After an initial rise in interest rates, what is the investment strategy?
Didier Bouvignies, Managing Partner & CIO Rothschild & Co Asset Management.
The beginning of the year is characterised by a much less pronounced economic slowdown than expected on both sides of the Atlantic. Overall, business sentiment in the service sector is becoming positive again, suggesting that the economy is holding up better than expected, even though the industrial sector, while having stopped deteriorating, is still showing some signs of weakness. The good news comes mainly from the reopening of China, a turnaround that is likely to raise business leaders' morale to a level not seen since 2012.
However, inflation remains a major concern as central bankers are struggling with their assessments and there is growing concern about their ability to keep prices down. Overall, the figures were reassuring in the autumn, largely thanks to the fall in commodity prices, particularly gas in Europe. However, it must be noted that the so-called "core" part of prices, i.e. excluding food and energy, is showing only a slight decline in the United States and is still rising in Europe. Moreover, the fall in productivity observed in relation to the pre-covid period is leading to an increase in labour costs, the indicator most likely to indicate a sustainable inflation regime.
In this context, the central banks cannot change a discourse which, in summary, reinforces the idea that they will remain very dependent on macroeconomic data, in particular on a labour market which, for the time being, is not perceived to be deteriorating. Moreover, a further decline in unemployment registrations illustrates a certain tension and suggests that the rise in rates could be set to continue for a prolonged period. While the markets gave little credence to these arguments, they have nonetheless been led to revise their outlook, with a terminal rate(1) estimated at 5.8% at mid-year in the US and 4% in Europe(2). The decline could turn out to be much slower than anticipated, particularly in the Old Continent where the year-end rate will probably not be very far from this 4% level.
In this environment, the focus is also on the residential property sector. After a strong rise during the "Covid period", prices have started to fall but, given the recent rate movements, the decline remains relatively moderate for the time being. There are three reasons for this pattern: indexation of rents to inflation which improves returns, low unemployment which ensures high levels of occupancy, but also the scarcity of supply which keeps the sector under pressure. An acceleration of this decline would nevertheless be a very bad signal because, historically, real estate crises have accelerated economic slowdowns. We must therefore remain vigilant.
The good resistance of the economy, despite exogenous shocks linked in particular to the health crisis, and then to the war in Ukraine, is largely explained by the unfailing support of the States. The measures put in place have contributed to inflating the level of household savings, allowing companies to pass on the rise in input costs in their sales prices, without putting a strain on consumption power. This raises the question of corporate margins. Although the results published for the year 2022 show strong growth in turnover and a slight compression of margins, they reflect the ability of companies not to absorb the cost of rising input costs. For 2023, without giving any precise indication, the managers do not report a strong deterioration either. In an environment of more limited real growth, in which consumers will be more reluctant to accept price increases, companies will probably have to squeeze their margins, taking into account the rise in wage costs, which will certainly be more acute in 2023 than in 2022.
As a result, investing in the equity markets is more complex. On the one hand, because of the risk on 2023 results, which are nevertheless expected to rise by 7.3%(4) excluding commodities, and on the other hand, because of the deterioration in the relative valuation of this asset class compared to the fixed income markets. Indeed, the equity risk premium(3), which had always been very positive since 2007, has since deteriorated significantly. Whereas it was around 4% in the United States last year, it is now at 1.5% despite the fall in the equity market, essentially due to the 300 basis point rise in US rates in 15 months(5). A similar dynamic has been observed in Europe, as rates have risen, but to a lesser extent, with a risk premium of 4.5%, compared with around 6% in recent years(5). Dans cet environnement, les stratégies value(6) parviennent toutefois à tirer leur épingle du jeu. Certains secteurs faiblement valorisés voient effectivement la hausse des taux contribuer à l’amélioration de leur capacité à générer des résultats (banques et assurances, notamment) et conservent des niveaux de valorisation très inférieurs à leur moyenne historique. Plus globalement, face à cette dégradation des critères de valorisation des marchés d’actions, il nous paraît opportun d’essayer de capter du rendement sur des obligations d’entreprises de bonne qualité et de maturité moyenne (5 ans). Ce positionnement permet de bénéficier d’un portage durablement positif en captant un rendement nominal susceptible d’offrir une protection dans l’éventualité d’un contexte d’inflation persistante, sans prendre de risque de moins-value si la partie longue de la courbe des taux se tend.
Even after the narrowing of spreads(7) observed over the last six months, credit bonds continue to offer margin levels that allow them to generate a higher yield than government bonds. Therefore, taking a position in Investment Grade(8) securities implies a lower yield than in the High Yield(9) segment, but it avoids exposure to high risk in the event of a downturn and allows investors to benefit from a much more attractive relative valuation by historical standards. Furthermore, valuation levels within the Investment Grade market incorporate an implied probability of default that is much higher than the peak of actual defaults observed over the last thirty years (6% versus 4%)(5).
This analysis prompted us to launch a 2028 Investment Grade fund in September 2022. This product represents an arbitrage opportunity for many investors with little exposure to the asset class. 800 million(10) since its launch from a wide range of profiles (individuals, private banks, institutions).
(1) The level to which a central bank is willing to raise rates.
(2) Source : Bloomberg, 28/02/2023
(3) An additional return expected by an investor to compensate for taking a risk compared to a risk-free investment.
(4) Source : Bloomberg, 28/02/2023
(5) Source : Bloomberg, 28/02/2023
(6) A “value” strategy is when the investor seeks out companies that are undervalued by the market at a given time, i.e., whose stock market valuation is lower than it should be in light of the company’s earnings and asset value. Value investors select stocks with low price-to-book ratios or high dividend yields.
(7) The difference in yield between a bond and a loan of equivalent maturity considered “risk-free”.
(8) High-yield bonds are issued by companies or governments with a high credit risk. Their financial rating is below BBB- on the Standard & Poor’s scale.
(9) Debt securities issued by companies or governments rated between AAA and BBB- on the Standard & Poor’s scale.
(10) Source : Rothschild & Co Asset Management Europe, 28/02/2023.
Press Contact:
Gunther De Backer