Normally, the stock market always looks about six months ahead. Only when uncertainty increases, the investment horizon is shortened to one week. The stock market then reacts mainly to the here and now. That uncertainty is largely caused in the stock market this year by the development of inflation and, as a result, interest rates. Economists still do not have a good model for predicting inflation and this is causing central bankers to misjudge developments. The current policy thus seems mostly a reaction to earlier mistakes. It has also made central banks unwilling to look ahead and base their judgements solely on developments in the recent past. Yet now is precisely the time to look ahead. There are increasing indicators that inflation has peaked for the time being and with it, the peak in interest rates is also fast approaching. In this correction, that peak in interest rates coincides with a bottom in the stock market.
The level of interest rates is an important variable in the choice between equities and bonds. Interest rates are now back above the dividend yield on equities and the same interest rate has caused the risk premium on equities to fall rather than rise, despite the price declines. There are now fears that the slowing economy, whether combined with a recession or not, is putting pressure on profits and, as a result, equities are still overvalued. Such a recession has not yet been factored into current stock prices, it is argued. At the same time, it should be borne in mind that in a recession, interest rates normally fall, by an average of 3 percentage points since 1970. The stock market cannot discount a recession twice. If on one hand, prices go down when corporate profits are down 20 per cent, on the other hand, valuations soon go up by more than 20 per cent because interest rates are going to fall. Then we are back to square one. Especially companies with few employees, which use little energy, have no debts, and are also excellent at raising prices, benefit doubly in such a situation. Their profits remain intact, while lower interest rates ensure higher valuations. Let these be the very stocks that have been severely punished this year.
We are in the middle of the numbers season. This week is the busiest week. According to initial reports from companies that have already reported, profits in the United States are on average 4.4 per cent better than expected on the basis of sales that are 0.9 per cent higher than expected. Of course, what helps is that the US economy grew by about 3 per cent in the third quarter and inflation rose by about 8 per cent year-on-year in the same quarter. That means that in a company's revenue, growth of more than 10 per cent is possible. Costs are also rising, but less rapidly. Often, energy prices, rents, and wages are fixed for long periods. Companies that have no debt but hold large cash positions actually benefit from increased interest rates. Moreover, the coming recession is the most predicted recession ever, which means that business owners are not sitting still and are saving plenty of costs.
A big difference between the United States and Europe is that inflation there is mainly caused by excess demand, while here inflation is mainly caused by supply-side problems. This means that here, corporate profits may well fall because high energy prices alone have caused several companies to close down. Also, high energy prices are causing a lot of demand outages. The European target is to save 2 to 5 per cent of energy this winter, as things stand it is more likely to be 20 to 50 per cent. The good news is that gas and electricity prices are now falling fast, although consumers may not notice much of that yet. The government first required power companies to replenish stocks at any cost, while the same power companies are now benefiting from the price cap. The only industry is benefiting faster from falling prices.
This week, the ECB will once again raise interest rates. There are increasing calls to raise interest rates here too, to the same level as in the United States. There are some objections to this. First of all, raising interest rates does not lower energy prices. The central bank can only control the demand side, not the supply side. Furthermore, the ECB's first priority is the survival of the euro. In that light, interest rate hikes are quite understandable. Among other things, the rising interest rate differential with the US has caused the euro versus the dollar to fall 20 per cent in a year. But further rising interest rates cause weaker member states to get into trouble. That while it is precisely in Europe that inflation rates can fall faster than in the US. As of this month, the basis of comparison in that respect is already starting to improve. At the moment, natural gas is even cheaper than at Christmas 2021. So if the price stays like this or even falls even further, the moment is getting closer when natural gas and, by extension, electricity prices will depress inflation. At such a time, rapidly falling inflation may prompt the ECB to pause. That is when the peak in long-term interest rates is reached.
This month, interest rates rose sharply in both the United States and Europe. Despite this, the stock market is moving sideways, whereas earlier this year rising interest rates always caused stock prices to fall. This is another signal that the stock market is starting to look more forward. Moreover, investor sentiment is still extremely negative. This is also the reason why the start of a recession is historically an excellent time to enter. As a result, it is even possible that share prices could rise by about 10 per cent until year-end. We currently have an overweight recommendation for equities and underweight for bonds. However, we have clearly increased the portfolio's interest-rate sensitivity, now that bonds are again a fully-fledged alternative on the basis of sharply higher interest rates. Besides equities, the focus is on alternative investments in the portfolio, including real estate and private equity.
Comments