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Market adjustments are fast and furious these days. The past week was a case in point. On Thursday, February 10, the upside inflation surprise across US headline and core CPI, printing at 7.5% and 6.00% YoY levels, pushed 2-year Treasury rates up by 30bp intraday from 1.33% to 1.63%. Geopolitical uncertainty, short-positioning reduction or active repositioning brought the 2-year rate back to 1.50% at the end of a notable high-volatility week. The silver lining that results from such high volatility moments is that it lowers uncertainty. Uncertainty drops as the path forward becomes unambiguous. Indeed, the shape and intensity of DM central bank hiking cycles comes to the surface. Monetary reaction functions became transparent.
The hiking cycle for the US FED, the BoE and the RBNZ (New Zealand) will mainly pan out over 2022 with few additional hikes over H1 2023. Interestingly, market participants have started to price in the first BoE policy rate cuts over 2024 and 2025. Same goes for the FED, albeit to a lesser extent. The ECB is set for lift-off over Q4 2022, adopting a steady hiking pace over 2023. The terminal policy rate debate will start to coalesce around 2.00% for the US and the UK. For the ECB, the market pencils in 0.75% to 1.00%.
That markets started to price policy rate cutting cycles across DM (BoE) and EM (Czech Republic) central banks reveals late business cycle concerns. We detect these across the Euro area where German industrial production or trade balance indicators underwhelm, US consumer sentiment is cratering, quarterly UK GDP prints disappoint and mirror German trade-balance and industry issues. Monetary policy concerns will make room for discussions and uncertainty around fiscal drag and the consumer-demand headwinds. The above-average inflation prints over the next couple of years, mainly resulting from energy, goods and shelter inflation, will impact real disposable income over the medium term. In combination with less fiscal stabilisers expect growth to decelerate towards potential levels.
The above tendency marks the distinct differences between today and the 1970s or early 1980s. Back then, inflation expectations became unanchored as a result of persistent supply shocks, ill-directed fiscal policy largesse in combination with erratic monetary policies. Today, long-term company, consumer and market-based inflation expectations remain well-anchored. The University of Michigan’s 5 to 10-year inflation expectations’ latest print stood at 3.1%, whilst during the 1970’s this metric flashed above 6%. Clearly companies face important rigidities in the pass-through of increased labour costs – as their retain and hiring expenses rise seeking stability in talent pools. Often firms in highly competitive market places take increased labour costs on the chin through reduced margins rather than take the risk of passing these on to the consumer or serviced client. Expect that the composition of consumer goods spending and the relaxation of supply chain bottlenecks will flip back towards pre-pandemic profiles. Next big stop will be the US core PCE (Personal Consumption Expenditure) index release on February 24. Over January, the key inflation indicator for the FED posted a new high at 4.9%. End of 2022 estimates range between 3.00% and 3.5% and are in line with market-based inflation expectations over the short, medium and long-term.
Market-based inflation expectations captured through inflation breakeven rates (difference between comparator nominal and real US Treasury rates) point to solid anchoring. The breakeven rates curve settled for an inversion over the past year, reflecting normalising inflation over time. That is a strong signal. Whereas 2-year and 3-year inflation expectations still averaged 3.53% and 3.18% respectively, 30-year inflation expectations sat at 2.19% close of business February 11. 10-year inflation expectations read 2.46%. Such long-term inflation observation complies with a successful FED targeting towards a stable inflation rate around 2.00%.
Above messages might come as a surprise as financial markets have been heavily disrupted since the start of 2022. However, at times, investors should embrace these drawdowns. Drawdowns across specific equity and fixed income sectors should be treated as a welcome opportunity for long-term investors to reposition, rotate into sectors that have gotten too little love and attention (and weight) in the past. Expected returns across bond and certain equity sectors have gone up quickly over the past 6 weeks. Equity is the long duration asset class of choice. So, the current correction should not lead to panic but a moment of reflection. If the correction does not deliver harm on your ability to achieve longer term objectives, all is well. If it does, you overallocated.
The mediatised metric of negative yielding bonds as a % of total has dropped towards about 6%! We lived in a world of +20% for this metric just before Christmas 2021. Unmistakably a dose of value has returned to global fixed income markets.
Current drawdowns across fixed income sectors point to recovery times between 6 to 18 months conditioned on rates and credit spreads stabilising around current levels. Such statements are also unambiguous, as across bond investment solutions, future performance outcomes are, most of the time, baked in the cake. The base case calls for less financial market volatility ahead of us.