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10-year German bund rates peaked at around 2.50% on October 21st while reaching a low of just below 0.80% in early August, starting the year at -0.18%. This key benchmark for EU long-term rates closed at 1.92% last Friday or a YtD rise of 2.10%. What a rollercoaster. 10-year US rates followed a similar track. Peaking at 4.25% around October 24, starting the year at 1.51% and experiencing a moment of relief in early August when they dropped to 2.56% closing at 3.54% last Friday. Again, an almost similar rise of 2.03% YtD. The beta between both markets on the 10-year point of the yield curve was almost 1.
It is important to reflect on those moments when markets turned, up or down, during this peculiar 2022. It is paramount to realize that if the peak policy rates of 5.00% by the Federal Reserve (FED) or 3.00% by the European Central Bank (ECB) were to remain in place over the next 10 years, the current valuations of 1.92% or 3.54% for German and US 10-year government rates do not add up. Both would correct upwards given the expectations theory, whereby short-term rates translate into longer-term rates. For the sake of clarity, such a scenario would see another painful adjustment as 10-year German rates would shift 1.08% higher compared to an increase of 1.46% on the US 10-year rates, taking them to 3.00% and 5.00% respectively. This simple exercise is important. In the above scenario, we ask ourselves, again and again, if our view on inflation and inflation expectations across EU and US economies align or not with the historical 2.00% level currently aimed for by central banks. Does inflation settle back to pre-covid ranges of about 1.5% to 2.00% or do we need or even want to account for inflation between 3.00% and 4.00% over the next decade? The former calls for ECB policy rate equilibrium levels of 1.00% to 1.50% and a FED 2.50% longer term ‘neutral’ policy rate.
A response to that question triggers the debate on the intensity of the current wage inflation spiral. Is it persistent or transitory? About a year ago, we conducted such a debate on headline inflation. We concluded that the combined and mutual reinforcing effects of energy scarcity and supply bottlenecks tilted us towards high headline inflation readings.
However, we should prepare for flat or deeply negative base effects to curb goods inflation over the next 12 months. Wage and services inflation remain the volatile components. Clearly, while the covid-related surge in apparel goods demand (linked to home and garden) leading to supply bottlenecks is well past, we notice that demand for travel, leisure, hospitality, restaurant, and entertainment is robust or even intensifying. Spending has been redirected. As a result, the labour market in those sectors is crying out for workers. More generally, we notice wage inflation evidence across low and higher margin service sectors.
So, as we move into the last weeks of 2022, do we need to attach a higher probability to the scenario that leads to persistent wage inflation over 2023 and beyond?
The first proof is given by labour markets across the EU and the US, which remain tight. In a peculiar way, it’s as if the negative impact of increased policy rates across real estate, car sales, or digital advertising revenues is isolated. Aggregate demand remains surprisingly robust. The covid and post-covid episodes have turned into a rise of household and corporate savings. Both surpluses continue to have a positive impact on consumption today. This allows companies to offer competitive wages in order to attract and retain talent. Most sectors have pricing power, which effectively results in nominal GDP growth rates at high single to low double-digit percentages. Only governments are running persistent deficits as they continue to subsidize households and specific private sectors in order to stomach energy -related headwinds. Positive output gaps (aggregate demand outpacing aggregate supply) remain in place, which makes core inflation persistent. Be assured, watch, track, and interpret core inflation readings and focus less on volatile headline inflation numbers.
In summary, our thoughts should not be focused on the level of (peak) policy rates but rather on how long central banks might be forced to keep policy rates at those peak levels. Whatever they might prove to be over the next 12 months, the higher peak rates are and the longer they remain in place, the higher longer-term 10-year rate estimates ought to be.
This brings us to the question of whether central banks can hold onto peak rates for long. In a financially-driven economy, is the ‘system’ capable of operating under persistently high policy rate conditions? Again, this is another persistent, transitory debate that we should all foster.
Going into 2023, we are left with more questions than answers.
However, one thing we do have an answer for is that the reset across asset classes over 2022 has improved long-term return expectations. A boldly diversified global 60/40 fixed income-equity portfolio solution should deliver an expected return of between 5% and 6% over the next decade. Such a portfolio requires exposures across EM to DM equity and yes, EM to DM bond markets accepting, on top, a good dose of non-Euro FX risk. Harvesting carry or income on an international scale is the name of the game.
There is no such thing as a free lunch. A global, active investment solution might or will be required in order to survive financially in an above average set of volatility conditions.
Degroof Petercam Asset Management SA/NV l rue Guimard 18, 1040 Brussels, Belgium l RPM/RPR Brussels l TVA BE 0886 223 276 l
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