Slava Ukraini

February 24, 2023

In the week marking the anniversary of the Russian invasion, Biden’s surprise visit to Kyiv sent a powerful message.

Key Points

  • Recent signs of economic strength have global investors scratching their heads as to the path of future central bank policy.
  • Questions abound regarding the likelihood of a ‘soft landing,’ a ‘hard landing’ or ‘no landing’ with respect to economic growth.
  • Geopolitical risk is rising yet again, with all eyes on Ukraine, Russia and China.
  • Elevated uncertainty may force markets to demand higher risk premia, which could limit upside potential.

Global yields continued to push higher over the past week, as investors review the likely path of central bank policy in the wake of recent upbeat economic data. Meanwhile, it appears that this shift in sentiment has started to have more of an impact on the valuation of risk assets, with equities trading lower and credit spreads wider in the wake of this.

Broadly speaking, markets enjoyed a strong start to the year in January, helped by the notion of a ‘soft landing’ with respect to economic growth. However, upbeat data represents a double-edged sword. Although an improved economic outlook is supportive for earnings and may supress the near-term outlook for corporate defaults, the prospect that rates may need to go higher for longer means that a narrative pertaining to ‘no landing’ can quickly give way to renewed fears that a ‘hard landing’ will result later this year.

In this context, it strikes us that we are operating in an environment where a small handful of closely-watched data prints may drive policy action and consequently have an outsized influence over asset price movements in the weeks ahead.

As we head towards March, we are inclined to believe that recent signs of economic strength can persist, and this biases us to believe that yields can continue to push higher. However, after a steep rise in rate expectations over the past couple of weeks, it is fair to acknowledge that the path is now looking more uncertain, with risk to yields more two-way in nature.

Meanwhile, we do think that risk assets have been slow to discount the notion that central banks may need to remain hawkish for much longer, than appeared to be discounted just a short time ago. From this point of view, we think there may now be more downside asymmetry in prospective risk asset price movements than there is to government bond prices via higher yields.

From this point of view, we have been inclined to book gains on short duration positions but to add further to credit hedges in order to protect returns, should a drop in equities see credit spreads re-price wider.

At the start of the year, it appears that there have been robust flows into credit products. With positioning now relatively long, we think that spreads are unlikely to rally much further, unless we see good news on inflation putting the ‘soft landing’ scenario back on the table, as the most likely trajectory.

Meanwhile, bad inflation news, or a sudden slowing in growth that may tip us towards recession, would likely negatively impact returns from risky assets. Similarly, an outcome in which growth remains strong is likely to deliver an outcome whereby central banks need to raise rates by more than expected. In this way, each of these scenarios we see as negative for equities via the transmission of slower earnings growth or the threat of a higher long-term discount rate.

Meanwhile, we would also observe that in an environment of elevated uncertainty, we might expect to see markets demand higher risk premia, by way of compensation, and this is a further factor which could be limiting to upside potential.

European markets have largely tracked developments in the US in the past several weeks. Generally speaking, as winter starts to draw to a close, there is relief across European capitals that the weather has been mild. This has helped cap gas prices and thus limit the disruption which could have badly impacted industries and households across the continent. The weather has been a relative blessing from a fiscal point of view as well, inasmuch that this has meant that governments have spent less than feared on subsidies resulting from price caps. In this context, Europe can feel that it got lucky.

However, the reality is that energy prices across the continent remain multiples higher than they were a few years ago, and in an international context, the price of energy renders much of European industry uncompetitive on a global basis at the current point in time. From this point of view, the problems that led to fears for a deep recession across Europe have not vanished and the forward-looking outlook remains highly uncertain.

This narrative is also true in the UK. Rising mortgage costs are now starting to bite, in a way that is not occurring in countries like the US and in many countries in the EU. Although recent data for the consumer has held up better than previously expected, the outlook ahead remains very depressed.

Sentiment towards the Sunak government remains very downbeat and there is a sense that we are now all waiting for Labour to take their turn in 2024. In that sense, the only debate now seems to be whether Starmer will be able to deliver just a one-term or a two-term government.

That said, Sunak’s desperation may see the Tories trying to spend their way out of the mess they are in. Memories of the debacle in the gilt market last September are already starting to fade and we think there is a growing risk that Sunak under pressure starts to repeat the mistake made by Truss and Kwarteng last year. In this context, it seems government resolve versus the unions is now waning. Moreover, there is little acknowledgement that the government coffers are largely bare.

At a time when geopolitical risk seems to be increasing once more, President Biden’s surprise visit to Kyiv at the start of the week sent a powerful signal of Allied support for Ukraine, in the week marking the anniversary of the Russian invasion.

Over the past several months, it has appeared that the West has concluded that Putin cannot be permitted to prevail in his nihilistic invasion. On the back of this, the US and others have continued to add to military and financial support for the Zelensky administration. During the last several weeks, Russia has accelerated its offensive operations without much to show for it. However, it is still going to take a lot for Ukraine forces to push the Russian army back, in the spring and summer.

Meanwhile, we have been interested to witness China stepping up its diplomatic efforts at the recent Munich conference. It appears that Beijing is growing concerned that a Russian defeat could open the door to a more western-friendly regime in Moscow, whilst a drawn-out war is pushing Europe closer to the US. These outcomes are potentially harmful to China from a geopolitical point of view.

Consequently, we see a Chinese push for peace, with a countervailing threat to supply Russia with Chinese weapons, if Ukraine and the US are not prepared to come to the table. It is yet possible that a consensus of a return to the February 2022 position is achievable.

Eventually, peace will be brokered, even if Ukraine wants to continue to push Russia back further, should arms and cash from the Allies start to dry up. However, for now, an early end to war continues to look some way off. Zelensky seems aware that he has the opportunity to push in 2023, before we get closer to the US Presidential elections in 2024.

Meanwhile, support for the war within Russia has hardened in recent weeks, as ‘sunk costs’ (in terms of accumulating losses) continue to mount and as the Putin regime becomes ever more forceful in crushing dissent.

Looking ahead

We are currently wondering whether, if January was the month of ‘soft landing’ and February has been the month of ‘no landing’, maybe it wouldn’t come as a massive surprise if March is the point where markets become more concerned by prospects for a ‘hard landing’ once more, as sentiment continues to gyrate.

The next week remains relatively quiet in terms of data, but European inflation prints will be closely watched. Otherwise, we will train our focus towards the next US payrolls and CPI report in terms of what this means for central bank policy. For now, we believe that the ECB will hike by 50bp in March, with the FOMC hiking by 25bp. We see both central banks then hiking again at their subsequent meetings by 25bp.

Beyond this point, there is plenty of uncertainty. The one thing we remain confident of, for now, is that it is unlikely that either central bank will be cutting rates before the end of the year, unless the growth outlook suddenly grows much darker.

Also in US politics this year, we expect to see plenty of hand wringing and finger pointing, when it comes to the extension of the US debt ceiling. Given the recent debacle with respect to appointing a Speaker for the house, it seems that the Republicans may struggle to bring elements of their own party into line and the Democrats may want to sit on the sidelines, in order to maximise their political advantage from any ensuing fallout.

Eventually, we are confident that calm heads will prevail. Beyond that, the focus will move to who will be contesting the election come 2024. DeSantis may usurp Trump, and if he does so, then this could pose a more serious threat to the octogenarian President, currently in office. That being the case, it seems that Biden’s trip on US Presidents’ Day was a great way of showing us that Joe isn’t so sleepy after all….

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