While sovereign rates had followed the advice of Mrs. Lagarde on the month of December, it seems that investors have decided to no longer trust her at the beginning of the year and we have observed impressive tightening over this first fortnight: the German 10-year rate evolving from 2.6 to 2.10%, the Italian rate rose from 4.7% to 3.9%.
While rates, like trees, cannot, it is true, climb indefinitely after their strong rise in 2022, we are nevertheless surprised by this movement, which we will consider erratic and unsustainable. We will give you in this weekly some notes on this subject.
Many international and even European investors systematically link European rates to US rates, which is generally true in the very short term, this time horizon being essentially driven by market flows. This coupling of interest rates and more generally of financial markets is much less true in the medium long term, as shown by the past decade, as evidenced by the graph below.
Evolution of the S&P 500, Stoxx 600 and US and German 10Y rates between 2012 and 2022
It is precisely this perception of an excessive coupling of the American and European situations that leads to this tightening, as investors often consider the Eurozone as a derivative of the USA. However, investors in the US are currently anticipating a relatively strong rise in rates for the coming months, immediately followed by a much more convenient policy, constrained by a rather strong recession and therefore a fairly close rate cut in the USA, then, by derivative, in the Eurozone.
This seems premature on two levels:
- US statistics show for the moment few signs of weakness despite the recent rate hikes of the Fed and its balance sheet reduction: unemployment remains low, consumption solid, few signs of major crisis are observable in companies as could be the case in 2000 or 2007, except perhaps the still very high valuation of technology stocks from the pure point of view of P/E or more generally. equities versus bonds (see graph below)
Share of listed companies with Dividend Yield > Credit Yield
Indeed, if the world today suffers from a colossal inflation of raw material and energy prices, let us not forget that the USA:
a/are endowed with raw materials and in particular petroleum,
b/benefit from an industrial and technological fabric with very high added value to limit the impact of the price of these raw materials.
Finally, many companies have accumulated such a competitive edge and such amounts of cash that they can approach the current crisis with confidence. (see below)
Several members of the Fed have warned the markets in the past weeks by saying that the recession does not seem, for the moment, to become clearer and that it was therefore premature to anticipate rate cuts by the Fed.
2. The situation of the Eurozone is totally different from the American situation, at almost all levels as shown in the table below.
From this table we will highlight two major points:
a/ if the Fed clearly has growth and unemployment as objectives of its mandate, which could lead it in case of to temporarily divert from its objective of moderate inflation to practice an accommodative policy, this is not the case of the ECB which has only one objective: inflation at 2%. accompanied by a continuation of inflation would not necessarily push it to change its rate hike trajectory, Germany’s weight on this subject being major and the diffuse political power of the Eurozone having more difficulty twisting the arm of the ECB than the central power of the USA that of the Fed.
b/ inflation in the USA is endogenous and linked to the traditional vectors – growth, employment – of a reducible inflation by a restrictive central bank policy. Conversely, inflation in the Eurozone is exogenous and essentially linked to raw materials and other imported products as well as to the drastic fall of the Euro. The ECB’s ability to absorb this inflation is therefore very limited and if we have recently observed price falls in many of the underlying inflation and a rebound in the Euro, it is quite premature to think that inflation will not experience a second round on 1/ consumer prices, 2/ wages, driven by increasingly numerous and violent social crises.
Finally, let us not forget that the ECB must and will have to manage the particular situations of each European country through a common policy, which cannot lead to an effective result. The USA took 4 or 5 years to get out of the subprime crisis, the Eurozone is never really before experiencing two new crises back-to-back… it is likely that it will be in the same situation for the next decade and that the ECB will have a hard time with:
- Italy has 150% debt to GDP and a trade balance that collapses due to the price of energy (Italy is the world’s 4th largest importer of electricity)
- The France and its difficulty in restructuring and renovating aging fiscal, social and budgetary systems
- Germany, former locomotive of the Eurozone, suffering from its industry and wishing to take advantage of its cash cushion alone.
A lot of uncertainty and a propensity of the financial markets to think that the Eurozone is as agile and fast as the USA, which the past has contradicted almost systematically…
Beware of sovereign rates, beware of bonds that are too long and of good credit quality whose current yields will barely absorb a small unexpected increase of 100 basis points spread between rates and credit spreads as evidenced by the small simulation below.
Iboxx IG yield: 3.7%
Gap of 100bps = -4.4% + carry = -0.7% over the year
As always, markets move very fast and the fear of missing the train at the beginning of the year is, on a recurring basis, a powerful force of conviction for investors. But let us not forget that the forces involved, central banks, geopolitics (Russia and China in particular), sovereign debt (a fortiori Italy whose trajectory is worrying, in parallel with a reduction in the ECB’s bond purchases in the coming weeks) and weakness of the European economic fabric in the face of the international market are long-term vectors that it is hard to believe that the financial markets can erase them in a few weeks… Yet this is what they have done on the equity markets with an increase of almost 10% at the beginning of the year, even though the uncertainty about the results is major and the outlook not as exciting as it was at the beginning of 2022, pre-Ukrainian crisis…
For our part, we continue on a comparable positioning at the end of 2022:
- Increase in financials, well capitalized and benefiting from rate hikes, against High Yield
- Increase in hybrids in the face of High Yield
- Moderate duration without sovereign exposure or specific hedging due to high carry
- Reduction of sectors sensitive to inflation and/or recession (leisure, fashion, heavy industry, chemicals,…)
- Increased granularity
- Increase in idiosyncratic credit situations, little related to macro uncertainties, the main vector of volatility for the coming weeks and months.
This positioning, by its carry well above the indices should allow 1 / to absorb volatility, 2 / to compensate for the lower duration by additional credit, better controlled by increased communication with companies just as cautious as investors in the current context, 3 / to offer a potential return to better fortunes in the face of the capital losses of 2022 more easily apprehendible, as shown in the table below.
Matthieu Bailly, Octo Asset Management