During the worst moments of the pandemic, we tried to imagine the post-covid world: more virtuous, greener, less globalized, more cautious about the well-being of individuals… Wishful thinking: this year 2022, which is coming to an end, marks the return of a certain global radicalism. It will therefore be remembered in several respects: the return of war in Europe and a very high level of international geopolitical tensions, inflation at levels unimaginable until recently, at the highest level in 40 years, economic slowdown, social tensions and the decay of political powers everywhere. And the culmination, reopening of coal-fired power plants in Europe in the area that wants to be the greenest. Central banks, this time, could not intervene procyclically: they were forced to tighten their monetary policies to counter inflation with the aim of curbing aggregate demand. The first part of the year was therefore characterized by a simultaneous “Bear Market” between equities and bonds, which is also quite rare in financial history.
In this very anxiety-provoking context, the strong rebound of the markets is impressive. It is based on a more positive potential scenario for 4 main reasons:
1 – Inflation will begin to fall. The bottlenecks stemming from the reopening of economies in the wake of the Covid pandemic are fading. For example, the cost of transporting a container between Shanghai and Los Angeles has dropped by more than 80% this year and is almost back to 2019 levels. At the same time, commodity prices are stabilizing and base effects will help stabilize price increases. There remains the “salaries” parameter. They tend to rise and unemployment rates remain very low in both the United States and Europe. But the slowdown caused by tighter monetary and fiscal policies should eventually weigh on employment and thus limit wage increases.
2 – Under these conditions, interest rates should now stabilize. The price of all other assets should therefore no longer be penalized by the rising rate factor.
3 – Then, from mid-2023, markets should focus on the expected recovery of activity in 2024, as the recession or slowdown in 2023 is expected to be shallow. They were created somewhat artificially by tighter monetary policies and soaring energy prices in the wake of the war in Ukraine and the closure of supplies from Russia. This brutal shock will take some time to be resolved but, gradually, new circuits will be set up with other suppliers, including American liquefied gas. In addition, China will be in the recovery phase in 2023, as will Asia as a whole. Signs of reopening of the Chinese economy and relaxation of the “zero Covid” policy are indeed multiplying. The government seems willing to support the economy, notably through measures to support the very depressed real estate sector for 2 years.
4 – Finally, geopolitically, the year cannot be worse than the one we have just experienced. The war in Ukraine has been balanced by Western, and especially American, weapons, and Russia should not use nuclear weapons: even China, a country declared friendly, has condemned the potential use of such an extreme. A negotiation scenario therefore does not seem to be excluded. As far as China is concerned, the example of Western sanctions and the West’s military supremacy should also calm the possible eagerness to seize Taiwan. China should focus on reviving its economy to calm the popular discontent that is beginning to manifest itself throughout the country.
Overall, we support this positive scenario for 2023. We expect long-term bond yields to stabilize slightly above current levels, around 4.0%/4.5% on the US 10-year and 2.0%/2.5% on the Bund. Indeed, we think that bond markets are a little optimistic by anticipating a relaxation of money rates at the end of 2023, which seems random to us. Rather, we believe that Central Banks will pause for a fairly long time before possibly easing monetary policies. Equities could rise over the whole of 2023. Overall valuations are reasonable, and from mid-2023 investors could start pricing in a rebound in corporate earnings in 2024. In geographical terms, we believe that Chinese equities offer the most potential: they remain very undervalued in absolute and relative terms and could benefit from the expected economic recovery in the country.
There are two main risks, however:
- The most important is a continuation of the rise in inflation, with China’s recovery leading to a rise in commodity prices. In this case, the terminal rate of the Fed Funds would no longer be around 4.5% but could reach the zone of about 6.0%, resulting in a violent rise in bond yields. This would have a strong impact on asset prices, including shares.
- The other risk would be a deeper recession than initially anticipated. Bond markets would rise, but equities would be hit hard by downward earnings revisions.
We maintain a neutral assessment on equities and take our overall constructive view on bonds to a notch. Whatever the scenario, we believe that recent market movements have been a little too strong and call for at least a pause or even consolidation.