Were we too quick to claim victory over inflation?

Finally, the publication of the US consumer and producer price indices has unearthed the axe of the war on inflation. 

FED rate swaps are adjusting upwards: up to 5.3% expected in July, more than 60 basis points above the Bank’s effective rate. Loretta Mester (Cleveland Fed) openly supports a further 50bp hike. The probability of a first rate cut at the end of the year is decreasing. Schnabel (ECB) thinks that the markets are too complacent about inflation. 

US 1 year breakevens (short term inflation expectations) are rising to the highest level since last October (over 2.9%). 
Logically, yields are rising at all maturities of the curve, sometimes to their highest levels of the current year.
Since the low points (1 February) of its 4-month drawdown[1] (-11.3%), the dollar index has recovered 3.2%…

Are these figures enough to shake the market’s current belief that peak inflation is behind us?

Not yet. But they do show that the speed of disinflation is already slowing down. 
This bodes well for a scenario that is certainly not the worst case scenario… but not the ideal roadmap (Goldilocks[2]) that investors would like to follow.

They would have to deal with the less harmonious score of a “no (soft) landing” in which inflation moderates in a cacophonous manner, surprisingly rising and falling at times, without falling back significantly (no remarkable rise in unemployment). 

If this music is not that of a new episode of war embarking central bankers against price slippage, it is not a call to smoke the peace pipe. 

On the whole, it helps to justify persistently higher rates, which are not conducive to the expansion of equity[3] valuation multiples. 

Without a clear upturn in GDP growth, and therefore earnings, the upside potential of equity markets (some of which, like the CAC40, are setting new records) is diminishing. With a risk premium two standard deviations below its five-year average (4.8%), the valuation of the MSCI Europe (based on the Bloomberg consensus earnings forecast for this year) is less attractive than at the end of last year…

In this context, the dividend and shareholder return approach can protect the portfolio from the dark scenario of the 1970s, a lost decade for the asset class. 

In addition, investors will have to keep an eye on commodities and oil in particular, which has been in negative territory since the beginning of the year. 
This move may surprise the observer who focuses on fundamentals. The decline in the probability of recession in the West, the reopening of China, the drop in production in Russia (500k b/d) not compensated by Opec: apart from the fragility of growth, everything points to higher oil prices…

Nevertheless, commodities as a whole have declined with the fall of the dollar, which is supposed to mechanically increase the price of real assets.
Are they part of a more pessimistic scenario than the equity markets, which are hovering around their highs since January 2022?
This would not be the first of the contradictions that investors have seen this year. 
For the past six months, while the ISM[6] manufacturing index remains weak and economic sentiment (as measured by the European Commission) has only just begun to rebound, European cyclicals have outperformed defensives by 30%: the first time this has happened in five years.

The big brother of this risk appetite indicator, the gold to copper ratio, provides a very different version of equity market optimism, which is also benefiting European high yield[4] credit. The OAS spread[5] of the Bloomberg European High Yield Index has indeed compressed by 240 basis points since last October…

The precious metal is also the subject of an unprecedented record in 2022. According to the World Gold Council, central banks have never bought so much gold in one year for 55 years. While ETFs experienced 110 tonnes of redemptions (compared to 189 in 2021), central banks took the opposite view of private investors by amassing 1136 tonnes, more than double the volumes of 2021. 

The rescue of this reserve asset is welcome for emerging countries that suffer from a fragile economy and a weak currency against the dollar. 
Especially since, despite its decline against the currencies of developed countries, the greenback remains very expensive compared to the currencies of emerging nations. The Real Emerging Market Economies Dollar Index of the Saint Louis Fed is at a 10-year high! This could aggravate the question of the sustainability of the debt of large emerging countries. This question is likely to arise for investors as the wall of high yield debt expected between 2025 and 2026 approaches…

Unfortunately, the countries that need it most are unlikely to have strengthened their balance sheets. 
Overall, the IMF notes that its emerging market reserve adequacy indicator has deteriorated since 2021. Of the countries monitored, a quarter are below the IMF’s safe level. The foreign exchange reserves of Turkey, Argentina, Egypt, Romania, Hungary, Chile, Malaysia and Poland are no longer sufficient to cover foreign currency debt. 

Among the first to show tangible signs of weakness, Egypt, Pakistan and Lebanon had to end their currency peg[7] with the dollar between January and February in order to unlock IMF aid.
From then on, the downward spiral began. The Egyptian pound, the Pakistani rupee and the Lebanese pound plunged by 50%, 25% and 90% respectively after the monetary authorities’ decision. Other countries may follow. 

War-torn Ukraine could be next on the list. 
Ghana and Nigeria are in equally precarious situations. 
Neighbouring Syria, which is in the grip of endless conflict and one of the biggest earthquakes in the region’s history, Turkey, which has been battered to its core, could see the bill for the disaster approach $100 billion. By 2023, this would cut GDP growth by at least one point. Challenged by out-of-control inflation that has weighed heavily on the lira, Governor Sahap Kavcioglu has dramatically increased the Turkish central bank’s gold reserves in 2022.
Unfortunately, even if it could rain on the families of the victims, all the gold in the TCMB cannot outweigh the pain of the multitude affected by the tragedy…

Thomas Planell, Portfolio manager – analyst at DNCA. This article was finalised in February 17th, 2023.

This promotional document is a simplified presentation and does not constitute a subscription offer or an investment recommendation. No part of this document may be reproduced, published or distributed without prior approval from the investment management company.

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Termes et définitions
1. drawdown. Le terme “drawdown” est utilisé pour décrire la perte de valeur d’un investissement ou d’un fonds. Plus précisément,…
2. Goldilocks ( Goldilocks ) L'expression "Goldilocks" en économie est utilisée pour décrire une situation économique qui est considérée comme étant "ni trop chaude, ni trop froide", c'est-à-dire une période de croissance économique modérée et stable, avec un équilibre entre la croissance et l'inflation, sans excès ni contractions sévères.
3. equity. Equity est un terme qui désigne une forme d’investissement à long terme dans une entreprise. Lorsqu’un investisseur achète…
4. high yield. L’expression “high yield”, en français “haut rendement”, est couramment utilisée dans le domaine de la finance et des…
5. spread. Le terme “spread” peut avoir plusieurs significations dans le domaine financier, en fonction du contexte. Voici les principaux…
6. ISM ( ISM ) L’indice ISM, également connu sous le nom de rapport sur l’activité manufacturière de l’Institute for Supply Management (ISM),…
7. Price-earnings to growth ( peg ) Le ratio Price-Earnings to Growth (PEG) est un outil d’évaluation utilisé pour déterminer la valeur relative d’une action.…
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