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After concentrating on inflation during the first half of the year, investors may now be moving on to focus their attention on the slowdown in global growth.
This seems to be the message sent in recent weeks by the direction of sovereign bonds yields, which are reassuming their safe haven status. After US 10-year rates flirting with 3.5% and their German counterparts with 2%, they have declined to 3% and 1.2%, respectively, in a sign that investors are now less frightened of an inflation spiral. This is also an indication of the fragility of future growth. The reason for this is the constant deterioration in macroeconomic data, although there is not yet any clear indication of a recession in the short term. Another interesting factor is the decorrelation between equities and government bonds, which is being re-established gradually. Generally, equity prices fall as bond prices rise and vice versa, but this has mostly not been the case since the start of the year, with equities and bonds falling in tandem.
Of course, the prospect of a slowdown in growth, or even recession, is not a happy one for the valuation of equities, as it automatically depresses the corporate earnings outlook. But this new environment increases the attraction of companies and sectors that can withstand such situations. For this reason, in recent weeks, defensive and high-quality companies have tended to outperform their more fragile or cyclical counterparts. Here again, equity markets seem to have moved onto the issue of economic growth, abandoning their focus on price inflation.
In contrast, the US Federal Reserve is still fully focused on inflation issues. This is clear from the minutes of the FOMC meeting of 14 and 15 June: the term “inflation” appears 90 times, whilst GDP growth is mentioned just 10 times. Unlike markets, the Fed only has eyes for inflation at the current time.
With forthcoming second quarter corporate earnings reports, preliminary GDP estimates, and new corporate and consumer sentiment surveys, the next few weeks will be key to determining who is right – the Fed or markets. After their recent bungling of inflation – characterised as temporary for far too long – are central bankers once again behind the curve ? Or have markets got it wrong? That remains to be seen.
Written on 11 July 2022 – by Olivier de Berranger, CIO, LFDE