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Equity and bond markets, victims of rising interest rates

The unprecedented monetary tightening cycle that the central banks of the main developed countries have embarked on marks the end of more than a decade of ultra-accommodative policies (notably zero or even negative interest rates and asset buybacks). The fallout is a significant correction on the equity and bond markets.

A massive inflationary surge, initially wrongly considered as a temporary phenomenon, has forced the central banks to declare the fight against inflation their absolute priority, despite the negative effects of tighter financial conditions on economic activity. The risk of ‘de-anchored’ inflation expectations, with the potential for runaway price increases, is seen as the main threat.

Inversion of the US yield curve

The central banks’ resolute words and actions have led to a sharp rise in interest rates, for both short and long maturities. In the eurozone, at the end of 2021, German yields were firmly in negative territory for all maturities up to 15 years. Today, the entire German yield curve is back in positive territory. In the US, the yield curve is sharply inverted with a 2-year rate close to 4.75%, around 0.5% higher than the 10-year rate. This level of inversion sends a negative signal about growth prospects.

Europe facing an energy crisis

Economic data are deteriorating, as illustrated by recent trends in the leading indicators, particularly for manufacturing. The eurozone has been weakened by soaring energy prices and consumer confidence is at rock bottom. The central scenario is that a recession is imminent. However, the sharp decline in gas prices (due to substantial stock replenishment, abundance of liquefied natural gas, warm weather, etc.) over recent weeks is an encouraging factor which, if continued in the coming months, could limit the extent and duration of the contraction in activity. However, the energy crisis will not be resolved in the short term, with the replenishment of stocks for the winter of 2023 looking problematic as Russian gas imports (significant at the beginning of 2022) will almost certainly need to be replaced in full.

Sharp correction on the financial markets

On the financial markets, steep interest rate hikes have caused a slump in bonds. The pan-European market has seen a record decline, losing almost 20% since the start of the year. In equities, the correction is less severe but nevertheless significant, with the world index falling by more than 10% in euros. However, there is a marked difference in performance between sectors. IT, communication services and consumer discretionary are the sectors that have been hardest hit by the rise in interest rates, while energy and more defensive sectors such as consumer staples and healthcare have been less affected.

Long-term focus is best for investors

In this environment of a sharp economic slowdown and significant monetary tightening, it makes sense to take a cautious approach to equities. Investors’ recent expectations that the Federal Reserve was poised to move to a more accommodative monetary policy were soon dashed. After this sharp correction in the two main asset classes, there is a silver lining: for a balanced portfolio, expectations for long-term returns are rising due to lower valuation levels in the equity and bond segments. But it is important to bear in mind that the close relationship between valuation and performance only works over a long-term horizon.

Damien Petit, Head of Private Banking, Banque de Luxembourg