Financial markets have shown high resilience in the face of crisis as its diversifying capacity stood firm over the past 40-years. The supercharged globalization of trade and finance since the turn of the century never intimidated markets for long. The Great Financial Crisis of 2008, the European Debt Crisis of 2011, the Bernanke 2013 taper tantrum, the Greek default outcome of 2015, the Chinese growth scare early 2016, the 2015-2018 US FED ‘returning to normalcy’ episode followed by the mid-cycle adjustment over 2019, followed by the Global Health Crisis of 2020 always ended up well as concerted central bank action came to the rescue and bailed out markets. Today, it seems that the rules of the game have changed.
The combination of high YoY inflation numbers across a broad set of components, next to a geopolitical and war-inspired energy & food crisis, has jacked up the complexity and uncertainty to a level rarely experienced. The main question everyone asks himself: “What’s in the price today across rates, credit and equity markets?” Are we going through a moment of peak complexity and should we look beyond the harsh winter in front of us?
Over the past 50 years the average differential between 10-year US Treasury rates and core PCE YoY inflation has been +2.60%. Today, with 10-year US rates at 3.20% and core PCE YoY inflation at about 4.5%, this spread sits at -1.30%. The negative stretch started in March 2020 when the global pandemic erupted. The previous negative episode occurred between mid-1974 and late 1975. 95%+ of the time this differential was positive and long-term rates offered a comforting buffer above inflation. However, if we split this 50-year history in two parts across 1962-2008 and 2009-2022, we come to a less worrisome condition. We split history by setting apart the time under conventional FED policy versus unconventional US central bank policy. Over 1962 till end of 2008 the spread stood at a hefty 3.25% and investing in 10-year Treasuries was highly accretive. 10-year real rates fluctuated between +2.00% and +4.00%. As of 2009 till today, the average spread sat at 0.40% due to an interventionist QE-addicted FED. If we apply a return-to-the-mean narrative, the core PCE YoY inflation can drop by 1.7% to 2.8% by next year achieving a positive +0.40% average spread with the 10-year rate around the prevailing 3.20%. If a scenario unfolds where core PCE inflation drops by 2.5% hitting the 2.00% target by the end of 2023 there is value in 10-year US rates today. However, if the FED fails in its mission dragging inflation towards 2.00% quickly, expect upward pressure on US long-term rates to persist. For arguments sake, if core US PCE inflation would already bottom at 3.60%, we could be in for a push towards 4.00% on US 10-year rates. The FED’s reaction function is data dependent. We are data dependent.
Performing a similar exercise for EMU rates is littered with pitfalls. A safe path is taking our lead from implied ECB policy rates. The market pencils in a top policy rate at 2.15% by June 2023. Assuming flat curve conditions we might see 10-year Bunds in a 2.00% to 2.25% range by the summer of 2023, above the 10-year bund rate 1 year forward priced at 1.66% today. At worst, the ECB Transmission Protection Instrument should hold the 10-year BTP rate at current levels between 3.75% to 4.00%.
European and US investment grade corporates, as governments, have profited from a decade of near zero or negative policy rates to lengthen average debt maturity whilst forcefully reducing their cost of debt. That reality insulates many financial and non-financial companies against current higher refinancing rates. The EUR corporate IG universe yields 3.35%. The EUR High Yield universe matches a 7.16% yield. At current spread levels both sectors protect investors well if hit by past run-on-the-mill 5-year cumulative default rates. In the US we lock-in 4.87% and 8.48% yields across US IG and US HY respectively. Both offer investors protection under shallow recessionary conditions.
The current energy crisis, mainly worrisome for the EU and the UK, is the elephant in the room that might trigger a nasty recession and put outsized pressure on governments and central banks alike to come to the rescue. The tail risk is represented by a stark and lengthy recession. An outcome that is not priced for today. If galloping energy costs eat away bigger and bigger chunks of GDP components the contraction might surprise. A school of independent analysts puts the EU energy share of GDP at nearly 20% today versus 3% to 7% over the past decade. If growth crumbles, we can expect deteriorating bank balance sheets and rising cost of risk. Such events could morph into a contagious credit crunch quickly spreading into non-financial sectors. Again, Europe has the fewest options. So, speed of execution in preparing medium-term alternatives and immediately launching winter 2022-2023 support programs are required. Over this weekend German Chancellor Olaf Scholz announced an emergency program worth €65bn to help millions of households amidst the energy crunch. Other EU countries will follow.
Above complexities came to roost over the second half of August. The Jackson Hall central bank gathering nailed the message that central banks are on a mission to conquer inflation. Equity and bond risk premia rose, markets retreated in sync. End of August consensus revenue growth forecasts for the S&P 500 range point at +3.5% over 2023. Consensus operating earnings per share for the S&P range between $235 and $245 over 2023. Considering the actual confident FED tightening path towards 3.75%-4.00% and the S&P reaching operating earnings of $240 per share over 2023, the index would land at 3840 on a 16 P/E multiple or 4320 at 18 multiple. This is in between where the market clears today. A continued downward rerating towards a 14 multiple generates an index at 3360 or drawdown of just over 14%, a 12 multiple projects an S&P at 2880 or an adjustment over 26%. The latter estimates fall into the tail risk scenario where global growth decelerates heavily.
Effectively, the multipolar construct configuring and shaping global economic growth provides plenty of cushions represented by commodity and/or energy exporting countries over the LATAM economic block or over resilient emerging players. Coalitions get reinvigorated among China, Russia, India or Turkey.
If complexity is peaking, we might actually witness reduced contagion effects. The fragile economic blocks are represented by the EU and the UK. To our credit, the EU and the UK have dealt with many past crisis moments adequately. Notwithstanding, the current energy crisis threatens our economic fabric at the core. Solutions will need to be bold and well-directed across the board.
