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Will the decoupling of bonds and equities begin?

“The cities that Europe offers us are too full of the rumours of the past […] This is not enough silence” wrote Camus, in love with the calm desert of Algeria. And there is hardly any silence in the big capitals: the airports are drowning under the floods of foreign tourists who are taking advantage of the weak euro, while Europeans are savouring the last sunny days of this first year finally free of any health restrictions… Alas, we have forgotten it a little early, but wasn’t 2022 supposed to be the jubilee of the long-awaited “return to normality? Which is probably why the urban spectacle has nothing to offer anyone looking for signs of an economic downturn in everyday life. No, the torpor of the recession has not yet taken the place of the deafening reopening of the economies, which is still going strong… Moreover, among the first companies to reveal their activity over the last few months, Accenture, the world’s leading IT services and strategy consulting firm, has seen its order book grow by 30% and is forecasting an 8 to 11% increase in its activity for next year.
 
And yet, with inflation at around 9% on both sides of the Atlantic and rate hikes of between 50 and 75 basis points at each ECB, BOE or FED conclave, the tightening of financial conditions is working hard to push us into recession. 
Investors are less concerned about the imminence, which is considered certain, than about the nature of the economic contraction that awaits us: monetary in the US? Energy and industry in Europe? Technical or total? Will it slash profits more than consumption? The optimists see reminder forces: the investment cycle (relocation, energy efficiency, renewables) visible in the robust order books will support industrial activity, whose downturn will not have the violence of 2020 or 2008. But profits will fall: the energy burden, still difficult to quantify, will weigh on margins. However, unlike electricity bills, rising wages have the merit of trickling down to the economy. For some economists (as well as Henry Ford), paying employees is not just an operating cost, it is also an investment… The fact that the historically high share of profits in GDP is shrinking in favour of employee remuneration is not bad news, quite the contrary: it supports consumption. 

For shareholders, on the other hand, the exercise becomes delicate. Most of the work of raising rates by central banks is probably done. Expected to reach 4.6% by mid-2023 in the US and 2.5% in Europe by the middle of next year, terminal rates now have a possible, but reduced, margin of increase: the rise in the cost of capital determined by the central banks is therefore well integrated. What awaits equity investors, however, is a deluge of earnings and cash flow revisions that is likely to take several months. The spike in inflation anxiety will now be followed by a painful but more rational return to fundamentals. The question now is how much of a drop in earnings can be expected: 10-30%? What risk premium should be added for equities at higher nominal rates in 2023? And when will equities be able to hit their final low point from the upcoming peak in rates? With key rates close to 2.50% at mid-year, a normative risk premium of 4.5 to 6% on the equity market requires the asset class to deliver a solid 7 to 8.5% profit return… based on estimated profits, which, for the sake of prudence, should include a significant profit recession scenario… This is enough to lower the “ideal” entry point for the most demanding investors by 8 to 15% on the Stoxx Europe 600… So, the next few months may well see them turn to the bond markets, which are emerging from one of the most violent bear markets in their history. On the eve of a possible recession, government bonds could post attractive multi-year yields provided that the inflation peak is near… And provided that central banks keep their rates below the level that the highly theoretical Taylor rule seems to require. The calculation formula that is supposed to define the level of key rates according to inflation, growth and/or unemployment currently estimates them at between 6 and 9% (according to the ELB, balanced or Taylor & Okun formulas)… 
If these conditions hold and we buy the scenario that monetary policies are starting to soak the economy, auguring 3 to 5 difficult months for equities but endorsing the possibility of a high point on inflation and the first tangible signs of a FED pivot somewhere in 2023, then sovereign rates could finally regain their protective role within portfolios…

The main risk of this scenario echoes the resentment of Camus who wanders through the streets of European capitals: “one feels there the vertigo of centuries, of revolutions, of glory. One remembers that the West was forged in the clamour”, a wind of revolution blows in, […] of vanquished greatness”… The risk is that downgrading, political instability and social unrest will prevail, exacerbated by Vladimir Putin’s uncontrollable determination, whose stubbornness in Ukraine could cause the continent to slide into stagflation… In this case, there is not much, apart from the dollar, that can save European wallets…

Thomas Planell, Portfolio manager – analyst at DNCA. This article was finalised in September 23rd, 2022.

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