The big theme of the markets in the coming weeks will be inflation and its consequences for global interest rates. This marks a stark contrast to the underlying deflationary conditions that have prevailed over our economies in recent years.
Inflation is at its highest levels for several decades, close to 7% in the US and 5% in the eurozone. At the moment, markets remain somewhat convinced that this will not last, as long-term inflation expectations have not risen much: they stand at around 2.75% in the US and 2.50% in the eurozone.
In addition, investors have fully taken in the Fed's message and its plans to raise key interest rates fairly quickly. So they see the fed funds rate reaching around 2% by the end of this cycle, that is, by the end of 2023. By then, 10-year rates should be around 2.5%, since that yield curves naturally tend to flatten towards the end of a cycle. As a result, US bond yields have only been stretched moderately, at least for now, although the strain has intensified since the beginning of the year.
There are currently two schools of thought on the subject of inflation. The first is consensual and maintains that it is only a temporary situation. It is the core assumption adopted by central banks and is based on the fact that the latest statistics refer to temporary situations created by bottlenecks that formed when economies started to open up again.
Similarly, base effects are unlikely to be long-lasting: Used car and house prices, for example, have soared in recent months, but they are the kind of goods consumers don't buy every year. So prices should calm down once the euphoria created by reopening economies has faded. The same goes for energy prices: oil prices have more than doubled since bottoming out in 2020, and they're not going to double every year.
In the meantime, it should also be noted that if prices go up too fast, they can drag demand down and then prices will end up going down as well. So, in a way, inflation tends to "self-absorb". Supporters of this school of thought believe that the underlying deflationary forces still exist: the structural increase in debt levels, the digitization and robotization of world economies, the aging of the population...
But this central scenario is increasingly questioned, and the idea that inflation will last is increasingly widespread.
First, inflation is beginning to affect wages, especially in the United States. This is known as the price/salary spiral. Wages have risen 4.7% in a year in the US and close to 15.0% in certain segments of the service economy, while unemployment is back at 3.9% (which is close to its pre-crisis level of 3.6%). This labor shortage has been exacerbated by a combination of factors: the deeply emotional nature of this crisis has led some to rethink their search for meaning in their lives, to the point that they have neither returned to the job market nor they will in the current circumstances.
There are those who have taken advantage of the situation to retire a little earlier, with the substantial help of pension funds, which are performing at their best. But this anti-work movement, which took off in the early 2010s with the Occupy Wall Street protests, has gained steam, especially among young people during the lockdown. This movement can also be found in China these days, again among the young, with what is called the "laying down" trend.
Second, the energy transition is generating costs. The decarbonisation of the economy means that the existing energy production capacity will have to be dismantled and replaced by another, but without ultimately increasing the amount of energy produced: this will therefore mean a cost that will have to be paid, above all because this transition could cause an increase in the prices of the metals necessary to develop these new energies.
Finally, offshoring is a problem. This crisis has shown us how vulnerable supply chains can be if they are too dispersed, especially in critical sectors like healthcare and agriculture, but also in the tech industry. Offshoring is a trend that could increase further due to the "new cold war" between the US and China. Thus, Western companies could try to rely less on China. Above all, the carbon footprint of the products we consume will become a major consumer issue and the solution will be to relocate production, which is likely to drive up prices.
Thus, inflation is not a black and white issue. We are of the opinion that the world has indeed changed and that inflation could be structurally higher in the coming years, cruising above the 2% targets set by the US and European central banks. Therefore, an inflation scenario of ~3% seems plausible, and would also make reducing the public debt-to-GDP ratio less painful over time.
Amid all the uncertainty, we think markets could become more volatile, especially at the long end of the yield curve; this would spill over into equity markets and a drop of around 7-10% would create opportunities to invest again.
Central banks: a matter of speed and scale
The market is now expecting four interest rate hikes by the Fed in 2022. This is more than expected, but has not boosted expectations for final interest rates as they are still well below the final rate. of the Fed for the moment (2.5%). Until this happens, the 10-year interest rate will not skyrocket. However, we think expectations will tighten further, pushing bond yields to just above 2%. Furthermore, the uncertainty surrounding the timing and magnitude of the Fed's efforts to reduce its balance sheet through 2022 suggests that the term premium will increase.
