“We are sailing in the fog”recognizes an equity manager. “There is no longer a pilot on the plane”, regrets for his part a bond manager. In the turmoil that has hit the markets since the start of the year, with a clear drop in September, investors and traders no longer know where to turn and are clinging to new compasses to try to find a course.
On the bond market, which is experiencing one of its largest declines in decades, of the order of 20%, it is the American unemployment figures that are watched as fuel on the fire in an attempt to predict the Fed’s next decisions. On equities, the main driver is now based on the evolution of long rates. This is the great novelty of recent months – and the nightmare of diversified funds – equities and bonds are now sailing together: if rates rise (thereby lowering the value of bonds), equities also fall, and vice versa. Not one asset to catch up with the other.
The rebound in equities that started three sessions ago, and more clearly on Tuesday, is the perfect illustration of this. In the wake of Wall Street, European equities resumed their upward path after hitting year-to-date lows in late September. The CAC 40 thus finished above 6,000 points with a gain of more than nearly 4%, like the main European indices. And the US stock market remains well oriented this Tuesday at the opening after the sharp rise on Monday.
Bond relaxation
It is indeed the relaxation on the bond market which explains this turnaround on equities. The German Bund’s benchmark rate thus fell back below 2% to 1.85% after reaching 2.3% and the yield on ten-year US Treasury bonds fell to 3.6% after hovering around 4%. . These movements, both up and down, are violent, especially for risk-free assets.
This decline in interest rates can be explained by several factors. First of all, recession expectations are beginning to take shape, especially in the euro zone. Household confidence is in freefall and the leading indicators, such as the manufacturing and services ISM, are deteriorating very quickly, settling below 50. Who says recession, says drop in long rates.
Another important element which calmed the game, the intervention of the Bank of England (BoE), last week, to save a British debt very attacked on the markets since the announcement of a massive plan of reduction of taxes . “It’s a major event, which we would never have imagined in a country that is the sixth largest economy in the world. Suddenly, this can also be the premises of an announcement from the European Central Bank if things were to go really badly in the euro zone”. Curiously therefore, the BoE’s decision, unthinkable a few days earlier, was rather reassuring.
Attractive valuations
Finally, after the extremely firm tone of the central bankers on the fight against inflation, Fed in the lead since the Jackson Hole symposium at the beginning of September, the participants are beginning to perceive a slight inflection in the discourse, with some nuances “more doves than hawks “. Clearly, market expectations have already factored in the upcoming increases in key rates, without fear of new unpleasant surprises. Moreover, the Fed’s latest projections are based on those of the market. And, François Villeroy de Galhau, member of the Governing Council of the ECB, indicated on Tuesday that the central bank will raise its rates ” as necessary “ to stem inflation, although the pace of monetary tightening could ” to slow down “ after the end of the year.
This rate news was immediately welcomed in equity markets, which have been under severe strain since mid-August. The rebound even allows the indices to avoid a frankly bearish technical configuration for the moment, according to the chartists. The stock markets have fallen so much (-16% for the CAC 40) that valuation levels are starting to become really attractive, around 11 times estimated earnings, compared to a historical average of 13 in Europe. The drop in yields therefore allowed investors to take on some risk on equities. This same reasoning can also be applied to corporate debt, which is very cheap, with yields of more than 5% for the best signatures.
The big unknown will be the magnitude of the revisions to earnings forecasts around the time of corporate earnings releases in the third quarter. For the moment, the market is pricing in a drop of around 10 to 15% in the estimated results. For now, corporate discourse remains surprisingly cautious, without lapsing into pessimism. It must be recognized that companies have had time since 2020 to acquire a certain know-how in terms of crisis management.
A season of quarterly results without too much damage – this is the preferred scenario – could therefore lead to a revaluation of equities towards the historical average. It remains to be seen whether the historical average still makes sense in a period of deep recession…or war.