Equity markets continue to show considerable resilience despite a downgrade in global economic growth forecasts, rising commodity prices and further evidence of the strength of inflationary pressures. After the first sell-off in global stock markets, the MSCI All Country World Index returned to above its pre-war level, while the VIX Volatility Index — an indicator of expected market volatility — fell back below its long-term average.
No alternative to stocks?
March is on track to be the worst month for US Treasuries since July 2003. In March, the Bloomberg US Treasury Aggregate Index posted a negative return of 3.5% through 3/30/2022 (negative 5.6% since the start of the year).
Short-term US Treasuries weathered the worst of the selloff as markets price in significant monetary policy tightening from the US Federal Reserve to contain inflation.
Market expectations for fed funds have shifted significantly to value more than 200 basis points of Fed rate hikes by the end of 2022, on top of the 25 basis point hike earlier this month. . If this were to happen, it would move federal funds closer to the Federal Open Markets Committee (FOMC) long-term DOT median by the end of 2022.
Yields on two-year US Treasuries this week topped those on the 10-year US Treasury for the first time since August 2019, inverting part of the yield curve. Two-year yields hit 2.45%, the highest level since March 2019. They have since fallen back to 2.31%, with the yield on 10-year US Treasury bonds now at 2.35% (see charts). graphs 1 and 2 for the variations of 2 years and 10 years American and German).
Eurozone bond yields are also suffering
Markets are now pricing in several rate hikes from the ECB to bring policy rates down to zero by the end of 2022. Data released this week shows German inflation hit its highest rate in 40 years . A 39.5% year-on-year rise in energy prices was the main driver behind a higher-than-expected rise in Germany’s Harmonized Index of Consumer Prices (HICP) to 7.6 % year-on-year. These data arrived a few hours after the The German government has taken the first official step towards rationing the gas supply. The German government is taking precautionary measures in the event of a stoppage of gas deliveries from Russia due to a dispute over payments.
Data on overall price growth in the euro zone in March are due on 2 April. Omens are not good. High-frequency data suggests the monthly increase in eurozone petrol prices could be the largest on record and data released yesterday showed annual inflation in Spain hit 9.8% in March , the highest level since 1985. It is therefore likely that inflation data in the euro zone will provide a ninth consecutive monthly increase topping consensus expectations and likely setting a new record well above 6% in pace. annual, after 5.9% in February.
In response to inflation news, the yield on Germany’s benchmark 10-year bond rose this week to 0.70%, a four-year high. Yields on German 2-year government bonds crossed zero for the first time since 2014 (they started the year at -50 bps). In March, Bloomberg Euro Aggregate Treasury Index returns are negative 3.07% through 3/30/22 and negative 5.98% year-to-date.
What happens next?
Our fixed income team has long believed that inflationary pressures would cause the ECB and the Federal Reserve in particular to raise rates faster and further than the market expected. The magnitude of the rise in rates this month is such that bond yields have reached levels close to those that we might have expected at the end of the year. We therefore took some profits on our underweight duration positions, but remain underweight interest rate risk overall.
The question now is whether we agree with current market prices, which continue to imply that the current surge in inflation and rates will eventually subside, with the previous paradigm of “secular stagnation” which reaffirms itself. The fed funds futures curve, for example, currently implies that rate hikes will stop below 3% by mid-2023, with policy weakening thereafter.
The answer to this question depends mainly on the holding of economic growth and the continuation of the inflationary shock. In a recent intermediate economic outlook the OECD estimates that as a result of the conflict in Ukraine, world production will be 1.1% lower than it would have been otherwise. The impact on the United States is estimated at only 0.9%, but on the euro zone it will be 1.4%. The comparable impact on inflation would be +2.5% for the world, +2% for the euro zone and +1.4% for the United States. Rising energy and food prices will reduce real consumer incomes far more than these gross domestic product losses suggest.
the German IFO business climate index for March saw the largest drop in history, even exceeding the Covid-19 drop. This highlights the risk of a technical recession in Germany, one of the eurozone economies most vulnerable to the Russian-Ukrainian conflict.
We continue to believe that the ECB will remain on the path to policy normalization. However, the impact of the Russian-Ukrainian conflict on Eurozone growth, combined with more balanced medium-term inflationary risks, is increasing uncertainty about the timing of ECB rate hikes. Indeed, wage growth in the Eurozone remains subdued and recent developments suggest that unions are moderating near-term wage demands in light of the conflict.
In one March 30 speech, ECB President Christine Lagarde summarizes the outlook as follows:
“Europe is entering a difficult phase. We will face, in the short term, higher inflation and slower growth. There is considerable uncertainty about the magnitude of these effects and their duration. The longer the war lasts, the higher the costs are likely to be.”
All opinions expressed herein are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may have different views and make different investment decisions for different clients. The opinions expressed in this podcast do not constitute investment advice.
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