La Française: Change in the inflation dynamic

14 december 2023

The magnitude of the rebound in almost all asset classes over the past month is extraordinary: +4.54% for the US 7-10 year bond index, the biggest increase since August 2011; +6.85% for the European 'Coco' debt index, the strongest increase since March 2016 if we exclude April 2020 and the post-Covid rebound; +14.56% for real estate equities, not seen since March 2009.

The main factor behind these massive increases in all asset classes is the sharp fall in rates and the repricing of monetary expectations. Since the end of October, rate cut expectations in the United States in 2024 have gone from 79 bps to 137 bps, i.e. almost three additional rate cuts.

The same is true in Europe, where rate cut expectations have risen by 50 bps. This repricing is intrinsically linked to the collapse of inflation expectations, which have fallen from 20 bps to 50 bps for the year 2024 after a stronger repricing in the United States than in the Eurozone. 

The market is increasingly convinced that the risk of inflation is a problem of the past and that within 3-6 months, things should return to normality. It's hard to argue when you read the latest Eurozone inflation figures: core inflation is now very close to the ECB's target over the last 6 months, and it seems that it is only a matter of time before the ECB changes its stance.

The figures for producer prices point in the same direction. The monetary policy meeting scheduled for December 14th should therefore lead the ECB to significantly revise its macroeconomic forecasts for the end of 2023 and potentially those for 2024. Will this be enough for a radical change of tone? Probably not, but unless there is a drastic change in the inflation dynamics, the issue is being postponed in the Eurozone. 

On the other hand, reaching the 2% inflation target seems a more significant challenge in the United States, even though the market makes little distinction between the two areas. The services sector shows inflation is still above the Fed's target (including over the last three months), Michigan's inflation expectations have been rising for the past two months and the indicators of the NFIB and JOLTS show strong resilience in the labour market.

This does not suggest a rapid return to the 2% inflation target, but rather for inflation to be around 2.5% to 3%, at least initially. The magnitude and especially the timing of the rate cuts expected by the market in the United States therefore seem a little optimistic to us.

A positive scenario for all bond asset classes.

OPEC+ members, for their part, struggled to reach an agreement to cut oil production by 2.2 million barrels per day in the first quarter. A significant part of these reductions was already planned (Saudi Arabia and Russia) and compliance with production quotas appears to be potentially uncertain in view of the disagreements within the organization.

Still, this should steer the market towards a supply deficit at the beginning of next year. Beyond the negative market reaction after the announcement, in our view the price per barrel should remain around current levels in the coming months. 

The economic situation has changed very slightly. In the euro area, the pace of growth is still around 0, but could improve slightly in early 2024 if the rebound in leading indicators (ZEW, IFO, Sentix, etc.) materializes. Wage increases which are now above inflation should also contribute towards a slight rebound in consumption. In the United States, there has also been little change.

The pace of growth in the 3rd quarter (5.2% annualised) is obviously not sustainable, but consumption remains solid and the situation of households is rather good, so there is little reason to see the economic situation deteriorate quickly. 

The market is now anticipating inflation to return close to central banks' targets and activity to remain resilient without being exceptional. This scenario is positive for all fixed income asset classes and consequently for equity markets.

More specifically, this should allow sectors that have been hit very hard by rate hikes and whose valuations have fallen sharply over the past two years to regain attractiveness for investors. Utilities, real estate and medium-sized companies are among these investments that could continue to benefit from the sharp decline in inflationary risk.

However, we are more comfortable with this scenario in Europe than in the United States for the reasons explained earlier, as well as due to the very high upcoming issuance in the United States, which could put some pressure on the long end of the American yield curve. The Treasury's upcoming announcements on the amounts and types of issuances will be closely monitored, especially in view of financial conditions that have eased sharply.

December/January outlook

The movements in November were very aggressive, but the consequences of the sharp decline in inflationary risk should not be underestimated, especially in the Eurozone. Some sectors that have suffered a lot are regaining attractiveness and count with historically low valuations. We currently favour these sectors.