The equity conundrum: It is all about a recession or not

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.