Exposure rates of the Dorval Asset Management Range – September 9TH, 2022

The disinflationary process now seems to be under way and could spread to Europe over the months ahead. This development will be crucial if the equity markets are to stabilize, but it does not put a stop to the hike to money-market rates, with major consequences for investment management in Europe.

The easing in inflationary pressure has been particularly visible in the US since the start of the summer and is now beginning to amplify. In August, the New York Fed’s Global Supply Chain Pressure Index hit its lowest since the start of 2021 (cf. chart 1). In addition, a number of commodities are experiencing a drop in prices, dragged down by the persistently sluggish Chinese economy. Meanwhile gasoline prices in the United States have slid more than 25% again since their high in June, and stand only 5% from levels prior to Russia’s invasion of Ukraine.

 

Sharp decrease in supply chain pressure
Composite index including transportation costs, inventories, delivery times, etc.

However, Europe has undergone the most significant changes very recently, with Germany agreeing in principle to a revision in European Union electricity price calculations. Intense discussions are under way, as the Commission is determined to implement a price cap of €200 per megawatt-hour on non-gas generated electricity. This development has already had a massive impact on German electricity futures prices, which had been on a wholly unsustainable trajectory since the start of the summer (cf. chart 2).

 

 

 

Electricity prices in Germany
Annual futures contracts, euros/MWh

 

 

Disinflation could therefore spread to Europe over the months ahead, and this process will obviously be the key to unlocking better showings on the financial markets. However, the benefits of this situation could run up against two main obstacles. Firstly, the bond markets have already priced in this disinflation, with long-term yields at 3.25% in the US and 1.7% in Germany. Inflation-linked bonds reflect investors’ expectations of inflation at around 2% over the next ten years (cf. chart 3). Only the threat of an imminent recession could warrant buying bonds at these rates. Yet the beneficial effects of current disinflation for the economy make this scenario less credible, particularly in the US.

 

 

 

Projected inflation and real rates are too low to make bonds attractive

US – projected 10-year inflation / US – 10-year real rates
Germany – projected 10-year inflation / Germany – 10-year real rates

 

 

The second obstacle is the change in the central banks’ reaction function as announced over the past few months. Inflationary pressure has eased much too recently to stop the Fed and the ECB pursuing their hikes to money-market rates, which are still far short of inflation, particularly in Europe. The Fed has its sights firmly set on the overheating labor market and is keen to apply restrictive monetary policy with rates of at least 4% at the start of 2023. In Europe, the ECB is determined to normalize interest rates, which means at least 2% on money-market rates in 2023. Meanwhile the central bank has left it up to the fiscal authorities to offset the recessionary effects of Russian gas supply interruption. Monetary conditions are therefore set to continue tightening despite disinflation. 

 

A new landscape is emerging for savers and investors in Europe, creating a situation that is without precedent over the past ten years and more. The average rate on 3-month negotiable debt securities already stands above 1% for the first time since 2012 and is set to exceed 2% by the start of next year (cf. chart 4). Cash has long been challenging, but is now resuming its prized status in asset allocation and offers the easiest and safest way to take advantage of current and forthcoming rises in short-term rates.

 

 

Positive money-market rates in Europe: we’ve only just begun

France, 3-month BTF (fixed-rate discount Treasury bills)
Average rate on 3-month negotiable debt securities (investment grade, Bloomberg index)
ECB deposit rate

 

 

In our flexible funds, we continue to steer our equity risk hedging in response to economic statistics and market momentum (investor positioning, RSI, etc.). We remain on standby on our equity allocation for now, while in our international funds, we continue to overweight Japan, which offers a haven of interest rate stability. We maintain our approach to bond duration, with a fully divested stance and a short position on German 2-year bonds. Lastly, the large cash position in our portfolios is beginning to benefit from the emergence of positive money-market rates in Europe and this upbeat trend should continue to gather pace over the weeks ahead.

 

Download the weekly letter in PDF version: Exposure rates of the Dorval Asset Management Range – 9th September 2022

 

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