In search of a new equilibrium
A month and a half on from the banking stress triggered by the failure of two US banks and the difficulties encountered by Credit Suisse, the markets appear to have calmed down after the First Republic case was resolved with its acquisition by JP Morgan.
The main stock market indices are still trading at their highest levels of the year after a good earnings season. To see the impact of the financial stress episode, we need to look beyond the major stock market indices: in the US financial sector and on the bond market segment, where long-term interest rates have not returned to their start-of-the-year peaks.
On a more macroeconomic level, the April PMI1 surveys show that the US and the euro zone are still experiencing strong expansion, entirely driven by a new upturn in the services sector, while the manufacturing sector is still in decline. In the euro zone, the gap between the two sectors is at an all-time high (more than 11 points)2, so we think it is safe to assume that the two sectors will start converging again in the coming months. From a forward-looking perspective, the statistics show signs of a slowdown in the US economy with less favourable winds on household consumption, retail sales that are starting to slow down and the beginning of a retreat on open positions, although they remain historically high. The slowdown should thus intensify over coming quarters, given that the deterioration in credit conditions is expected to weigh on business investment.
US inflation, as measured by the consumer price index, fell slightly more than expected to 5.0% in March (vs. 6.0% in February), due to a significant base effect on energy prices, and is thus back to its May 2021 level. Underlying (or core) inflation is fairly stable, at 5.6% in March versus 5.5% in February3 with the expected mechanisms: the easing of goods inflation has run out of steam for the time being and we will probably have to wait until the second quarter for services inflation, in particular via its housing component, to take over the driving down of inflation.
In the euro zone, total inflation fell sharply to 7.0% in April versus 8.5% in February4 due to substantial base effects on energy prices, while core inflation remains high at 5.6% (vs. 5.7%)4. Indeed, the first easing of inflation for manufactured goods at the beginning of 2022 is unable to offset the renewed rise in services, which weigh much more in the household basket and whose evolution is very similar to that of wages in the euro zone, currently around 5% year to year4.
To summarise, total inflation is falling on both sides of the Atlantic, notably thanks to the base effects of energy prices, but core inflation remains stubbornly high. It is therefore services inflation, which is most closely linked to wage dynamics, that central banks will be monitoring to guide their monetary policies during the second half of the year. Within this context, the Fed (Federal Reserve System) is unlikely to change its key lending rates after early May’s hike. We also believe that the three interest rate cuts expected by the market by the end of the year are exaggerated. The US central bank will wait until it is convinced the core inflation index will continue to fall before easing its monetary policy. Otherwise, the US recession in the second half of the year would have to be violent, due to the accumulation of numerous rapid rate increases and the tightening of credit conditions resulting from the shock wave on regional banks. If that were to be the case, we find US equities far too high and at multiples unable to absorb this kind of bad news.
In Europe, the European Central Bank should continue to raise its key lending rates once or twice between now and the summer before stabilising and, like the Fed, remaining in restrictive territory to see core inflation decline during the second half of the year.
Long rates should not fall significantly in our main scenario. Having in mind a longer investment horizon, the necessary global energy transformation could become a growth opportunity that would allow us to enter a long growth cycle and thus see nominal growth, inflation, and short and long rates remain high for a substantial period of time (inflation higher than the central banks' target being a less painful aid to reducing government debt than tax increases or public spending cuts).
From our point of view, we have thus undoubtedly changed the regime for the absolute level of interest rates, thereby restoring the status of the money market and investment grade assets, two asset classes that had markedly lost their appeal in the previous decade. The asset allocations of major investors will therefore inevitably change, leading to a future rebalancing with those that were previously favoured. Last but not least, this new interest rate equilibrium will also probably go hand in hand with a shift in the correlation matrices between stocks and bonds, similar to what we experienced in the early 2000s, once again modifying the construction of many asset allocations and portfolios.
Eric Bertrand, Deputy Managing Director, Chief Investment Officer, Ofi Invest Asset Management