Bond/currency markets: attractive yields
In the eurozone, the ECB speech on 15 December 2022 was more hawkish than expected, promising further rate hikes and announcing a timetable for balance-sheet shrinkage. However, since the start of 2023, markets have been ratcheting down their expectations for short-term rates. They now price in 125 bps of rate hikes over 2023 (Figure 11).
In the United States, the Fed’s December speech was also tougher than expected, mentioning an upwardly revised federal funds rate peak and elevated rates throughout 2023. Market expectations are considerably more moderate, with investors anticipating rate cuts as early as the second half of 2023 (Figure 12).
In Japan, the rise in domestic rates could lead to capital flows returning home with the Japanese repatriating some of their USD 2.4 trillion international bond holdings, which in turn could exert upward pressure on western rates. Indeed, Japanese investors seeking to hedge US dollar exposures are facing effective negative yields on US 10-year notes.
In the credit segment, yields have returned to around 4% for good quality European companies (Figure 13). This could cushion credit spreads from widening back to 2012 levels. Credit spreads for lower quality European companies could still temporarily widen under a recession scenario, although yields are already attractive at around 7%.
In foreign exchange, the euro-dollar continues to move in line with the short-term interest rate differential. A likely upward adjustment in Fed rate expectations could therefore lead to another rebound in the US dollar. In the longer term, we can expect the exchange rate to return to levels more consistent with purchasing power parity, the implication being that a sharp rebound in the euro against the dollar lies ahead (Figure 14).
Overly optimistic equity markets?
We believe that earnings expectations for 2023 are too optimistic. While the buoyant start to 2023 may bring further surprises to the upside, an ineluctable recession will, at some point, drag on growth (Figure 15).
In addition, equity market valuations are not especially cheap. Indeed, while the valuations in most markets sit below historical averages, they remain well above recession levels (Figure 16).
As interest rates rise, equity returns become relatively less attractive. European bond–equity spreads are at their narrowest for the past decade and in the US, equity risk premia are very low.
Conclusion: financial markets
Most asset classes are facing challenging times as central banks raise rates in a bid to combat inflation while concomitantly raising the risk of triggering a recession.
While we cannot rule out positive surprises in the next 3–4 months given the resilience of the economy, we believe that equity markets remain threatened by further monetary policy tightening and a very likely recession in the year ahead. Aside from the fact that valuation lows are usually reached after the onset of recession (Figure 17), current valuation levels do not appear exceptionally cheap. Patience remains the order of the day.
However, given the higher interest rates and widening credit spreads, bonds are currently offering attractive yields. The context calls for a gradual approach to fixed-income investment in the months ahead.
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See also : https://latribune.lazardfreresgestion.fr/en/fixed-income-in-2022/
The opinion expressed above is dated January 2023 and is liable to change. Latest available data as of publication date.
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