Exposure rates of the Dorval Asset Management Range - October 14, 2022

The bond market crisis in the UK combined with doggedly high inflation in the US are fueling severe volatility on the financial markets.

Against this backdrop, it is valid to consider whether this tension offers an opportunity to invest with a view to a likely year of disinflation in 2023.

Caution should be the watchword, yet resolution of the gilt crisis in the UK may be under way after the Chancellor stepped down, and with the prospects of a less expansionary budget in the country. This would pave the way for slightly less restrictive monetary policy and this prospect has soothed tension on the bond market for now (cf. chart 1). However, it will be crucial to ensure that pension funds do not run into fresh liquidity problems, with the Bank of England poised to halt its intervention as lender of last resort from October 17. Stabilizing gilt yields from then on would obviously be good news for the financial markets.

 

Whatever the outcome, the latest crisis in the UK has fanned the flames in the debate over the best policy mix for Europe, which is facing the threat of stagflation. The current consensus seems to support expansionary – although not overly – fiscal policy to combat the energy crisis without sending public deficits through the roof, stage a swift readjustment on money-market rates, while keeping them well below inflation. However, this consensus is derived from an average that glosses over some vastly diverging views, notably within the ECB, between those who feel that interest rates need to go much higher, and those who favor a more restrained approach given the high risk of recession. Yet we can be fairly certain of one thing – the ECB’s rates should sit at around 2% by the start of next year. The next steps will hinge largely on the European economy’s resilience to “General Winter”. Despite these uncertainties, it still seems challenging to take positions on European bonds with yields that carry virtually no risk premium to cover a greater rise in money-market rates than expected in 2023 (cf. chart 2).

 

 

 

The situation is different across the pond. The likelihood of a US recession is faint for the months ahead, and inflation remains the only material difficulty. Consumer prices surged again in September (+0.6% excluding food and energy, and +6.6% yoy, hitting a 40-year peak) and do not yet reflect the drop in inflationary pressure visible in a number of indicators. This is particularly true for rents, where the pace of the uptrend has started to slow for new rental contracts, which will only very gradually trickle through to the overall stock of existing rentals. Recent research suggests that rent inflation in the consumer price index will peak at the start of 2023 before slipping most notably in the second half of next year (cf. chart 3).

 

 

Against this backdrop, the Fed is set to pursue its rate target for at least 4.5% in the Spring of 2023 (vs. 3.125% currently), bar a forthcoming sudden slowdown in the US economy. However, the markets have already priced in this policy and expect the Fed to steer its rate to 4.88% in March 2023. Additionally, US long-term bond yields now enjoy very positive real rates, with +1.6% on the 10-year TIPS. The US bond market’s risk/return ratio is more upbeat than the equivalent indicator in the euro area, in our view.

US long-term rates may therefore end up stabilizing close to 4%. If this scenario materializes, the equity markets may well steady in their wake given the close correlation between the two over recent years, particularly since 2018. However, in the absence of a substantial economic slowdown in the US, we are not sufficiently convinced of this scenario to increase our risk exposure rates at this stage. We still have a preference for the money market and stand poised to adjust our positions as necessary to address these highly challenging markets, although opportunities will certainly materialize over the weeks ahead.

 

 

Download the weekly letter in PDF version: Exposure rates of the Dorval Asset Management Range –14th october 2022

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