Fast and furious…

Financial markets are off to a strong start in 2023, buoyed by a solid rebound of the major asset classes. This is in contrast to 2022 when both equity and fixed-income markets fell sharply. With a number of ways to explain this reversal, we take a look at the primary factors and summarise our expectations for 2023.

First, inflation exploded in 2022 prior to a recent slow-down, feeding hopes that disinflation could help to move close to the central bank’s target of between 2% and 2.5%. US headline inflation came down from 9.4% to 6.5% in December on the back of declining commodity prices and overcoming unfavourable base effects. The improvement had been noticeable but the pace of change remains limited, most notably for core inflation (excluding energy and food). Wage pressures have continued to push prices higher in the services sector whilst in housing, rising rental prices and activity slow down combined with rising mortgage rates. Under these conditions, the scenario under which inflation can drop to 2% by year-end, allowing the Fed to cut rates, remains too optimistic for us; especially as China’s reopening could help to revive commodity tensions.

Barring any geopolitical issues, this momentum should continue with assets remaining particularly low in investor portfolios, especially after a period of ‘panic selling’ by foreign investors last October.

In China, economic hopes have been ignited by the end of the country’s zero-Covid policy. Barring any geopolitical issues, this momentum should continue with assets remaining particularly low in investor portfolios, especially after a period of ‘panic selling’ by foreign investors last October. As for China’s effect on the rest of the world, it should remain rather more limited. Fiscal stimulus is lower than in 2008; the real estate crisis is weighing on sentiment; the rupture between China and the US is at an end and China is no longer a deflationary force in globalisation.

Thanks to a mild start to winter, voluntary policies to reduce consumption and the build-up of stocks, Europe has escaped the worst-case scenario for the time being.

Finally, 2023 has started with a few surprises despite negative expectations for the Euro and the eurozone. This is in contrast to recent fears of a major energy crisis that would have resulted in a hard recession. Thanks to the mild start to winter, the steps taken to reduce energy consumption and strong reserves of natural gas stocks (see chart 1), Europe has escaped a ‘worst-case’ scenario. As it stands, gas prices have returned to their pre-Ukraine invasion levels (see chart 2). This has proven to be an effective trigger for a rally and short covering of undervalued European assets including currency, credit and equities. These are trends we covered in our last newsletter and they have been amplified by the light positions held by investors in European assets. Whilst the situation remains largely similar, there has been less of a shock than anticipated.

Chart 1: European gas storage capacity fill rate

Source : Bloomberg, Banque Eric Sturdza, 2017-2023

Chart 2: TTF gas future contract price EUR/MWH, Dutch reference

Source : Bloomberg, Banque Eric Sturdza

After a challenging 2022, January 2023 has been a good one for investors patient enough to stay invested. This “fast and furious” rally leaves us circumspect. The year is long and caution
is warranted. Though the reasons for hope should not be downplayed (China, disinflation, the FED’s pivot, reset valuations) some of these factors may already be priced in.

Fixed income: A strong start for fixed income

What will the Fed do?

The US labour market has started the year with unemployment at 3.5% while inflation has begun to drop. Despite an encouraging -0.1% published this month, the pace of change remains slow. The Fed will continue to pursue a restrictive monetary policy but in small steps. It has a strong case, at least for now: with unemployment at 3.5% and no signs of a sharp slowdown in growth, the hawks have not completed their mission. We will have to successfully anticipate the behaviour of central banks throughout the year. On the Fed side, monetary policy appears to be predictable so far, but we remain sceptical. The market is obsessed with rate hikes, the date and the level of the Fed funds peak. Few are discussing the impact of quantitative tightening and when the Fed will stop reducing the size of its balance sheet. This last point is of great concern to us;if the Fed is going to make a policy mistake, it is likely to come from here, not from decisions on policy rates. For the ECB, several rate hikes are expected, but this will be a tricky exercise; inflation is much higher than in the US and too restrictive a monetary policy will potentially push the continent into a deeper recession than in the US.

If the Fed is going to make a policy mistake, it is likely to come from its programme to reduce the size of its balance sheet, not from decisions on policy rates.

Fixed income markets

So 2023 has begun on a high note for the bond markets. We are therefore starting the year with confidence and optimism, but also caution. The US Treasuries curve (2-10 years) is still inverted by about 70bp, beware! As soon as the markets feel that the Fed is coming to the end of its bullish cycle, we will see a steepening that could prove intense and abrupt. Adding duration today is tempting in absolute terms, but not with long-term rates at 3.5%. It is either too early or too late and it is not totally impossible that the 3.32% level reached by the US 10-year on 19 January will prove to be the low point for the whole year.

