This month’s Editorial by Olivier de Berranger, Deputy Chief Executive Officer and CIO, La Financière de l’Echiquier.
The resilience of the global economy, and particularly that of the G7 countries other than the United Kingdom, was surprising throughout the first half of 2023. 2022 was already a year of surprising resilience. Despite the war in Ukraine, the energy and commodities crisis, double-digit inflation in many member countries and much more aggressive tightening than expected from the European Central Bank (ECB) and the US Federal Reserve (Fed), not to mention heightened tensions between China and the United States, growth in the euro zone came in at 3.5%. Quite simply, it was the zone’s third-best performance since its creation in 1999.
The first half of 2023 went on in a similar vein, even though the figures were much more moderate. At the end of last year, most economists were forecasting a recession in the United States during the first quarters of 2023, but the Fed’s 10 consecutive rate hikes have not been enough to bring one about. So how do we explain the fact that these rate hikes, on a scale not seen for 30 or 40 years, have failed to curb inflation and trigger a sharp slowdown?
Karl Otto Pölhl, Chairman of the Bundesbank’s Executive Board from 1980 to 1991, once famously compared inflation to toothpaste: “Once it’s out,” he said, “you can hardly get it back in again.” Pölhl resigned from the Bundesbank in 1991, in deep disagreement with Helmut Kohl over the 1-to-1 exchange rate between Western and Eastern deutschemarks at the time of reunification, believing that secular inflation was inevitable. German interest rates, taking all European rates in their wake, were raised from 2.5% in mid-1988 to 8.75% in July 1992, just before France’s referendum on the Maastricht Treaty, triggering a recession.
Today, it is generally accepted that there is at least a 12 to 18 month gap between a rate hike and its impact on the real economy. Rates left zero in the United States just over a year ago, and just over nine months ago in the euro zone. What’s more, the service sector, which is often less capital- and as such less debt-intensive than the manufacturing sector, is becoming increasingly important in our advanced economies, making rate hikes less painful overall. And the English-speaking world, historically adept at using variable rates to finance housing, has clearly switched to fixed rates: in the United Kingdom, for instance, while variable rates accounted for 70% of home loans to individuals in 2011, they now account for just 10%. Lastly, the hiring difficulties encountered in many professions following lockdowns seem to be encouraging companies to retain their skilled workers more than usual, even as a slowdown looms, thereby keeping consumer spending higher than anticipated.
Against this backdrop, the half-year ended on very commendable stock market performances, as the long-awaited recession failed to materialise, with gains of 38.8% for the Nasdaq 100 – the best first half in 40 years – 15.9% for the S&P 500 and 9.0% for the MSCI Europe, the second quarter having been much more muted in Europe than in the United States.
Whatever the scale of the economic slowdown to come, whether sluggish growth or recession, there are no signs at this stage of a hard recession. The financial sector, the traditional amplifier of any marked slowdown, remains sound, despite the anxiety-inducing episodes at SVB and Credit Suisse. While corporate earnings will, as usual, decide the day, the extreme concentration of US performance on the tech sector giants points to a pause in the second half. Buying on pullbacks and selling on sharp rallies could be a profitable strategy for the summer months on this type of mega-cap, while small and midcaps, particularly in Europe, are clearly at medium-term entry points in our view. Corporate credit, whether Investment Grade or High Yield, offers attractive risk/return ratios in the euro zone, while duration risk is easing after the active sequence of interest rate hikes.
