Overly aggressive interest rate hikes?

Investment Policy, October 2022

Overly aggressive interest rate hikes?

The major central banks are getting serious: Interest rate hikes are now approaching levels that pose a threat to the global economy. In particular, the European Central Bank’s (ECB) radical prioritisation of combating inflation over ensuring a stable economy, which it has set out to achieve with its strongest interest rate hike yet, poses several risks. If inflation stems more from a shortage of supply than from excessive growth in demand, massive interest rate hikes represent a threat to corporate earnings prospects, especially in the Eurozone. We therefore remain underweight Eurozone equities versus Swiss equities and continue to be cautious on both equities and bonds.

The outlook for global economic growth in the months ahead has once again taken a turn for the worse, driven by the situation in the Eurozone. The energy crisis, triggered by the disruption in gas supplies from Russia, is giving rise to a stagflation shock, i.e. higher-than-expected inflation as well as weaker economic activity, in the European Union (EU). The ECB is prioritising the fight against inflation over the safeguarding of a stable economy, an approach that will weigh on economic growth and corporate earnings via higher interest rates. The stance of the US Federal Reserve (Fed), which has been gearing up for much more marked interest rate hikes since its meeting in Jackson Hole, Wyoming, also demonstrates the risks for the global economy. Much higher interest rates are causing global financing costs to spike and are weighing on consumption in the US and, in particular, the Eurozone due to the worsening of so-called “financing conditions”. The central banks’ idea is likely to put the brakes on inflation by massively reducing consumer and corporate demand. However, as inflation tends to originate from the supply side, this strategy is risky: The prospect of another monetary policy mistake is on the horizon – and the markets already suspect this.

Equities

The partial recovery of the financial markets during the summer months has been followed by a renewed period of weakness triggered by the announcement of further interest rate hikes by the central banks. After a relatively robust earnings trend driven by tourism and other services was observed over the summer holidays, the earnings situation is likely to become more difficult for many companies in the autumn. This is not least due to rising costs for wages, energy and financing. It is therefore to be expected that there will be no choice for analysts but to revise down their earnings forecast consensus for the months ahead. Some companies, even if faced with a decline in demand, which would come as no surprise over the coming months, could once again be faced with high inventory levels, which could in turn lead to price reductions and put additional pressure on profit margins. We therefore remain underweight equities and are continuing to focus on companies with more stable earnings. In addition, we are maintaining an underweight position in Eurozone equities, which tend to be cyclical in nature, versus their more defensive Swiss counterparts.

Further massive interest rate hikes will weigh on bond and equity markets via rising financing costs.

Gérard Piasko, Chief Investment Officer


Bonds

The Fed has stepped up its policy of “quantitative tightening”, a programme that will see a more restrictive monetary policy achieved through a reduced central bank balance sheet and bond sales. The same is also true with respect to the Fed’s interest rate hikes, which have likewise increased. The ECB has not started to reduce its balance sheet so as not to put Italian government bonds at additional risk. Instead, it has massively increased key interest rates and held out the prospect of further interest rate hikes going forward. Even though bond yields in the US, Europe and Switzerland are now at high levels, further bond price declines are quite conceivable. The reason for this is the additional interest rate hikes that have been announced by the central banks with the objective of improving their credibility among the population as “inflation fighters”. Generally speaking, as the risk of a slowdown in economic growth and corporate earnings increases, investors should give preference to higher credit quality over weaker credit ratings, as default risks tend to increase in a weaker economic climate. We remain underweight bonds overall.

Currencies

The ECB’s extremely strong interest rate hike should also be seen against the backdrop of several months of weakness in the euro. This is because the weak euro and strong US dollar have made rising commodity prices an even bigger inflation problem for the Eurozone this year. Headline inflation in the Eurozone is now even higher than in the US! Whether the ECB’s interest rate hike of 0.75% will be enough to improve the euro’s fortunes remains to be seen. In light of the weakening of the Eurozone economy, however, there is every reason to be sceptical. This also applies to the euro against the Swiss franc, as inflation in Switzerland is lower than in the Eurozone, a situation that is weighing on the euro. Recent weeks have also shown that fluctuations on the currency markets – similar to those observed on the bond markets – are almost succeeding in keeping pace with the volatility seen in the equity markets. As the historically high level of volatility represents a risk, we caution against the adoption of a radical positioning in the foreign exchange space.

Commodities

Commodities that are especially dependent on Chinese demand, including copper, have undergone a correction when viewed relative to those characterised by a significant supply shortage. Since the start of the year, the diversified energy commodity index has therefore considerably outperformed the industrial metals commodity index, which is especially dependent on the price of copper. The commodity index of agricultural goods has also risen significantly during 2022. This has to be seen against the backdrop of droughts and is set to keep global inflation high via food prices. While precious metals have performed disappointingly compared to the high expectations of the market consensus, gold has held up much better than cryptocurrencies since the start of the year and also outperformed both equities and bonds.

Gérard Piasko

Gérard Piasko

Gérard Piasko is Chief Investment Officer and head of the investment committee of private bank Maerki Baumann & Co. AG. Before he was for many years Chief Investment Officer of Julius Baer, Sal. Oppenheim and Deutsche Bank.

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This publication is intended for information and marketing purposes only, and is not geared to the conclusion of a contract. It only contains the market and investment commentaries of Maerki Baumann & Co. AG and an assessment of selected financial instruments. Consequently, this publication does not constitute investment advice or a specific individual investment recommendation, and is not an offer for the purchase or sale of investment instruments. Maerki Baumann & Co. AG does not provide legal or tax advice. In addition, Maerki Baumann & Co. AG accepts no liability whatsoever for the content of this document; in particular, it does not accept any liability for losses of any kind, whether direct, indirect or incidental, which may be incurred as a result of using the information contained in this document and/or arising from the risks inherent in the financial markets.

Editorial deadline: 22 September 2022

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