Central banks will not come to the rescue of the markets – 04/04/2022 at 15:53


Gilles Seurat, Fixed Income and Cross Asset Manager, La Française AM.  (photo credit: La Française AM)

Gilles Seurat, Fixed Income and Cross Asset Manager, La Française AM. (photo credit: La Française AM)

By Gilles Seurat, Fixed Income and Cross Asset Manager, La Française AM

For investors, 2022 has started on a sour note with nearly all asset classes in negative territory. Equities are suffering, with European indices at -10%. The only equity sectors that are doing so far are basic resources and energy, which are both benefiting from the very strong rise in commodities.

However, the big loser is the bond market, which is doubly penalized by the rise in “core” sovereign rates (10-year German +76bps, 10-year American +96bps) and by the widening of spreads (Investment Grade Euro +42bps , High Yield Euro +92bps). Consequently, the Euro Aggregate index is at -5.42% since the start of the year. For equity investors who are used to double-digit declines, these losses may seem small. But for bond markets, 2022 is arguably the worst year on record. (Source: Bloomberg as of 03/25/2022)

The two culprits of this bond underperformance are Vladimir Putin, whose war in Ukraine has deteriorated investors’ risk appetite, and the central banks – in particular the Federal Reserve (Fed) and the European Central Bank (ECB) – which have adopted a very tough stance on inflation. The war in Ukraine raises fears of downward revisions to growth prospects as well as probable postponements of investment projects. We can already observe this through the fall in demand for consumer credit and visits to real estate in France.

The primary objective of central banks is and has always been price stability. However, the Fed is an exception to some extent as it has a second subsidiary objective, namely to keep unemployment low. Although the ECB and the Fed do not have the same tolerance for inflation, both react when they deem it necessary, and even with vigor like the Fed’s Paul Volcker in the early 1980s or Jean-Claude Trichet. of the ECB in the 2000s.

However, over the last ten years, inflation has been very low and central banks had no reason to tighten their monetary policy. It was quite the opposite! The political pressure to stimulate the economy via monetary easing was great: remember Donald Trump’s injunctions on the Fed’s rate cuts in 2019.

But today, inflation is at its highest in forty years and political pressure has turned 180 degrees. Governments are now declaring inflation the worst of all evils, and central banks are now worried that they are not getting tough enough. Thus, central bankers are rushing to close their asset purchase programs and begin a cycle of rate hikes that should have started much earlier. To get an idea, the Taylor rule recommends a key rate for the Fed around 10%, the highest level since the 1980s – a far cry from the current level of 0.5%. This Taylor rule is based on economic fundamentals such as inflation and the unemployment rate which are both at historic extremes. The same Taylor rule applied in the Eurozone recommends a rate for the ECB at 7%. Overall, the trend is resolutely upwards in rates.

Unfortunately, the war in Ukraine accelerated the upward trend in inflation. Indeed, Russia is a very important exporter of oil (10% of world production according to Reuters) and the war has caused prices to explode. The same type of remark can be made for many other raw materials such as wheat, of which Ukraine and Russia are key producers (respectively 8% and 18% of world exports according to UN Comtrade). The OECD estimates that the war will cost its members 1% growth on average, and 1.4% for Europe, which is the most affected: not enough to give up the announced monetary tightening.

In this context, the action of the central banks will not be a support for the financial markets in difficulty, quite the contrary.
Typically, when recession fears drove equity markets down, the Fed lowered rates and propped up the market. This safety net called “Fed Put” is no longer there, or else investors would have to anticipate a strong destruction of demand with a recession. In this case, the Fed Put strike would be much lower.

What is the outlook for the financial markets? We believe that the markets will continue to anticipate numerous Fed hikes over the next twelve months. That being said, we do not expect a significant rise in long rates because the long-term trends remain valid; high debt levels, sluggish population growth and digitization have downward consequences on growth or inflation, and therefore on long rates. As a result, the curves should continue to flatten in developed countries. From a geographical point of view, we find Euro zone rates more vulnerable to a rise due to Europe’s dependence on Russian gas. Indeed, the risk of upside surprises on inflation is greater than in the United States. And if Euro rates rise more than their US counterparts, then the Euro should appreciate against the dollar. Moreover, investor sentiment on the Euro is very negative; the unwinding of short positions should also push the parity up.

INFORMATIONAL DOCUMENT. THIS COMMENT IS INTENDED FOR NON-PROFESSIONAL INVESTORS WITHIN THE MEANING OF THE MiFID DIRECTIVE. The information contained in this document is given for information purposes only and does not constitute an offer or solicitation to invest, nor investment advice or a recommendation on specific investments. The items of information, opinions and figures are considered to be valid or accurate on the day of their establishment according to the economic, financial and stock market context of the moment and reflect the current sentiment of the La Française Group on the markets and their developments. They have no contractual value, are subject to change and may differ from the opinions of other management professionals. It is also recalled that past performance is not indicative of future performance and is not constant over time Published by La Française AM FINANCE Services, whose registered office is at 128, boulevard Raspail, 75006 Paris, France and approved by the ACPR under number 18673 as an investment firm. La Française Asset Management is a management company approved by the AMF under number GP97076 on July 1, 1997.



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