May the World Cup provide some much-needed cheer, as we reach the end of a challenging year.
Global yields have continued to push lower during the past week, as hopes for a moderation in US inflation in the wake of last Thursday’s softer CPI report have continued to support price action. Markets overlooked a relatively healthy Retail Sales report, choosing to focus on a moderation in PPI pressures, which might suggest that consumer prices may cool more quickly.
However, it may be somewhat premature jumping to conclusions that the Fed will end its cycle of rate hikes too soon. Financial Conditions indices have registered a notable easing in the past week and are not far away from where they stood in mid-June. Meanwhile, the labour market has remained firm and there is a risk that wage pressures could yet accelerate, even as growth cools and interest rate sensitive sectors, such as housing, slow to a standstill. Tech layoffs and a weaker outlook for construction suggest that the labour market may ease in the coming months, but job vacancies remain very elevated based on the most recent Job Openings and Labor Turnover (JOLTs) survey.
With US short-term rates still some way from peaking, we think that it will be difficult for treasury yields to rally too much further in the short term. However, it appears that some investors have been under-positioned in fixed income and so the pain train could be for the recent rally to run further. Cash credit has seen decent buying interest and with supply slowing up as we head towards Thanksgiving, so the market may appear to be in good technical shape.
Meanwhile, as investors look towards 2023, it may not be surprising that those taking a longer-term view may be inclined to think that in 12 months from now inflation will have fallen, the Fed will be contemplating rate cuts and war in Ukraine could yet be at an end. On this basis, owning investment grade bonds may be appealing, if one concludes that longer-dated yields have peaked already.
The outlook in Europe remains more depressed. The growth outlook continues to be subdued and inflation indicators seem unlikely to peak until next spring. Against this backdrop, the ECB is likely to continue to give a hawkish message and we see rates reaching 2.5% by the end of Q1. By this time, the authorities may hope that an end to US rate hikes could see the ECB also go on hold.
Yet until this point, Lagarde seems condemned to keep tightening monetary policy, even as recessionary pressure continues to build. We see output declining modestly on a full year basis in the Eurozone, but the risks are for a sharper contraction should the weather turn much colder after a mild start to the winter. In such a scenario, all eyes will be on the energy companies and the attendant need to ration gas supplies.
On a more constructive note, it has been interesting to observe that European sovereign spreads and swaps spreads have managed to rally over the course of the past month. In part, ECB moves are helping to mitigate a squeeze on German collateral, thus making German bunds less expensive on a relative value basis.
However, sentiment has also been helped by Fratelli D’Italia saying and doing the right things since winning the general election. This has pushed the 10 year BTP spread inside of 200bp, as bears have been forced to cover short positions. However, we would note that on a medium-term basis, Italy remains vulnerable to renewed fragmentation risk in 2021, should the economy continue to struggle in recession for too long.
Chancellor Hunt’s autumn fiscal statement has thankfully managed to generate a much more muted market response than his predecessor Kwarteng’s ‘mini-Budget’. In the course of two months, the UK has gone from a point of fiscal profligacy to austerity and with taxes rising alongside prices and interest rates, it seems the outlook for the UK economy remains bleak.
This week’s inflation print also disappointed to the high side and evidence that wage pressures are building must also be of concern to the Bank of England (BoE). However, we think that the BoE will need to allow inflation to overshoot, maintaining UK interest rates below 4%, if it does not want to crater the housing market and prompt financial and economic collapse.
This argues for a weaker pound and also a steeper UK yield curve. In this context, it has been interesting to see gilt yields converge relative to bunds, with a spread of 115bp, now actually inside the average for the past 12 months. On this basis, there may be a case to return to a short UK gilt position again relatively soon.
Meanwhile, markets have also been buoyed by policy easing and re-opening hopes coming from China in the past week. Yet, our assessment is that any China re-opening is unlikely to be in a straight line, with Covid cases likely to spike and a population that has been indoctrinated with a real fear of contracting the disease.
This may mean that the China experience is in contrast to how other economies have re-opened elsewhere and suggests that it may be some time before the country is fully able to plot a path back to ‘normality’. This is also not helped by the notion that the Chinese Communist Party has been enjoying its control over the populous just a bit too much and so is unlikely to let go too soon.
This is a narrative, which can also damage long-term potential growth prospects, as Xi and his acolytes continue to consolidate their grip on power. Meanwhile, with the property sector enduring a collapse and this weighing on regional government financing, policy easing steps may be welcomed, but these may serve to stem the bleeding, rather than putting the economy on a much stronger path.
In FX, the dollar has continued to weaken, as hopes for a Fed pivot have gained ground. We flagged that we had thought that the period of uninterrupted dollar strength had come to an end a few weeks ago. However, we find it difficult to call for a period of sustained dollar weakness, given that a large part of currency moves in 2022 seems fundamentally justified, in our opinion. The past year has seen a substantial shift in terms of trade, with the US benefitting as an exporter of energy.
Meanwhile, Europe imports both food and energy, meaning that it stands to reason that the euro should end the year much weaker than where it started, even before one considers rate and growth differentials, and the proximity of war on Europe’s doorstep.
As for the Ukraine conflict itself, hopes that Russia could be brought to the negotiating table seemed short lived this week under a barrage of missiles being aimed at the Ukrainian civilian population by Moscow. Our assessment is that Russia is losing the war and will need to acknowledge this before too long, especially as hopes for a return of Trump to the White House seem badly diminished in the wake of the US mid-term elections. Yet, a push for peace may be several months away.
As we head towards the end of a tumultuous year, it seems that markets may want to deliver a seasonal risk rally. Yet, we saw a similar narrative in 2018, only for December to be a very difficult month. Hence, we are wary that should stocks and credit rally too far too soon, the year could yet end with a sting in the tail if investors get sucked in, deploy cash and then data or central banks surprise on the more hawkish side.
Volatility has been dropping, but liquidity remains poor and all year, we have seen the market run like lemmings from one side of the boat to another, in conditions where either everyone is looking to sell, or everyone is looking to buy, all at the same moment in time.
Yet, on a longer-term view, there is value in assets and it is seeming more likely that US ten-year yields may have peaked already when they touched 4.3% in October. Treasuries may now be close to fair value. However, if the peak is truly behind us, then it is understandable that some investors will want to buy into long-term yields, which are more generous than we have seen for a decade.
Otherwise, one might hope that after everything being thrown at us in 2022, we are finally getting closer to the point where we can say that the worst is now behind us. With luck, there may be a quieter period in geopolitics, macroeconomic data and monetary policymaking, and we may be able to let our attention settle on more mundane events.
On that note, the World Cup kicks off this weekend in sunny Qatar and one hopes that it is a tournament in which love can triumph over hate, for all that the detractors have been saying in the run-up to the event. After all, the rainbow has always symbolised love and hope for a better future, ever since Biblical times. Let’s hope that nobody in Doha is as foolish as to take our rainbow away.