The past few weeks have been volatile for the markets, following a series of unusual financial and geopolitical events. In a very short period of time, a war broke out in Europe, while inflation data reached a 40-year high in the US leading the US Federal Reserve (FED) to adopt an aggressive monetary policy stance, impacting its path to raise US policy rates.
In this low-visibility environment, Equity and Fixed Income markets seem to have been integrating different information. US Equities posted a positive performance of +6.94% in March, showing a certain degree of optimism on the equity market. Conversely, 10-year US Treasuries jumped 72 bps over the same period to reach 2.50% and the 10y/2y US yield curve inverted, which has historically been a signal of an upcoming recession.
How can we reconcile those two trajectories?
US yield curve inversion vs US Recessions
This abrupt move in Treasuries was supported by February’s inflation rate figure of 7.9%. It was the highest data seen in 40 years, while price rises outpaced wage increases in the US for 11 consecutive months. Those inflationary pressures were broad-based, driven by energy, food and real estate. Further, they were posted even before the spike in commodity prices that led Brent crude oil to a 14-year high, leaving no doubt for us on the less-transitory characteristic of the US inflation.
Combined with tight employment and low initial jobless claims, the Fed had no choice but to pivot and adopt a tightening stance. Rate hikes of more than 200 bps are expected in 2022 with an additional 75bps likely in 2023, according to Markit.
US Real wages (YoY %)
Source: Refinitiv Datastream©
More persistent inflation and a more aggressive FED policy took an obvious toll on Treasuries, and US financial conditions have begun to tighten from their very accommodative level.
US Financial Conditions
Such conditions are not usually supportive for equities, but here comes the pain trade. Despite sharply higher rates and higher inflation pressures integrated by fixed income asset prices, risk appetite increased materially for US Equities. Indeed, inflows continued to flood into US Equities (+37Bn€1 of positive inflows), which posted a performance of +6.94% during March.2 On top of that, 2022 EPS growth estimates were revised slightly upward by 0.7% to 9.7% according to Datastream, showing a rather positive outlook from the equity analysts community.
This discrepancy in expectations among asset classes is reflected in the spread between Equity volatility and Treasuries volatility -- which has reached a multi-year high.
US Equity volatility vs US Treasuries volatility
It seems to us that this situation reflects the market focus on recent inflationary pressures, leading US Treasuries to price more hikes while by contrast, Equities have enjoyed positive inflows considering their inflation hedge characteristics. However current war in Ukraine and the worsening Covid situation in China will have negative impact on the global growth. It is however still very difficult at this period of time to assess their impacts.
The FED's ability to bring inflationary pressures back to 2% while ensuring a soft landing in this environment will be paramount for the equity markets. Our reference period for the FED is 1994, when it managed to achieve those two objectives simultaneously. However, with very little visibility on global growth and inflationary pressures, the FED’s leeway seems very narrow.
It leads us to keep a neutral stance on Global Equities. Also, considering the recent rise in 10-year yields, now already close to our year-end target (2.50% - 2.75%), we choose to add some duration and more specifically US duration to our portfolios.
1 Source Bofa ML- Flow Show – YTD as of 25 March 2022
2 S&P500, 1 March through 30 March.