Cash Is King

Europe’s streak of good economic news had to come to an end eventually, with data last week showing core inflation hit a record high last month. That means a 50-basis-point hike this month by the European Central Bank (ECB) is pretty much a done deal. The move would take the ECB’s deposit rate to 3%, but investors reckon there are lots more where that came from, with markets now fully pricing in a 4% peak ECB deposit rate by February 2024. The worrying prospect of higher-for-longer interest rates accelerated a bond market selloff, with yields on government bonds from Germany to the US all surging to multi-year highs last week. What’s more, those higher interest rates mean that cash is now looking more tempting, from a yield perspective, than a traditional stock-bond portfolio. Finally, over in China, data last week showed the country’s manufacturing sector notched its fastest expansion in over a decade. Find out more in this week’s review.

Macro

Data at the start of last week showed inflation accelerated in the eurozone’s second- and fourth-biggest economies. Consumer prices in France jumped by a euro-era record 7.2% in February from the same time last year. Economists had expected inflation to remain unchanged from January's 7%. In Spain, consumer prices rose 6.2% in February from the same time last year – higher than the 5.9% pace recorded in January and well above the drop to 5.5% economists had forecast. Even more worrying, core inflation, which excludes energy and fresh food components, rose to an all-time high of 7.7% in Spain.

France and Spain’s figures early last week were a preview of what was to come. Data for the entire eurozone came out a few days later and showed inflation barely slowed last month. Driven by food and services costs, consumer prices in the bloc were 8.5% higher in February compared to the same time last year. While that was slightly down from January’s 8.6%, economists had expected a steeper fall to 8.3%. But here’s where things got ugly: core inflation, which the European Central Bank (ECB) watches closely as it excludes energy and food prices to give a clearer picture of underlying price pressures, rose to a new eurozone record of 5.6% – up from 5.3% in the previous month. What’s more, on a month-on-month basis, headline and core consumer prices both unexpectedly increased by 0.8% in February (economists had expected a decline in headline prices and no change to core ones).

All in all, the hotter-than-expected inflation readings will cement the 50-basis-point hike that the ECB is planning for this month, and bolster those central bank officials who say more big moves are needed beyond that to get inflation under control. Investors certainly are betting on more aggressive central bank action, with markets fully pricing in a 4% peak ECB deposit rate by February 2024. That compares to a 3.5% rate expected at the start of the year, and would exceed the peak for euro-area interest rates seen more than two decades ago. The ECB’s deposit rate, currently at 2.5%, has never been as high as 4%.

The worrying prospect of higher-for-longer interest rates in the eurozone is already slipping over to the bond market, with a selloff in German government debt accelerating last week. That sent the yield on German 10-year bonds to around 2.6% – the highest since 2011 – while that of 30-year debt reached the most elevated since 2014. Strategists at Goldman Sachs anticipate more pain ahead for bond investors in the eurozone’s largest economy, forecasting 10-year German yields to rise to 2.75% in the coming weeks.

The bond selloff hasn’t been limited to just Europe: the prospect of higher-for-longer interest rates has gained a lot of traction with traders in the US on the back of a red-hot labor market and persistently high inflation. So much so that 10-year Treasury yields topped 4% for the first time since November last week. The yield on two-year Treasury notes, meanwhile, topped 4.9% – its highest level since 2007. The moves left the yield curve in its steepest inversion in 42 years. An inverted yield curve, in which yields on short-dated bonds are higher than those of longer-dated bonds, is often viewed as a harbinger of recession. Yikes…

Over in China, data last week suggested the world’s second-biggest economy is showing signs of a stronger rebound after Covid restrictions were abandoned late last year, with the manufacturing sector notching its fastest expansion in over a decade. The official manufacturing sector PMI came in at 52.6 – well above economists’ expectations for a reading of 50.5, and the highest level since April 2012. The 50-point mark separates expansion from contraction. A non-manufacturing gauge measuring activity in both the services and construction sectors, meanwhile, improved to 56.3, also topping forecasts.

The PMIs provided the first comprehensive view of the Chinese economy’s recovery after Covid restrictions were dropped late last year, infection waves began easing, and businesses returned to normal after the Lunar New Year holidays. So as you can expect, investors cheered on the better-than-expected PMI data, sending Chinese stocks higher and fueling a rally in commodities. What’s more, the figures came on top of other data that further points to signs of a rebound in the economy driven by a pickup in domestic demand. A separate release last week, for example, showed China’s home sales rose in February from a year earlier – the first such increase in 20 months.

Stocks

As the saying goes, cash is king. As of last week, cash is looking more tempting, from a yield perspective, than a traditional stock-bond portfolio. And that’s despite a big drop in stock valuations and a huge surge in bond yields over the past year. More specifically, some of the world’s most risk-free securities are delivering bigger payouts than the classic, widely followed 60/40 portfolio (60% invested in stocks and 40% bonds). The yield on six-month US Treasury bills rose to as much as 5.14% last week – its highest level since 2007. That pushed it above the 5.07% yield on the classic 60/40 mix of US equities and fixed-income securities for the first time since 2001, based on the weighted average earnings yield of the S&P 500 Index and the Bloomberg US Aggregate Index of bonds.

The shift underscores how much central bank monetary tightening has upended the investing world by steadily driving up risk-free interest rates, which are used as a baseline in global financial markets. The steep jump in these rates has reduced the incentive for investors to take on risk, marking a stark break from the post-financial crisis era when persistently low interest rates drove investors into increasingly speculative investments to generate bigger returns. What’s more, higher interest rates have all also driven up the cost for those investors who use leverage – that is, borrowed money – to boost returns. There really is no such thing as a free lunch – especially these days…

This week

• Monday: Eurozone retail sales (January).
• Tuesday: UK Halifax house price index (February). Earnings: CrowdStrike.
• Wednesday: China loan growth (February), Bank of Canada interest rate announcement.
• Thursday: Chinese inflation (February). Earnings: DocuSign.
• Friday: Bank of Japan announcement, UK GDP (January), US labor market report (February).