Central banks pivot as recession looms
by Natixis CIB Research | Reading 10 minutes
The main concern for investors today is the risk of inflation lasting far longer than expected, thus prompting central banks to pursue their monetary tightening policy and dragging the world into recession. A second major question mark is the risk of a real-estate crack, as rising interest rates automatically lead to a fall in property yields and values. Assets that no longer meet environmental criteria and new societal trends, such as the boom in remote working, are likely to suffer particularly badly.
In the latest Midyear outlook from Natixis CIB research, our economists note the end of high inflation, rule out the risk of a major recession and believe that we are close to the central banks' pivot. Indeed, they expect monetary policy tightening to end during the summer after a final rise of 25bp by the ECB and of 25bp by the Fed. The deceleration in headline and underlying inflation appears to be well underway.
However, this unprecedented 400bp rise in the space of just a few months, coupled with the energy crisis, has left the world with historically high interest rates - the highest for 22 years in Europe. What consequences does this have for the markets, particularly for commercial real estate (CRE) and offices? With central banks set to pivot, what portfolio allocations should be favored?
Discover the replays
With the insights of Marc Guillaume, property asset valuation expert at Cushman & Wakefield, in the French session
Europe avoiding recession, buoyed by services and employment trends
With a slight 0.1% fall in GDP over the first two quarters of the year, Europe is fulfilling the technical criteria of a recession, driven by Germany, which is more affected by weak manufacturing activity, the energy shock and inflation. However, Europe should escape recession with 0.8% growth in 2023 and a rebound of 1.4% expected in 2024. Growth in services is underpinning activity and fueling employment dynamic, with 1 million jobs being created every month. The deceleration in inflation, which has fallen from 10% to 6% over the year and is expected to stabilize below 4%, will restore purchasing power and even generate a slight scissor effect with wage trends, which are generally favorable to households.
What's more, the imbalance in European foreign trade was largely due to the price of imported energy. The energy crisis now seems to be well behind us: the price of gas is 10 times lower than it was a year ago, the fall in consumption is being confirmed and European stocks are almost 80% replenished. Prices are falling sharply and the transition to renewable energies means that energy content will be more local.
Fed to maintain its restrictive policy until late Q1 2024
The United States is set to enter a recession in the second half of the year. The rapid rise in the Federal Funds rate that began in March 2022 appears to be taking hold as credit conditions and credit demand have deteriorated. The country is on track to end the year with slight year on year growth of 0.8%, and hold steady at 0.6% in 2024.
Many indicators are pointing to a slowdown in the economy, particularly the fall in savings and a worrying property market. However, inflation should continue to decelerate, prompting the Fed to start cutting rates from March 2024 after a final hike in July raising the policy rate to 5.25% - 5.50%.
Slower growth in China, to the benefit of India
Meanwhile, for its reopening after three years of zero-Covid policy, China will struggle to meet our growth forecasts of 5.5% in 2023 and 4.5% in 2024, supported by rate cuts and a probable stimulus plan. Savings are not being spent enough, as consumption (of cars, property, etc.) remains low, as does tourism and investment. More globally, over the long run, China will have to deal with a slowdown in growth, which we estimate at 2.3% in 2035, a very low level for a country set to be the world's largest economy.
India should benefit from this downturn and achieve growth rates of 6-7%. India's population is rising sharply, while China's population is expected to shrink significantly by 2050. In addition, India has the critical mass to enable economies of scale, for example in the deployment of renewable energy technologies. However, India lacks savings and depends on international financing for its development.
Commercial Real Estate: how much downside risk and what consequences?
The rapid rise in interest rates is having a delayed impact on property valuations. Appraisal values are difficult to record given the low volume of transactions and in the morning session (in French), Marc Guillaume, Head of Advisory, Cushman & Wakefield, shared the criteria on which he bases his valuations as well as his insights on the different market segments.
By modelling prime yields or property asset values in Europe, we estimate that office valuations could fall by 20-30%, logistics by 13-23% and shopping centers by 9-20% - compared with H1 2022. Property companies will be directly affected by the deterioration in leverage and coverage ratios.
Commercial Real Estate (CRE) is especially affected. Lower CRE prices are set to generate higher losses for banks and in most countries, the CRE sector already accounts for a higher share of banks’ non-performing loans (NPL) than other sectors (15%).
We consider that the NPL coverage ratio for CRE loans is not sufficient to face expected losses. European banks, in particular, have a crying need to build up more provisions in the future. We estimate the cost of risk at 60bp in 2023-2024 versus 27bp at the end of Q1 2023.
Financial markets in the aftermath of central bank pivots
Both the ECB and the Fed will be done hiking by July. We can therefore expect investors to focus a lot more on rate cuts than before. The timing of the first move and how quick central banks will act will be key to understand how interest rates will evolve for the second half of the year. Nevertheless, with central bank speeches focusing on “long status quo”, downward potential in yields will remain limited, notably in Europe.
With rate cuts expected next year, short-dated bonds still have room to outperform longer ones, which means that yield curves will steepen, but at a rather progressive pace. Of course, given our more bullish Fed scenario, both the decrease in yields and the re-steepening of curves will be stronger abroad. When it comes to sovereign spreads, BTPs and OATs are expected to benefit from the lack of risk event and remain very resilient versus the Bund, with a target at 170bp for the 10Y BTP-Bund spread.
Overly-optimistic equity markets
Risk markets have been embracing a risk-on mode in the first semester with strong performances despite the March banking turmoil episode and hawkish central banks. The resilience of risk assets is currently morphing into exuberance as bullish signs are getting more widespread and boosted by the AI frenzy. We fear that the market is too complacent at this stage regarding the US macro recession risk and/or the stance of central banks.
We believe corporate margins and EPS growth will be limited in coming quarters. As such, we favor cheap (value) and quality names, sectors and countries. Given their high valuation, US equities and high yield, are the most vulnerable to adverse macro news and/or financial stress episodes. We believe hedging strategies will be key in the second semester and we continue to like systematic trend-following strategies to hedge both inflation trends and recession risks.
Banks: worries moved from capital to liquidity
The positive sentiment on banks at the beginning of the year was totally reversed when US banks failed and after Credit Suisse was acquired by UBS with the controversial wipe-out of AT1 bonds.
This banking crisis raised new uncertainties for the banking sector particularly in terms of liquidity. Worries moved from capital to liquidity and a downtrend in liquidity ratios is expected given the end of TLTRO’s, but we are confident that European banks will continue to maintain liquidity ratios well above the regulatory minimum.
Life insurers to seek positive net inflows on traditional products
The rise in interest rates had long been expected by life insurers as it has a positive impact on their returns. However, the extent and speed of the rise led to a fall in the value of their assets, and they are showing unrealized capital losses. To face up to competition from bank products - such as the Livret A in France - the yield on capital-guaranteed products has been improved. Net outflow, but not on a massive scale, has been noted except in Italy where there are no exit penalties on life insurance policies.
We expect insurers to seek positive net inflows on traditional products to quickly improve the average yield on assets and increase the credited rates to partially mitigate the lapse risk.