Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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The equity conundrum: It is all about a recession or not
Peter Garnry
Chief Investment Strategist
Summary: Economists and consensus were looking for an incoming recession back in the fourth quarter of last year with even big investors such as Warren Buffett holding tight despite global equities down 20%. Instead the economy has rebounded releasing animal spirits and a rally in growth stocks. Recently equities have absorbed higher bond yields suggesting that the interest rate sensitivity has mostly disappeared. The path from here will be dictated by whether the economy can continue to rebound or recession fears come back.
A flying start to the year
During October last year the interest rate shock reached its maximum impact on global equities and consensus shifting towards an incoming recession and that inflationary uncertainty combined with lower economic activity would increase the equity risk premium causing equities to fall. The fact that Berkshire Hathaway did not materially buy anything in the equity market during the fourth quarter suggests that the experienced investors of Warren Buffett and Charlie Munger were betting on the same thing. A recession in 2023 providing a backdrop of fear on which to capitalise with a new big bet. Things did not turn out that way.
Instead equity markets slowly recovered as long-term bond yields and inflation expectations came down. The new narrative was not a one-way street with a setback in December unfolding with increased nervousness around Tesla and cryptocurrencies. Those worries were put aside this year with the MSCI World Index up 8.3% and bubble stocks rallying 27%. Other growth segments such as energy storage, which we will do a longer equity note on next week, semiconductors, and e-commerce have also rallied 20% or more. With such a strong start to the year it begs the question whether technology is now back in town for longer or it is short-term trade as bearish positions in technology stocks have been squeezed?
Our playbook as described in our Q1 Equity Outlook: A painful phase transition is still that the physical world will continue to outperform the intangible world as our global economy is transitioning away from unconstrained globalisation to a regionalisation, a conflict between two value systems (authoritarian vs liberal democracy states), and rebuilding our physical infrastructure which was neglected for 10 years during the raging bull market in technology. The 1-year momentum across our theme baskets reflects this as the best performing baskets over the past year are defence, renewable energy, commodities, nuclear power, logistics, construction, and transportation infrastructure.
Interest rate sensitivity is no longer a focus
A question that we have been debating at Saxo is the interest rate sensitivity which was a big theme last year. One question that has been raised is why are equities trading at the current levels with the US 10-year yield back at 3.8% when the MSCI World Index was trading around 9% lower at the same interest rate level back in late September?
There are several factors that can explain this. One of them is that the interest rate sensitivity on equities has fallen because equity valuations have come down from very elevated levels to just above the historical average. Equities have also priced out the probability of a recession and thus increased growth expectations, and finally animal spirits have been released reflected in private investor surveys on their bullishness and bearishness which we highlighted in our equity note The equity market in four charts which have decreased the equity risk premium. Finally, the Q4 earnings season was better than feared when it comes to the margin pressure. So where is the real risk in equities?
It is all about a recession or not
The main risk to equities is whether we get a recession or not. As we have been writing many times the past couple of months the leading indicators in the US suggest that a recession is incoming and the Bloomberg US recession model has flashed 100% probability of a recession within the next 12 months since October last year. But economic data remains positive and are actually pointing towards a reacceleration in growth rather than a recession with the US economy experiencing a credit boom and improved construction activity as Caterpillar said on their recent earnings call. Now, a reacceleration in the economy combined with China reopening are likely to underpin inflationary pressures which might push long-term bond yields higher from current levels, but that is not something that will take equities down 15%-20% unless we see a significant profit margin deterioration in 2023.
Equities are right now priced for perfection with the assumption that the world economy is reaccelerating, inflation will ease down to 2.5% annualised, China will get back on the growth track, geopolitical risks will not worsen, and the energy crisis will slowly be solved. All those things can be true at the same time, so something has to give at one point, but for now equities are in an uptrend. One key market to monitor here, as it is right now not agreeing with the reacceleration narrative, is the commodity market. The Bloomberg Commodity Index is down 4% this year and has not responded positively to the Chinese reopening.
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