40-year high and political pressure has turned 180 degrees. Governments are now declaring inflation the worst of all evils, and central banks are now concerned that they are not getting tough enough. That’s why central bankers are rushing to exit their asset purchase programs and begin a cycle of rate hikes that should have started much earlier. To get an idea, the Taylor rule recommends a key rate for the Fed of around 10%, the highest level since the 1980s – far from the current level of 0.5%. This Taylor rule is based on economic fundamentals such as inflation and the unemployment rate, both of which are historically extreme. The same Taylor rule applied in the eurozone recommends a rate for the ECB of 7%. Overall, the trend is resolutely upward in rates.
Unfortunately, the war in Ukraine has accelerated the upward trend in inflation. Russia is indeed a very important exporter of oil (10% of world production according to Reuters) and the war has caused prices to explode. The same kind of comment can be made for many other commodities such as wheat, of which Ukraine and Russia are the main producers (8% and 18% respectively of world exports according to UN Comtrade). The OECD estimates that the war will cost its members an average of 1% growth, and 1.4% for Europe, which is hardest hit: not enough to give up the announced monetary tightening.
In this context, the actions of the central banks will not help the financial markets in difficulty, on the contrary.
When fears of a recession drove equity markets down, the Fed typically cut interest rates and supported the market. This safety net called the ‘Fed Put’ is gone, otherwise investors would have to anticipate a sharp drop in demand with a recession. In this case, the Fed Put strike would be much lower.
What is the outlook for the financial markets? We believe that markets will continue to anticipate numerous Fed rate hikes over the next 12 months. That said, we do not expect a significant rise in long-term interest rates as long-term trends remain valid; high debt, slow population growth and digitization have downward consequences for growth or inflation, and therefore for long-term interest rates. As a result, the curves in the developed countries should flatten further. Geographically, we find eurozone interest rates more vulnerable to a rise due to Europe’s reliance on Russian gas. Indeed, the risk of upward surprises on inflation is greater than in the United States. And if euro rates rise more than their US counterparts, then the euro should appreciate against the dollar. In addition, investor sentiment about the euro is very negative; unwinding short positions should also drive up parity.
INFORMATION DOCUMENT. THIS NOTE IS INTENDED FOR NON-PROFESSIONAL INVESTORS WITHIN THE MEANING OF THE MiFID DIRECTIVE. The information in this document is for informational purposes only and does not constitute an offer or solicitation to invest, nor an investment advice or recommendation on specific investments. The information, opinions and figures are deemed to be valid or accurate on the date of their incorporation, in accordance with the economic, financial and stock market context at the time and reflect the current sentiment of the La Française Group on the markets and their developments. They have no contractual value, are subject to change and may differ from the views of other management professionals. It is also recalled that past performance is not indicative of future performance and is not constant over time. Published by La Française AM FINANCE Services, with registered office at 128, boulevard Raspail, 75006 Paris, France and approved by the ACPR under number 18673 as an investment company. La Française Asset Management is a management company approved by the AMF on 1 July 1997 under number GP97076.