Credit spreads have not been left behind in this bull market. Today we feel investment grade in dollars is expensive;we certainly don’t regret having crystallised 3-year yields at very good levels in the autumn of 2022! The Euro counterpart is lagging slightly and looks more attractive to us. Even if we are now far from the lows, corporate hybrid bonds are still very attractive. In 2022, the market overestimated the extension risk and was confused by the setbacks in the REITS sector. So far this year, the market seems determined to finally separate the wheat from the chaff and the first issues in the primary market have been heavily oversubscribed, a sign of returning investor appetite for this asset class.

Equities: Fear of missing out

The first few weeks of trading on the financial markets set the tone for the rest of the year. Investors in search of rationality and solid macroeconomic fundamentals are in for a treat! A significant resurgence in risk appetite allowed the global index to gain 7% in just a few weeks.

The European market continued its momentum after a consolidation phase at the end of December, posting a performance of almost 7% since the beginning of the year (Stoxx Europe 600, Total Return). Across the Atlantic, it took a little longer to get started, but a December inflation figure published in mid-January, which was in line with expectations (and therefore down), reassured even the most cautious investors, who rushed to take a position for fear of missing an opportunity.

Has the US central bank changed its tune?

The Fed’s intentions are unchanged and the latest inflation figure is not enough to commit to the long-awaited Fed pivot. Looking at the components of price increases more closely, the decline is primarily due to a decrease in energy costs. On the other hand, another message can be seen with the shelter component that remains elevated. A reason to stay cautious.

The market now expects two to three hikes in the US policy rate by July and then a steady decline to start 2024 below the current level of 4.50%.

So why the renewed optimism?

The answer is certainly very simple: the fear of missing out on a potential rebound, even though our reasoning is to not overreact in the midst of rather disappointing macroeconomic indicators (US Citi Economic surprise negative).

The repositioning of investors in markets neglected last year such as Europe and China is supporting this rebound.

It is without large volumes and in the context of very low volatility that the Nasdaq rebounded to +11% YTD (performance to 30.01.2023) and the S&P 500 followed suit with a performance of +6.02% over the same period.

In terms of outcomes, around 15% of companies have already published their results for the last quarter. Even if it is too early to draw conclusions, sales have so far been in line with expectations, which were pessimistic for 2022, earnings, meanwhile, have generally surprised on the upside.

Unemployment figures do not reflect this (yet) but some large companies have announced significant lay-off plans and are cutting back in anticipation of an economic downturn.

Chart 3: International growth stocks vs. European discounted stocks

Source : Bloomberg, Banque Eric Sturdza, Janv. 22 – Janv 23

As covered in our previous newsletters, asset prices reflected a very bleak scenario last year, especially in Europe. Earnings growth expectations remain very low for 2023 (EPS 2023 S&P500: +4%; EPS 2023 Stoxx Europe 600 < 1%). The current increase is nonetheless supported by normalisation in the level of certain valuations that were largely impacted in 2022. The repositioning by some investors in markets that were neglected last year, such as Europe and China, is also supporting the rebound.

After 2022, a year marked by monetary tightening, higher-than-expected inflation and a strong compression of financial multiples, we start 2023 with a market driven by important flows. This, coupled with a low volatility, makes the level rise a little more each day… could it be enough for the situation to explode?

We remain cautious on equities and are taking full advantage of this good start, we are aware that recent movement has not been based on solid ground or fundamentals. We continue to enjoy the upswing but remain vigilant, ready to act if we feel the rally is exaggerated. We maintain a mixed exposure between growth stocks and undervalued stocks to limit style bias. 2023 is set to see an impressive recovery in the performance of growth stocks after a very favourable year for discounted stocks in 2022 (chart 3).

Contributors: Edouard Bouhyer (CAIA – CIO, Banque Eric Sturdza), Marc Craquelin (Senior Advisor, Banque Eric Sturdza), Jérémy Dutoit (Heady of Advisory, Banque Eric Sturdza), Pascal Perrone (Senior Portfolio Manager) and Eric Vanraes (Head of Fixed Income).

As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolios.

Adam Turberville
Director
+44 1481 742380
a.turberville@ericsturdza.com

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The views and statements contained herein are those of Banque Eric Sturdza SA as of 05/02/2023 and are based on internal research and modelling. Please click on BES Disclaimer to view Banque Eric Sturdza’s disclaimers. Please click on Disclaimer Page to view full disclaimers.