Exposure rates of the Dorval Asset Management Range - December 19, 2022
After a week that firstly featured very good inflation stats in the US, and subsequently saw a firm but unsurprising stance from Jerome Powell, the financial markets gave way under the weight of a major shift in tone from the European Central Bank. When applying its models, the ECB came up with the same result as the OECD two weeks ago i.e. growth in Europe will probably not be as weak as feared in 2023 (cf. chart 1) before taking a moderate upturn in 2024. Unemployment in the euro area is set to stick close to its current historical low at under 7%. The surprise surge in the German composite PMI in December – from 46.3 to 48.9 – also corroborates this.
Inflation is thus set to be more persistent, at over 6% in 2023, 3.4% in 2024 and 2.3% in 2025. As we have often noted over recent weeks, it was therefore very challenging to expect ECB rates to stay below 3% in 2023, as expected by the market so far. It is likely that the consensus will fairly shortly move towards a target rate of around 3.5% (cf. chart 2). We note that this 3.5% rate would be well below inflation expected for next year (but in line with inflation expected for 2024). However, the ECB’s tightening strategy will be bolstered by a reduction in its balance sheet (quantitative tightening) and a decrease in bank liquidity.
Any major central bank’s announcement of forthcoming restriction is never good news for the markets. However, the ECB is well and truly behind the curve compared to other central banks, which are getting closer to their pivot i.e. England, Canada, Australia, and perhaps the US shortly. Additionally, the ECB’s logical attitude is driven by good news on a question that raised considerable concerns for the markets in 2022 i.e. the European economy is not going to collapse. This improved outlook will probably consolidate the decline of the dollar, which is often fairly positive for the markets. Lastly, the disappearance of the disaster scenario for the European economy should eventually ease the risk premium on certain assets, such as European small-caps, in our view. With a forward median P/E of 11.5x, stocks on the MSCI Euro Small Cap Index already price in a lot of bad news.
In our international portfolios, we maintain our moderate investment. The market needs some time to absorb money-market events of the past few days, particularly as portfolio managers had retaken positions. We of course maintain our negative stance on European sovereign bonds (short position on German 5-year), and pursue our long position on Treasuries, which hedges part of our equity risk. We again upped our small-cap market exposure in Europe.