It would not be surprising if a global recession followed the global energy shock caused by the war on European soil.
- We are all facing the impact of the cost of living crisis.
- While governments will develop measures to address this, there is uncertainty as to how markets will react. If the aid does not lead to lower energy prices, this could affect growth prospects.
- It is therefore prudent to adopt a defensive position until cheaper valuations come to the fore again.
The return of the falling market
In view of the constant bad news that is reaching us, it is certainly advisable to ensure defensive portfolio management until the end of the year. Inflation remains high, the notion that the US Federal Reserve (Fed) might end its restrictive monetary policy is unfounded, the war in Ukraine continues and the energy crisis is impoverishing households and companies. After calling the peak in bond yields in June, we are now ready to endorse the view that yields could still rise above this level. This has already happened in the UK, with the capitalization rate on 10-year UK government bonds at 2.9%, up from 2.74% in June. Both the Fed and the European Central Bank (ECB) are expected to hike interest rates by 75 basis points (bp) at their September 8 and September 21 meetings, respectively.
A new test of the June low for stock markets?
Higher bond yields are not a good thing for equity markets. The increase in real yields recorded in the second quarter contributed to the negative development of the equity markets. The “growth” aspect performs significantly worse than the “value” aspect. The real yield on US 10-year securities – compared to the yield on Treasuries linked to inflation (TIPS) – rose to 71 basis points in mid-August from 7 basis points at the end of July. During the same period, the S&P 500 growth index underperformed the value index. A macro environment that suggests lower yields and higher yields is a negative association for stock markets. Once again, the June 2022 lows in US stock markets and elsewhere could be tested.
Energy, inflation, interest rates and growth
The view is blurry. In the United States, the job market remains solid, with the latest JOLTS survey showing more than 11.2 million open positions, more than double the number of registered unemployed. Recent gross domestic product (GDP) reports showed negative growth. However, the Fed remains committed to raising rates until the labor market collapses to prevent wage growth from fueling inflation. At the same time, high inflation is weighing on real incomes in most economies. European countries are anticipating possible energy rationing this winter. Governments are trying to solve the energy crisis quickly. Ultimately, however, it will be a political decision as to who pays the bill: consumers, taxpayers or energy companies. However, the fundamental problem remains that it is Russia’s war against Ukraine that has upset the global balance of supply and demand in gas markets. Until this is remedied, the prospects for sustained global economic growth are very bleak.
Relief in sight?
If the war didn’t end, what could limit the risks of a slowdown? Above all, the energy supply must be rebalanced. The increase in tank filling in Germany in recent months is positive, as data from Bloomberg shows that the tanks are 84% full and are therefore above the level of the previous year. Governments around the world are trying to make themselves more independent of Russia. Therefore, there are plans, or are already underway, to increase nuclear power generation, increase LNG imports and seek to increase production from various energy sources, including oil and gas, on the UK continental shelf, at least as much as possible. There may be a need to limit demand by improving efficiency, reducing energy use for non-essential activities and imposing some rationing where appropriate. Demand will also fall as households and businesses reduce their energy consumption. The fall in wholesale gas prices seen in Europe this week could be a sign that some of these factors are already impacting supply and demand. On the Dutch marketplace, prices for month-long deliveries fell by 25% last week (but are still 50% higher than two months ago).
When is the turning point?
It would not be surprising if a global recession followed the global energy shock caused by the war on European soil. Therefore, it is difficult to live with much higher interest rates. As has been said many times, central banks do not have the power to directly influence energy prices. They can do this indirectly by acting on a fall in demand, but it is likely that their actions are already exacerbating the fall in demand that is currently taking place. Eventually there will be a turnaround, but first the Fed needs to see lower inflation rates and a slowdown in the jobs market, and the ECB, which has also kept interest rates too low for a long time, needs to be sure it has reached a rate that allows it to adequately control inflation. We believe there could be a reversal in market expectations soon – the inversion of the US Treasury yield curve is a clear sign of this.
Interesting US government bonds
Meanwhile, US interest rates are expected to hover around 4 percent. If rates are hiked another 150 basis points, it will be the most aggressive cycle of rate hikes in decades, as measured by the rate hike progression. The delta seems to be more important than the level. In fact, each additional percentage point increase has the same effect, whether from zero or five percent. The fact that interest rates stayed so low so long before raising them sharply is central to determining how much more borrowers will have to pay.
Rising interest rate expectations since early August pushed yields higher along the curve and created some interesting opportunities. Looking at the Bank of America/ICE index for three- to five-year US Treasuries, the yield is now 3.4% and the average price of bonds in the index is 93.3%. While we are concerned about the markets in the near term, we do not believe that July will be the last month of positive returns for fixed income this year. It is possible to be defensive and still have a positive return.
Reluctance to British Gilts
Overcoming the livelihood crisis has top priority. However, there are no easy fixes and it is likely to weigh on the UK social fabric for some time to come. The rise in Gilt yields appears to be being driven by fears that inflation figures could rise further after the next two nationwide energy price ceiling adjustments. Either way it sounds crazy, because such an attack on household and small business finances will inevitably result in massive economic strains. Or Gilt yields could rise due to the potential fiscal cost of dealing with the impact of the energy crisis. In any case, no one seems ready to enter the Gilt market just yet.
The sterling movement reflects how the markets view the situation in the UK. Against the dollar, the pound sterling never recovered to the levels seen on the day of the June 2016 Brexit referendum. If the markets react badly to the new government, a exchange rate for the pound below one dollar cannot be ruled out. After exiting the Exchange Rate Mechanism in 1992, the pound had fallen 17% on a trade-weighted basis. After that, the economy recovered and political changes eventually led to a centre-left government in 1997. Since 2015, the trade-weighted index is down 18% – we wouldn’t bet against a political power shift in 2024.