Exposure rates of the Dorval Asset Management Range – 18th March 2022
Despite the shockwave triggered by the Ukraine conflict, the US central bank has hiked its Fed funds rates by 25 basis points and forecast a series of future rate increases, in line with the scenario already priced in on the markets. Only one of the Fed’s members indicated a preference for a 50bp hike, which would probably have been more popular in the absence of war in Ukraine. The Bank of England upped its rates the next day for the third time since December 2021, specifying that its future pace of rate hikes was now more unclear as a result of the possible fallout from the Ukraine conflict. In sum, all the major central banks – with the striking exception of the Bank of Japan – are still pursuing monetary policy normalization. However, the economic consequences of both the war and the ensuing sanctions will dictate the pace of this process. As a result, the long end of the yield curve has held up fairly well in the midst of the hike in short-term rates and rising inflation projections (cf. chart 1).
Despite inflation and rising Fed funds rate, the increase in long-term yields is hindered by the war in Ukraine
US 10-year rate / UK 10-year rate / Russia’s invasion of Ukraine / German 10-year rate
It will take quite some months to determine the war’s full effects on the world economy: consumer and business confidence surveys will provide some initial clues in this respect. The euro area preliminary consumer confidence indicator will be released on March 23rd, while preliminary PMI figures will be issued on March 24th and the German Ifo index on March 25th. Despite the lift from easing health restrictions, confidence is set to deteriorate considerably, especially in Europe. A recent Bank of America report suggests that euro area economic sentiment has already plummeted on a par with March 2020 lows (cf. chart 2), according to its big data-derived indicator, based on daily information analysis. The real shock is clearly less severe than two years ago, implying that the emotional jolt from the war could well drag down survey data to an excessive degree, so it will be crucial to tread carefully when interpreting the results.
Emotional shock from the war seems to have had a disproportionate effect on economic sentiment in Europe
When all is said and done, an economic slowdown looks inevitable in Europe: conversely the outlook in the US is more debatable, as the country’s economy is nowhere near as heavily dependent on Russia. However, additional inflation fueled by rising oil prices will act as a consumer tax, while recent indicators already seem to suggest an economic slowdown. The Federal Reserve Bank of Atlanta’s GDP Now estimate is for growth of just 1.3% in the first quarter (estimate at March 17th). However, this report also shows that this timid GDP gain is entirely due to a sharp drop in inventories. Excluding this effect, domestic demand remains very robust, with consumer spending potentially posting growth of more than 4% in 1Q, while investment is set to surge around 10% (cf. chart 3).
“GDP Now” estimates of US 1Q GDP
(source Federal Reserve Bank of Atlanta)
Residential real estate / Equipment investment / Intangible investment (intellectual property, etc.) Non-residential real estate / Consumer spending / Total GDP / Trade balance (contrib.) / Change in inventories (contrib.)
So we can still justifiably waver between two scenarios: either the shock from events in Ukraine sets the US economy on the path to a sustainable moderation in growth that would gradually alleviate underlying inflationary pressure, with the ensuing boost for the financial markets; or this shock is just a blip in the midst of a more resilient inflationary boom than we had imagined, driving fresh major tension on interest rates. It will probably take several weeks before we can truly decide between these two scenarios.
In our portfolios, we still steer clear of the bond market, where valuations have further worsened with real rates (excluding inflation) negative almost entirely across the board. In our flexible funds, we continue to focus on cash equity strategies, as equities offer much more attractive risk-adjusted valuations than bonds (including corporate bonds). Our risk exposure remains moderate for now and we continue to concentrate on the energy transition and ESG quality themes, particularly governance dimensions.