Financial markets got off to a good start to the year. Better-than-expected Eurozone inflation data topped by moderating US wage inflation readings, induced a stellar rally across bond sectors. The 10-year US government bond rates led the charge, dropping by 32bp over the week to finish at 3.56%. German 10-year bunds eked out a drop of 36bp, closing at 2.20%. The MSCI Europe net total return equity universe roared ahead by 4.78%. The Eurostoxx 50 led the performance chart, advancing 5.91%. The S&P 500 lagged, rising by a mere 1.45%. More of the same in USD terms: over the fourth quarter of 2022, the European Stoxx 600 recorded its biggest outperformance on record, beating the S&P 500 by an impressive 13%. The 12-month forward P/E ratio for the Eurostoxx 600 index, at around 12, is valued on the cheap side compared to a reading of 17 for the S&P 500. In addition to a promising valuation argument for European equity – with a high loading of value stocks – the universe benefits from being under owned, a weakening USD, and being positively geared to the reopening of the Chinese economy.
Could we have entered a market context where bonds and equities will climb their respective walls of worry?
For bond markets, the wall of worry is represented by the inflation path over the next couple of years. US inflation-linked Treasury markets are optimistic when looking at 1-year and 2-year inflation expectations, which closed at 1.70% and 2.11% respectively. Markets become less worried about US wage inflation as average hourly earnings drop towards 4.6% YoY. US labour markets become less tight as monetary policy, feeding through with a lag, starts to impact. As markets price a terminal rate around 5% over the second quarter, unemployment might jump over 4% and reach 5% by year-end. Under such conditions, US Treasuries can thrive.
In Europe, the inflation equation is more complex. The distribution of inflation figures across Eurozone countries is too wide for purpose. It reveals lack of synchronization in tackling the energy crisis by applying a diverse set of legislative initiatives in order to lower the consumer and/or corporate energy bill. It also reveals a labour market more sensitive to wage inflation compared to the US. Lack of labour mobility, an aging working population, and large skill mismatches increase the probability of wage inflation dynamics taking hold. Second-round effects do worry the ECB, and they show up in still-rising core inflation numbers at 5.2% YoY. US core PCE inflation numbers peaked in February 2022 at 5.4% and have been slowly declining since then, standing at 4.7% today. ECB policy rates will settle (well) above 3% by next summer. 10-year European Union bonds (AA+) offer an appealing yield of 2.90%, reaching highs around 3.25% over Q4 2022. As such, within rates, the wall of worry in the EU is higher than in the US. Track real rates. Real rates in Europe have just gone positive, while they are consolidating around 1.5% in the US in the belly of the real curve.
For equity markets, the wall of worry is linked to the resilience in earnings and related operating profit margins. The cost of goods sold has risen significantly. Applying a proper valuation effort has staged a comeback as discount rates normalize towards pre-GFC levels. US and EU equity markets have been decoupling over the past months, and this trend should continue given the stronger US broad technology sector tilt. The craft of stock picking stages a comeback. Momentum-only driven investment styles supported by zero or negative policy rates are history. In the decade ahead, astute active managers should be able to beat passive investment solutions. The derating in equity across 2022 has been brutal In order for equity markets to stabilize and/or realize high single-digit returns. A pivot in policy rates is not a key requirement. A mere confirmation by Powell and Lagarde that terminal rates are reached over the first half of 2023 will allow investors to climb the equity wall of worry as they look through this cycle that brought a lot of chaos due to impactful, exceptional global events from 2020 to 2022.
Fewer inflation worries, fewer geopolitical worries, and fewer worries about monetary or fiscal policy mistakes might start to take root. ‘Less of everything’ might trigger a drop in implied and realized volatility across markets. This is a scenario that few strategists predicted over the past week. Extrapolation of the market tendencies that we witnessed in 2022 has been the consensus. The consensus at the start of 2022 was that monetary policy normalization would be slow and prudent. Instead, we got aggressive frontloading. 2023 might see the climbing of many walls of worry.
