How can the markets emerge from their malaise? - 9 October 2023
The following analysis was written on Friday 6 October, before the dramatic events in Israel this weekend. Our thoughts are with the families and friends with ties to the region.
Investors are caught in a vicious circle: being more optimistic about the economy pushes up real interest rates and that just makes them nervous about future growth. How can they escape the paradox?
During the first half of the year, investors expected interest rates to start to fall in Q4 2023, a slide that would pick up pace in 2024 amid a hypothetical recession. With such a scenario made unlikely by resilient Western – especially the US – economies, investors have had to adjust their outlook. They now expect interest rates to remain high for a while longer, in line with the relentlessly hawkish language coming out of the central banks. Naturally, rising long-term yields ensue. In essence, there is no reason for this to overly concern the equity markets, because it reflects a less pessimistic view of the economy. However, the speed of the increase in long-term yields creates a malaise affecting the price of all risky assets, including equities (cf. chart 1).
Long-term yields must stabilise for this malaise to end. The most helpful scenario would see long-term yields stabilise as a result of more attractive valuations and the continuation of a relatively benign macroeconomic scenario. Real long-term rates in the United States are well above 2% and have returned to their pre-2008 crisis level (cf. chart 2), which seems manageable. Moreover, the latest inflation figures were clearly favourable, the price of oil has fallen and the US economy seems neither too strong nor too weak at this stage. If this environment continues, the recent adjustment of long-term rates should be sufficient, and the economic outlook does not appear to be at risk.
There are other, less pleasant, scenarios that would put an end to the upward spiral in long-term rates. The first, which is what happened in Q4 2018, is that a change in the real interest rate environment causes the risky-asset markets to capitulate, forcing higher safe-haven bond prices and therefore lower long-term yields. There are also fears that financial institutions may experience a slump in the value of their bond and/or property portfolios, which is what happened to the US regional banks in the spring. Such an event could also attract investors to safe-haven bonds and force central banks to change tack. Finally, with the situation as it is, investors have grown more sensitive to any shred of data hinting that, after several months of very good news on this front, inflation is taking hold, which in turn would make a Fed-orchestrated recession more likely (September US inflation will be released on 12 October).
In our diversified international funds, we have slightly reduced our exposure to equities in favour of positions (in the future) on US 5- and 10-year bonds and on German 2-year bonds. We believe that the markets have already properly adjusted their interest rate expectations, and sovereign bonds could end up as a safe haven if equity markets continue to decline.