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Are the markets anticipating an end to the tightening of financial conditions too quickly?

Eighteen months ago, the market did not believe in a rate hike by the FED in 2022. 
It did not envisage a full-scale war on European soil. 
It was more worried about zero covid than an invasion of Taiwan. 
This week, FED Fund futures were up 5% for the first time in this economic cycle. Russian strategic forces conducted their first round of nuclear exercises since the outbreak of the most serious conflict in European history since 1945. In response, the US announced that it was ready to use its arsenal. And several thousand kilometres from the Ukrainian theatre of operations, Xi Jinping’s assertion of dominance over his party raises fears of a new front. The US Joint Chiefs of Staff expect China to soon use force to carry out the reunification of the island and the mainland that the party’s first secretary intends to accomplish “by any means available.”
 
In recent sessions, markets have shown surprising resilience to this accumulation of asymmetric geopolitical and economic risks. With interest rates expected to peak, investors are once again turning their attention to corporate credit. Investment grade and high yield stocks recorded their first positive flows for 8 weeks. 
 
Despite the disappointing results of technology stocks (Alphabet, Meta, Amazon on its cloud part), they are benefiting from a return of capital, the first since March. And while Chinese stocks are suffering from the Communist Party reshuffle, emerging markets are showing the first signs of renewed interest from global managers since April. 
 
Following the extremely pessimistic positioning of the markets, the perception of a less hawkish tone from central banks (FED, ECB, Bank of Canada) explains these portfolio shifts. The dollar is no longer rising (the euro is back above parity) and risky assets are surrounded. 
 
However, the problem of inflation has not yet been solved, especially in Europe. Price inflation is accelerating, particularly in France, where it rose by 7.1% over one year in October. This is 0.6% higher than expected. Such a gap between expected and realised figures is rare in our country. 
 
Despite the fall in gas prices (the shortest maturities even showed a negative price due to a lack of storage capacity!) inflation is not weakening in Italy, where consumer prices are up by almost 12%. At this rate, European inflation risks breaking through the symbolic 10% ceiling. A challenge for the European Central Bank, which notes that the drying up of the bond market caused by its asset purchase programmes is counteracting the tightening of financial conditions… The same is true for the Atlantic, where the rebound in growth in the third quarter exceeded expectations and the new housing market remains vigorous. 
 
On the corporate side, earnings sagged very modestly in Europe, where operating performance remained good in the third quarter. The signs of a sharp decline in earnings expected by strategists in 2023 have not yet materialised. 
 
We are entering a delicate market phase. The hope that drives investors is based on the feeling that the tightening of financial conditions is now sufficient. The reason why this is not yet really visible in the macro and micro economic data is allegedly due to a natural lag effect between monetary action and its consequences on the real sphere. 
 
While it is typical of markets to anticipate these lag effects, sometimes erring on the side of optimism, prudence suggests that we wait for the first concrete signs of a landing in the economy, employment and inflation before acknowledging the end of the tightening cycle. There is a risk that the rebound of the last few sessions, similar to that of this summer, will be one of the bear market rallies that punctuate the phases of long bear markets. In this case, the risk of disappointment could strike all the more violently as risk premiums (the spread between the profitability of equities and 10-year interest rates) have compressed sharply, already falling back below their historical average in Europe. 

Thomas Planell, Portfolio manager – analyst at DNCA. This article was finalised in October 28th, 2022.

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