Global Economy & Markets, Weekly Roundup 07/03/23
Bond yields rise as investors weigh strong euro area inflation data
Key Takeaways
Global government bond yields are again on the rise on both the short and the long end, following stronger-than-expected euro area core inflation data. Long-term German government bond yields increased by 18 bps to 2.72% with short-term (2s) yields increasing by 20 bps to 3.21%, their highest level since 2008. Sovereign bond spreads narrowed slightly, with BTP/Bund and GGB/Bund down by 10 bps to 183 bps and 175 bps, respectively.
Euro area core CPI rose by 5.6% yoy in February from 5.3% in January, above consensus expectations. Moreover, food, alcohol and tobacco prices accelerated significantly to 15% yoy in February from 14.1% in January suggesting that, inter alia, the pass-through of pipeline cost pressures remains strong, as international prices of food continue to decelerate, according to the OECD FAO index. Finally, energy prices decelerated to 13.7% yoy in February, the lowest annual rate since June 2021, from 18.9% in January.
Market participants’ expectations of euro area policy interest rates continue to move higher amid the assessment that price pressures will persist for longer, based on positive activity data (i.e. PMIs > 50) and stronger-than-anticipated actual inflation. The ECB is expected to increase interest rates by 50 basis point in the next week to 3% (DFR) and 3.5% (MRO), while ECB commentary suggests that further interest rate hikes are likely in the course of 2023 (see graph below).
So far, euro area equities have climbed the wall of “interest rate” worry with success. The Eurostoxx index has recorded gains of +12.5% year-to-date, with valuations reverting, from below, to neutral levels. Indeed, on 13.4x P/E (+11% year-to-date), euro area equities are now trading broadly in line with long-term averages.
12-month forward EPS expectations (⅚ 2023 EPS of €34.0 and ⅙ 2024 EPS of €37.3) have increased slightly to €34.5 (+1.5% year-to-date). If earnings do not increase on a rolling basis, P/E valuations need to expand for euro area equities to edge further higher in the course of 2023.
Euro area banks have led the increase year-to-date (+23%) amid the higher interest rate environment which support the profitability of the banking sector through higher net interest margins, as bank lending rates increases more-than-offset higher funding costs. Bank profitability has improved, with the four-quarter forward Return on Equity (ROE) expected at 9.2%, according to Factset consensus analysts (SX7E: #22 banks).
While market expectations for profitability may prove optimistic, assuming an unexpected deterioration in economic outlook and significantly lower loan volume growth (currently at 4.9% yoy, see Economics), the relationship between banks’ P/BV and profitability (ROE) suggests that market valuations are not frothy (P/BV: 0.85), despite the significant revaluation year-to-date (see graph page 3).
Moreover, the recent over-performance of bank equity prices relative to the market is a drop in the ocean compared to the massive underperformance of euro area bank equity prices since 2010 by -70% (see graph page 3).
Key Takeaways
Global government bond yields are again on the rise on both the short and the long end, following stronger-than-expected euro area core inflation data. Long-term German government bond yields increased by 18 bps to 2.72% with short-term (2s) yields increasing by 20 bps to 3.21%, their highest level since 2008. Sovereign bond spreads narrowed slightly, with BTP/Bund and GGB/Bund down by 10 bps to 183 bps and 175 bps, respectively.
Euro area core CPI rose by 5.6% yoy in February from 5.3% in January, above consensus expectations. Moreover, food, alcohol and tobacco prices accelerated significantly to 15% yoy in February from 14.1% in January suggesting that, inter alia, the pass-through of pipeline cost pressures remains strong, as international prices of food continue to decelerate, according to the OECD FAO index. Finally, energy prices decelerated to 13.7% yoy in February, the lowest annual rate since June 2021, from 18.9% in January.
Market participants’ expectations of euro area policy interest rates continue to move higher amid the assessment that price pressures will persist for longer, based on positive activity data (i.e. PMIs > 50) and stronger-than-anticipated actual inflation. The ECB is expected to increase interest rates by 50 basis point in the next week to 3% (DFR) and 3.5% (MRO), while ECB commentary suggests that further interest rate hikes are likely in the course of 2023 (see graph below).
So far, euro area equities have climbed the wall of “interest rate” worry with success. The Eurostoxx index has recorded gains of +12.5% year-to-date, with valuations reverting, from below, to neutral levels. Indeed, on 13.4x P/E (+11% year-to-date), euro area equities are now trading broadly in line with long-term averages.
12-month forward EPS expectations (⅚ 2023 EPS of €34.0 and ⅙ 2024 EPS of €37.3) have increased slightly to €34.5 (+1.5% year-to-date). If earnings do not increase on a rolling basis, P/E valuations need to expand for euro area equities to edge further higher in the course of 2023.
Euro area banks have led the increase year-to-date (+23%) amid the higher interest rate environment which support the profitability of the banking sector through higher net interest margins, as bank lending rates increases more-than-offset higher funding costs. Bank profitability has improved, with the four-quarter forward Return on Equity (ROE) expected at 9.2%, according to Factset consensus analysts (SX7E: #22 banks).
While market expectations for profitability may prove optimistic, assuming an unexpected deterioration in economic outlook and significantly lower loan volume growth (currently at 4.9% yoy, see Economics), the relationship between banks’ P/BV and profitability (ROE) suggests that market valuations are not frothy (P/BV: 0.85), despite the significant revaluation year-to-date (see graph page 3).
Moreover, the recent over-performance of bank equity prices relative to the market is a drop in the ocean compared to the massive underperformance of euro area bank equity prices since 2010 by -70% (see graph page 3).