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2022 will be remembered as the big reset year. The reversal of monetary policy from an unconventional steady QE state towards a classic conventional state has taken most market participants by surprise. In retrospect, even central bank governors would not have imagined how markets would give them an exit pass that has come so far with little collateral damage of systemic nature. The reset is most visible in the level of long-term 30-year US real rates. This long-term real discount rate rose from -0.50% start of the year to +1.84% currently. A remarkable adjustment that catapults us close to an average 2.00% level in 30-year real rates witnessed over 2000-2008. Indeed, central banks have broadened their wiggle room decisively. Central banks can make use again of the interest rate policy instrument in order to steer for cyclical or countercyclical outcomes. What a result!
Because the speed of the adjustment was so brutal it takes time for monetary policy to trickle down. Monetary policy works with a lag. It trickles down to the level where capital investment decisions are made, be it in the context of households or a business context. This last sentence merits some pausing. What one needs to realize is that such a sudden reset might have altered potential economic growth to the downside as it alters the ambitions of households and private enterprise under financial constraints.
At the level of households there is the dream of buying a house. Now, the housing affordability index for first time home buyers has dropped towards 68 end of Q2 2022. This series started back in 1986. The last time we witnessed such a level was over the summer of 2006. Between 1986 and 2006 the index averaged about 80. I want to include the Bloomberg description of this index because it embodies the US middle class: “This affordability index shows the ability of renters who are potential 1st time buyers to qualify for a mortgage on a starter home. When this index equals 100, the typical first-time buyers can afford the typical starter home under existing financial conditions with a 10% down payment. The first-time home buyer median income represents the typical income of a renter family with wage earners between 25 and 44 years old.”
The rise in long-term nominal and real rates has driven the 30-year fixed mortgage rate towards 7.25%, close to the highest levels printed over 1999-2000. The October Homebuilder Sentiment index tanked towards 38 closing in on the 30 low print of March 2020, the pandemic outbreak, and a far-cry away from the 90 levels end 2020, as central banks depressed long rates to historic lows. Housing demand is faltering quickly. Monthly supply of new houses onto the market place rose to over 10.4 months, levels not witnessed since, yes again, 2008. The picture becomes clear as the health of the housing market and economic growth conditions are positively correlated. Even with correct Q3 US real GDP growth figures in the offing, we can expect tough readings in the quarters ahead. Financial conditions for households have tightened sharply. Full stop. A similar set of conditions is present in the UK, exacerbated by the clash between a central bank that pivots towards orthodox policies whilst the Chancellor of the Exchequer wanted to apply unorthodox fiscal policies. A combination that markets detest. It nearly killed the Gilt market. On the European continent, housing affordability has not worsened to US or UK levels, but the trend is clear.
When we briefly zoom in on private businesses it also becomes evident that a prudent and hesitant boardroom becomes mainstream. The geopolitical uncertainty, wage inflation and overall higher input costs confront business leaders with difficult budgetary negotiations for next year. Operating income will incur headwinds under various recessionary scenarios whilst operating expenses are rising, and on top, talent becomes a precious asset. The CEO confidence index, that measures the level of optimism or pessimism for the US economy 1-year out, sits at 5.92. It bounced from a low 5.12 print mid-year. Interestingly, it holds up at summer of 2006 levels. It is what’s called a coincident indicator that changes simultaneously with economic conditions.
So, CEOs still lean towards optimism as inflation wreaked havoc over 2022 but a credit crunch might not be on our doorstep and is not a base case scenario… yet
It is here that looking at the past and especially the 2008 Great Financial Crisis (GFC) becomes essential. At the start of 2008 real 30-year rates fluctuated around 1.70% and broke the 2.00% resistance level over spring. However, by end October 2008, 30-year real rates had skyrocketed to 3.25%! The damage that trickled down was horrendous. A credit crunch rolled over global markets only countered by an understanding of market participants that central bank large scale asset purchases or QE, launched end of 2008, would be able to reliquefy the system and restore credit markets.
The FED is well aware that a further rise in real rates from current levels might lead to unwanted, undesired outcomes. The market implies a terminal policy rate of 4.75% – 5.00%. A level that should be reached by the spring of 2023. The US 30-year real rates at 1.84% fully reflects that information as well.
The key message today is that any move in expectations beyond 5.00% for US policy rates might trigger a non-linear increase in credit crunch probabilities as effectively ensued over H2 2008. Credit spreads might leap higher. Stocks might fall victim to another painful leg lower. At this juncture, the FED has not made a policy mistake. But they find themselves on the edge. To be continued but, the base case scenario should call for a FED terminal rate (well) below 5%. Such a scenario, with a FED signalling prudency, would stabilise equity markets and possibly propel fixed income. The risk scenario, with policy rates expectations going beyond the 5.00% threshold, might morph quickly into a black swan.