Twilight Struggle

With the defeat of the Law and Justice party, Poland is closing ranks with Brussels.

But the diplomatic rift is deepening between the “North” and what some still refer to as the anachronistic and clumsy “Global South”, angered by the Western bloc’s automatic support for Israel. A godsend for Putin, whose attempts to unite around an anti-G7 axis were hampered by the war in Ukraine.

In this atmosphere of the twilight of the Pax Americana, global managers are facing “the most threatening and uncertain geopolitical environment they have ever experienced”, in the words of Paul Tudor Jones, who adds that, at the same time, “the United States is in its most precarious fiscal deficit situation” since the start of the first Cold War. Against this backdrop, Bank of America’s market sentiment indicator is extremely pessimistic.

The problem is that government bonds, the historical shock absorbers of portfolios, are no help at all.

In August 2011, despite S&P’s downgrading of the US credit rating, US sovereign bonds played their part, while the equity markets (down 13% for the Stoxx 600 Europe) were suffering from the effects of the euro crisis. Not so in 2023. Despite 36 consecutive weeks of buying, the fall in yields the day after the Hamas attack (-30 basis points on the US 10-year yield) was short-lived. The bond sell-off that followed pushed US yields to their highest levels since 2007 (5% for 10- and 30-year yields). Among the sellers was China, which sold off $21.6 billion of US assets in August, the most in four years.

The third global debt crisis occurred in 1981. For the next 10 years, Washington conditioned its aid on borrowers implementing pro-market reforms. As Hal Brands notes in his Twilight Struggle, the US doctrine was that debt “could and should be used as leverage”. Are the roles changing?

This is not the message being sent by the foreign exchange market. The hegemony of the greenback does not (yet) seem to be in question, despite the 33,669 billion in public debt. Since 2008, at 106.2 points, the Dollar Index has risen by 50%. Against a backdrop of pressure on hydrocarbon prices, the country’s market share (now the world’s leading producer of natural gas and oil!) is perhaps not unrelated to this phenomenon. Is the dollar a commodity currency?

The strength of the greenback is not stopping gold from rising. It is approaching $2,000, a robust performance given that the barbarian relic generally suffers when real interest rates are high (2.5% for 10 years today!). Of course, geopolitical tensions explain a large part of the gains. But they are not the only reason. The question of whether the market or Powell is steering rates remains unanswered, and it is adding to the nervousness.

Powell, who spoke this week, is sailing in the dark, trying to convince people that his inaction is a sign of prudence. Monetary tightening has been extraordinarily rapid, but the Chairman echoes Milton Friedman when he reminds us that monetary policy has a lag effect on the economy, although he cannot quantify the duration. “It’s been a year since the last 75 basis point hike”… “We should be seeing the first effects, and not all of them at the same time”.

This is true. On the one hand, default rates for small businesses and households on their consumer loans are rising, and mortgage rates are sometimes in excess of 8%, increasing the burden of debt for households. And yet, since the last FOMC meeting, retail sales have defied pessimistic expectations, job creation is accelerating again, and super-core inflation rose in September, followed by 10-year break-even inflation, back to 2.5%. As a result, the likelihood of a US recession is receding and the market is once again sceptical about the Fed’s ability to bring inflation back to target. Against this backdrop, Powell is likely to pause again at the beginning of November, without suggesting that the end of the rate hike has finally come. He concludes: “Clearly, monetary policy is not currently too tight”.

Against this backdrop, investors are likely to find it difficult to focus on the fundamentals of companies as they begin to publish their quarterly results.

The previous season ended with around forty profit warnings for Stoxx 600 Europe companies.

The third of the year has barely begun, with around fifteen of these profit warnings sanctioned by an average drop of 17% on the same day. Disappointment over organic growth and margins has hit companies of all sizes, with LVMH shedding 10% since its publication. At 4% (more or less the €STER rate!), the return on free cash flow as a proportion of the group’s enterprise value is in line with its average over the last 10 years. But will the interest rate regime over the next decade be as benign as in the past?

Similarly, the valuation of Birkenstock (which operates in the ultra-competitive footwear market) at more than 6 times sales (a level worthy of the software sector) has reminded the market that the largesse of the 0% interest rate era seems at least temporarily over, with the share price shedding 20% since its flotation on 10 October.

In search of yield and resistance to geopolitical tensions, equity investors are turning to diversified oil companies. The stoxx600 Oil & Gas (between 11% and 15% free cash flow yield on average) is widening its gap with the rest of the market (+5.5% positive relative performance since the start of the year). Although far from being risk-free assets, oil companies should this year (along with banks) be the mainstay of earnings growth for European indices. They are also attracting US funds. More and more of them are buying into Total Energies, for example.

Thomas Planell, Portfolio manager – analyst at DNCA. This article was finalised in October 20th, 2023.

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