The important thing is not the fall…

What, after all, is this soft landing that is supposed to open the gates to the heavenly Jerusalem of the Goldilocks scenario, synonymous with disinflation, a resilient economy, falling interest rates and relaxed valuation multiples?

According to Alan Blinder, Vice-Chairman of the FED in the 1990s, it is nothing less than the Holy Grail of the central banker, “the sacred fire of all monetary policy”, he confesses in his latest contribution to the Journal of Economic Perspectives. He refers to the rare instance in monetary history when the FED managed to raise its key rates without causing GDP to fall by more than 1% a year later.

Since 1965, there have been eleven successive monetary tightening programmes in the United States. The bad news for investors is that 70% of these programmes have resulted in the economy going off track and equity markets spiralling out of control: on average, a maximum drawdown of 30%!

On only three occasions has the US economy managed to make a soft landing, (sometimes) limiting the damage done to the markets: -22% maximum for the S&P500 between 1965 and 1966, -14% between 1983 and 1984 and -8.9% between 1993 and 1995. “To pull off a soft landing, with little or no control over economic aggregates, a central bank has to be both lucky and gifted…” concedes Blinder… The ‘parachute’ of the presidential election, which is often credited with raising hopes of a fiscal stimulus, will therefore be of great help to the markets… except that the textile fibre of the emergency device has been somewhat worn out by its frequent use in recent years…

In the cockpit, we’ll be keeping an eye on the warning signs as we approach the runway. This week, the PMI indices for Chinese industry sent us mixed signals about the state of domestic demand and export outlets. Europe, more than the United States, is vulnerable to the economic slowdown of its main trading partner. It is also in the front line when the volatility of energy prices resurfaces: energy tensions remain topical, with the risk of new oil quotas in Saudi Arabia.

Despite rebounding by more than 8% since the end of October, on the back of a greater likelihood that the ECB will cut rates next year (perhaps as early as the first half of the year), European (and emerging…) equities are trading at a near-record discount to US equities. This is a double whammy: the fall in nominal interest rates (against a backdrop of disinflation) has been less beneficial to the expansion of multiples in our stormy latitudes, while the outlook for nominal growth, which has yet to materialise, is cutting significantly into margin and earnings expectations.

Earnings are still expected to rise by 7% in Europe (compared with 11% in the United States!), but profits for 2024 (excluding banks and financials, which have seen the best flows since August 2022!) continue to be revised downwards. The most cautious strategists are expecting a rude awakening the day after New Year’s Eve. They are expecting earnings to fall by up to 15% in the first half of next year. The discounting of European equities, which are not benefiting from Chinese domestic flows or international capital transfers to the artificial intelligence theme in the United States, has been amplified by 38 consecutive weeks of outflows….

After the ECB raised interest rates by 4.5%, the eurozone economies will have to digest the rise in financial conditions. With a lag effect that is difficult to estimate and significant disparities between European economies. You hardly owe your creditor the same thing depending on whether you borrow north or south of the Alps.  The average interest rate paid by non-financial companies exceeds 5% in Italy and 4% in Spain. That’s two points higher than in Germany and France. The conditions for repricing and the average maturity of bond lines are also less favourable in the southern countries.

As a result, investors may once again have to play hardball to protect themselves against credit risk, which is likely to become more pronounced next year. Will France remain in their favour when, for the first time under the Macron presidency, S&P threatens to downgrade the country’s credit rating?

Thomas Planell, Portfolio manager – analyst at DNCA. This article was finalised in December 1st, 2023.

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