Exposure rates of the Dorval Asset Management Range - October 21, 2022

Fairly reassuring 3Q corporate earnings are having little success in shoring up the equity markets as they heighten tension on interest rates. A more persuasive economic slowdown in the US is still the prerequisite for a sustainable shift in trajectory on the financial markets.

Stabilization on the UK bond market combined with the relatively upbeat start to the earnings reporting season (particularly in the US) have initially stemmed the tide on the equity markets. However, this good news also has a fairly logical – and conflicting – effect i.e. it fuels the trend towards rising rates. With no financial difficulties and in the absence of a slowdown on the US labor market, investors can only continue to expect further rate hikes from the Fed (cf. chart 1). The financial markets now expect the Fed to hike rates to 5% by March, far overshooting inflation figures expected by the Bloomberg consensus (+3.4% for the core PCE deflator). However, we note that these fairly optimistic inflation projections could continue to rise, thereby ultimately putting further pressure on interest rates.

 

 

Markets are expecting the Fed to soon become unmistakably restrictive

Fed rate expected by the markets in March 2023
Fed rate expected by the markets in November 2022
Core PCE inflation expected for 2023 (Bloomberg consensus)
Fed rate

 

 

These projections – which Jerome Powell will probably see no reason to dampen at the next Fed meeting on November 2 – are fueling fears of a US recession over the coming 12 months, which economists surveyed by Bloomberg now deem to have a greater than 50% chance of materializing (cf. chart 2).

 

Probability of US recession within 12 months as projected by Bloomberg consensus

 

Strangely, this end-of-cycle impression is not – or at least not yet – confirmed by showings on the yield curve. The surge in fears of a recession should logically trigger a stabilization on the long end of the US yield curve, or at least an under-reaction from long-term yields to the rise in short-term rates. However, this is not what we have been witnessing over the past several weeks (cf. chart 3). US 30-year yields have even taken a swifter upturn over recent days. Are we seeing a rise in the liquidity premium, which we had witnessed in the UK before the BoE stepped in? Whatever way we look at it, showings on the Treasuries market are fairly disconcerting.

 

Long-term yields vs. short-term rates: atypical behavior for end-of-cycle scenario

Yield on 30-year US Treasury
Yield on 3-month US Treasury

 

 

Beyond uncertainties on how to analyze current markets, we continue to believe that only a sufficiently convincing economic slowdown in the US could sway the market trajectory. With some inflationary pressure already dwindling, such a slowdown would decrease the likelihood of a severe recession scenario triggered by the Fed. Indicators to watch include activity in the services sector, which is the main source of jobs, along with jobless claims, which still point to a very vigorous job market for now.

In our international flexible portfolios, we maintain our low equity exposure and zero bond duration for the moment. In the absence of a significant economic slowdown in the US, we are not sufficiently convinced of a “peak in long-term yields” scenario to hike our risk exposure rates substantially. We still have a preference for the money market, which benefits from regular rises in short-term rates. We stand poised to adjust our positions at any time to tackle these challenging markets, which nonetheless are beginning to harbor potential again on US bonds and on equities.

 

 

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