The global rise in yields has eased again somewhat over the past two weeks. Bond prices have stabilized at low levels since then. In the UK, the turbulence on the bond markets has subsided again since the resignation of Liz Truss and Kwasi Kwarteng. Ten-year Gilts are currently trading at yields of 3.5% compared to highs of 4.6% a few weeks ago. Inflation remains persistent and is expected to reach a new high in Europe in October. Eurostat expects annual inflation to reach 10.7%. The picture is similar in the US, with inflation at 8.2% and core inflation at 6.6% in September. According to economists, global inflation is likely to have peaked at around 10% in the third quarter and halve again by the end of 2023. We also expect inflation rates to decline in the coming quarters. Various data point to this. Energy prices in Europe have come down significantly from their extreme levels in August and continue to fall sharply (see FOKUS). In the USA, current data already suggest that goods inflation is likely to decline further. Freight rates, commodities (ex food and energy) and DRAM prices have already been falling since the beginning of the year. In addition, supply chain bottlenecks have improved in various sectors. Rental rates for first-time leases have also been falling for a few months. However, rising wages due to the still solid US labor market will counteract this development to a limited extent. Regional Fed surveys, the Atlanta Fed Wage-Growth Tracker and declining JOLTS suggest that wage growth may have peaked as well. Whether this trend continues depends on how long labor shortages persist. The Fed is countering this with its aggressive monetary policy. If inflationary pressures ease more significantly in the coming months, the Fed will continue its tightening path in a less pronounced manner, buying time to better quantify the impact of monetary policy on the labor market and the real economy. The risks of a very deep recession could thus be alleviated somewhat, although the bond market is presenting a clear warning here with the inversion between the 3-month and 10-year interest rate term structure. The ECB is likely to act similarly. The growth outlook and financial stability in the euro zone without a regulated fiscal union are disproportionately more complex than in the USA. Equities are likely to receive further support in this phase thanks to curbed interest rate policy, before a reality check takes place in which earnings estimates for the coming year will have to be revised downward. This is likely to put renewed pressure on equity prices, even if the valuation exaggeration of recent years has been selectively reduced and current valuation levels are back at fair levels in a historical context. Bonds have now also returned to more attractive levels.
The renewed setbacks in mid-October were accompanied by pessimistic sentiment, a high intraday volatility and a record number of S&P 500 options contracts traded. In the days that followed, Western equity markets set out on a rally that lasted through the end of the month. The S&P 500 gained +8% and the Nasdaq 100 gained +4%. European indices gained between +5% and +9%, with the SMI at +5.5% and UK at +3% bringing up the rear. Chinese stock indices moved in the opposite direction, which were the focus of the 20th Party Congress shortly after the weeklong Golden Week holiday of early October. Xi Jinping's bundling of power, lack of reforms and the clear primacy of ideology triggered a sell-off on Chinese stock markets. The Hang Seng loses -14.7% in HKD and the CSI 300 loses -8.7% in CNY in October. Only about half of the companies have released the numbers in the current earnings reporting season and so far earnings growth in the U.S. is at 1.9% and sales are up 11%. The energy sector has the strongest earnings growth, up 140%, while the basic materials sector has the largest earnings decline, down -34%. The big tech stocks (Microsoft, Amazon.com, Alphabet, Meta) clearly disappointed earnings expectations, while Apple still managed to surprise on the upside. In the coming quarters, the pressure on margins is likely to intensify and have a more pronounced impact on earnings. Accordingly, earnings expectations will have to be revised downward. A profit recession is likely to lead to a renewed increase in volatility and lower share prices.
Yields on ten-year government bonds rose for twelve consecutive weeks, marking the longest period of bond losses since 1980. In the meantime, global bond yields have eased somewhat from their mid-October highs. Short-term policy rates in the U.S. and Europe are also approaching restrictive levels (neutral rate). Accordingly, the Fed and the ECB may gradually slow the pace of rate hikes in 2023. In addition, businesses and consumers in the euro zone continue to face strong headwinds - this environment points to lower yields. In the U.S., the U.S. consumer remains resilient despite ongoing price pressures, and should real wage growth continue to rise and inflation decline, consumer spending should continue to support the U.S. economy. In the mid-term elections, it is highly likely that the Democrats will lose their majority in the Senate, which should put some brakes on U.S. government spending going forward - and could also thus alleviate inflationary pressures through less government interventionism.
The USD is a countercyclical currency and continues to trade strongly due to its attributes as the most important "save-haven" reserve currency and the positive interest rate differential against the major trading currencies. Measured against purchasing power parity, however, the USD is significantly overvalued. In anticipation of another ECB rate hike of 0.75% in October, the EUR strengthened against the major currencies and reached parity with the USD in the short term. The CHF trended correspondingly weaker in the reporting month. After OPEC announced production cuts, oil prices rose again significantly (Brent +11%). Gas prices in Europe continued their decline, which will provide some relief for inflationary pressure (see FOCUS).
The high inflation rates are likely to entail further interest rate hikes by central banks. However, the pace of rate hikes is likely to be much less pronounced should signs of easing inflation be reflected in aggregate data. This would give a short-term boost to bonds and equities. The earnings recession is yet to come and we expect the impact of margin pressure and lower growth to become clear in the first half of 2023. The profit declines and lower growth rates will potentially result in renewed losses and higher volatility in equity prices. However, we do not currently expect the economic slowdown and increased geopolitical risks to lead to a systemic crisis. At the moment, however, relative valuations still do not support a "screaming buy" for equities: the real earnings yield for US equities is -7% compared to risk-free government bonds, which are valued at -3%.