Financial markets got off to a good start to the year. Better-than-expected Eurozone inflation data topped by moderating US wage inflation readings, induced a stellar rally across bond sectors. The 10-year US government bond rates led the charge, dropping by 32bp over the week to finish at 3.56%. German 10-year bunds eked out a drop of 36bp, closing at 2.20%. The MSCI Europe net total return equity universe roared ahead by 4.78%. The Eurostoxx 50 led the performance chart, advancing 5.91%. The S&P 500 lagged, rising by a mere 1.45%. More of the same in USD terms: over the fourth quarter of 2022, the European Stoxx 600 recorded its biggest outperformance on record, beating the S&P 500 by an impressive 13%. The 12-month forward P/E ratio for the Eurostoxx 600 index, at around 12, is valued on the cheap side compared to a reading of 17 for the S&P 500. In addition to a promising valuation argument for European equity – with a high loading of value stocks – the universe benefits from being under owned, a weakening USD, and being positively geared to the reopening of the Chinese economy.
Could we have entered a market context where bonds and equities will climb their respective walls of worry?
For bond markets, the wall of worry is represented by the inflation path over the next couple of years. US inflation-linked Treasury markets are optimistic when looking at 1-year and 2-year inflation expectations, which closed at 1.70% and 2.11% respectively. Markets become less worried about US wage inflation as average hourly earnings drop towards 4.6% YoY. US labour markets become less tight as monetary policy, feeding through with a lag, starts to impact. As markets price a terminal rate around 5% over the second quarter, unemployment might jump over 4% and reach 5% by year-end. Under such conditions, US Treasuries can thrive.
In Europe, the inflation equation is more complex. The distribution of inflation figures across Eurozone countries is too wide for purpose. It reveals lack of synchronization in tackling the energy crisis by applying a diverse set of legislative initiatives in order to lower the consumer and/or corporate energy bill. It also reveals a labour market more sensitive to wage inflation compared to the US. Lack of labour mobility, an aging working population, and large skill mismatches increase the probability of wage inflation dynamics taking hold. Second-round effects do worry the ECB, and they show up in still-rising core inflation numbers at 5.2% YoY. US core PCE inflation numbers peaked in February 2022 at 5.4% and have been slowly declining since then, standing at 4.7% today. ECB policy rates will settle (well) above 3% by next summer. 10-year European Union bonds (AA+) offer an appealing yield of 2.90%, reaching highs around 3.25% over Q4 2022. As such, within rates, the wall of worry in the EU is higher than in the US. Track real rates. Real rates in Europe have just gone positive, while they are consolidating around 1.5% in the US in the belly of the real curve.