Decoupling between stocks and bonds

“The cities that Europe offers us are too full of the rumors of the past […] That is not enough silence” wrote Camus, in love with the calm desert of Algeria. And silence, there is hardly any in the big capitals: the airports are drowning under the waves of foreign tourists who take advantage of the weak euro while the Europeans savor the last sunny days of this first year finally free of all restrictions sanitary. Alas, we forgot it a little early but wasn’t 2022 supposed to be the jubilee of the long-awaited “return to normal”? This is probably the reason why the urban spectacle has nothing to offer those who look in everyday life for signs of an economic downturn. No, the torpor of the recession has not yet taken the place of the deafening reopening of the economies which continues.

A painful return to basics

And yet, with inflation around 9% on both sides of the Atlantic and rate hikes between 50 and 75 basis points at each conclave of the European Central Bank, the Bank of England or the Fed, the tightening financial conditions is working with all its might to push us into recession.

Investors’ questions focus less on the imminence, considered certain, than on the nature of the economic contraction that awaits us: monetary in the United States? Energy and industry in Europe? Optimists see restoring forces: The investment cycle visible in robust order books will support activity in the industry whose decline will not have the violence of 2020 or 2008. But profits will fall: the charge still difficult to quantify will weigh on margins. However, unlike electricity bills, rising wages have the merit of trickling into the economy. For some economists, the payment of employees is not just an operating cost, it is also an investment. That the historically high share of profits in GDP is shrinking in favor of employee compensation is not bad news, quite the contrary: it is support for consumption.

Most of the work of raising rates by central banks is probably done.

For shareholders, on the other hand, the exercise becomes tricky. Most of the work of raising rates by central banks is probably done. Expected at 4.6% in mid-2023 in the United States and 2.5% in Europe in the middle of next year, terminal rates now have a possible, but limited, margin for growth. What awaits equity investors, however, is a deluge of revisions to earnings and cash flow expectations that should take several months. The peak of anxiety surrounding inflation will now be followed by a painful but more rational return to fundamentals. The whole question now is to know what will be the amplitude of the decline that we can expect for profits: 10 to 30%? What risk premium to add, for equities, to higher nominal rates in 2023. And from when, since the peak soon reached by rates, equities will be able to reach their final low point? With key rates close to 2.50% at mid-year; a normative risk premium of 4.5 to 6% on the equity market requires that the asset class deliver a solid 7 to 8.5% profit return on the basis of estimated profits to which a scenario of significant earnings recession, enough for the most demanding investors to lower the « ideal » entry point on the Stoxx Europe 600 by 8 to 15% lower. come out of one of the most violent bear markets in their history. On the eve of a possible recession, government bonds could post attractive multi-year yields provided that the peak of inflation is near. And on condition also that the central banks contain their rates below the level that the very theoretical Taylor rule seems to require. The calculation formula that is supposed to define the level of key rates according to inflation, growth and/or unemployment currently estimates them at between 6 and 9%.

If these conditions hold and we buy the scenario according to which monetary policies begin to soak the economy, auguring 3 to 5 difficult months for equities but confirming the possibility of a peak in inflation and the first tangible signs of a Fed pivot somewhere in 2023, then sovereign rates could finally regain their protective role within portfolios.

The main risk of this scenario echoes the resentment of Camus who wanders the streets of European capitals: “one feels the vertigo of centuries, revolutions, glory. We remember that the West was forged in the clamours, there blows a wind of revolution, […] of vanquished greatness”. This risk is that downgrading, political instability, social upheaval prevail, exacerbated by the relentlessness of Vladimir Putin, uncontrollable, whose stubbornness in Ukraine could drag the continent towards stagflation.