Putin squeezes the pipe

July 29, 2022

Europe faces a tough outlook, although actions by Russia are likely to accelerate a move towards clean energy.

This week’s Federal Reserve (Fed) meeting saw the FOMC hike rates by 75bp to 2.25%, in response to overshooting inflation. However, an indication that the pace of tightening may slow from this point, as policy rates approach neutral, was taken in a constructive light by financial markets, with this fitting a narrative that a peak in rates may be seen in just a few months from now.

Yet the evolution of policy will be entirely data-dependent. From this perspective, Chair Powell was at pains to play down any notion of forward guidance. By the next FOMC meeting in September, there will have been two additional inflation and labour market prints and in this context, there will be plenty for the Fed to evaluate in the weeks ahead.

As US yields have rallied, we are inclined towards a short-duration bias, as we doubt that the US growth outlook will be as bad as many currently fear. This is especially true if a peak in Fed rates comes at a lower point than had been feared a few months ago.

By our judgment, if US rates move above 4% then this will almost certainly push the economy into recession, but a peak at 3.5% or below seems unlikely to result in a material contraction in output. As we write, a weaker-than-expected Q2 GDP print has given added impetus to the downdraft in US yields. Without wanting to dismiss this data point entirely, we side with what Fed Chair Powell said on Wednesday; the first GDP cut is a poor representation of the trajectory of an economy, given the revisions that inevitably occur through time and the relative strength of other indicators, in particular the labour market.

With risk assets also supported by hopes for rate cuts in 2023 and financial conditions easing, we think the balance of risk could now be the Fed disappointing markets by being slow to shift towards an easing bias for some time after inflation is back close to its 2% target, which seems unlikely for at least another 12 months, in our view.

Meanwhile, sentiment in the eurozone continued to deteriorate, as actions taken by Russia to restrict gas pipeline flows have continued to feed a recession narrative. With throughput at 20% of capacity, EU ministers met this week to agree a 15% reduction in national gas consumption.

This agreement is voluntary in nature and has a number of exemptions to it. Consequently, it will be interesting to see how much of an impact on demand this manages to have.

As things stand, reserves will be depleted towards the end of winter. This could mean that some rationing is inevitable in the months ahead and the risk of energy blackouts is looking material. This is likely to have a notable impact on production, with governments wanting to prioritise domestic supply as much as possible.

Meanwhile, Putin will be hoping that economic pain may be able to win concessions with respect to sanctions and western support for an eventual ceasefire deal that sees Russia retaining substantial Ukrainian territory. But for the time being, such a peace accord continues to look distant, with attitudes hardening towards Russia rather than softening as the war continues.

At a national level, Germany and Italy are the two large economies most exposed to Russian gas imports. In the context of Italy, the economy will be a significant factor shaping the upcoming election campaign that will see voters take to the polls in September.

The squeeze on living standards is seemingly pushing politics in a more populist direction, with tax cuts and spending pledges being proposed in order to limit the fallout from the energy crisis.

However, this may mean that Italy’s debt starts to rise from existing levels, above 150% of GDP. With interest rates rising and Italian funding costs moving upwards, these deteriorating fundamentals are weighing on the Italian spread. Yet as this approaches 250bp in the 10-year part of the curve, it is not clear that this is something that the newly unveiled Transmission Protection Instrument from the ECB can do much about – especially with spreads little changed across the rest of the eurozone.

If the ECB were to activate the TPI to support BTPs, then this could be seen as a green light to fiscal indiscipline. Moreover, the ECB has been propping up the BTP market via asset purchases for several years. If it starts again now, having just exited QE, then it is debatable if it will ever be able to cease its support. In addition, there is not the sense that the TPI is actually ready to be deployed just yet, and last week’s unveiling of the instrument still left a number of questions with respect to the mechanism unanswered.

Arguably, the pre-existing OMT instrument would be the clearest means of support for Italy should spreads come under pressure. However, it is difficult to see how an interim administration could sign up to the conditionality required by an OMT programme in the middle of an election campaign.

Hence, there is a risk that recent spread widening starts morphing into more of an old-style BTP crisis by the time that voters go to the polls; it will be interesting to see how voters and policymakers adjust their thinking, should this start to occur.

In the UK, it seems increasingly likely that Liz Truss will be chosen as the next UK Prime Minister by Tory Party members. This may mean more tax cuts (plus a desire to influence the Bank of England not to hike rates too much) in order to improve the growth backdrop. However, we see a real risk that this will end up perpetuating the inflation overshoot in the UK in 2023.

In recent months, one event that we have been surprised by is that UK inflation has moved up in line with other major economies with no evidence of any underperformance. However, in the months ahead we look for greater inflation divergence with UK inflation continuing to rise, even as CPI prints fall elsewhere.

This should point to structural underperformance for UK assets ahead, though in the short term we look for the BoE to remain more dovish than other central banks and think that it may only hike rates by 25bp next week, with rates rising by materially less than is discounted in the remaining months of 2022. However, we think that UK rates will need to continue to go up in 2023, even as they peak elsewhere, and so more divergence is expected in the months ahead.

In Japan, yields have rallied somewhat in the past month, mirroring declines seen in other global markets. However, with inflation still trending higher and the yen continuing to trend weaker, we expect to see the BoJ changing policy and ending yield curve control in coming months. Hence, we favour the asymmetric return profile offered by running a JGB short when yields are just 0.20%.

Elsewhere in Asia, China continues its stop-start pattern, moving into, and out of, regional lockdowns with the zero-Covid strategy continuing to weigh on sentiment.

In emerging markets, weaker credits have continued to underperform, even as some of the higher-quality names have been better supported in the last few weeks with risk assets elsewhere having performed better of late.

Credit markets have enjoyed a positive month, recouping some of the losses recorded in June. With sentiment having been universally bearish, there may be scope for spreads to continue to squeeze tighter in the short term. We think that levels on CDS indices around 120 on Main and 600 on iTraxx Crossover represent medium-term value, but at the same time it would feel premature to conclude that we have reached the wides in spreads for the cycle just yet.

In FX, we continue to hold a negative view on European currencies, but have been switching our stance towards a bigger short in Central and Eastern Europe. We believe that the Czech koruna and Polish zloty are both overvalued and should underperform, while we continue to hold a positive view on the Norwegian krone.

Looking ahead

It seems appropriate to continue to highlight the elevated level of macro uncertainty. Policy is being conducted meeting-to-meeting as market participants and policymakers react to economic data, rather than moving more pre-emptively. Trade-offs between growth and inflation are being carefully weighed and it is hard to have too much confidence beyond the likely trajectory in the next few months.

That said, we are inclined to believe that markets may be somewhat more concerned by slowing US growth than they should be, with the US likely to continue to outperform on a global basis as US exceptionalism continues for the foreseeable future.

In Europe, the outlook seems grim. That said, we do expect European policymakers to deliver fiscal support for economies and they won’t want to stand idly by as otherwise healthy companies are subject to stress.

On a medium-term view, Putin’s actions are likely to accelerate a move towards clean energy in Europe and in a few years, Russian gas may become irrelevant across the Continent. The short term will be rocky and responding to this, the question will be whether Europe has the leadership it needs to navigate these challenging times. Apparently, there is a talented former prime minister and ex-central banker who will be looking for another job pretty soon...

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