Equity markets were mixed and volatile last week, much as the weather in April for most of central Europe. After a horrible March for global equities but summer-like weather, April, which is a traditionally good month, has not started well for both. There are many open issues which haunt sentiment, with interest rates spiking, inflation yet to come down, a war in Europe, Covid19 surge in China and now the French elections to keep us awake for another two weeks.
US markets were the worst performer, with Nasdaq falling 4% for the week. European performance was very mixed. The rally in Swiss large capitalization stocks pushed the local index higher by 3% and UK’s stocks moved higher by almost 2%. But French stocks slumped by 2%, as banks and other sensitive sectors saw huge selling pressure as the fear of a Le Pen presidency grew bigger. Healthcare continued to move higher, together with the other defensive sectors such as Consumer Staples. Having been very positive on these two sectors, we now think that the time has come for a pause, as too much negativity is being built in the financial system too fast and too early.
The first-round outcome of the French elections came out slightly better than feared, as Macron received 27% (up from 24% in 2017) while Le Pen received 24% (up from 21%). The far-left received a stable 20% of the votes, and their leader Mr. Melenchon, already has urged his voters to not vote for Le Pen. Still however, the polls show a very narrow lead for Macron at 52% vs 48% for the far-right candidate and French markets will remain volatile.
More sanctions were levied on Russia, both by the EU and the US. The EU placed a ban on Russian coal imports while the US banned most Russian ships and trucks to enter the US territory, while Russian oil imports were also banned. With the war entering a new phase, where Russia seems to be abandoning Kiev and focusing on the south-east, the last weapon, perhaps, remaining is a complete ban of Russian gas/oil by the EU, an idea which has been floating by certain countries.
The FED minutes of the last meeting revealed the intention of its members to go “all-in” in their fight against inflation. We now know for sure that the next rate hike in May will be 50bps (0.5%) and that several more similar increases could follow through the summer. It does look that the FED would wish to take interest rates closer to 2.5% by year’s end, while at the same time starting almost immediately to reduce its balance sheet, by letting bonds mature without re-investing them. If all this materializes, it would constitute one of the fastest and most aggressive monetary tightening campaigns of the last decades if not ever. It is no surprise that the bond market has had one of its worst 4 months in its history, but we should be getting to the point that the worst are behind us.
Bond prices continued to fall and yields to move higher. The 10-year US yield is now standing at 2.75%, the highest since 2018 and close to the highest one could forecast it to be, at least for the foreseeable future. The 2-year yield is at 2.50%, while the 5-year yields of about 2.8-2.9% seem to be offering now the best risk-return profile in the bond market and cannot be ignored.
The International Energy Agency (IEA) followed the example the US and is going to release 60mn barrels of oil, from strategic reserves to bring prices down. Indeed, the WTI crude fell to almost 95$ again and as we are entering a period of warmer weather and slowing economic activity due to the interest rates hikes, we probably have seen the highs. However, if there is finally a ban on Russian oil/gas by the EU, prices could skyrocket again.
Corporate earnings in the US for the first quarter of 2022 are starting this week. Major banks are expected to be the first to report and it would be fundamental to closely monitor their guidance given what has happened in the bond market.
Gold moved slightly higher to 1940$ but remains rather muted, after the surge to 2070$ a few weeks ago. The USD was stronger across the board, with the EURUSD trading close to 1.0900.
Charts of the Week
This chart shows the path of the FED interest rates (the orange line) since 2004 and what the market expectations for the future path is. The yellow line shows the current pricing, while the pink line shows the pricing of March 2021, one year ago. The green dots represent the FED’s own forecasts of where the rates will be. The first thing to notice is the aggressive move of the market expectations for 2022, since last year, as it became evident that the FED wishes to move faster towards the 2%-2.5% interest rate. Comparing the current situation with the previous rate hike cycle of 2016-2018, one sees that the FED will now perform in just 8 months the same monetary tightening that took 3 years previously. It is no surprise that the bond market has fallen by a significant amount in just the first four months of this year. What is also clear, however, is that the current expectations are that the FED will then probably stop for a few months or maybe the whole of 2023, to assess the situation. If inflation were to come down in the coming months and the economy slows down then we could assume that the worst in the bond market is probably behind us.
The chart shows the total return (prices coupons) of the government bonds of the three major regions (US, Europe, China) since 2020. The orange line with an 8% total return is the Chinese Government bonds, for which we have been positive for the last two years. The light blue line which shows the worst performance with -6% is the Eurozone, while the dark blue line is the US with a slightly negative performance in the same period. The big difference between the US and Europe in total return is due to the fact that for most part of this period the yields on the Eurozone bonds was negative, while the US at least offered some small positive return. China does not have an inflation issue (yet) and due to its decision to maintain a disciplined and balanced growth, it was never forced to take its interest rates to zero (like the US) or to negative (like the EU). Chinese government bonds should continue to perform well and currently offer about 2.5% for medium to long term bonds, but maybe the time has come to revisit the other two regions, who also now offer more competitive yield than one year ago.
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