The political and financial waltz continues. Liz Truss is leaving the government at the end of the shortest term in the country’s history. During the parliamentary session that saw the disintegration of the mini-budget, she appeared inexpressive, resigned… Her departure was telegraphed on both sides of the House: “A Prime Minister in name only”, said the majority and the opposition.
Kwasi Kwarteng (author of the mini-budget that toppled Truss), a 17th century currency historian, will be able to indulge his academic passions once again. Currency movements are historic this year. After the collapse of the euro, and then of sterling which only temporarily greeted the departure of the Prime Minister, the yen is sinking against the dollar to the levels of the lost decade of the 1990s. Interest rate differentials (4.25% at 10 years in the US, the longest bear market since 1984 for bond assets! ) and the current account balance between the two trading partners are no support for the Japanese currency.
Many investors got their fingers burnt in the Japanese markets. The fall of the Yen makes them seem attractive. Unwilling to invest and take on debt, Japanese companies have excessively healthy balance sheets. This apparent virtue is a symptom of a sickly and counter-productive prudence. The lack of reinvestment of this mass of dormant capital is as penalizing for the country as the fragmentation of public and private nuclear regulatory authorities, none of which dares to take the first step towards reviving the nuclear park. The country, the world’s largest importer of LNG, is in dire need of it. Immobility remains the great enemy of the contemplative Empire of the Rising Sun.
As the end of this unique year approaches, the work of strategically building portfolios for the next few quarters begins. Investors need to gain perspective, but the task is made difficult by impending short-term events.
The US elections are important for the bond markets, especially as the final results could take several days or even weeks to be validated after the vote! The risk of a blue wave in favour of an expansionary budget and filibuster reform is not zero and could lead strategists to revise upwards their expectations of terminal and neutral rates from the FED! A stronger steepening of the US yield curve could continue to push the dollar higher despite its historic rise this year.
So how far could US real rates, the cornerstone of international finance, go? At 1.7%, they are already delivering an attractive rate of return and inflation indexation. It is estimated that an additional 25 basis points of upward movement could cost the S&P500 5-6% in performance…
The valuation of the US equity market is not very attractive. Two-year nominal rates (4.6%), which are used to protect portfolios in the event of a recession, offer a higher yield than the S&P500 dividend… Gold is also suffering from high rates and a strong dollar: it lost another USD 1.5 billion over the week.
Like Japan, Europe is unfortunately suffering from many vicissitudes. It is entering the peak period for the publication of corporate results. A quarter of the companies in the Stoxx Europe 600 will unveil their accounts this week. For managers, the challenge will be to discern cyclical changes from new structural trends, among which commodity inflation, rising producer prices and the rebound in wages seem to be set for the long term…
In China, wages are rising faster than in the West. Is there a country capable of replacing the Middle Kingdom as an exporter of disinflation in the world? Vietnam, which benefits from the exile of low-cost manufacturing from China, remains a small country. Its Cambodian neighbour is barely recovering from the 1970s. Indian society does not have the same industrial culture as its Chinese adversary. And even though… the ecological point of no return has been reached, the time of cheap industrialisation that is disconnected from climate imperatives is behind us.
Contrary to expectations, customs barriers are not coming down. Globalisation at half mast will therefore compress cost arbitration for companies. European groups are repatriating their factories to the Maghreb, preferring higher wages and the proximity of their domestic market to the risks of customs duties, logistical pitfalls and slippage in freight costs.
“Lower for longer’ used to be the mantra for real interest rates as central banks persisted with quantitative easing.
“Lower for longer” is now the sentence that is likely to apply to the returns investors can expect on their risky assets.
With higher financial costs, margins are likely to fall. The historically high share of profits in GDP has room to fall. Balance sheets are likely to become tighter, with more expensive, less sustainable debt and lower profit runoff across all items. Asset turnover, inventory turnover, return on capital employed: profitability measures on short or long capital will not be able to be more flamboyant than in the past.
Expectations of returns on equity markets must therefore be lowered. With the withdrawal of liquidity around the world, there is no sign that volatility will follow this direction, quite the contrary. In the face of higher rates, the decline in risk-adjusted excess returns will result in a significant deterioration in the Sharpe ratio. Mechanically, this should point to a decline in the equity class in the strategic allocations of diversified funds.
Thomas Planell, Portfolio manager – analyst at DNCA. This article was finalised in October 21st, 2022.
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