28 March 2022 - Lessons from the 1970s




US equity markets moved higher against a backdrop of rising bond yields, as the local markets managed to recapture some significant technical levels and short-term traders joined the rally. The S&P500 closed above its 200-day moving average again, which currently sits at 4490. The Nasdaq rose above its 50- day moving average but remains about 4% below its longer-term support level (200-day average). European indices remain suppressed, despite their impressive rally from the lows of February 24, as the ongoing war in the region and the dependence on Russian oil & gas keeps investors nervous. Chinese markets are torn between the Covid19 lockdowns (Shanghai this time) and the potential for significant monetary support by the central bank.


Speaking of central banks, the FED’s Chairman, Mr. Powell, shocked his audience with the admission that there could be rate hikes of 50bps (0.5%) at several meetings this year. After his speech, several members of the FED also made public comments in the same direction showing a very tough stance against inflation. If the 1970s crisis left any message for the future authorities, is that they should fight rising inflation expectations at any cost, even hurting temporarily the economic growth and making unemployment rise. The message from the FED is now very clear. They will engineer an economic slowdown, which they hope it will be minor and temporary, to bring inflation down. Implications for the valuation of asset classes will have to incorporate higher interest rates and slower growth.


The UK February Inflation (CPI) rose higher than expected, at 6.2% on an annual basis. Having already raised interest rates three times to 0.75%, the central bank will likely raise one more time and pause to gauge the effects of these increases as well the impact of high energy prices to economic growth. The Eurozone March CPI number is out this week and is expected to rise to 6.7% on an annual basis, Markets are already discounting action by the ECB.



The March PMI (Purchasing Managers Index) in the Eurozone were announced better than expected. These were the first data to include the invasion of Ukraine, so they are closely watched. The Services Index fell by less than one point to 54.8, vs expectations for 54.3, while the Manufacturing index fell to 57.0, vs expectations for 56.2. These numbers show that 1st quarter GDP growth in the Eurozone will still be positive, avoiding recession. Looking in the details of the reports however, the input/output prices which affect inflation are at all time highs.


Government bond yields rose to the highest levels in many years, as investors continue to price the aggressive FED policy with respect to short term interest rates. The 10-year US yield rose to 2.50%, while the move is even more pronounced in the short end. The 2-year yield is now at 2.40, threatening the yield curve to “invert”. A yield inversion is when short term rates are higher than longer- erm yields and is usually associated with an upcoming recession. However, one should note that a recession might not happen for at least another 12-18 months, so investment decisions should not be hasty.


Corporate results for the first quarter of 2022 are starting soon. Profit expectations in the US have been going slightly up during the last weeks, although the full year guidance is what will drive the markets.


Oil prices continue to be very volatile, but appear to have peaked for now, After reaching 130$ at the peak of the crisis they fell to 95$, only to recover soon to almost 115$. Any signs of a deal between Russia and Ukraine will probably make oil drop below 100$ again, while markets will probably soon start to discount the destruction in demand due to high prices and the pending economic slowdown as a result of higher interest rates.


Gold has been trading in a narrow range of 1910- 1930$, losing its shine after the initial panic buying.



Charts of the Week


This is the chart of the yield of the 5-year US Treasury bond for the previous ten years. Currently trading at 2.60%, the bond market has already discounted a lot of interest rate increases. The yield of the same maturity bond was just 0.2% during the pandemic, having fallen from the high of 3% in 2018. It is interesting to note the year 2018, as it was when the FED became more aggressive with rate hikes and the bond market started then discounting an economic slowdown. Hence the yield moved lower during 2019, despite the equity rally, to almost 1.5%, before the pandemic hit. Of course, inflation is now at much higher levels, but the current levels of these relatively short duration bonds is getting really interesting and attractive. Having been negative on bonds for almost two years, we would be looking to add USD government bonds of duration between 3 and 5 years as a hedge against a severe economic slowdown. Buying at these levels, if the yield moves again towards 1.5%, there will be capital gain and the coupons received.



The left chart shows the yield of the 2-year US Treasury bond, for the last twenty years. It is clear that the yield has been on a structural downtrend since the beginning of the century, trading in a very well defined, range. During the pandemic, the yield hit the lower boundary close to 0% and has been moving higher since then. What is impressive is the speed of the rise. It took the yield almost 8 years to reach the same levels of today in the period 2011-2018. It took the yield a little over a year to make the same trip. We argue that the 2-year yield is very difficult to sustain levels of close to 3% without a recession, which will bring the yield again down closer to 1%, as bonds will start discounting the next cycle of the FED lowering again rates in order to boost an economy at the brink of recession. As mentioned before, one should acknowledge that historically we are experiencing a much higher inflation so yields could move higher out of control. But the current levels should not be left unnoticed by investors who are wishing to hedge against an upcoming economic slowdown.





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