Global equities and bond markets declined sharply last month, as some indices reached new yearly lows, while rates jumped in the opposite direction and US and German 2-year yields culminated at yearly highs.
Consequently, balanced multi-asset strategies such as the typical 60/40 portfolio are down more than 10% in 2022, their worst start for the year since 2008.
Real rates thus rose substantially over a short period of time, and the question now is whether this surge is near the end, as history would suggest.
Given the central banks’ overarching aim to tame future inflation expectations, we believe that real rates have further to rise.
April real rates repricing
Contrary to the prophecies of main prime brokers and Wall Street gurus, that April should be very good month for stock markets based on flow seasonality, global equities declined sharply last month, as most indices reached new yearly lows.
The S&P 500 tumbled 8.8%, its worst month since March 2020, when US equities plunged 12.5%. Consequently, VIX futures jumped above 32 and the VIX forward curve inversed once again.
The S&P 500 equal weighted index beat the market capitalization index by 2.5%, as Value outperformed the other factors and Energy continued to post positive relative gains versus most other sectors.
Thanks to a weaker currency, Japanese and European indexes fared better than US ones, while emerging markets suffered from the new decline of Chinese equities over the period.
The key element behind this bearish trend is the aggressive stance adopted by major central banks.
Short-term rates jumped again across the board, with US and German 2-year bond yields reaching new yearly highs, at respectively 2.7% and 0.3% mid-April.
As a result, balanced strategies, typified by the 60/40 portfolio, dropped more than 10% in 2022, suffering the worst start of the year since 2008.
Real asset performance was mixed, featuring a renewed jump in energy prices, mainly natural gas, while industrial metals suffered from new lockdowns in China.
Fighting inflation has become the priority for central bankers, regardless of the impact on financial assets or short-term growth momentum.
In our view, the “re-anchoring” of long-term inflation expectations toward the central bank inflation targets implies higher real rates.
As shown in the graph below, US 10-year real rates, approximated by the spread between the US 10-year nominal rates and the US 10-year breakeven, rose by 50bp in April.
Historically, this monthly change represents a 2-sigma move and is thus a rare event.
Distribution of monthly changes in US 10-year real rates (1999-2022, bps)
How do assets historically react to higher real rates?
Intuitively, higher real rates would imply negative returns for most growth-oriented assets because of the discount factor model.
Nevertheless, an academic breakdown of nominal bond yields dissociates the inflation premium (inflation breakeven) from the growth premium (real rates), and the latter as key the driver of long-term treasury rates.
In this well-known framework, positive and rising real rates point to higher and stronger growth.
When we analyze the relationship between US 10-year real rates and monthly asset returns, there is no statistically significant relationship between the change in real rates and returns for most cyclical assets.
However, the US dollar exhibits a positive and high sensitivity to higher US real rates.
Nevertheless, when we focus on the right side of the distribution curve, which corresponds to the current situation, when real rates increase by one sigma or more, growth-oriented assets tend to post positive returns, with a high hit ratio (above 60%).
Asset performance when the 10-year US rate monthly change rises more than one sigma
The graph shows how different the reaction of assets was this this year with respect to higher real rates.
Indeed, this year Energy and US equities delivered much larger average monthly performances compared to history and above all, in the opposite direction of those observed between 1999 and 2021.
We see two reasons behind this unusual pattern.
Firstly, a bigger monetary policy surprise linked to the quick and sharp U-turn by the central banks, prompted by the shift from a “transitory” to “persistent” inflation shock. Secondly, the volatility triggered by the geopolitical situation, raising the risk of a policy mistake.
Guilhem Savry is head of macro and dynamic allocation, cross asset solutions at Unigestion.