Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Market update April 2023
Retrocessions
Saxo Bank
Animal spirits and banking crisis
Global equities rallied 7.7% in USD in Q1, extending the 9.8% gain in Q4, as animal spirits were unleashed in January with technology stocks and cryptocurrencies rallying. Economic indicators showed that economic growth is continuing and the Chinese reopening, after ending its strict Covid policies, helped increase the global growth outlook. As investors were getting excited over the Chinese reopening and the good start to the year, Fed Chair Jerome Powell surprised the market in a speech with a hawkish rhetoric, signalling higher rates for longer. This ignited a strong rally in US long-term bond yields and pushed down global equities.
The rally in interest rates added to the ongoing interest rate shock in US markets and a new source of risk came out of nowhere. Silicon Valley Bank failed as the first significant US bank since the Great Financial Crisis, following a run on the bank from its customers as the bank had incurred steep losses in its bond portfolio and investors were afraid of losing their deposits. The Bank ultimately filed for bankruptcy on 17 March. Panic spread across the global financial system, tightening liquidity and financial conditions and putting pressure on a bank such as Credit Suisse, which eventually led to the Swiss government’s forced merger with UBS on 19 March. In the merger process, the Swiss government imposed a complete loss on additional tier 1 (AT1) capital, which is totally unprecedented and has changed this vital source of tier 1 capital for European banks. As of this writing, the AT1 market is still trading at a significantly higher risk premium, meaning funding costs have gone up for banks, which is expected to have a negative impact on credit conditions going forward.
Global equities rallied 7.7% in USD in Q1, extending the 9.8% gain in Q4, as animal spirits were unleashed in January with technology stocks and cryptocurrencies rallying. Economic indicators showed that economic growth is continuing and the Chinese reopening, after ending its strict Covid policies, helped increase the global growth outlook. As investors were getting excited over the Chinese reopening and the good start to the year, Fed Chair Jerome Powell surprised the market in a speech with a hawkish rhetoric, signalling higher rates for longer. This ignited a strong rally in US long-term bond yields and pushed down global equities.
The rally in interest rates added to the ongoing interest rate shock in US markets and a new source of risk came out of nowhere. Silicon Valley Bank failed as the first significant US bank since the Great Financial Crisis, following a run on the bank from its customers as the bank had incurred steep losses in its bond portfolio and investors were afraid of losing their deposits. The Bank ultimately filed for bankruptcy on 17 March. Panic spread across the global financial system, tightening liquidity and financial conditions and putting pressure on a bank such as Credit Suisse, which eventually led to the Swiss government’s forced merger with UBS on 19 March. In the merger process, the Swiss government imposed a complete loss on additional tier 1 (AT1) capital, which is totally unprecedented and has changed this vital source of tier 1 capital for European banks. As of this writing, the AT1 market is still trading at a significantly higher risk premium, meaning funding costs have gone up for banks, which is expected to have a negative impact on credit conditions going forward.
A key reaction in financial markets to the banking crisis has been changing expectations for the Fed’s policy rate this year, with the market now pricing in one rate hike by June and then, subsequently, two rate cuts by January 2024. This downward sloping forward curve on the Fed Funds Rate and a lower 10-year bond yield in the US, combined with the banking crisis not evolving further, helped equities to recover the lost ground in March.
The first quarter of 2023 ended with both the US and European economies in low gear, but with a positive momentum compared to three months prior. Financial conditions in the US are still looser than the historical average but naturally tightened in the first quarter due to the brief banking crisis. The global composite PMI Index stood at 53.4 in March, a significant improvement over the past three months, indicating that the global economy is accelerating as energy markets are less tight and China is adding a growth impulse into the global economy. This is also reflected in South Korean exports, which have improved over the past three months.
The first quarter of 2023 ended with both the US and European economies in low gear, but with a positive momentum compared to three months prior. Financial conditions in the US are still looser than the historical average but naturally tightened in the first quarter due to the brief banking crisis. The global composite PMI Index stood at 53.4 in March, a significant improvement over the past three months, indicating that the global economy is accelerating as energy markets are less tight and China is adding a growth impulse into the global economy. This is also reflected in South Korean exports, which have improved over the past three months.
