“The problem is not to find the answer, it’s to face the answer.”
– Terence McKenna
Friday 10th June, 2022
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Having reached new lows for the year in the first three weeks of May, a powerful relief rally took hold in financial markets towards the end of the month, pushing many indices back up to their late-April levels by the start of June. However, the sell-off resumed this week, and most markets (bar Asia) have fallen sharply in the past few days in nervous anticipation of May’s US inflation data. As of the close of trading on Thursday evening, the S&P 500 Index was down -2.8% for the month, the NASDAQ Composite was down -2.7%, the EURO STOXX 600 Index was down -2.0%, and the MSCI Emerging Market Index (in USD) was down -1.0%; and, so far this morning, bourses in Europe and America are all well in the red.
The choppy market conditions make managing portfolios much harder. However, bouts of equity and bond market volatility are inevitable (and will continue) so long as investors must forecast how central banks will respond to the twin threats of soaring inflation and a faltering real economy. To address these concerns individually would necessitate two conflicting monetary policies… and finding the right balance to strike between them is no easy feat. At the end of May, the emphasis seemed to shift from beating inflation (at almost any cost) to supporting growth, causing expectations for the pace of US rate hikes to temper and the dollar to fall. This provided investors in treasuries and other rates-sensitive assets a chance to catch their breath after months of rising rates. But the US 10Y yield is now back above 3% and few expect a significant recovery in bonds anytime soon. Headline inflation is running at +8% YoY in the US (indeed, at +8.6% as of the end of May), and the drivers of high inflation – including disrupted supply chains, soaring energy prices, a historic lack of commodity-related CAPEX, the war in Ukraine, and fluctuating labour market dynamics – are likely to persist for some time to come. In the current environment, it makes sense to steer well clear of US interest rate risk in fixed income even if absolute yields are much more attractive today.
Moreover, the US is not the only region for which taking rate risk still does not pay. European rates have finally begun to rise on a more consistent basis and European bond yields have now reached levels not seen since the Sovereign Debt Crisis in 2014. This has been driven by the much more hawkish posture adopted by the European Central Bank (ECB) in recent weeks. Indeed, on Thursday, the ECB said that it would almost certainly raise rates by 25bps in July and suggested that a further rate hike in September was likely (perhaps even a 50bps move). At the same time, the ECB confirmed that quantitative easing (QE) would conclude at the end of the month. This announcement coincided with the revision of the ECB’s expectations for European economic growth (down) and inflation (up), with the latter contributing to the former, but not enough to avert the need for a monetary response.
Europe has been slower than the US to respond to inflation, not least because the continent had been stuck in a deflationary trap for nigh-on a decade before the pandemic struck and labour market slack remains substantial (particularly in Southern Europe, where unemployment is pervasive). In addition, Europe recovered much more slowly from the covid-19 contraction than the US, and the ECB could not afford to act aggressively last year when so much uncertainty prevailed across the block. Nevertheless, the impact of the war in Ukraine on European energy prices and supply chains has made any further delay to raising rates inexcusable. German inflation now stands at +8.7% YoY (which is even higher than in the US) and the government just increased the minimum wage by >20%! Action therefore must be taken. However, as ever with the Eurozone, what works for some countries will almost certainly not work for all of them. Spreads on Southern European government bonds are already widening sharply in anticipation that higher policy rates will cause significant pain for these economies: 10Y Italian BTPs are hovering around 3.6% (vs. 1.2% at the start of the year), while 10Y bunds are at 1.4% (vs. -0.2%). The ECB can and must develop tools to address any funding issues faced by Italy et al. as rates rise. But what was considered the nightmare scenario – out-of-control German inflation and soaring Italian rates – is now a reality. A steady hand and smart policy action has never been more important to avoid the disintegration of the Eurozone. Perhaps they could tap UK PM Boris Johnson for advice once his party finally gives him the boot…
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