By Thomas Hempell, head of macro & market research and Vincent Chaigneau, head of research at Generali Investments.
With markets bearishly positioned and panicking central banks raising rates
aggressively, even faint hopes of a looming Fed pivot can send markets soaring. For the
3rd time since summer, Fed pivot optimism has pushed rates lower (see chart) and
equities higher, helping the MSCI World to end October in the green (+7.7% by Oct 28).
Risks of a policy mistake are rising as the euro area nose-dives into recession. US
housing and business surveys point to a more severe slowdown than resilient hard
data. The economic impact of past rate hikes will materialize only with a lag. As rates
move deeper into restrictive territory, central banks will slow the tightening and need
to pivot at some point to not risk economic and financial havoc. Markets are ready to
quickly price these hopes and did so following last week’s ECB meeting.
As flagged earlier, a full pivot may be a key trigger for a more sustained market
recovery – but we are unlikely there yet. Inflation pressures have broadened so much
that the Fed and ECB are still more worried about pivoting too early than too late. The continued overshoot in actual inflation continues to steer their hands for now. The
economic setup remains challenging, too. A warm autumn has helped Europe to refill
gas storage and see gas futures falling back to June lows. Yet fundamentally, the
energy crisis is not behind us. Cold weather into winter may see gas storage deplete
quickly, with outright rationing and a deep recession a significant risk. Exceptionally
high uncertainties about inflation, policy and geopolitics will keep business and
consumer confidence depressed. Risk positioning is bearish and equity valuations have
corrected sharply, but still look elevated vs. surging real yields (see chart).
Financial risk on the rise
The UK turmoil has laid bare the limits of fiscal relief, as did a poorly received Bund
auction to finance the €200bn energy relief package. The looming unwinding of the
ECB’s APP holdings will add to net bond supply. And as the US Treasury’s OFS financial
stress index remains close to 2-year highs, mounting margin calls, tightening financial
conditions and persistent USD strength provide little relief.
Amid the conjecture of depressed positioning vs. severe headwinds from economics
and policy, we stick to a prudent allocation – with an underweight (UW) in riskier
assets (Equities, HY Credit) – but are likely to partly neutralise positions into yearend.
We continue to overweight (OW) safer buckets in Fixed Income benefitting from a
higher carry, incl. IG Credit. We trimmed the exposure to financials – exposed to the
recession and punitive policy measures, e.g. TLTRO reform – to the benefit of USTs and
Cash. We keep a tactical UW in EM bonds amid the headwinds from tighter global
financial conditions, the strong USD and global growth weakness, even if the long-term
outlook looks more benign. USD looks stretched, but still has upside near term thanks
to its countercyclical properties and a more resilient US economy.