The real cost of funding

In the latest instalment of Simply Put, we explore the difference between macro and market real rates, and consider why market real rates are more influential for equities during periods of high inflation.

 

Highlights: Real rates can be calculated in different ways and currently carry different messages – macro real rates hint at extremely easy funding costs, while market real rates suggest otherwise. The current revival of the value/growth rotation correlates more to market than to macro real rates. The Federal Reserve’s quantitative tightening plan points to higher market real rates; keeping a diversified equity positioning is advisable as long as this process continues.

 

Real rates have become a key element of price action during 2020-2022. Declining real rates profited growth stocks, while their rise caused a reverse rotation back towards value stocks. However, there are different ways to calculate real rates and these different methodologies diagnose a different situation today in terms of funding costs. Let’s take a look.

There are two ways to calculate real rates – a market-based one or a more macro version. The market formula takes nominal rates and subtracts the breakeven inflation rate (the market’s assessment of forward-looking inflation over a given future time period). The macro formula takes nominal rates but subtracts the realised inflation (for example YoY CPI). Most professional investors use this method when they need to benchmark the current period to what happened in the 1970s as breakeven data has only been available recently – it remains a young market. Therefore, the main difference between the market and macro methods is inflation: it is either expected (anticipated) or realised (backward looking).

Figure 1 represents the two approaches for 1-year, 5-year and 10-year from 2010 until April 2022. Interestingly, market and macro real rates were very similar over the period up to 2020, when we observe a rift. Macro real rates plunged whereas market real rates stayed the course. This is due to the fact that real inflation increased significantly on the back of pandemic-related fiscal stimulus, supply constraints and the commodity shock. As opposed to expected inflation, which increased but at a slower pace, current skyrocketing inflation is expected to mean-revert in the future towards lower levels. On one hand, market real rates are currently close to 0% whereas macro real rates are well into negative territory which implies a very stimulative environment. This issue is essential, as macro real rates indicate that “financial conditions are extremely accommodative” while market real rates see them as neutral, on their way to becoming a constraint for the economy. So which cost of funding should investors focus on while looking at the equity rotation?

 

FIG 1. One-year, five-year, and 10-year market and macro real rates

Source: LOIM. Bloomberg. 2010-2022. Market real rate=nominal rate minus breakeven. Macro real rate=nominal rate minus realised inflation.

 

Figure 2 represents the correlation between these two approaches for the 1-year, 5-year and 10-year and the MSCI Growth to Value Ratio for the periods 2010-2022 and 2021-2022. Over the period 2010-2022, both methods are equally negatively correlated to the MSCI growth to value ratio. However, over the 2021-2022 period, we can observe a significant gap. Macro real rates have almost no correlation to the growth value ratio whereas the market real rates are slightly more negatively correlated. This suggests that, today, expectations are more important than realised inflation in deciphering the volatile evolutions of the equity market. In the upcoming period of quantitative tightening, this point could be essential: central banks’ next move should push for a further increase in the market version of real rates. Seeing them near 0.5% would not be too much of surprise. There are many factors affecting equities in the meantime, but we think that from a cross-asset perspective, investors should keep in mind that the cost of funding is progressing, as well as the cost of living.

 

FIG 2. Two-year, five-year, and 10-year market and macro real rate correlations to the MSCI growth-to-value ratio over 2010-2022 and 2021-2022

Source: LOIM. Bloomberg. 2010-2022

Simply put, as central banks continue their tightening activity, inflation will decrease and real rates will increase, hindering growth stocks in the process. Remain diversified!

 

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Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

This week saw two key events. First, in the US, the inflation report showed inflation was still high. In year-over-year terms, inflation has now reached 8.5% for headline CPI – an unprecedented number over the past 40 years. Ex-food and energy, inflation actually showed the first signs of moderation: key components such as transportation and recreation goods saw a drop in prices month-over-month. Out of the 1.2% month-over-month rise, 0.8% is explained by the progression of energy prices and 0.4% by service costs (shelter essentially). Inflation remains high and higher energy costs are likely to increase inflation again later this year. However, goods’ costs are showing initial signs of stalling; let’s not disregard this welcome evolution. Another key piece of news is a further decline in real earnings in the US, now reaching -3.8%. This is fresh evidence that the inflation shock is adding to the risk of a recession.

In Europe, the ECB’s meeting was the second key macro event of the week. Expected to deliver a rather hawkish statement, Mrs Lagarde uttered a very different message: growth is at risk in Europe; Europe is in “a very different state from the US’”. This surprising dovishness could be welcomed by market observers who are becoming increasingly worried that the next step in this cycle could be a recession. This risk is mounting, alongside that of inflation, and the ECB has provided a clear assessment of the complexity of this situation. It is still in the process of pondering whether it should end its buying programmes or not – a very different statement to what the Fed has delivered so far.

The key macro message of the week is therefore: more inflation, but also more downside risk.

Factoring in these new data points, our nowcasting indicators currently point to:

• Worldwide growth remaining solid. The US and the Eurozone are still showing solid numbers. China, consumption and housing data hint at a further deterioration, while external demand is not as supportive as before.
• Inflation surprises should remain positive, but our signals have shown a recent decline which follows the moderation of commodity prices. Still, higher inflation is more likely for now.
• Monetary policy is set to remain on the hawkish side but, with the commodity moderation, these numbers are retreating.

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)
   
World monetary policy nowcaster: long-term (left) and recent evolution (right)Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

RISERVATO AGLI INVESTITORI PROFESSIONISTI

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