The US inflation rate declined further in the first quarter, ending at 5.0%. While the headline inflation rate is coming down, the core inflation rate has shown remarkable stickiness in the past three months, suggesting interest rates will remain higher for longer. The US total unemployment rate (including marginal workers) stood at 6.7%, a historically low unemployment level, which is slightly higher compared to three months ago. Despite this small uptick in the unemployment rate, the US labour market remains solid, with a high level of job vacancies to unemployed, suggesting that wage growth will continue at a higher pace. The Fed increased its policy rate by 50 basis points in the first quarter.
A bumpy start to China’s reopening and rally in technology stocks
As of 18 April, financial markets are generally expressing a positive outlook. US technology stocks are up 13% in the past month and Chinese equities up 4% after a bumpy start to the reopening due to the Lunar New Year. Energy spot prices are down 7% over the past three months; as China’s economy increases its speed, demand for energy will increase as well, and in the first quarter OPEC+ was out announcing further production cuts to keep prices at attractive levels for oil producers. Agriculture spot prices are slightly up compared to three months ago, being the only positive segment together with precious metals in the entire commodity sector. Industrial metals are down 8% over the past three months as investors are awaiting more data confirming Chinese growth and demand. Latest data is suggesting that demand for diesel has declined in the US and Europe, suggesting economic growth is slowing.
A bumpy start to China’s reopening and rally in technology stocks
As of 18 April, financial markets are generally expressing a positive outlook. US technology stocks are up 13% in the past month and Chinese equities up 4% after a bumpy start to the reopening due to the Lunar New Year. Energy spot prices are down 7% over the past three months; as China’s economy increases its speed, demand for energy will increase as well, and in the first quarter OPEC+ was out announcing further production cuts to keep prices at attractive levels for oil producers. Agriculture spot prices are slightly up compared to three months ago, being the only positive segment together with precious metals in the entire commodity sector. Industrial metals are down 8% over the past three months as investors are awaiting more data confirming Chinese growth and demand. Latest data is suggesting that demand for diesel has declined in the US and Europe, suggesting economic growth is slowing.
The USD was down a lot in the fourth quarter of 2022 and has declined slightly since then. The US 10-year yield is up 20 basis points over the past three months, eclipsing the 13 basis points increase in the 10-year inflation expectations, suggesting that the market is pricing in an improving economic outlook. The US yield curve (30Y vs 5Y) is also still positive and has steepened by 4 basis points in the past three months.
Can the rally in technology continue?
Taking a look across the different global industry groups, Q1 was marked by a large divergence in performance. The two best-performing industry groups were semiconductors and automobiles, driven by a lot of excitement in AI technology, with the launch of GPT-4 from OpenAI improving the capabilities of the ChatGPT engine (the user-friendly consumer interface for the GPT-4 AI system). The new capabilities of GPT-4 have ignited a new hype cycle in AI but also hopes of great productivity increases in various digital tasks. This, combined with the momentum in semiconductor investments due to the US CHIPS Act, will continue to underpin a positive sentiment in semiconductors.
The automobiles industry group delivered strong results in Q1 due to the Chinese reopening, which has lifted the outlook for car sales. In addition, lithium carbonate prices are collapsing in China, leading to cheaper batteries for electric vehicles and creating a cycle of price cuts from Tesla and other carmakers increasing growth outlook.
The two worst-performing industry groups were energy and banks, with the drivers being global average oil prices down 7.2% during the first quarter and the banking crisis changing the profit spread for banks due to higher funding costs.
Can the rally in technology continue?
Taking a look across the different global industry groups, Q1 was marked by a large divergence in performance. The two best-performing industry groups were semiconductors and automobiles, driven by a lot of excitement in AI technology, with the launch of GPT-4 from OpenAI improving the capabilities of the ChatGPT engine (the user-friendly consumer interface for the GPT-4 AI system). The new capabilities of GPT-4 have ignited a new hype cycle in AI but also hopes of great productivity increases in various digital tasks. This, combined with the momentum in semiconductor investments due to the US CHIPS Act, will continue to underpin a positive sentiment in semiconductors.
The automobiles industry group delivered strong results in Q1 due to the Chinese reopening, which has lifted the outlook for car sales. In addition, lithium carbonate prices are collapsing in China, leading to cheaper batteries for electric vehicles and creating a cycle of price cuts from Tesla and other carmakers increasing growth outlook.
The two worst-performing industry groups were energy and banks, with the drivers being global average oil prices down 7.2% during the first quarter and the banking crisis changing the profit spread for banks due to higher funding costs.
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