In Europe, German interest rates are expected to turn positive again in the first half of this year. They will be boosted, among other things, by US types. The ECB is slowing down its debt purchases faster than European treasuries are reducing their net issuance programs (by -€120bn vs. 2021). This means that markets will have to absorb some €300bn more sovereign debt this year than in 2021. We think this will help keep German bond yields in positive territory over the long term, with a target of 0, 25%/0.50% sometime in 2022.
Investment grade credit spreads (spread between rates) have come under a bit of pressure so far this year from higher interest rates. Although yields on Investment Grade bonds denominated in euros have risen since last August (+0.50%), we believe that risk premiums could widen slightly more and the interest rate hikes that we expect will then offer investors investors a very attractive entry point into this asset class.
High yield bond spreads have been a bit more resilient in the first two weeks of this year, but the market is cautious. We maintain our positive stance on this asset class and note that companies are financially strong: their credit ratios have improved, liquidity is abundant after historically high issuance volumes in 2021, and the outlook is good. However, this asset class is likely to be affected by market volatility resulting from regime change by central banks, creating attractive entry points for investors.
Taking positions in a volatile context
The evolution of the equity markets in 2021 can be described as exceptional. The year 2022, meanwhile, has started more turbulently, although the indices continue to hover around their all-time highs in both the United States and Europe. If our central scenario is confirmed, we will see a slight increase in short and long-term interest rates, without the equity markets being less attractive than the fixed income ones.
With global economic growth forecast at between 4.5% and 5.0%, earnings per share for US and European companies should rise this year by 8% and 7%, respectively. We know that earnings are closely correlated with global economic growth, which will be supportive. Of course, our central scenario does not take into account a sudden resurgence of the Covid virus pandemic, which would affect economic growth and therefore earnings growth. The other risk is the persistence of inflation, which would erode margins if companies fail to pass on higher production costs in their sales prices.
Precisely the question of inflation has been decisive for the results of the sector so far this year. We weren't used to seeing performance gaps of more than 25% accumulate in the space of two weeks between banking, auto, and oil stocks, on the one hand, and stocks in "growth" industries such as luxury and technology, on the other. But there is a simple logical reason for this: if interest rates are going to rise a little more than expected, sectors that are valued mainly by discounting their future profits will be penalized, in contrast to the banking sector, for example, or the sector energy, which is benefiting from the sharp rise in oil prices (among other factors). There is no reason for this rotation to reverse soon.
At the beginning of December we had upgraded our recommendation by one notch, due to the consolidation of the market caused by the appearance of the Omicron variant. We now return to a neutral recommendation after the rally seen over the past 6 weeks as we expect stock market gains over the year to be in line with earnings growth (there is no reason for market cap multiples to market rise amid rising interest rates). Equity returns are likely to be much more modest than last year and into the single digits. They should be attractive compared to those offered by the bond markets, but there is no doubt that the next bout of volatility will create entry points below current levels.
OFI AM Central Stage
Monetary tightening in line with rising inflation rates is creating periods of market volatility. Until inflation indices pull back sharply, the speed and magnitude of the measures taken by central banks will continue to fuel concerns about the risk asset market.
We see that expectations for interest rates and asset purchases will continue to adjust upwards until inflation subsides.
Therefore, we expect interest rates to continue to rise and equity markets to adjust accordingly relative to overall indices levels as well as individual investment styles. Having realized the gains of the last six weeks, we anticipate that this period of uncertainty will create better entry points to get back into equity markets.
ASSET ALLOCATION RECOMMENDED BY OFI AM
Bond markets could become more volatile as there is growing uncertainty over whether inflation is really temporary and whether the US will soon start tightening its monetary policy.
Equities are not expected to move in any particular direction in the coming weeks.
There is little room for credit spreads to narrow at this point. Emerging market local currency bonds in 2021 were hit hard by rising inflation in many countries, driving interest rates higher and dragging currencies lower. Investors could return to interest in bonds in the coming weeks
Corporate profits will continue to grow this year. This will provide strong support, to the point that equities will remain attractive in the medium term, so investors should strengthen their positions in the asset in the event of declines. European equities could do better this year.
Equities by styles
Securities that are sensitive to rising interest rates can outperform. They tend to be more represented in the “Value” category. “Dividend” stocks, meanwhile, also look attractive as we don't see the markets making big gains in the coming months.
Investors seem to have taken into account the rise in interest rates in the United States. This momentum appears to be waning. We do not expect the euro/dollar exchange rate to fluctuate much. The appreciation of the The appreciation of the Chinese yuan should also slow down this year.