Gilles Seurat, Manager of Fixed Income and Cross Assets, La Française AM. (Photo credit: La Française AM)
By Gilles Seurat, Fixed Income and Cross Assets Manager, La Française AM
For investors, 2022 has started on a sour note with almost all asset classes in negative territory. Stocks are suffering, with European indices down -10%. The only equity sectors that are doing so so far are basic resources and energy, which are benefiting from the very strong rise in commodities.
However, the big loser is the fixed-income market, which is doubly penalized by the rise in sovereign “core” rates (10-year German +76bp, 10-year American +96bp) and by the widening of spreads (Investment Grade Euro +42bps, High Yield Euro +92bps). Consequently, the Euro Aggregate index is at -5.42% since the beginning of the year. For stock investors accustomed to double-digit declines, these losses may seem limited. But for bond markets, 2022 is arguably the worst year on record. (Source: Bloomberg as of 03/25/2022)
The two culprits in this poor bond yield are Vladimir Putin, whose war in Ukraine has eroded investors’ risk appetite, and central banks, particularly the Federal Reserve (Fed) and the European Central Bank (ECB). , who have adopted a very harsh policy. stance on inflation. The war in Ukraine raises fears of downward revisions to growth prospects, as well as probable postponements of investment projects. We can already see this through falling demand for consumer credit and visits to real estate in France.
The main objective of central banks is and has always been price stability. However, the Federal Reserve is an exception to some extent, as it has a secondary subsidiary objective, namely to keep unemployment low. Although the ECB and the Fed do not have the same tolerance for inflation, they both react when they see fit, and even with vigor like Paul Volcker of the Fed in the early 1980s or Jean-Claude Trichet of the ECB in the 2000s.
However, during the last ten years, inflation has been very low and central banks had no reason to tighten their monetary policy. It was the opposite! The political pressure to stimulate the economy through monetary easing was great – remember Donald Trump’s court orders on Federal Reserve rate cuts in 2019.
But today, inflation is at its highest level in forty years and political pressure has turned 180 degrees. Governments are now declaring that inflation is the worst of all evils, and central banks are now concerned that they are not getting tough enough. Thus, central bankers are rushing to close their asset purchase programs and start a cycle of rate hikes that should have started much earlier. To get an idea, the Taylor rule recommends a key Fed rate of around 10%, the highest level since the 1980s, a far cry from the current level of 0.5%. This Taylor rule is based on economic fundamentals such as inflation and the unemployment rate, which are at historical extremes. The same Taylor rule applied in the Eurozone recommends a rate for the ECB of 7%. In general, the trend is decidedly upward in rates.
Unfortunately, the war in Ukraine accelerated the upward trend in inflation. In fact, Russia is a very important oil exporter (10% of world production according to Reuters) and the war has caused prices to skyrocket. The same type of comment can be made for many other commodities such as wheat, of which Ukraine and Russia are key producers (respectively 8% and 18% of world exports according to UN Comtrade). The OECD estimates that the war will cost its members an average growth of 1%, and 1.4% for Europe, which is the most affected: insufficient to give up the announced monetary tightening.
In this context, the action of the central banks will not be a support for the financial markets in difficulties, but quite the opposite.
Typically, when fears of a recession sent equity markets down, the Federal Reserve lowered rates and propped up the market. This so-called “Fed Put” safety net no longer exists, or investors would have to anticipate heavy demand destruction with a recession. In this case, the Fed Put strike would be much lower.
What is the outlook for the financial markets? We believe markets will continue to anticipate numerous Fed hikes over the next twelve months. That said, we don’t expect a significant increase in long rates because long-term trends remain valid; High levels of debt, slow population growth and digitization all have downward consequences on growth or inflation and thus on long rates. As a result, the curves should continue to flatten in developed countries. From a geographical point of view, we find euro zone tariffs most vulnerable to a hike due to Europe’s reliance on Russian gas. In fact, the risk of surprises to the upside in 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. Furthermore, investor sentiment on the euro is very negative; the liquidation of short positions should also boost the pair.
INFORMATION DOCUMENT. THIS REVIEW IS ADDRESSED TO NON-PROFESSIONAL INVESTORS WITHIN THE MEANING OF THE MiFID DIRECTIVE. The information contained in this document is provided for informational purposes only and does not constitute an investment offer or solicitation, nor investment advice or a recommendation on specific investments. The elements of information, opinions and figures are considered valid or accurate on the day of their establishment 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 evolution. . They have no contractual value, are subject to change and may differ from the opinions 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 authorized by the AMF under number GP97076 on July 1, 1997.